Distributions are made to mutual fund unitholders, which is how funds transfer their taxable income to fund investors.
Most mutual funds are set up as trusts, which are taxed at the highest personal tax rate on any earnings not distributed to unitholders. For tax purposes, mutual fund trusts are designed as flow-through vehicles, meaning all earnings get distributed to investors.
Mutual fund corporations are a more limited kind of flow-through vehicle, with only Canadian dividends and capital gains able to be passed on directly to unitholders. Interest and foreign income are first taxed inside the corporate structure.
Exchange-traded funds (ETFs) are pooled investment funds like mutual fund trusts, but are traded on an exchange intra-day and can distribute interest and other income, foreign income, Canadian dividends, return of capital and capital gains, directly to unitholders.
Determining who gets a distribution
Distributions are due to investors who own units of a mutual fund or exchange traded-fund (ETF) on what’s called the record date. This is separate from the actual distribution date, to allow time for recordkeeping, processing of the distribution instructions, and ensuring everything gets executed properly.
Typically, the distribution date is the next business day after the record date. Distributions are set as a dollar amount per unit and done pro rata, based on the number of units of a mutual fund or ETF an investor owns.
Cash vs reinvested distributions
Mutual fund distributions can be received in two ways: (1) cash or (2) reinvested units of the fund.
If received in cash, the value of an investor’s holdings will decline by the amount of the cash distribution paid to them, which equals the number of units multiplied by the per unit distribution amount.
If reinvested, the purchase of additional units occurs at a net asset value per unit (NAVPU) or price that is lower by the per unit distribution amount. The total value of an investor’s holdings in the fund is unchanged as a result of the reinvestment; they will simply have more units at a lower NAVPU.
Note that ETF distributions are usually only paid in cash, but year-end distributions may be reinvested in special circumstances.
Distributions can be paid monthly, quarterly, semi-annually or annually. Mutual fund trusts ordinarily distribute interest and dividend income throughout the year (monthly or quarterly), while any net capital gains get distributed at year end.
The combined effect of a fund’s portfolio transactions determines net capital gains, which cannot be known with any certainty far in advance. That’s why these distributions tend to happen at the end of the year.
A fund’s income can be offset by fund expenses like management, legal, custody and audit fees, while capital losses can also be used to offset capital gains. Any remaining net capital gain amount is distributed to unitholders. Mutual funds must distribute all net income and net realized capital gains by the end of each tax year.
If a fund does not, then it gets taxed on undistributed income and capital gains at the highest marginal tax rate – a form of tax penalty – for not distributing net income and capital gains.
Most monthly, quarterly, semi-annual and annual distributions are paid in cash to ETF investors. These distributions are expected to consist primarily of income, but may include capital gains or return of capital. Any remaining undistributed income and net capital gains are paid in December, as cash.
If not paid in cash, additional units are immediately consolidated with the units previously outstanding, so that the number of units outstanding following the distribution will equal the number of units outstanding prior to the distribution (referred to as a notional distribution).
There are also funds with a fixed rate distribution. These funds are designed for investors who wish to receive regular cash flow. They can be standalone mutual fund trusts or funds that are part of a corporate class structure. These funds will have a set payout percentage and frequency.
The distribution amount per unit is calculated at the beginning of the year, using its year end NAVPU. The calculation is the fixed distribution rate (%) multiplied by the last NAVPU for the previous calendar year and divided by the number of periods. This yields the distribution amount that investors will receive on the set frequency for every unit owned on the record date.
Distributions are not a bad thing
Nobody likes to pay taxes, but if you have to, paying less is always preferred.
Distributions of income reduce the taxes paid by the fund. This is because the earnings distributions to unitholders are taxed at each investor’s personal tax rate and it’s unlikely every investor would be in the highest bracket. In the case of registered plans, the taxes get deferred. Any income retained by a fund would be subject to more tax and the tax bill would be due immediately.
Additionally, reducing the amount of tax paid by the fund improves the investment return. Many investors overlook this component of a fund’s total return, which we’ll cover in a separate distributions article.