On an account statement, a mutual fund distribution looks simple: cash arrives, or the number of units increases. What is less obvious is what has happened inside the fund, and what it may mean for your taxes, adjusted cost base and future investment decisions.

What are distributions?

A mutual fund distribution is a broad term for income and gains passed from a fund to its investors.

Dividends are one possible component, which is why the two terms are sometimes confused. A dividend is a portion of a company’s earnings paid to its shareholders. A mutual fund distribution may include dividends, interest, realized capital gains, return of capital, withholding taxes and other amounts.

The amount and frequency of distributions can vary considerably. Some funds pay them annually or quarterly, while others may make no distribution at all. Receiving a distribution in one year does not necessarily mean there will be a similar one the next year.

Why do mutual funds make distributions?

Tax is one of the main reasons.

Mutual funds are generally structured as unit trusts. To maintain their non-taxable status, they must distribute the income and gains earned within the calendar year. Amounts retained within the fund may otherwise be taxed at the highest marginal rate.

Once the income or gains are distributed, any tax is generally paid by the investor at their own marginal rate, which is usually lower than the rate the fund would pay. This applies even when the distribution is automatically reinvested rather than received n as cash.

If the fund is held in a registered account, such as an RRSP, TFSA, RRIF or RESP, you generally will not pay tax in the year the distribution is received. The tax treatment of future withdrawals will depend on the type of registered account.

A fund only needs to distribute enough to preserve its nontaxable status. That amount can change from one quarter or year to the next.

Where do distributions come from?

What a fund distributes depends on what it owns and what it has sold.

A fund invested in fixed-income securities, such as bonds or money market instruments, may receive interest income. An equity fund may receive dividends from the companies it owns. Both forms of income may be passed along to investors through a distribution.

A fund may also realize a capital gain when it sells an investment for more than it originally paid. Those gains may also form part of the distribution. 

The mix of investments helps explain why the level and consistency of distributions vary between funds. A fund that holds dividend-paying companies, for example, may generate more income than one that does not. Some funds are structured to pay 5% of their net asset value each year, while others may pay nothing.

If a fund with a targeted payout experiences negative returns, part of that payment may be a return of invested capital, which is tax exempt. Funds that hold investments producing little or no income may not make distributions at all.

How do distributions affect the value of a fund?

When a fund makes a distribution, its net asset value, or NAV, declines by the amount paid out. That decline does not represent an investment loss. The value has either been paid to you as cash or used to purchase additional units in the fund.

There can be a short delay between the two sides of the transaction. Depending on the institution holding your account, you may see the NAV decline 24 to 48 hours before the cash or additional units appear on your statement.

The example below shows what happens when a distribution is taken as cash or reinvested.

Taking Distributions as Cash

Reinvest the Distribution

Whether the distribution is taken as cash or reinvested, the total value remains $10,000 immediately after the distribution, before considering any tax consequences.

If the distribution is reinvested in a non-registered account, it also increases the adjusted cost base of your investment. This reduces the capital gain that may be realized when the units are eventually sold. Accurate recordkeeping becomes especially important when units have been held for many years or purchased at different times.

How are distributions taxed?

The tax treatment of a distribution depends on where it came from and the type of account in which the fund is held.

In a non-registered account, interest income from bonds is generally taxed at the investor’s marginal rate. Dividends from Canadian corporations and capital gains generally receive more favourable tax treatment than interest income and dividends from foreign companies.

You may owe tax on a distribution even when the proceeds are reinvested. While no cash has been paid directly to you, the distribution is still considered income for tax purposes.

In a registered account, reinvested distributions are not taxed when received and do not use additional contribution room. The new units are simply added to the account, even if you have already made the maximum allowable RRSP or TFSA contribution for the year.

These differences are one reason the types of investments held in registered and non-registered accounts deserve careful consideration.

Why does the timing of a purchase matter?

One of the less obvious issues with distributions is the timing of a purchase in a non-registered account.

If you buy a fund shortly before it makes a distribution, you will generally receive your share of that distribution and may owe tax on it. This can be particularly important with equity funds that make one larger annual distribution. For most Mawer Funds, the taxation year-end is December 15.

In effect, you may face an immediate tax liability for income or gains that accumulated before you purchased the fund. The fund's NAV will decline by the amount of the distribution, while the distribution itself becomes taxable to you.

Depending on the size of the expected distribution and how soon it will occur, it may make sense to wait until after the distribution before purchasing the fund. The decision should also take into account your broader portfolio, tax position and investment objectives.

How does Mawer handle distributions?

At Mawer, investment decisions are guided by each fund’s objectives. Some investments generate income, and others do not, so distributions can vary by fund and from year to year.

Seven Mawer funds tend to pay monthly income distributions on the last business day of the month:

• Mawer Global Balanced Fund
• Mawer Balanced Fund
• Mawer Tax Effective Balanced Fund
• Mawer Canadian Bond Fund
• Mawer Short Term Bond Fund
• Mawer Canadian Money Market Fund
• Mawer Global Credit Opportunities Fund

Mawer’s other funds hold only equities, unlike the funds listed above, which include a fixed-income component. These equity funds generally make distributions annually, provided distributable amounts have accrued.

Understanding how a distribution affects the fund’s NAV, your adjusted cost base and your tax position can help you interpret the transaction within the context of your overall portfolio.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the fund facts and prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Mutual fund securities are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that a money market fund will be able to maintain its net asset value per unit at a constant amount or that the full amount of your investment will be returned to you. 

Mawer Mutual Funds are managed by Mawer Investment Management Ltd. Mawer Mutual Funds do not have trailing commissions. If you purchased units of the Mawer Mutual Funds through a third-party dealer, you may be subject to commissions or additional sales charges. Please contact your dealer for more information.