Canadians who invest in mutual funds in taxable accounts usually pay tax on their investment income in two different ways. While they still own the fund(s), they pay tax on the income that the fund has distributed to them, and when they sell their fund(s), they pay tax on the profit they earned on the sale, if any.
Mutual funds are set up as flow-through entities. That means any income earned by a mutual fund is passed on to its unit-holders and taxed in the hands of unit-holders. This is done because otherwise the mutual fund would be taxed at the highest marginal tax rate, while many of the fund's investors may be taxed at lower rates or hold the fund in a tax-sheltered account such as an RRSP. Mutual funds pass on (or "flow through") different types of income as distributions. Investors receive this income in the same form in which the mutual fund originally received it. Distributions may either be paid to investors in cash or be reinvested as new units in the fund, but taxes are owed on the distributions the same way in either case.
The different types of income distributions are capital gains (that have been realized in the fund, which is done when a fund manager sells a security for a profit), Canadian dividends (which are issued by some Canadian stocks), interest income (received from bonds or money market instruments), foreign income, and return of capital.
These are all taxed at different rates:
- Interest income is taxed at the investor's marginal tax rate.
- Canadian dividends are taxed more favourably than interest income; investors report a dividend amount that is 25% more than actually received, but are then usually eligible for dividend tax credits.
- Capital gains are taxed even more favourably, as only 50% of realized capital gains are included in income and taxed at the personal marginal tax rate.
- Foreign income, which may include dividends and other income from foreign investments, is taxed at the marginal tax rate, but foreign tax credits may be applicable.
- Return of capital is not an actual distribution of income, but, as the name says, a return of the investor's original capital, and is therefore not subject to tax. (Some mutual funds at times make distributions that exceed their net taxable income. Funds, for instance, that pay out regular distributions to meet investors' income needs may find that those distributions can't always be covered by interest, dividends, and capital gains. The amount of the distribution that exceeds the income and realized capital gains earned in that year is referred to as a return of capital.)
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