Thanks to everyone who took Investor Clinic’s annual money quiz. If you missed it, you can find it here.
As promised, today I’ll explain a few of the questions that tripped up some readers. We’ll start with question No. 1.
1. Clarice holds an exchange-traded fund in her tax-free savings account (TFSA) and noticed that the ETF distributed a large sum of return of capital (ROC) in 2018. For tax purposes, she is required to:
A. Subtract the ROC from her cost base
B. Add the ROC to her cost base
C. Report the ROC as a capital gain
D. Do nothing
If Clarice held the ETF in a non-registered (i.e. taxable) account, she would have had to deduct the ROC from her adjusted cost base to correctly calculate her capital gain (or loss) when she eventually sells the security. However, because the ETF is held in a tax-free savings account – a detail some readers skipped over – no capital gains tax applies and the adjusted cost base of her investment is irrelevant. The correct answer is therefore D.
Several readers asked for an explanation of question No. 10.
10. Justin wanted some U.S. exposure for his non-registered account. In January, 2018, with the Canadian dollar trading at 80 US cents, he bought 100 shares of Microsoft for US$90 each. He later sold the shares for US$112 each when the Canadian dollar was trading at 75 US cents. His capital gain, in Canadian dollars, was:
To determine the capital gain for tax purposes on a U.S. stock, you must calculate both the cost and the proceeds in Canadian dollars based on the exchange rate in effect at the time of each transaction. Justin’s cost for 100 Microsoft shares was US$9,000 (100 times US$90) which is equivalent to $11,250 in Canadian dollars (US$9,000 divided by 0.8). His proceeds of US$11,200 (100 times US$112) are equivalent to $14,933.33 in Canadian dollars (US$11,200 divided by 0.75). His capital gain in Canadian dollars is therefore $14,933.33 minus $11,250, which is B. $3,683.33.
Of all the questions, No. 11 and No. 12 were the most difficult, based on reader feedback.
11. Wilma buys 400 shares of Slate Rock and Gravel Inc. for $20 each. She later sells 100 shares at $25 each. She then buys 200 shares at $27 each. Ignoring commissions, what is the adjusted cost base per share for her 500 shares?
Many readers fell into my trap and incorrectly chose B. They arrived at this answer by calculating Wilma’s initial cost of $8,000 (400 times $20), subtracting the sale proceeds of $2,500 (100 times $25), adding the cost of $5,400 (200 times $27) and then dividing the result of $10,900 by 500 to get $21.80 a share. The problem here is that, when shares are sold, it’s the cost of those shares, not the proceeds, that must be subtracted. In this case, Wilma would subtract $2,000 (100 times $20) from $8,000 to get $6,000, add $5,400 (200 times $27), and then divide the result of $11,400 by 500 to get the correct answer of C. $22.80. The key thing to remember is that, when you sell a portion of your shares, the average cost per share of your remaining shares does not change.
12. When an ETF or mutual fund declares a year-end reinvested or “phantom” non-cash distribution, the amount usually consists of ________ and must be _______ the investor’s adjusted cost base.
A. return of capital; subtracted from
B. dividends; subtracted from
C. return of capital; added to
D. capital gains; added to
Reinvested or “phantom” distributions usually consist of capital gains that were realized during the year. These gains are typically reinvested in the fund immediately but are “distributed” to investors in December for tax purposes; it’s really just an accounting move to push the tax liability out to unitholders. Because the gains were plowed back into the fund, the amounts are added to the investor’s adjusted cost base (ACB) in much the same fashion as a dividend reinvestment plan. The correct answer is therefore D. Tip: If you fail to add reinvested distributions to your ACB, you’ll end up paying more tax because you’ll report a larger capital gain, or smaller capital loss, when you eventually sell your units.
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