Why do mutual funds pay distributions?
What are the main types of income that I may receive from holding mutual funds?
What is the second type of 'capital gain' that I may generate from holding mutual funds?
If my mutual fund did not pay a distribution, is it performing poorly?
Why do distributions matter?

Unless you hold your mutual funds inside a tax-deferred account such as an RRSP or RRIF, you will need to pay taxes to Canada Revenue Agency (CRA) on your mutual fund distributions. Whether you receive your distributions in cash or have them reinvested in the mutual fund, you are still required to report the distribution income annually.

Why do mutual funds pay distributions?
All investment income earned by Canadian mutual funds is subject to income taxation. All interest and dividend income received, as well as any capital gains that are realized by the fund during the year are taxable.

Mutual funds are structured as "flow-through entities", which means that a fund's tax liability is passed onto individual investors or unitholders. Since many investors are generally taxed at a lower rate than the fund, most investors are better off when the fund pays out a distribution and they pay the tax personally.

If you hold your mutual fund investments inside a registered plan, you do not have to pay taxes on these distributions. If you do hold mutual funds in a non-registered account, you will be mailed a T3 Supplementary or T5 Supplementary form at tax time stating your tax position for each fund that you own. If your mutual funds were held in a non-registered account at BMO InvestorLine, you will receive a T3 or T5 Supplementary from each respective fund company whose funds you own.

What are the main types of income that I may receive from holding mutual funds?
A single mutual fund may earn three types of income: capital gains, dividends and interest. The tax treatment for each type of income is different.

Capital gains are generated when the fund sells an investment and realizes a gain on it. Do not confuse this capital gain with a second type of capital gain that is generated when you sell your mutual fund units for a profit.

Dividends are generated whenever the fund receives dividends from holding shares of corporations.

Both capital gains and Canadian dividends receive favourable tax treatment in that you are only taxed on 50% of the capital gain and Canadian dividends are eligible for the dividend tax credit.

Interest income is generated whenever the fund receives interest from bonds, mortgages, Canadian T-bills or other fixed-income products. Interest is fully-taxed, that is, at the same rate as your salary.

The type of income that you receive as a mutual fund unitholder will vary depending on whether the particular mutual fund is structured as a "mutual fund trust" or a "mutual fund corporation". Mutual fund trusts are "flow-through entities" in that the fund can distribute the full range of income to their individual investors. Mutual fund corporations cannot flow through the full range of income - only Canadian dividends and capital gains. In Canada, most mutual funds are "mutual fund trusts".

What is the second type of "capital gain" that I may generate from holding mutual funds?
This capital gain is the profit you generate when an investment is sold for more than what it cost. For example, if you have purchased $5000 of a fund at a unit price of $10, you would have held 500 units. If you sell all of your no-load mutual fund holdings later at a unit price of $11 for total proceeds of $5500, you would have generated a profit or a taxable capital gain of $500.

If my mutual fund did not pay a distribution, is it performing poorly?
Distributions are not indicators of a mutual fund's performance.

A mutual fund's performance or total return comprises three different components. The first component consists of interest and dividends earned. The second is the realized gain on the sale of securities in its portfolio. The third is the unrealized gain resulting from an increase in market value of the securities it continues to hold in its portfolio. While the first two components are taxable, the last is not.

Your fund is generating positive returns when the market value of the securities in its portfolio appreciates. And if your fund's manager has not sold these securities, the fund does not generate any income on which it must pay out distributions.

Why do distributions matter?
Most funds pay distributions at the end of each calendar year. If you are purchasing a mutual fund in December in a non tax-sheltered account, you will be liable to pay taxes on any distributions that are paid out; even if you have not sold any of your units.

Although you should never invest solely on the basis of tax considerations, you may wish to consider the tax issue when making a mutual fund investment late in the calendar year.