Financial Definition of ROC
What It Is
How It Works
With funds, ROC is usually done because their underlying investments have not generated the annual income necessary to make the expected dividend payments to investors in a year. This essentially forces the manager to dip into the fund/trust/partnership's principal to come up with the money.
With a trust, it's a different story. Trusts often have very high depreciation expenses. While these expenses affect net income, they do not affect the amount of cash available to the trust. When the trust distributes more than its net income, the excess portion of the distribution is considered return of capital.
Cash generated from the sale of capital assets can also constitutes a return of capital in the sense that the cash did not come in the entity's normal course of business and instead represents a portion of the original investment in the business.
Returns of capital are not considered income and are thus tax-exempt -- that is, until the returns of capital exceed the original investment. For example, if you invested $10 in Company XYZ and received a $5 return of capital after one year, that $5 payment would be tax-exempt. If, however, you received a $6 return in the second year, for a total of $11 in returns of capital, the amount that exceeds the original investment ($1 in this case) is taxed as ordinary income at your marginal tax rate.
A return of capital decreases the cost basis of an investment. If you invested $10 and then received a $1 return of capital, your cost basis becomes $9. This has important tax implications discussed below.
Why It Matters
There are two significant attributes of returns of capital. First are the future tax effects. If, in our example above, you sell your Company XYZ investment after year one, when the basis has fallen to $5, the taxable amount associated with the sale is based on the difference between $5 and the sale price. So even though you may have paid $10 for the investment, you calculate the taxable amount as if you paid only $5. Any gain on the sale is taxed at your ordinary income tax rate. This can significantly increase your tax bill, but some investors find the cash inflow from the return of capital worth it.
Second, issuers sometimes make returns of capital to keep up the level of distributions shareholders have come to expect. If, for example, Company XYZ only generated enough revenue to pay a $3 per share dividend rather than the $5 per year the shareholders expect, it might make a payment in the form of a $3 per share taxable dividend and a $2 per share return of capital so that the shareholders will receive $5.
The tax effects of returns of capital can be particularly prickly for some investors, and they should consult with a qualified tax advisor to make the best decisions about the treatment of investment distributions.
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