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Eaton Vance Closed-End Funds
Return of Capital Distributions Demystied
What does it mean to receive a nondividend, or return of
capital, distribution? Different from taxable income and
capital gains distributions, return of capital distributions
are not subject to current tax. Instead, the tax cost basis of
each shareholder receiving a return of capital distribution is
reduced by the amount of the distribution, which increases
the amount of capital gains (or decreases the capital loss)
to be recognized when a shareholder sells his or her shares.
Because of the generally more favorable tax consequences
of return of capital distributions, funds that are managed
for after-tax returns may seek to maximize the amount of
distributions treated as return of capital by, for example,
selling securities they hold at a loss to offset gains on sales
of appreciated positions.
A common misconception about return of capital
distributions is that they are somehow less legitimate, or
less valuable, than other fund distributions. In this thinking,
dividends and capital gains distributions are based on
fund returns, and therefore earned, while return of capital
distributions are not based on fund returns, and therefore
unearned. A key distinction that may elude those who
take this view is the difference between return of principal
(economic concept) and return of capital (tax concept).
While they sound like the same thing, they are not. A simple
example to illustrate:
Most closed-end funds pay regular monthly or quarterly distributions to their shareholders. Like open-end
mutual funds, they are required after each year-end to provide an IRS Form 1099-DIV to every shareholder
who received distributions during the year stating the distributions’ federal income tax character. Fund
distributions may be characterized variously as: (1) dividends,1 (2) capital gain distributions or (3)
nondividend distributions, also known as return of capital distributions.
A few key takeaways
to remember:
• Return of capital is a tax concept, not an
economic concept.
• Return of capital distributions are not subject
to current tax. Compared to ordinary dividends,
they offer the potential advantages of reducing
(to long-term capital gains rates) and deferring
(until year of sale) shareholder taxes.
• The tax character of a fund’s distributions
tells little about whether the distributions are
supported by fund returns – dividends and
capital gains distributions may be unearned and
return of capital distributions can be earned.
• The best measure of whether a fund has earned
its distributions is the change in its NAV net of
distributions. Regardless of how distributions
are characterized, if a fund’s NAV increases, the
fund earned its distribution. If not, the fund did
not earn its distribution – the economic concept
of return of principal.
1Fund dividend distributions may include non-qualied ordinary dividends (taxed at ordinary income tax rates), qualied dividends (taxed at rates applicable to
long-term capital gains) and exempt-interest dividends (not subject to regular federal income tax). 2This example is hypothetical and for illustrative purposes only.
It does not consider transaction costs (such as brokerage commissions) associated with reinvesting distributions via open market purchase. It is not representative
of any actual closed-end fund product, nor does it represent actual results. Actual results will vary, perhaps to a signicant degree.
Fund ABC begins a year with a net asset value (NAV)
of $10.00 per share. It has a total return on its
investments of 5% ($0.50 per share) and distributes
7% ($0.70) during the year. Its NAV falls by 2%
($0.20) to an ending value of $9.80.2
Eaton Vance Closed-End Funds
Investors in Fund ABC would appropriately consider
$0.50 of the Fund’s distribution to be “earned” (i.e,
supported by Fund returns) and $0.20 of the distribution
to be “unearned” (i.e., in excess of Fund returns). This is
true regardless of the character of the distribution for tax
reporting purposes.
Perhaps surprisingly, the tax character of a fund’s
distributions reveals very little about whether distributions
are supported by the fund’s total return. Returning to our
example, Fund ABC may have invested in xed-income
securities yielding net income of 7% (supporting 7%
dividends) and lost 2% in principal value due to bond
defaults, trading losses or markdowns in position values.
Alternatively, Fund ABC may have invested in growth
equity securities generating 7% in net realized long-term
capital gains (supporting 7% capital gains distributions)
and lost 2% in principal value as net unrealized losses on
its portfolio investments increase relative to net unrealized
gains. In both cases, Fund ABC distributed more than its
5% total return for the year, causing its NAV to fall by the
amount of the excess distribution (2%).
As demonstrated by the foregoing, fund distributions
characterized as dividends or capital gains may not
necessarily be supported by fund returns, and may represent
economic return of principal. But can the opposite be true
for return of capital distributions? Yes, that can be the case.
A second example to demonstrate:
So if the tax character of a fund’s distributions cannot be
relied upon to reveal whether or not a fund has earned
its distributions, how can a shareholder determine this
important information?
It’s actually quite simple, and requires only information that
is readily available to every fund shareholder. Look at the
change in a fund’s NAV per share (net of distributions) over
the course of a year: if NAV has increased, the fund earned
more than it distributed. If NAV has gone down, the fund
distributed more than it earned. Said differently, if a fund’s
total return based on NAV has exceeded its distribution rate
for the year, it earned its distribution. If not, the opposite.
Pretty straightforward, right?
©2017 Eaton Vance Management
Two International Place, Boston, MA 02110 800.225.6265 eatonvance.com
6348 12.11.17
Fund XYZ begins a year with an NAV of $10.00 per
share. It realizes a total return on its investments of
9% ($0.90 per share) and distributes 7% ($0.70)
during the year. Its NAV rises by 2% ($0.20) to
an ending value of $10.20. If Fund XYZ has no
net investment income (because deductible fund
expenses equal or exceed income and net realized
short-term gains) and no net realized long-term
gain (because realized long-term gains are fully
offset by net realized losses), then its distributions
are all characterized as return of capital. Fund
XYZ can achieve this outcome (desirable from
a shareholder tax perspective) by, for example,
owning growth equity securities that appreciate
by an aggregate 9%, and matching net realized
gains on appreciated securities sold with net losses
realized by selling portfolio positions that have
declined in value.2
2This example is hypothetical and for illustrative purposes only. It does not consider transaction costs (such as brokerage commissions) associated with
reinvesting distributions via open market purchase. It is not representative of any actual closed-end fund product, nor does it represent actual results. Actual
results will vary, perhaps to a signicant degree.
The information contained herein is provided for informational purposes only and is not intended as investment or tax advice and does not constitute a
solicitation of an offer to buy or sell specic securities. Information contained herein is not representative of any Eaton Vance fund or other product. The views
expressed are those of Eaton Vance, and the information contained is not all-inclusive. Reliance upon this information is at the sole discretion of the reader.
Past performance is no guarantee of future results. There is no assurance that a fund will achieve its investment objective. Investments involve risks, including
loss of principal.
