Return of Capital (ROC)

Return of capital (ROC) refers to payments back to "capital owners" (shareholders, partners, unit holders) that exceed the growth (net income/taxable income) of a business. It should not be confused with return on capital which measures a ’rate of return’. The ROC effectively shrinks the business, because it exceeds the amount that earnings grew the business. Most public companies pay out only a percentage of their income as dividends, but in some industries it is common to pay ROC.
  • Real Estate Investment Trusts (REITs) commonly make distributions equal to the sum of their income and the depreciation (capital cost allowance) allowed for in the calculation of that income. The business has the cash to make the distribution because depreciation is a non-cash charge.
  • Private business can distribute any amount of equity that the owners need personally.

Tax consequences

There will be tax consequences that are specific to individual concerns. As examples only:
  • REITs may also flow through the depreciation expense they do not need to shareholders. It may be decades before the property is sold and taxes payable. It is better to give the excess cash and the tax write-off to the shareholders.
  • Since the ROC shrinks the business and represents a return of the investors’ own money, the ROC payment received may not be taxed as income. Instead it may reduce the cost base of the asset.

Misconceptions

It is wrong to think that the concept of ROC is only a tax issue. It is an economic measure. But the measurement of ROC resulting from accounting financial statements will be different from the tax man’s ROC.

It is wrong for the investor to think of the ROC as income. Income is a measure of how much "better off" you are now than you were then. The ROC simply transfers assets from the business to the investor. As the investor benefits from the payment, the business shrinks, and the investor’s interest in that business shrinks. An example is the only way to illustrate this.

Example

You start a delivery business with one employee and one contract. Your initial investment of $12,000 goes to buy a vehicle.

  • The contract is for four years and pays you $7,000 each year.
  • The employee is paid $2,000 each year.
  • Gas to run the vehicle will cost $1,000 each year.
  • With perfect foresight the accountant knows the vehicle will die at the end of the four years, so he expenses it at $3,000 each year.

At the end of each year:

  • Cash flow will be $4,000 (= 7,000-2,000-1,000). It is paid out to you.
  • Net income will be $1,000 (= 7,000-2,000-1,000-3,000).
  • The ROC is $3,000 (= cash received - net income) (= 4,000-1,000).

At the end of four years:

  • You have received cash payments of $16,000 (= 4,000*4).
  • Total ROC payments equal $12,000 (= 3,000*4).
  • Total income payments equal $4,000 (= 1,000*4).
  • Your initial investment has been 100% recovered by the ROC (= 12,000-12,000).
  • Your vehicle is now dead and worth nothing.
  • Without it, you need to repeat your investment in order to keep operating, so the business is worth nothing.

Conclusions

  • Cash flows do not measure income. They measure only cash flows.
  • Depreciation, depletion and amortization cannot be ignored as "non-cash expenses". They are valid allocations of a one-time cash flow over the time period that the asset helps generate revenues.
  • In the process of normalizing rates of return between different investment opportunities, ROC should not be included in the consideration of ’income’ or ’dividends’.

Time value of money

Some people dismiss ROC (treating it as income) with the argument that the full cash is received and reinvested (by the business or by the shareholder receiving it). It thereby generates more income and compounds. Therefore ROC is not a "real" expense.

There are several problems with this argument.

  • No one is arguing that the income earned on the full cash flow reinvested is not additional real income.
  • If the original asset purchase had not been made, its cash cost would have been invested and earning returns in that same way.
  • If you consider that depreciation is an allocation of the original cost of the asset, then you must agree that time-value-of-money considerations make the original cost HIGHER than the sum of the subsequent ROC expenses not realized until many years in the future.
  • If you consider that depreciation measures the amount of cash that must be retained in order to finance the eventual replacement asset, then you must agree that the cost of that replacement will have increased in cost in the interim by inflation. Inflation is the basis for the time-value-of-money.