Return of capital (ROC) refers to principal payments back to "capital owners" (shareholders, partners, unitholders) that exceed the growth (net income/taxable income) of a business or investment. It should not be confused with Rate of Return (ROR), which measures a gain or loss on an investment. Basically, it is a return of some or all of the initial investment, which reduced the basis on that investment.
The ROC effectively shrinks the firm's equity in the same way that all distributions do. It is a transfer of value from the company to the owner. In an efficient market, the stock's price will fall by an amount equal to the distribution. Most public companies pay out only a percentage of their income as dividends. 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.
- Oil and gas royalty trusts also make distributions that include ROC equal to the drawdown in the quantity of their reserves. Again, the cash to find the O&G was spent previously, and current operations are generating excess cash.
- Private business can distribute any amount of equity that the owners need personally.
- Structured Products (closed ended investment funds) frequently use high distributions, that include returns of capital, as a promotional tool. The retail investors these funds are sold to rarely have the technical knowledge to distinguish income from ROC.
- Public business may return capital as a means to increase the debt/equity ratio and increase their leverage (risk profile). When the value of real estate holdings (for example) have increased, the owners may realize some of the increased value immediately by taking a ROC and increasing debt. This may be considered analogous to cash out refinancing of a residential property.
- When companies spin off divisions and issue shares of a new, stand-alone business, this distribution is a return of capital.
Read more about Return Of Capital: Tax Consequences, Example, Conclusions, Time Value of Money
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