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Source: p 371, Investing For Canadians For Dummies, 3 Ed (2009) by Tony Martin, Eric Tyson

[...] [1.] First, the programs can calculate your effective or “internal” rate of return (IRR) by comparing the original amounts you invested to the current market value. [...]

[2.] The tax or cost-basis method is the second way software may calculate your returns. All the packages that we’ve reviewed calculate your adjusted cost base for accounting purposes. Your adjusted cost base is your original investment plus reinvested dividends and capital gains, for which you have already paid taxes in a non-retirement account. To get an accurate adjusted cost base, you need to key in all of your investments, including reinvested distributions. [...]

[3.] But here's what really happens: When the distribution is reinvested, it's added to your cost basis. Although the money was "earned" on the original investment by way of a distribution, it's not considered part of the investment's performance. Instead, the number of shares you own increases, as does the cost basis for those shares.

For this reason, cost basis should be used only to calculate capital gains and losses for tax-filing purposes—not to measure performance.

  1. Why are reinvested dividends and capital gains not considered part of the investment's performance? An investor can choose not to reinvest dividends, but dividends and capital gains both did originate from your original investment.

  2. Why are investment taxes calculated using 2? Do governments marvelously trying to help investors by imposing less tax?

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The key point is from the penultimate sentence in your second paragraph:

for which you have already paid taxes

When you receive a dividend or realise a capital gain, you get taxed on that then, and you shouldn't have to pay taxes on it again in future. So the cost basis gets adjusted to reflect that.

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