Income trusts demystified

The income trust (IT) phenomenon exploded so quickly onto the Canadian financial stage that it’s not surprising that many people are still trying to come to grips with this relatively new type of security. However, if you’re retired and using income trusts to supplement your investment revenue, you need to exactly what you’re buying.

Judging by the e-mails I receive every week, investors are intrigued by the cash flow and the tax breaks offered by trusts but are unsure of how they work, don’t understand the risks involved, and are somewhat suspicious about the whole idea.

Here are some of the questions that have come in recently with answers that I hope will clarify matters.

Question: We have a few income trusts. Could you please tell us the advantages and disadvantages of this type of investment? A simplified explanation as to what they are would be really helpful too. – P.C.

Answer: Fundamentally, it’s a simple idea. A trust is set up and acquires partial or full ownership of a revenue-producing asset. In doing so, it may also receive some accumulated tax benefits. It thesells shares (units) in the venture to the public. The attraction is that revenues and tax advantages will flow through to the unit holders, after management fees and other expenses have been deducted.

There are several ways of classifying these trusts but at the core there are really two types. The first is the commodity trust. It’s based on a resource asset. The most common are trusts specializing in the petroleum, iron ore, and coal sectors.

This was the first type of trust to appear in Canada and they were known as royalty trusts in the mid-‘90s. Initially, the returns were extremely attractive. Then this class of IT ran into problems as commodity prices fell and an economic crisis in Asia reduced exports of such key products as metallurgical coal. The subsequent decline in cash flow and market valuations brought home one of the main problems with commodity ITs—they can be volatile and, unlike bonds, the returns are not guaranteed. Thanks largely to rising energy costs, these investments made a good comeback in recent years.

The other type of income trust is what I call a commercial trust. These trusts own a commercial asset of some type—it could be anything from a hydro-generating plant to a tree nursery to shopping malls, or even a sardine-processing operation. Again, the revenue from the asset is flowed through to investors. Yields are usually higher than you’ll receive from a GIC or bond. Most commercial trusts don’t have any tax advantages, but they have tended to be more dependable in cash flow and market price than the commodity-based ITs.

Question: Through various means I have come to have a small portion (about 5 per cent) of my stock portfolio in conservative income trusts. What I cannot get a clear answer to is the matter of their tax efficiency. 

They are billed as having a “dividend” of such-and-such which I assumed meant they were taxed as are dividends coming from stocks. However, when I receive my T3 forms some trusts list their payments as “return of income” and/or “dividends” and/or “interest” and or “other income”. No two trusts that I own have the same combinations. 

I’m now asking myself just how tax-efficient are these trusts? When they are advertised as having a “dividend” of, say, 8.75 per cent, is this the same as the dividend I receive on my Dofasco or BCE stock? Is it treated the same way? Is each trust free to establish its own way of allocating returns among the various categories? Can they change the apportionment each year? Are there any Revenue Canada rules by which they must abide? – K.Q.

Next page: The answer, and a common misconception

Answer: Let me begin by clearing up a common misconception. Income trusts do not pay “dividends” and if you read the information about them carefully you will see that none claim to do so. They make “distributions”. The distinction is very important and is the main source of your confusion.

An income trust distribution can be treated in any one of five ways for tax purposes. In fact, one portion of a distribution may be treated one way, say as interest income, while another amount is treated differently, perhaps as return of capital. These rules are set down by the federal government and administered by the Canada Revenue Agency. No trust can arbitrarily decide how the distributions are to be treated. You receive a reporting slip every year that shows you the total allocation for tax-filing purposes.

Here are the five ways in which trust distributions may be treated.

• Capital gains. In this case, 50 per cent of the relevant amount is tax-exempt.
• Dividend income. Payments that fall into this category are eligible for the dividend tax credit.
• Interest or “other income”. These amounts are taxable at your full marginal rate.
• Return of capital. This is a bit tricky. Any payments designated as return of capital are tax-deferred in the year they are received. You pay no tax on those amounts. However, you must subtract the total of such payments from the price you originally paid for the shares to arrive at what is known as an “adjusted cost base” (ACB). This is the figure that will apply for capital gains purposes when you eventually sell your shares.
• Rental income. This applies in the case of real estate investment trusts (REITs). Rental income is eligible for depreciation deductions that will reduce the amount of tax payable. The ACB rules apply here as well.

Of course, if income trusts are held inside a registered plan, none of this applies.

Question: Income trusts have been dropping in trading value lately, and with the possibility of interest rates rising, is it wise to consider selling and taking a small loss rather than waiting for this sector’s bubble to burst? – J.P.E.

Answer: First, stop and ask yourself why you bought the trusts in the first place. Was it for capital gains or steady income? If the answer is income, and the trusts you own are still doing the job, why would you sell them? And what would you replace them with?

Many (but not all) income trusts are interest rate-sensitive. That means their market value will be affected by rate movements, in much the same way as bonds. However, not all trusts are equally affected by rate hikes. REITs are among the most vulnerable, along with pipeline and power trusts. Those least affected are energy trusts (which are more susceptible to fluctuations in oil prices) and trusts which focus on economically-sensitive businesses, like pulp and paper.

I think it unlikely that “the bubble will burst”, as you put it. Yes, we will see downward pressure on the income trust sector as rates rise. But the effect of that will be to drive yields higher, which will make the trusts even more attractive to income-seeking investors. Of course, when the cycle turns and rates start to fall again, the opposite effect will be seen – trust prices will rise and yields will fall.

If you are investing for income, my advice is to ignore day-to-day or even month-to-month price movements. As long as you are satisfied with the cash flow you are receiving and the trust remains sound, consider it a long-term hold. If you want to actively trade securities, you would be better off sticking with stocks.