# Understanding trust distributions

I recently received a question from a reader who was very confused about income trusts and taxation. He had purchased units in an income trust that was recommended in my Internet Wealth Builder newsletter, called PrimeWest Energy Trust.

He wrote: “The share price is down from when I bought it, but each year I have a taxable amount that is classified as ‘other income’. There is also a sizable amount of ‘return of capital’. If I were to sell right now, would I have a capital loss? Would I have to pay tax on the return of capital as a capital gain? If so, would it not make sense to hold the trust in a RRSP?”

There is no doubt that the tax rules governing these securities are complicated, but let’s see if we can simplify matters.

There are two separate and distinct financial components to consider from a tax perspective when you purchase units in an income trust. The first is relates to your capital investment: the value of the shares when they are bought and later sold. The second is the distributions that you receive while you own the units. The two are treated differently for tax purposes, although they are tied to one another.

Let’s use PrimeWest tillustrate. Let’s assume the reader purchased the shares at the time of the original recommendation in the newsletter, in October 1999. He would have paid \$28.20 a unit (the price has been adjusted to reflect the subsequent share consolidation). At the time he wrote, the units were trading at \$25.51, so he would appear to have a capital loss of \$2.69 a share at this point.

But now let’s look at the distribution side of the equation. From Nov. 15, 1999 to May 15, 2003, our reader received the equivalent of \$23.60 per unit in distributions. Of that amount, \$9.86 was considered to be “return of capital” and therefore is not taxable. The balance, \$13.74 per unit, was fully taxable as “other income” in the year received.

Here’s how the distributions tie back to the original capital investment. All “return of capital” payments must be subtracted from the original purchase price to arrive at an “adjusted cost base” (ACB). This is the figure used to determine the amount of capital gain or loss for tax purposes when you sell.

Applying this rule to our illustration, the reader’s ACB for PrimeWest as of May 15 was \$18.34 (the original \$28.20 purchase price minus \$9.86 received as “return of capital”). So if he were to sell the shares at \$25.51, he would be deemed to have a capital gain of \$7.17 per unit for tax purposes, not a capital loss as it appears at first glance. Of that, 50% or \$3.585 per unit would be taxable. As long as he keeps the shares, however, he does not have to pay this tax because he has not crystallized the gain. (This calculation uses PrimeWest’s estimate that 55% of its 2003 distributions will be taxable.}

It’s important to understand that even though the reader may eventually have to pay tax on what amounts to a capital gain that exists on paper only, he will still come out ahead by keeping the units outside a registered plan.

If the PrimeWest shares were held in an RRSP or RRIF, the full amount of the distributions received (\$23.60 to date) would be taxed at the marginal rate when the money is withdrawn from the plan. By keeping the units in a non-registered portfolio, 27% of the distributions to date (totalling \$6.37 per unit) effectively escape taxation entirely, even if he should sell tomorrow.

By the way, taking the total distributions received to date and subtracting the market value capital loss, PrimeWest shareholders who bought at the time of our newsletter’s original recommendation have a gain of \$20.91 per unit, for a net return of 74% on their original investment. That works out to an annualized return of just under 18%.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail publication featuring financial guidance from some of Canada’s leading experts. For details on a three-month trial subscription for 50plus.com visitors, go to http://www.buildingwealth.ca/promotion/50plusproducts.htm