Wednesday, 8 July 2009

Income Trust Tax Issues for Investors

For an investor who seeks regular and substantial cash returns, income trusts are a potential investment. Currently the TSX Income Trust Index, which is the average of all the income trusts traded on the TSX, provides an annual cash yield (cash / market price) of over 9%.

It is important to recognize however, that income tax can alter the net return. The cash distribution can be one or several types of income that are taxed at markedly different rates when income trusts are held in a taxable non-registered account.

The income may be composed of one or more of:
  • Other Income, including Foreign Income - taxed at the highest rate, 100% of a taxpayer's marginal rate (see the page with links to the rates for all Canadian provinces)
  • Eligible Dividends - taxed at the lowest rate for most tax brackets, the amount varies by province but gradually scales up with total taxpayer income till it is about equal to capital gains
  • Capital Gains - in most tax brackets is in between Income and Dividends at 50% of a person's marginal rate
  • Return of Capital (ROC) - not taxed at all immediately though it reduces the Adjusted Cost Base of the investment with the effect that one pays capital gains when the income trust is eventually sold
Other Income does comprise the bulk of the distributions for most income trusts. The iShares Canadian Income Trust Sector Fund (symbol XTR on TSX) invests in the aforementioned index and its 2008 distributions broke down as approximately 81% Other and Foreign Income, 18% ROC, 1% Eligible Dividends and negligible Capital Gains.

The story doesn't end there because individual income trusts may diverge greatly from the norm and therein lies a potentially more attractive investment after tax.

Examples (2008 figures):
Many of the trusts offering a good dollop of ROC or Dividends in fact fall into the utilities sector.

How To Find the Tax Distribution Breakdown
Unfortunately, there seems to be no centralized source with the breakdown for all income trusts. It is therefore necessary to look on each trust's website where the information for past years can be found under a link for Investor Information, Distributions or Tax Information. Most often a pattern is visible by looking at several years past - sometimes ROC is decreasing as companies use up the depreciation that generates the ROC, sometimes it bounces around a lot, as seems to be with Epcor and, sometimes it is stable.

Each year an investor will receive a T3 from the trust showing the actual numbers to report on the tax return. For the LP legal structure adopted by Epcor, the form is a T5013.

The Rule Change in 2011
Investors need to keep in mind that in 2011 all income trusts, except qualifying REITs, will begin to be taxed as corporations, ending the current system whereby all income is passed through before taxes to be taxed in the individual investor's hands. This means trusts will have a lot less cash to distribute after paying the corporate taxes. But the Other Income will then become dividends and the net after-tax amount for taxable investors will be about the same according to PriceWaterhouseCoopers' Planning for 2011 and Beyond (see page 6 of the report). Many trusts provide a statement on their website and in the annual reports as to how they plan to deal with the rule change and it is recommended reading before making an investment in a particular trust.

A previous post on Income Trusts discussed their potential and listed other important factors to investigate before investing. It is never a good idea to invest solely for tax reasons. Tax should be part of the overall assessment.

Disclaimer: this post should not be taken as investment advice or a recommendation of any particular securities. It is meant for information and to stimulate thought for the DIY investor.

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