The Ins and Outs of Income Trusts

Canadian income trusts were a beneficial alternative corporate structure for companies due to their lower tax liabilities. They are known as “flow-through” vehicles because taxation was avoided by paying out all earnings, less expenses, as dividends directly to unitholders.

Income trusts first became popular investments in the early 2000’s when interest rates declined.

The main attraction of income trusts is the payout of consistent cash flows for investors, which is especially attractive when bond yields are low. Investors enjoyed generous yields, often in excess of 10%.

The Halloween massacre

Even though the Conservatives gave a campaign promise not to tax income trusts, in October 2006 then Finance Minister Jim Flaherty claimed that the income trust structure hurt the economy by depriving the government of tax revenue plus it restricted company growth. He announced new rules for income trusts which closed the loophole and ended the tax benefits. Immediately after the announcement share prices of the trusts dropped.

Related: How to calculate capital gains and adjusted cost base (ACB)

The deadline to change the structure of income trusts was January 1, 2011. Since they lost their special tax privileges many companies found it beneficial to convert to traditional corporate structures. The trust units were exchanged for common shares. Under the new corporate tax structure high dividend yields would not be sustainable, so most dividends were cut.

This was a big slam to retirees who had loaded up on income trusts in their RRSPs to enjoy secure retirement income. “We’ll remember this at the next election,” the betrayed seniors cried – and apparently they did.

After the conversion

Many of the former income trust companies remained solid and continue to offer above average dividend yields.

Some corporations that were once popular income trusts:

• Cineplex Inc. (CGX.T)
• Rogers Sugar (RSI.T)
• Liquor Stores (LIQ.T)
• Precision Drilling (PDS.T)

Some companies changed to quarterly distributions, but many continued to be monthly payers. The question to ask is – are they sustainable?

Pengrowth Energy (PGH) and Enerplus (ERF) at first maintained their payouts, then they were reduced, and finally dropped, and we all know what happened to Canadian Oil Sands (COS). Liquor Stores will also be reducing their distribution.

Some companies did not convert and found it more beneficial to retain their trust status.

• Royalty trusts – companies related to energy products e.g. Argent Energy Trust (AET.UN)
• Business investment trusts – have strong steady cash flow e.g. Keg Royalty Income Fund (KEG.UN)
• Utility trusts – companies in power, pipelines & telecom e.g. Brookfield Renewable Energy (BEP.UN)

REITs – the exception to the ruling

The most common forms of income trusts are Real Estate Investment Trusts (REITs) which escaped the new tax ruling. REITs own or operate income producing real estate – offices, residential, retail, industrial, hotels and healthcare.

If this type of investment is of interest to you, don’t be swayed by large dividend yields.

Choose quality properties based on current trends, e.g.

• Retail tenants may be shifting from traditional “brick-and-mortar” stores to online shopping.
• Senior residences and assisted living facilities are on an upward trend.

Rather than holding several individual REITs, you may choose to invest in a diversified REIT ETF such as:

• iShares S&P/TSX Capped REIT Index ETF (XRE) – Yield = 5.73%
• Vanguard FTSE Canadian Capped REIT Index ETF (VRE) – Yield = 5.7%

Both hold similar popular companies in their top ten, such as RioCan (REI.UN), Cominar (CUF.UN) and Boardwalk (BEI.UN) and pay monthly distributions.

The biggest risk is an increase in interest rates – higher rates will reduce the demand for REITs when investors flock to more secure bonds.

Taxes

It’s more advantageous to hold income trusts in a RRSP or other registered account.

In a non-registered account, cash distributions which are usually made up of taxable Canadian dividends – reported on T3 slips – are eligible for the dividend tax credit, and you also receive return of capital (ROC). ROC is not taxable but it reduces your adjusted cost base when you sell.

Final thoughts on Income Trusts

REITs and other income trusts can be passive income producing investments. Yields can be higher than those from dividend stocks and are often paid monthly which is desirable for retirees looking for regular income. But, they are not without risk. Do your research to find the ones most appropriate for you.