Income Trusts Raise Returns - and Risk

Income trust units have their place but make no mistake: when you buy one of these investments you're not buying a Government of Canada bond.

The increase in the number and types income trusts has been spurred to a large extent by income-oriented investors seeking higher yields than those available through traditional income-generating investments like bonds, GICs and money market funds.

In addition, because income trusts benefit from tax efficiencies not available to conventionally structured companies, many corporations have been hurrying to convert themselves to income trust arrangements to attract investor financing.

Income trusts can offer yields ranging from about 7% to more than 20% because of their legal structure that sees them hold cash-generating assets for which no reinvestment is planned. That lets them distribute all their profits and tax liability to investors (unitholders).

Conventional corporations, on the other hand, retain and reinvest most of their earnings to develop their assets. In doing so they fall victim to the Canadian system of double taxation. First, they must pay corporate income tax on revenues, net of costs. Then, if they pay dividends from after-tax income, the dividends are taxable again only this time in the hands of shareholders.

Many income trusts further enhance tax efficiency through a tax deferral mechanism in which a portion of the distribution is deemed to be a non-taxable return of capital (ROC).

When investors receive non-taxable ROC, the amount of the ROC reduces the cost base of the original investment. Then, when an investor sells non-registered income trust units, tax is payable on any capital gain calculated as the difference between sale proceeds for the units and their adjusted cost base at time of sale.

Tax is payable on only 50% of the amount of the capital gains, as opposed to the much higher marginal tax rate on other forms of investment income such as interest or, to a lesser extent, dividends.

Although most income trusts are RRSP-eligible, holding then inside a registered plan like an RRSP eliminates these tax advantages. Therefore, if you want to use income trusts to boost retirement plan cash flows, the focus should be on the relative rates of return and not any special tax breaks.

While their high yields make income trusts sound pretty attractive for those seeking a regular source of income, wise investors always keep in mind that "the higher the return, the higher the risk."

Many experts predict that income trusts won't be able to maintain the high total returns of income trusts, which are made up of capital gain or loss plus distributions. One key risk to unit pricing is a rising interest rate. This will result in a higher discount rate used to value cash distributions.

Also, income trusts are like bonds in that their unit prices typically go down when interest rates go up, and vice versa, because of the increase in yield of other competing fixed-income investments. Interest rates having been so low for quite a long time, they can be expected to go up at some point, probably triggered by rising inflation numbers. When they do rise, traditional fixed-income low-risk investments like GICs will become more attractive by comparison.

On October 31, 2006, the federal government announced new rules for the taxation of "specified investment flow-throughs", or SIFTs. SIFTs will generally include publicly-traded income trusts, as well as publicly traded partnerships holding significant investments in Canadian properties.

These changes applied in the 2007 tax year for income trusts that begin trading publicly after October 2006, but didn't apply until 2011 for income trusts that were traded publicly prior to November 2006.

Under old rules, when calculating taxable income, income trusts could deduct the income and capital gains paid to unitholders. Any remaining taxable income was taxed at the highest personal tax rate of 29%, plus applicable provincial taxes.

Under the new rules, SIFT trusts wouldn't be able to deduct most of these amounts (non-portfolio earnings).

The tax rate that is applied to the "distributed non-portfolio earnings of a SIFT trust" will be reduced to a rate equivalent to the corporate tax rate, plus provincial taxes. The distributed non-portfolio earnings of the SIFT trust will be taxed in the hands of investors as Canadian dividends eligible for the enhanced dividend tax credit.

Undistributed taxable income of a SIFT trust will still be taxed at the old rates.

Return of capital (ROC) treatment won't change - distributions of ROC are not deductible to the trust, and not taxable when received by investors. The ROC amounts reduce the cost basis of the investor's holdings of the trust.

Some types of income trust are less risky than others because they're well suited to the income trust structure. The best fit is a mature company with stable cash flow, low growth, predictable capital expenditures, small risk of technological change, and a large, loyal customer base. Yields of higher quality trusts tend to be below 10% - again it's that old story of high yield being linked to high risk.

Income trusts are generally grouped into 3 categories:

Real Estate Income Trusts (REITs)

These own and operate income-producing real estate such as apartments, hotels, shopping centers, offices, warehouses, and extended-care homes. Cash flows and distributions depend on the underlying business fundamentals of the specific real estate market a given REIT is active in.

While REITs are generally more stable than other income trusts, they do have lower yields. Advantages of REITs include predictable income, generally from long-term leases; inflation hedge characteristics since rents increase with inflation; non-depleting assets; and diversification.

Oil and Gas Royalty Trusts

These trusts are essentially collections of producing oil and gas wells.

Investors receive a portion of net revenues from these properties without exposure to the high-risk exploration activities of traditional oil and gas companies. While usually offering the highest yields, they're also the most volatile. Oil and gas prices can fluctuate dramatically due to a variety of economic conditions and world situations, which can then drastically affect profits available for distribution to unit-holders.

Although oil and gas royalty trusts operate under the premise they will replace their reserves on an ongoing basis, there are no guarantees they can maintain reserve levels as production depletes them over time.

Reserve replacement brings cost and risk. That became evident in 2004 when the Canadian Oil Sands Trust, one of the oldest and largest, announced bad news. A big expansion in capacity of its underlying asset, the Syncrude Joint Venture tar sands project in Alberta, ran into serious delays and huge cost overruns. Since the trust is paying for part of that expansion, these developments scared the market.

The result was a sharp fall in value of the units from the 12-month high of $53.64 to $44.50, which trade on the Toronto Stock Exchange. Only high oil prices prevented a more serious hit. Canadian Oilsands unitholders discovered that their trust has some of the high-risk features of a traditional oil company.

Business and Utility Trusts

This general category is growing and becoming quite diverse.

It now includes companies supplying fast foods, long distance trucking, mattresses and pet food. Some of these might not be well suited to the income trust structure. Utility trusts, however, represent investments in privately-owned oil and gas pipeline systems and power-generating facilities and usually have long-term fuel supply requirements and sales contracts.

While cash flows and distributions from utility trusts are the most stable, they're also the most sensitive to interest rate changes.

So, if you haven't yet jumped on this bandwagon, should you be investing in income trusts?

If you already have units, should you be holding or thinking of selling? Only you and your investment advisor can determine if any given income trust, with its specific features and inherent risks, is suited to your personal goals and objectives. For sure, however, these are not investments to buy (or not buy) and forget about. They can be quite volatile and warrant regular reappraisal.