Investors who flock to income trusts often cite high yields and large cash
distributions as their primary motivation. But be forewarned, when it comes to
income trust distributions, not all are created equal. In fact, the nature of
the distribution can dramatically cut the yield after tax is taken into account,
as the accompanying table shows.
Because income trusts are known as "flow-through vehicles" for tax purposes,
any income earned inside the trust will retain its characteristics when paid out
to investors. Consequently, trust distributions generally take one of four
forms, with each one taxed differently: ordinary income, Canadian dividends,
capital gains or a return of capital.
Ordinary income, like interest or salary income, is taxed at your full
marginal tax rate. This income forms the primary portion of many income trust
distributions, which explains the frequently touted maxim that income trusts
that pay out a large portion of their distributions in this form are ideally
suited for tax-deferred accounts such as registered retired savings plans or
registered retirement income funds, where the income is deferred until
Capital gains distributions are more tax advantageous since only half the
gain must be included in your income. Unfortunately, they seldom make up a
significant portion of income trust distributions.
Canadian dividends, as a result of last month's federal budget, are poised to
eclipse capital gains in tax efficiency. It all depends, however, on whether the
province you reside in agrees to fully co-operate by increasing its dividend tax
credit as Ottawa assumes they will.
A return of capital, the final form of cash distribution to discuss, may
actually be the most beneficial, surpassing both capital gains and Canadian
This arises when an income trust distributes cash that may be tax-sheltered
by certain deductions. The deductions vary depending on the nature of the trust.
For example, resource royalty income trusts may be able to reduce the taxable
portion of cash distributions through the amortization of resource and
exploration expenditure pools, while REITs often have significant tax
depreciation that can be used to reduce their taxable distributions.
A return of capital is particularly advantageous in that it is not
immediately taxable, yet it reduces the tax cost or adjusted cost base (ACB) of
your investment. On the sale of your income trust units, the lower ACB generally
results in a higher capital gain (or lower capital loss).
At the end of the year, income trust distributions are reported to
non-registered investors on a T3 slip, which breaks down the taxable attributes
of the distributions and what portion, if any, represented a return of capital.
Investors in taxable accounts should pay close attention to the nature of
distributions of a trust as it can significantly affect after-tax yields. As the
chart indicates, an investor in a 40% tax bracket who invests $10,000 of
non-registered money in five different income trusts, all of which yield 8%, can
end up with significantly different current after-tax yields.
These after-tax yields may be misleading in that, while the return of capital
is not immediately taxable, it will reduce the ACB, resulting in a deferred
capital gain on the sale of the units that will affect the after-tax yield over
the life of the investment. That being said, if the investor has capital loss
carryforwards with which to offset this final gain, then there may be no tax
bill at all upon ultimate disposition.
GRAPHIC: Chart/Graph: AIM Trimark Investments; National Post; Different
Distributions, Different Taxation.: (See print copy for complete chart/graph.)