Tax breaks at root of popularity

National Post


The tax benefits of income trusts are high on the list of reasons why they've
become so successful. There are two main tax advantages: the tax efficiency of
the structure itself and the potential tax-favourable treatment of the

The income trust structure itself is tax efficient because it eliminates, or
at least tries to minimize, corporate taxation on profits. In a typical basic
income trust structure, investors own units of the trust, which then invests in
an operating company that produces cash flow.

This investment often takes the form of both equity and debt. The debt is
often structured as high-yield notes, sometimes bearing interest at rates as
high as 15%.

The interest paid by the operating company is tax deductible and is
structured in such a way it will eliminate all the corporate net income in the
operating company, and thus any corporate tax payable. The operating company
pays its interest on the debt to the income trust, which then distributes the
cash flow to investors.

The government, fearing a substantial loss of tax revenues, attempted to curb
the market for new income trusts last year by imposing a cap on the amount a
registered pension plan could invest in trusts. After an outcry by pension
funds, it backed down.

In last month's federal budget, Ottawa announced it will continue to consult
with stakeholders on the various tax issues associated with income trusts and
will soon be releasing a consultation paper on how best to deal with the
perceived loss of tax revenues.

The other significant tax advantage is the favourable tax treatment
associated with cash distributions. Since an income trust is what is called a
flow-through vehicle for tax purposes, any income earned inside the trust will
retain its characteristics when paid to investors.

While any interest or other income you receive in the form of a cash
distribution is fully taxable to you if you hold your income trust units outside
a registered plan, if the income trust realizes a capital gain which is then
flowed out to you, you will only be taxed on half the capital gain, the same as
if you had realized the capital gain personally.

Similarly, if Canadian dividends were paid by the underlying operating
company to the income trust and then flowed out to you, you would be entitled to
the dividend tax credit, reducing the tax payable on the dividends.

But, there is a fourth type of cash distribution which is even more
tax-efficient than capital gains or Canadians dividends: a "return of capital."
This arises when an income trust distributes cash which may be tax-sheltered by
certain deductions. The deductions vary depending on the nature of the income

For example, resource royalty income trusts may reduce the taxable portion of
their cash distributions through the amortization of various resource and
exploration expenditure pools, while real estate investment trusts often have
significant tax depreciation that can be used to reduce their taxable

At year end, the income trust will report to you what portion of its
distributions was taxable and what portion represented a return of capital.
Before last year, this information was often provided in an ad-hoc basis,
through statements or on the trust's Web site.

As a result of last year's federal budget, however, any investor who held
units of an income trust outside of tax-sheltered plan in 2004, will receive a
T3 tax reporting slip which will indicate the portion of the distribution
classified as a return of capital. A return of capital is particularly
advantageous in that it is not immediately taxable but instead reduces the tax
cost or adjusted cost base (ACB) of your investment. When you sell your income
trust units, the lower ACB will generally result in a higher capital gain (or
lower capital loss).

Not surprisingly, a return of capital is so tax-advantageous to investors
some income trusts use it as a marketing tool to compare their trust against
less tax-efficient trusts in their sector.

Just last week Priszm Canadian Income Fund, which owns and operates more than
450 KFC, Pizza Hut and Taco Bell restaurants across Canada, promoted the fact
only 52% of its 2004 cash distributions were taxable, the balance being a return
of capital.

One final caution for investors who may have borrowed money to invest in
income trusts. While the interest on such borrowing is generally tax deductible
because they were borrowed for the purpose of earning investment income, where
an income trust distributes a return of capital that is not subsequently
reinvested, either in additional units of the trust or in some other income
producing asset, Canada Revenue Agency says the amount of interest deductible in
the future must be reduced proportionately by the return of capital received.