Tax Articles
What's the Real Deal with Investment Trusts?
Ken Karakashian
BDO Dunwoody LLP
May 2005, Planning for Profit
With today’s stock market uncertainty, income, royalty and real estate investment trusts are attracting greater interest. Yields are often more attractive than those of such other investments as bonds or preferred shares. But before investing, it’s important to consider how these trusts are structured and the tax consequences of owning them.
These types of investments are effectively closed-end trusts, having a limited number of units. In order to get in or out of these trusts, you generally buy or sell the units on a public stock exchange.
An income trust typically holds debt and shares of a corporation that carries on an active business; currently, these include propane distribution, coffee decaffeination and cheque supply. The trust earns interest income from the debt it holds, receives debt repayments from the corporation, and receives dividends or other distributions from the shares it holds. The trust makes cash distributions (net of certain trust expenses) to unit holders, often on a monthly basis. These usually exceed the trust’s taxable income and therefore the unit holder receives taxable income (interest, dividends and, sometimes, capital gains) plus a return of capital -- the unit holder’s portion of debt repayments and other distributions on the shares held by the trust.
A royalty trust holds a royalty interest in petroleum and natural gas or mineral production, which is carried out by an operating corporation. Net revenue is flowed to the trust as royalty income. The trust deducts Canadian oil and gas property expense (COGPE) or Canadian development expense (CDE) deductions and financing deductions from its royalty income. Cash income of the trust is usually higher than taxable income earned from the royalty interest. Therefore, when cash income is distributed to unit holders, they receive both taxable income and a return of capital, which is the COGPE, CDE and financing deductions passed on to unit holders. These deductions shield some of the unit holder’s cash income from tax.
A real estate investment trust (REIT) owns, maintains and manages real estate. REIT investors indirectly own real estate assets, such as shopping malls and office towers, through the trust. Net income earned from the properties in the REIT (rental income and capital gains) is paid out to unit holders after any management fees are paid from the trust. In determining net income, the trust deducts capital cost allowance (CCA) on the properties it holds. Therefore, unit holders usually receive cash distributions that exceed the REIT's taxable income. Again, this return of capital is effectively CCA deductions on the properties passed along by the trust, which thereby shield some of the unit holder’s cash income from tax.
Unit holders must include the taxable income portion of the distribution (interest and dividend income, net rental or royalty income and capital gains) in taxable income in the year of receipt. Distributions received in excess of cumulative taxable amounts are not included in taxable income. While this excess is generally considered a return of capital, the unit holder must reduce the adjusted cost base of the units by the total return of capital distributions. This will increase any capital gain, or reduce any loss, realized on disposition. The gain arising on the disposition of the units is only 50% taxable and it is generally not taxed until the unit holder sells the units.
Most of these trusts are structured as mutual fund trusts; therefore they generally qualify as investments for RRSPs and certain other deferred income plans. However, although the tax on income earned in the RRSP is deferred until the income is withdrawn, withdrawals are fully taxed, so unit holders won't benefit from the low tax rate on capital gains.
Investment trusts can offer tax benefits and attractive yields without full exposure to stock market fluctuations. But, before investing, discuss the likely impact on your financial situation with your accountant.
Ken Karakashian is a Partner in the Mississauga office of BDO Dunwoody LLP, one of Canada’s leading accounting firms, which helps entrepreneurs and family businesses succeed. If you have questions about this article, or would like to receive BDO’s Tax Factor newsletter, contact Ken at 905.270.7700 or kkarakashian@bdo.ca.
