Canadian income trusts, also known as Canadian royalty trusts and business trusts, are business entities that buy assets generating steady cash flows. Income trusts are attractive to investors because they pay out generous dividends. Usually, trusts are set up by corporations, because of the preferential tax treatment. Unlike corporations, which are subject to double taxation, Canadian trusts are taxed only once- on individual level.
In most cases well-established businesses in oil and gas industries are converted to an income trust. At the transition point, the business is stable, generates a lot of cash and is in its mature stage of its product life cycle. Therefore, all or most of the available cash is designed to be taken out of the company and distributed to the unit holders. There is really no money left to reinvest in operating activities of a new aggressive growth infrastructure.
Being a tax-friendly means of stable income, business trusts attract many American investors, who seem to perceive potential investment opportunities paying as sky-high dividends as 21% in Canada. In fact, investing in Canadian companies would expose the investor to a wider range of companies related to natural resources. This gives the beneficiary an extra protection from the expected depreciation of the US dollar because of the United States economic swings, while Canadian dollar value increases with the soaring economy.
Despite the investment attractiveness of the Canadian income trust, the future unit holder has to be consistently aware of a number of red flags before putting money in these cash generating entities. First of all, stay away from trusts that pay to unit holders more than their net income. Living in an increasingly volatile and resource constrained world, this is not a sustainable business practice. It is extremely vital for the investor to do a thorough assessment of the fund's cash flow by comparing the annual net profit per unit to the total annual dividend distribution per unit.
A blinking red light for the beneficiary could also be the unlimited liability structure of the trusts, which corporations do not have. Businesses can always run into unforeseen problems, and accidents can always happen. Therefore, most business owners would rather take the less advantageous tax situation that comes with owning that business through a corporation, and enjoy the limited liability that the corporation provides in comparison with the trust model.
Under Canadian tax law, the trust's profit is not taxed if it is annually distributed to the shareholders. Afterwards, based on their personal tax brackets, the beneficiaries may have to pay income taxes on the money received. Unfortunately, Canadian Finance Minister Jim Flaherty has proposed a taxation of Canadian income trusts the same as ordinary corporations. If the new government policy goes through, all existing trusts would lose their tax-exempt status by the beginning of 2011. As a result, a large portion of the money that could have been used to pay dividends to the shareholders or reinvest would have taken away by the government. Ultimately, the new tax regime will result in a reduced spending power of all current unit holders and the corporations would become more attractive means of profit generation than the Canadian income trusts are.
Whichever way the Canadian government decides to pitch its hat, Canadian income trusts present and excellent opportunity for investors and should be thoroughly considered for any dispute minded stock portfolio.