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Types of income trusts
Tax deferral not always a return of capital

I was going to devote much of this week's article to 'income trust' fund recommendations when I realized there was a bit of education needed before proceeding to that point. Hence, this week's discussion focuses on the sources of trusts' tax deferral and how this compares to the tax deferral offered by high payout mutual funds.

Source of tax deferral

Income trusts can flow through some cash to unitholders on a tax-deferred basis (i.e. taxed later, rather than sooner) thanks to industry-specific tax deductions. The tax deductions typically take the form of "depreciation" - something known as capital cost allowance (CCA) for tax purposes. When a business buys a "capital asset" (i.e. a building, equipment, or any asset whose life is long and used in the business), it cannot deduct the cost outright - as with employee salaries and supplies that are used up in the year - but rather a portion deducted each year to represent the asset's "wear and tear".

Capital assets are, by nature, assets that are used over a period of time. As the logic goes, the amount of the purchase that is expensed each year should also be spread out over time - typically spanning the asset's estimated life. Tax laws further allow certain assets to be depreciated more quickly than others - often as a result of the risk involved. Tax laws governing how quickly assets can be depreciated are also used as a way to induce investment in certain industries.

For instance, when an oil company buys a property it believes to hold some "black gold", it can qualify for special tax credits - both for the property and the equipment used for exploration and oil extraction. Since this is a risky industry, tax credits and deductions are more generous than those given to most other industries. As a result, it's not uncommon for oil and gas income trusts (aka royalty trusts) to defer nearly all of the cash it flows out to unitholders. Hence, royalty trusts offer the largest tax deferral potential.

For real estate investment trusts (REITs), CCA may be taken on buildings, some construction and other costs. REITs generally rank second when it comes to the tax-deferred portion of the total cash distribution - often ranging in the 40 per cent range.

Finally, general business trusts can claim CCA on all sorts of things but the amount is relatively small compared to the overall level of business income generated. The proportion of tax deferral really depends on the nature of (and assets used in) the underlying business.

Return of capital: a case in point

In the case of royalty trusts, the tax-deferred portion of the cash distribution (i.e. CCA) truly represents a return of capital. Since there is only so much oil in the ground, oil properties are depleting assets by nature - i.e. eventually they'll suck it dry. So, how do these trusts maintain a cash payout from a pool of assets with a limited life? In short, they must continue to acquire new properties with long lives. How they achieve that is a threefold answer.

First, a certain amount of total cash generated is kept inside the trust; which allows it to build up cash resources to help finance future property acquisitions.

The second, and most significant way this is achieved is by selling new units in the trust. We spoke last week about a public offering of shares. Existing royalty trusts will go to the market to "shop around" an additional offering of shares if it wants to raise money to finance acquisitions. This can pose a problem, one known as "dilution".

Remember that trusts, just like stocks, have a limited number of shares trading on the stock exchange. Hence, when investors buy and sell units, they do so from and to other investors - not directly from the trust. So, for the trust to raise more money, it has to sell new shares to the public (i.e. a public offering). While a new share offering doesn't affect how many shares each investor holds, it does affect the proportionate amount of total shares held. That implicit cost to shareholders is known as dilution. This can be alleviated if the trust's management is savvy enough to make accretive acquisitions - i.e. the benefits of the acquisitions outweigh the costs of dilution.

Some royalty trusts have been successful in this regard while others have not.

Tax treatment of return of capital payouts

Very simply, when cash is paid out of a trust (be it a mutual fund or income trust), the cost of the investor's holding in the trust for tax purposes is reduced. If the distribution is reinvested, it bumps up the tax cost, for a net effect of 'nil'.

Suppose a fund pays out distributions of $1,000 of business income and $2,000 as a return of capital (for a total distribution of $3,000). If the distribution is taken in cash, $1,000 is taxable while the other $2,000 attracts no tax. If the $3,000 is instead reinvested, the net effect on the investor's tax cost is an increase of $1,000.

When tax deferral is not a return of capital

(For tax purposes all CCA amounts are treated as return of capital; and hence are not taxed when paid. This section discusses CCA in pure economic terms.)

While CCA is considered a return of original investment in the case of royalty trusts, that's not the case with most other trusts. Sure, the CCA deduction each year is an estimate of an asset's usage during the year, in dollar terms. However, it wouldn't be fair to call it a return of original investment.

This is an important distinction due to the proliferation of mutual funds that pay big distributions. The difference: those mutual funds hold primarily regular stocks and bonds. The return of capital feature in those funds is not the result of any special tax deduction, but rather an internal mechanical process.

Interested readers can revisit those high payout mutual funds in three articles previous published in this space: Phantom Yields (December 2001), Reality Check (December 2001), and Payouts Cut (July 2002). The articles can be viewed here.

Clarification

Last week I mentioned that trusts are taxed on all income at the highest marginal rate, which I quoted as 46.4 per cent in Ontario. That's true, but it's worth clarifying that the top marginal tax rate on dividends and capital gains are 31.3 and 23.2 per cent, respectively.

Next Week, without further delay, I'll talk about the class of income trust funds and my top picks.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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