Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Canadian Income Trust

What it is:

A Canadian income trust is a type of investment trust that holds stable, income-producing assets and pays out at least 90% of its net cash flows to its unitholders (shareholders are known as unitholders in trust lingo). These trusts usually hold assets such as oil, coal, natural gas, or other natural resources, which generally have a steady demand and therefore steady revenues

How it works (Example):

Canadian income trusts usually have no management or employees but are instead run by financial institutions. They are neither corporations nor partnerships. Their distributions are usually monthly or quarterly and like master limited partnerships (MLPs), a portion of them are considered returns of capital, which reduces the investor’s cost basis instead of generating a current tax liability. By paying out most of their cash flows, Canadian income trusts are able to avoid taxation, thus making this business structure very appealing.

Canadian trusts can raise money by issuing shares or borrowing money, and they often use this money to buy new reserves or develop existing properties. This ability to sustain and increase distributions indefinitely is what makes Canadian trusts more attractive to many investors. However, they are not usually listed on American exchanges (although some Canadian trusts are interlisted, meaning they trade both in Canada and in the U.S.) and their values are affected by exchange rates. For example, if the U.S. dollar weakens, then the Canadian dollar is worth more and U.S. investors get an extra kick from the currency exchange.

But because oil and gas are priced in U.S. dollars and the trust's expenses are in Canadian dollars, a falling U.S. dollar can also squeeze profit margins and reduce corporate earnings. For example, let’s assume that today the Canadian dollar is worth about 84 cents to the U.S. $1.00. That means if a Canadian trust pays a $1.00 per share distribution, the payment translates to just 84 cents in U.S. currency. If the greenback strengthens and the Canadian dollar falls, then you'll get even less. But if the buck weakens and the Canadian dollar rises in value, then the investor gets a higher distribution.

The tax implications of investing in royalty trusts are complicated. Canadian energy trusts tend to be more tax efficient than U.S. trusts because they reinvest their cash flow, making their dividends generally eligible for the 15% dividend tax rate. It is important to note, however, that most dividend payments from Canadian trusts are also subject to a 15% Canadian withholding tax. American investors can claim a foreign tax credit on IRS Form 1116, but this can be difficult if an investor is holding the shares in a tax-exempt IRA-type account.

Canadian investments do offer a hedge against the falling U.S. dollar, but for trusts the currency issue is also complex. Foreign companies are harder to track, their financial performance is reported in a foreign currency, and their operations are affected by factors that may not be reported in the U.S. news. Foreign stocks also carry the political and economic risk of their home countries. Additionally, the ticker symbols of some Canadian trusts vary by broker.

Contrary to other dividend-paying securities, dividend yields from trusts usually stay high when the trust’s profit (and hence the unit price) rises. Likewise, when earnings fall, dividend yields from energy trusts usually suffer. This happens because when the price of the underlying assets is high, the trust makes more income, which it must then pay out. The reverse is also true: lower commodities prices mean lower profits, which mean lower distributions and a lower unit price.

Why it Matters:

Royalty trust distributions are more volatile than MLP distributions because they generate income directly from the production of commodities, which are very price sensitive. Although this means more risk for the investor, royalty trusts are also a way to participate in the commodities markets without entering the futures market. Regardless, some income investors might find the tight commodities correlation and the distribution volatility too risky, even if that risk can be mitigated through diversification.

It is important to note that Canadian income trusts differ from American income trust trusts.

American income trusts commonly focus on maintaining their existing assets rather than making capital expenditures. They generally distribute cash until their natural-resource assets are depleted (this is why knowledge of a particular trust’s reserves is important). The high payout of American trusts may be attractive in the short-term, but the downside is that it leaves the trusts with very little cash for future growth.

Distributions from American income trusts are taxed as regular income rather than at the lower 15% dividend tax rate and investors may have to file tax returns in the states where the trust operates. Fortunately, investors don't pay taxes on a portion of these distributions until they sell their units. Unitholders are also entitled to certain deductions based on the depreciation of the trust's assets.