What it is:
A royalty trust is a type of corporation created to act as the owner of the mineral rights to wells, mines and similar properties. It exists only to pass income generated from the sale of the property's assets (gold, oil, etc.) to shareholders. No income tax is paid at the corporate level as long as the bulk of income (at least 90%) is passed-through to shareholders in the form of distributions or dividends.
How it works (Example):
Royalty trusts are most common in the U.S. and Canada. In the U.S., an outside company performs the actual operations of the properties and the trusts are not allowed to acquire additional property. The trusts are neither partnerships or corporations and usually have no management or employees but are instead run by financial institutions. Other companies actually produce the resources and pay royalties to the trust.
The typical energy royalty trust holds production rights to a group of oil and gas fields. Generally, the oil and gas fields held are mature and will gradually be depleted over a number of years. Until the fields are fully exploited, they continue to produce solid cash flows with minimal need for investment: infrastructure to pump, store and transport oil are already in place. It is these safe, stable cash flows that back up the trust's large distributions.
In essence, owning a trust is like owning a piece of a continued stream of oil and gas production.
Types of Royalty Trusts
There are two main types of trusts: American and Canadian. American income trust 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.
In the mid-1980s, Congress limited the types of assets trusts could hold. Furthermore, U.S. trusts were no longer allowed to fund new acquisitions by either issuing new units or raising debt capital. Now when their reserves run dry, U.S. energy trusts have no value and are dissolved. In addition, thanks in part to this legislation, U.S. trusts' distributions do not qualify for the recently-reduced 15% tax rate on dividends.
Canadian trust law never changed as drastically as in the U.S. As a result, many Canadian royalty trusts are able to now pay double-digit percentage yields and offer income investors tax-advantaged exposure to the lucrative energy market. 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. Investors should note that recent legislation may change the taxation of Canadian trusts, thereby limiting their yields.
Why it Matters:
The tax implications of investing in royalty trusts are complicated. Distributions from U.S. 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 because they are considered returns of capital, which reduces the investor's cost basis rather than generating a current tax liability. Unitholders are also entitled to certain deductions based on the depreciation of the trust's assets.
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.
As mentioned earlier, the Canadian government has formed recent legislation that would initiate the taxation of Canadian trusts on a corporate level. While nothing is definite, it is possible that this could severely limit the future distributions of these trusts.