Income Trust Distributions and Taxation
There has been a little bit of confusion in the comments regarding how income trust distributions are taxed. The confusion is in what the distributions are composed of. Typically, when you look at a stock on the market with a distribution, you can safely assume that it’s a dividend. Dividends are great as they are paid out of company pockets with after tax dollars which means a tax break when received by the investor.
Income trusts (stock symbols ending in .un) are different however. Even though they have a distribution that appears like a dividend, they are not always tax friendly. Since income trusts flow through their pre-tax income to investors, it’s the investors who face the bulk of the taxation.
Income Trust Distributions and Tax Implications
Income trust distributions are typically made up of 4 components.
- Return of Capital – You may be surprised to hear that a large portion of some income trust distributions are based on return of capital. What is return of capital? It’s basically taking shareholder money and returning it back to the shareholder. Return of capital is not taxed immediately but reduces your adjusted cost base. In a taxable account, this defers the potential increased capital gains taxation until you sell.
- Other Income/Interest – Other Income (ie. interest) is also usually a large portion of the distribution. Any interest received in a non-registered account is taxed 100% at your marginal rate.
- Dividends – This is typically a smaller portion of income trust distributions but is very tax efficient.
- Capital Gains – Capital gains is another popular method of distributions and is taxed 50% of your marginal rate.
Lets take a look at some popular real world income trusts and their distributions. I typically look into a particular companies distribution by visiting the company website.
- Arc Energy Trust (AET.UN) – A popular energy income trust with distributions that consists of 97% income/interest and 3% return of capital (ROC).
- Calloway REIT (CWT.UN) – This is a popular REIT that specializes in commercial properties. The distributions (2007) consist of 45.3% income/interest and 54.7% ROC.
- Yellow Pages (YLO.UN) – The distributions of this popular brand consists of a wide mix of income sources. 1% capital gain, 1% non-eligible dividend income, 5% eligible dividend income, 2% ROC, and 91% other income/interest.
Tax Efficient Strategies
As you can see from the examples above, there’s no set pattern as to how the distributions are divided. As you can see though, other income is typically a large percentage of the distribution which in a taxable account, is taxed at your marginal tax rate. In addition to that, any ROC distributions need to be tracked as it reduces the adjusted cost base of the held position in a non-reg account.
As the taxation (and tracking) of an income trust can be inefficient, I personally keep my income trusts in a tax sheltered account like an RRSP or TFSA. In fact, one of my TFSA strategies is to create an income fund as the distributions can be withdrawn completely tax free. As I have very little exposure in the REIT market, I may start my research there.