Income Trust Distributions and Taxation

Written by FrugalTrader on Jan 26, 2009 filed under Tax Minimization

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.

Examples

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.

22 Comments, Comment or Ping

1. Traciatim

This may be a silly question, but what happens when you run out of capital to return? Is your distribution now simply cut in half?

Lets say that Fictional Income Trust (FIT) is selling for $100 per unit, and is yielding 5%, 50% of which is interest, and 50% is ROC.

In year 1 you get 2.50 in interest, 2.50 gets returned to you making your ACB $97.50. So you buy this when your 25 looking to retire in 40 years at 65, at 65 you have no capital to return. Do you now just get back the 2.50 of interest (assuming nothing else has changed in 40 years [yeah right])?

Jan 26th, 2009 @ 10:05 am
2. Finance Matters

I keep all my ITs in my RRSP as well, just to cut down on the headache of tracking all the different types of income come tax time.

Jan 26th, 2009 @ 10:09 am
3. Dividend Growth Investor

I have always been under the impression that the only reason why Canadian Income Trusts can maintain high yields is because of very high returns of capital. 2 out of the three trusts in your example however have a very small portion of distributions which actually are ROC. That’s very odd..

Jan 26th, 2009 @ 10:24 am
4. David V

Traciatim: No, if you had all of your capital returned you’d continue to get ROC. The company doesn’t know who has what and when the they’ve been fully paid back.

Ultimately you could have an ACB of -$100, but under tax law that gets bumped up to zero.

Jan 26th, 2009 @ 10:35 am
5. Traciatim

David V, are you sure it would get bumped up, then you would have untaxed capital gains. For some reason I can’t believe that the CRA would let things go untaxed like that :)

Jan 26th, 2009 @ 10:55 am
6. FrugalTrader

That is a great question Traciatim. I will have to do some digging to find the answer to that one. Mean while, if you happen to stumble upon the answer, please report back.

Jan 26th, 2009 @ 11:25 am
7. Frog of Finance

I think that when your ACB has been reduced to $0, any further ROC has to be declared as a capital gain for the year.

So, for example, if your ACB for 2008 was $200 and the trust sends you a tax slip with $250 as ROC for 2008, your ACB gets reduced to $0 and you have to report a (realized) capital gain of $50.

Jan 26th, 2009 @ 11:32 am
8. Arthur

Stoopid question: What are the negative aspects of ROC? I am having some difficulty understanding this. The way I see it, you’re getting your money back; that should be a good thing right?

Jan 26th, 2009 @ 1:50 pm
9. Charles in Vancouver

Arthur: ROC can create the illusion that a company or fund is earning money for you when really they’re just giving your own money back. Any time they make a ROC distribution it’s going to ding the value of the investment unless they’re so immensely profitable that their unit price is still going up.

The idea with investing is that you’re making extra money on top of your principal, right? ;)

Jan 26th, 2009 @ 2:50 pm
10. Jewels (from MTL)

Thanks for the post FT. I’ve always wondered what the difference was with income trusts and dividends. Now I know it’s a lot more complicated than I thought. I guess those will be for my RRSP’s or TFSA as well ;o))

Jan 26th, 2009 @ 6:24 pm
11. Patch

Never knew I had to track those different streams of income…screw that, into the TFSA you go!

Jan 26th, 2009 @ 7:28 pm
12. Mark

Does anybody know the tax structure for dividends in Canada? 50% of your capital gains are taxed at your marginal rate if I am correct. How would dividend taxation compare to this?

Thanks in advance

Jan 26th, 2009 @ 10:32 pm
13. Traciatim

I think Frog of Finance is correct:

return of capital
not taxable
reduces adjusted cost basis (ACB) of units
the reduced ACB results in higher capital gain (or lower capital loss) when units are sold
if the ACB is reduced below zero, the negative amount is reported as a capital gain, and the ACB is reset to zero.

. . . Found on taxtips.ca, David V was almost correct, just left out the part about it becoming an instant forced capital gain.

Jan 27th, 2009 @ 7:06 am
14. LongTime Smither

Thank you for this article. Your argument is mostly correct, but there is one small flaw to your thought process about not investing in IT’s outside of a RRSP or TFSA.
To say not to invest in IT’s because the taxes are too high is kind of like saying I won’t work overtime because I will be taxed more, or, I will turn down that bonus that was offered to me for the same reason.
There are times when investing in IT’s can be better than normal dividend corporations. Especially if the goal is to create an income stream from the investment.
Please let me explain. Let’s pretend their are 2 investments. The first is in an IT that pays a distribution of 10%. The distribution is at or near 100% income/interest (similar to ARC Energy). The second investment is in a corporation that pays out a normal dividend of 4%.
Now lets say that I put $10,000 in each. At the end of the year the IT will have payed out $1,000, while the corporation payed out $400. My marginal tax rate is around 40%. This means the IT payout will cost me around $400 in taxes, leaving me with an after tax profit of $600. I’m going to stop the math right there. Because it doesn’t matter how little in tax I pay for the dividend I’m still up $200 before the dividends are taxed. After taxes it would be closer to $300. Almost half.
This math was applied to an IT that paid out 10%. Just imagine the gap if the pay out was higher.
Now this thought process would not work on a REIT or something similar that only pays out 6-7%. At that point it comes down to which stock has more of an upside in long-term market gains.
But again, if one is looking to create an income stream, good quality high yielding IT’s should not be automatically ingnored for a non registered account.
My personal “Smith” account has around a 50-50 mix between dividends and IT distributions. Last year I averaged around 10% in yields which gave me a gross profit of around $6,000 that was put directly to paying down my mortgage.
I will be taking advantage of TFSA’s for possibly REITS or a business trust.

Please let me know what you think.

Jan 27th, 2009 @ 12:57 pm
15. Tax Resource

With respect to return of capital (ROC). The payment automatically reduces the adjusted cost base of the trust unit. When you sell the units in the future, you will have a higher capital gain.

However, the question was asked above as to what happens if your ACB falls to zero. When ROC reduces ACB to zero and further ROC is an automatic capital gain when it is received.

Jan 27th, 2009 @ 1:48 pm
16. CanadianFinance

I plan to use my TFSA room for income trusts starting next year and going forward. This first year I’m going to finally setup an emergency fund.

Feb 2nd, 2009 @ 2:38 pm
17. 7

Wait… I’m confused…
I thought the distributions from income trusts aren’t taxed.

According to:
http://en.wikipedia.org/wiki/Income_trust
“the trust structure avoids any possible double taxation that comes from combining corporate income tax with shareholders’ dividend tax.”

Wiki also mentions “like Canadian REITs, mutual fund investment trusts have been exempted from taxation.” Does taxation of the distributions depend on the type of trust?

Mar 2nd, 2009 @ 7:53 pm
18. 7

Nevermind… I read more about ROC…

Mar 2nd, 2009 @ 8:17 pm
19. FrugalTrader

7, the trust itself pays very little or no tax. However, the government has to get their tax dollars somewhere along the line, which means if the trust isn’t paying the tax, the investor is.

Mar 2nd, 2009 @ 11:07 pm
20. Narajin

I don’t get how return of capital will affect my ROC?

Can anyone clarify that (maybe with an example)?

Mar 6th, 2009 @ 2:22 pm
21. FrugalTrader

Narajin, here is some more info on ROC:
http://www.milliondollarjourney.com/how-return-of-capital-works.htm

Mar 6th, 2009 @ 2:26 pm
22. Narajin

So the way I see it is ROC is deducted on the cost of investment. But you can reinvest the ROC right away and that wouldn’t lower your adjust cost base. Would that work?

Mar 6th, 2009 @ 2:45 pm