Comments on: Income Trust Distributions and Taxation

By: Narajin

Narajin — Fri, 06 Mar 2009 18:15:56 +0000

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?

By: FrugalTrader

FrugalTrader — Fri, 06 Mar 2009 17:56:57 +0000

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

By: Narajin

Narajin — Fri, 06 Mar 2009 17:52:54 +0000

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

Can anyone clarify that (maybe with an example)?

By: FrugalTrader

FrugalTrader — Tue, 03 Mar 2009 02:37:33 +0000

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.

By: 7

Mon, 02 Mar 2009 23:47:00 +0000

Nevermind… I read more about ROC…

By: 7

Mon, 02 Mar 2009 23:23:19 +0000

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?

By: CanadianFinance

CanadianFinance — Mon, 02 Feb 2009 18:08:45 +0000

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.

By: Tax Resource

Tax Resource — Tue, 27 Jan 2009 17:18:05 +0000

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.

By: LongTime Smither

LongTime Smither — Tue, 27 Jan 2009 16:27:33 +0000

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.

By: Traciatim

Traciatim — Tue, 27 Jan 2009 10:36:49 +0000

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.

By: Mark

Mark — Tue, 27 Jan 2009 02:02:14 +0000

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

By: Patch

Patch — Mon, 26 Jan 2009 22:58:45 +0000

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

By: Jewels (from MTL)

Jewels (from MTL) — Mon, 26 Jan 2009 21:54:48 +0000

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))

By: Charles in Vancouver

Charles in Vancouver — Mon, 26 Jan 2009 18:20:17 +0000

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? ;)

By: Arthur

Arthur — Mon, 26 Jan 2009 17:20:51 +0000

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?

By: Frog of Finance

Frog of Finance — Mon, 26 Jan 2009 15:02:57 +0000

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.

By: FrugalTrader

FrugalTrader — Mon, 26 Jan 2009 14:55:01 +0000

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.

By: Traciatim

Traciatim — Mon, 26 Jan 2009 14:25:30 +0000

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 :)

By: David V

David V — Mon, 26 Jan 2009 14:05:16 +0000

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.

By: Dividend Growth Investor

Dividend Growth Investor — Mon, 26 Jan 2009 13:54:21 +0000

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..