An Introduction To Canadian Income Trusts

There is a host of income-producing investment options in the market, but few instruments available to the regular investor produce the sort of yields often seen in Canadian income trusts. It is not rare to see yields on these units in excess of 10%, and they typically pay distributions monthly. But they are structured differently from regular corporations (they are trusts, after all), and investors need to recognize and understand what those differences mean for their investment portfolios.

What Are Canadian Income Trusts?
This particular type of investment vehicle goes by several names: Canadian income trust, Canadian royalty trust, or the more colloquial "CanRoy." Whatever name they go by, CanRoys are all corporate trust structures set up to direct royalties or income to trust holders. By legally bypassing corporate taxation, the CanRoy structure allows for larger distributions than would be possible through a normal tax-paying corporate structure.

CanRoys have proved to be a popular corporate structure in Canada, as roughly 10% of the companies on the Toronto Stock Exchange (TSX) are CanRoys. Of that number, roughly 40% (by market capitalization) are energy-related companies, while about two-thirds (by number) operate "regular businesses," which is not energy-related or REITs (as of 2008). (Read about the tax implications of REITs in The Basics Of REIT Taxation.)

Are They Like American Trusts?
There are trusts organized under U.S. laws, but they are very different animals from their CanRoy cousins. American trusts are typically static in that they are not allowed to acquire new assets, nor are they actively managed. By contrast, CanRoys are living, changing, active businesses that are in many cases indistinguishable from regular tax-paying corporations in terms of how they run on a day-to-day basis. (Read more about the benefits of active management in Words From The Wise On Active Management.)

It is also important to note that CanRoys can have an ownership twist. While some trusts are structured with no limits on non-Canadian ownership, others have structured their trust indenture in such a way that non-Canadian ownership is capped at a specified level; if the level is exceeded, the company can force non-Canadian owners to sell their units.

What About the Taxes?
There are many income-producing investments that have special tax treatments, and CanRoys are certainly among them. Before attempting to give some general observations on the tax treatment of CanRoys, it is critically important to emphasize that investors must seek out their own individual tax advice.

Because different CanRoys have different structures, there is some variation in how the IRS regards the distributions. In most cases, the IRS classifies CanRoys as regular operating companies and treats their distributions like dividends. In other cases, the CanRoys are treated as partnerships, and investors receive a K-1 statement each year. This can admittedly be quite confusing, but the good news is that many (if not most) CanRoys provide reasonably detailed information on the tax treatment of their distributions for U.S. unit holders.

Whether the IRS regards the CanRoy in question as a corporation or a partnership is another tax issue to keep in mind: the Canadian government applies a 15% withholding tax to foreign investors. While Americans can generally get this credited back to them when they file their taxes, there are some limits to this credit. It should also be kept in mind that this withholding cannot be credited back to IRA accounts.

To make matters more complicated, there are major potential changes on the way. In 2008, laws were put in place in Canada that will result in CanRoys paying corporate taxes beginning in 2011. While Canadian REITs will be exempt, this change could have major impacts on the CanRoy sector. Some trusts will likely consider converting to a regular corporate structure, while others may look to expand their asset base or sell out entirely. Investors considering an investment in CanRoys should spare a few moments to research the current tax situation for CanRoys in both Canada and America before investing. (Are Bigger Funds Always Better? explores the implications of an expanded asset base.)

How Do You Analyze CanRoys?
One of the attractive aspects of CanRoys is that investors really do not need any additional expertise to analyze these investments. It is crucial that investors remember that they are still analyzing an operating business, and the normal rules apply - a bad business is a bad business, even if it momentarily has a 12% dividend yield. (Read Blending Technical And Fundamental Analysis for more on evaluating a business.)

That said, dividend coverage ratios are more than just an afterthought when analyzing CanRoys; most investors are attracted to these units for the income they provide, so the quality and stability of that income is certainly an important component to the unit price.

American investors should also realize that CanRoys are not widely followed by United States-based brokers. As a result, investors who typically rely on sell-side research to aid their investment process may find CanRoys more challenging than their typical investments. (Evaluating Your Broker can help you make sure yours is giving you the service you need.)

Good News and Bad News
There's no question that CanRoys can be very useful vehicles for some investors:

  • They are often excellent sources of income.
  • Unlike American trusts, they are not wasting assets.
  • The structure of CanRoys may impose a level of discipline on management that is beneficial for investors. There has been some academic research supporting the notion that the obligation of making and maintaining dividend payments steers corporate managements away from value-destructive maneuvers like excessive merger activity. (Read Putting Management Under The Microscope and Top 9 Questions Investors Should Ask Management to ensure you're not being taken for a ride.)
  • CanRoys can also represent better bargains than similar U.S. companies, as many institutional investors shy away from them because of their more convoluted tax treatment.

There are also some disadvantages to CanRoy investments:

  • Investors are sometimes seduced by eye-popping yields and end up investing in badly run enterprises that are not able to deliver on those great income expectations for very long.
  • There are also additional elements of volatility to consider in CanRoy investments. Because of their Canadian operations and their high yields, CanRoys are more sensitive to interest rate and currency fluctuations than the majority of regular U.S. equities.
  • Many CanRoys are energy-related enterprises, and the volatility of crude oil and/or natural gas prices can add yet another element of volatility.
  • CanRoys can also be more difficult to buy, hold and sell for some investors. Many CanRoys are not listed on U.S. exchanges, leaving American investors with the options of buying the stock on Canadian exchanges (which can be inconvenient and expensive through many U.S. brokers) or through the pink sheets, where sponsorship and wide bid-ask spreads are problematic. (Read more about this problem in How do I buy an over-the-counter stock?)
  • Of course, there's also the taxation issue. While the tax treatment of CanRoys is really not so difficult once you do your research and get familiar with the terminology, some investors may still regard it as more of a hassle than they can handle.

The Bottom Line
Canadian income trusts are a very practical option for many investors who would like to increase the income generated from their portfolios. While there are some technical and practical differences, CanRoys really aren't all that much different from corporate equities when you really get to the bottom line. The good companies are sound stewards of investor capital and reliable and trustworthy managers, but it requires some homework and ongoing diligence to maximize the return from these unique income-producing entities.

Canadians can read more about investing strategy in How Portfolio Laziness Pays Off.

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