What Is a Canadian Income Trust?
- A Canadian income trust is an investment fund that holds income-producing assets and distributes payments to unitholders, or shareholders, on a periodic basis.
- Canadian income trusts usually hold assets that generate consistent demand and steady revenues, such as oil, coal, natural gas, or other natural resources.
- Distributions from a Canadian income trust can be volatile because they generate their income from the production of commodities, which are subject to frequent price fluctuations.
Understanding Canadian Income Trusts
The units of a Canadian income trust are traded on a stock exchange, but they pass on the majority of their income to unitholders through distributions. These trusts usually hold assets that have consistent demand and generate steady revenues, such as oil, coal, natural gas, or other natural resources.
Canadian income trusts are run by financial institutions and usually have no management or employees. Because a portion of their distributions are considered returns of capital, Canadian income trusts generate less tax liability for investors and reduce their cost basis. By paying out most of their cash flows, these trusts are able to avoid taxation, thus making this business structure very appealing.
These trusts can raise funds by issuing shares or borrowing money. They often use this capital to buy new reserves or develop existing properties, and this ability to increase their distributions over time makes Canadian income trusts appealing to many investors. However, their values are impacted by exchange rates.
Advantages and Disadvantages of a Canadian Income Trust
The tax consequences of investing in Canadian income trusts are complex. For U.S. investors, these trusts can be more tax-efficient than U.S. trusts. Canadian income trusts reinvest their cash flow so their dividends are generally eligible for the 15% dividend tax rate. However, it is important for U.S. investors who are interested in investing in a Canadian income trust to keep in mind that payments from these trusts are subject to a Canadian withholding tax of 15%. In some cases, depending on where the shares are held, it's possible for U.S. investors to claim a foreign tax credit with IRS Form 1116.
There are additional challenges that can arise when U.S. investors decide to invest in a foreign trust. Foreign trusts are harder to track; their performance is reported in a foreign currency; and they may be impacted by geopolitical events that are not reported in the U.S. news.
In addition, many investors do not realize how much risk is involved in investing in Canadian income trusts. Distributions can be volatile because these trusts generate their income from the production of commodities, which are subject to frequent price fluctuations. For investors who want to participate in the commodities market but are not ready to enter the futures market, Canadian income trusts can be a good option. The risk of this kind of investment can be mitigated through a diverse portfolio.