What are Canadian Income Trusts

By definition, an income trust refers to an investment establishment that holds debt instruments, equities, real properties, or royalty interests. What makes these investments particularly attractive is the fact that they yield high cash, which is especially important in the conditions of global economic crisis and market stagnation. Also, income trusts are stable and predictable investment establishments, as they are not allowed to expand their business activities to unrelated economic sectors. If, for example, an income trust operates in the energy sector, it cannot make forays to the sector of gambling and vice versa. Although the concepts income fund and income trust are often used interchangeably, income trusts are with a narrower scope of business activities in comparison to funds. At present, income trusts are among the most popular investment instruments in Canada.

However attractive income trusts may be for their high yield and certain taxation preferences, it is also true that they pose some serious risks to investors. First and foremost, investors in income trusts can’t rely on some important safeguard provisions, embedded in the Canada Business Corporations Act, and they are seldom, if ever, allowed to elect a board of directors. Second, income trusts cannot guarantee return of capital or minimum distribution to their investors. In other words, if a company starts losing money, the trust can simply turn off the distributions tap. Also, if the interest rates in the treasury market go up, the trust units, which are the equivalent of a company’s shares, may start losing their value. Last but not least, the shareholders’ capital may decline over time, because an income trust fund is designed to pay out more than the net income.

Economists have estimated that two-thirds of the biggest Canadian business trusts pay out more than what they earn. Finally, because a trust’s value is boosted by tax reduction or deferral, it may drop significantly, Canadian Income Trustsif the federal government changes the current tax legislation with a view to limit the income trusts’ taxation benefits.

As to the taxation principles regarding income trusts, the income that an operating entity pays the trust is deductible from the entity’s taxable income, because it is paid in the form of lease payments, royalty or interest. As a result, the tax payable by the operating entity can be reduced to zero percent. On the other hand, the income trust pays out distributions to its unitholders, which in turn reduces the trust’s taxable income, while all taxes due are payable by the unitholders.

Depending on their business activities, income trusts in Canada fall in four general categories:

Investment trusts – established on a community principle, these trusts deal with a variety of investment instruments including bonds, stocks, futures, etc.

Real estate investment trusts – as it is suggested by their name, these investment trusts invest primarily in income-generating real properties or mortgage-backed securities.

Royalty/energy trusts – these trusts are dealing with the exploitation of oil wells and coal mines and other natural resources.

The last category includes the so-called business income trusts – business entities that for tax reasons converted a portion of or their whole stock equity into an income trust capital structure.