INCOME TRUSTS - A Betty Way To Produce Fixed Income
K.K. Choong
Choong & Associates
Every portfolio should contain a portion of fixed income securities. Although they are not the best performing asset, they help to diversify the risks especially during a volatile market.
If you want fixed income but you are not happy with the recent low return generated by investment such as bonds, T-bills and money market, then you may want to consider investing in an income trust.
Income trust is an entity created to pay out the cash flow generated by a business in the form of cash distributions to unit holders. Most income trusts are based on businesses that are stable, relatively mature, and have a generous and predictable cash flow. These traits allow much of the cash flow generated by the business to be distributed rather than reinvested.
These regular cash distributions (usually monthly or quarterly) are what make income trusts so attractive to investors, especially those seeking income in their portfolios. Often, yields for income trusts can be much higher than for bonds or other fixed income investments because they are more tax-efficient.
Investment returns are generally classified as either income, dividends or capital gains, each taxed at their respective rates. Capital gains are considered the most tax-efficient because only 50% are taxable, followed by dividends and then interest income.
Income trusts introduce a wrinkle: return of capital (ROC). Return of capital is, in reality, a label for income tax purposes. It characterizes income that is not interest, dividends or capital gains. In fact, income trust funds may not receive significant income or dividends in any given year and will not see capital gains, unless during the year they sell a particular trust for a profit. But they do receive distributions from the underlying trusts, which are passed on to investors tax-deferred.
For example, let's take a look at two investors who each purchase an Income Trust for $150. Initial each trust has a Net Asset Value (NAV) and Adjusted Cost Base (ACB) of $150. Let's assume that both Income Trusts, through its underlying assets, generate $12 profit annually (prior to distribution). Each trust also distributes $10 per annum.
For investor A, the total $10 distribution is considered ROC, while for investor B, $6 is considered ROC and $4 is interest income. Finally, let's assume that both investors keep their investment at least until yearend.
The chart, below, shows the impact of distribution on the NAV, adjusted cost base, return of capital and reported income.
| | Investor A
100% ROC | Investor B
60% ROC and 40% Income |
| NAV before distribution | $162 | $162 |
| NAV after distribution | $152 | $152 |
| Adjusted cost base | $140 | $144 |
| Return of capital (ROC) | $10 | $6 |
| Income reported | $0 | $4 |
| Total distribution | $10 | $10 |
Both investors receive the same distribution, but investor B owes taxes on the $4 of distribution received, thus reducing after-tax income. The $6 (initial investment $150 - adjusted cost base $144) of ROC will be taxed as capital gain when Investor B will sell his fund at $150. For investor A, the entire $10 distribution will be tax deferred until he sells his fund. At that time when his fund is sold at $150, the $10 ($150 - $140) will be treated as capital gains.
Even though Investor A is receiving higher after-tax income, he's not taking more money out of the fund than Investor B (both A and B still has $152 NAV).
Another thing you need to know is that the return of capital doesn't mean the investor has removed his original capital from the fund. When the original capital is removed, it will reduce its future earning power. Imagine an investor who sells(removes) 10% of his units every year, unless the fund grows faster than 10% a year, at some point in time, the investor will have no assets left. Therefore, every year he was removing at least some of his original principal.
Income trust structures, by contrast, are designed to maintain distributions, without drawing on the original capital invested in the trust. Instead, should an income trust face a cash crunch-because poor performance of its underlying assets, it will most likely cut its distributions.
What is the final impact of tax-deferred income? The market value of the investment has increased, but the book price has actually decreased. When the investment is eventually sold, a capital gain, which is the difference between the book price and the market price, is realized. Although this trigger taxes implications, the investors would benefit from returns being taxed as capital gains. Also, certain investors may have reached retirement and be subject to a lower tax bracket.
If an investor holds onto a fund for a long period of time, taxes will ultimately come due, as return of capital will reduce the investor's original purchase price to zero. This will occur somewhere between 13 to 15 years. At that point, the distributions will trigger taxes. Although it is ' a burden, it is less of a burden than if that same distribution were taxed entirely as income, as it would be from a bond. Hence, the tax-efficient investor still comes out ahead.
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