What is a Canadian income trust?
Key points to remember
- A Canadian income trust is an investment fund that holds income-producing assets and periodically distributes payments to unitholders or shareholders.
- Canadian income trusts usually hold assets that generate constant demand and stable income, such as oil, coal, natural gas or other natural resources.
- Distributions from a Canadian income trust can be volatile because they derive their income from the production of commodities, which are subject to frequent price fluctuations.
Understanding Canadian Income Trusts
Units of a Canadian income trust are traded on an exchange, but they pass the majority of their income on to unitholders through distributions. These trusts generally hold assets that have a constant demand and generate stable income, such as oil, coal, natural gas or other natural resources.
Canadian income trusts are managed by financial institutions and generally have no officers or employees. Because a portion of their distributions are treated as returns of capital, Canadian income trusts generate less tax liability for investors and lower their cost base. By paying out most of their cash flow, these trusts are able to avoid taxation, which makes this business structure very attractive.
These trusts can raise funds by issuing shares or borrowing money. They often use this capital to purchase new reserves or develop existing properties, and this ability to increase their distributions over time makes Canadian income trusts attractive to many investors. However, their values are influenced by exchange rate.
Advantages and disadvantages of a Canadian income trust
The tax consequences of investing in Canadian income trusts are complex. For US investors, these trusts may be more tax-efficient than US trusts. Canadian income trusts reinvest their cash flow so that their dividends generally qualify for the 15% dividend tax rate. However, it is important for US investors wishing to invest in a Canadian income trust to keep in mind that payments from such trusts are subject to a 15% Canadian withholding tax.In some cases, depending on where the shares are held, it is possible for U.S. investors to claim a foreign tax credit with IRS Form 1116.
Additional challenges can arise when US investors decide to invest in a foreign trust. Foreign trusts are harder to track; their performance is reported in a foreign currency; and they can be impacted by geopolitical events that are not reported in US news.
In addition, many investors do not realize the risk involved in investing in Canadian income trusts. Distributions can be volatile as these trusts derive 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 may be a good option. The risk of this type of investment can be mitigated through a diversified portfolio.