Investors (unitholders) create a pool of money and it is invested in income- producing assets, which are placed into a trust. The managers of the trust collect the revenues and pay the expenses of the business in the trust and the excess cashflow is then distributed to the unitholders (usually monthly). Unlike a corporation, the trust does not pay corporate taxes. The unitholders pay tax at their personal tax rate based on the cash distributions they receive from the trust.
Unlike a bond there is no pre-set annual interest rate or maturity date.
Instead the cashflow from the business is distributed to unitholders and the value of the assets underpins the unit price the trust trades at on a stock exchange. There are no guarantees, therefore it is important to concentrate on trusts that own long-life assets with a proven ability to generate the cashflow targeted to pay out to the unitholders.
Current yields are lowest for REITs (8% - 9%), while oil and gas royalty trusts pay the highest yields (12% - 18%), but distributions can vary from month to month as oil and gas prices rise and fall. Oil and gas royalty trusts were paying close to 30% early in 2001 when oil and gas prices rose sharply. Yields from business trusts currently range from 8% - 14%, with the lowest yielding trusts being safer and more conservative.
There are also diversified income trusts, where a professional manager purchases a mixed basket of income trusts into a fund (similar to a mutual fund). This offers smaller investors the opportunity to own a diversified portfolio of different businesses. The managers earn approximately a 1% management fee, which is deducted before distributions are paid. They are also exchange traded and offer yields of 9% - 11%.
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Most income trusts held in non-registered accounts (outside RRSPs, RRIFs, etc.) receive favourable tax treatment. Depending on the income trust, part of the unitholder's distributions are considered a return of capital. This is not taxed as ordinary income in the year that it is received. The return of capital component reduces the adjusted cost base of the trust units, ultimately deferring tax until the units are sold, triggering a capital gain which will then be taxed at 50% of the unitholder's marginal tax rate.As with most investment products, income trust unit prices and cash distributions can rise and fall, depending on the nature of the business that the trust owns. Most trusts pay monthly cash distributions, while some pay quarterly. These products should not be considered a fixed income product like a bond. Income trusts offer a higher yield and favourable tax treatment. If a longer term view is taken, this asset class could produce 8+% annual returns, which is similar to long term equity market forecasts, but with less price volatility.
[REIN LEE is an Investment Advisor who can be contacted by E-Mail rein.lee@researchcapital.com Telephone 416-860-7758]
