Income Trust Tax not as bad as some think

The income trust taxation announced by the Canadian Government on halloween 2006 is somewhat misunderstood.

1) Canadians in the highest tax bracket who hold their trusts in a taxable account will see little if any decline in after tax income. However, Canadians with little or no taxable income (ie the dividend tax credit is non-refundable) will feel the full effect of the trust tax. This Trust tax actually screws the low income investor and investors who have retirement accounts.

2) USA investors with trusts in the non-taxable accounts will find that there will be no more 15% withholding tax on distributions that will go into that account, reducing the net effect of the Trust tax up to 50%.

3) USA investor placing certain trusts into a retirement accounts, they will be hit with little or no tax (except for tax paid by the income trust under the new trust tax regime) and no 15% withholding tax, which is somewhat better than investing in the current income trust structure.

4) Some investors are under the mistaken impression that the distributions of all trusts will decline by 31.5% starting in 2011. That is not necessarily true. There are oil and gas, pipeline, power and other infrastructure income trusts that will pay no tax or minimal tax for years after 2011 due to tax pools and depreciation allowances on assets.

5) It appears the income participating units (units that consist of a common share plus a bond "stapled" together) will not be affected by the trust tax. If this strtucture is allowed I think we will see some existing trusts convert to this structure and new IPO's issued using this structure.

Income Participating Security (IPS)

IPS (Income Participating Security), also known as a “stapled” security (like DR.UN) consists of a piece of equity ownership and a piece of debt, which get traded together (some can be separated which are called "paper clipped units").

Each month, they pay a "dividend" and the remainder is interest. These types of income producing securities are not subject to the distribution tax on trusts that was announced on October 31, 2006.

These types of securities do not pay distributions. They pay “dividends” and they pay interest on its debt most of which is held by the same people that own the equity.

The Canadian Government seems to have exempted these types of securities from the new "Trust Tax". However, we are all waiting for the final legislation before we decide how to go forward.

If this type of structure is exempted from the new Trust Tax then I suspect we will see quite a few of the existing Trusts convert to this format.