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Canadian income trusts have always involved far more risk than most investors realize. This is why we’ve recommended so few of them in the past.
Income trusts are a type of investment trust that holds income-producing assets. Their units trade on stock exchanges, but they flow much of their income through to unit holders as “distributions.”
On January 1, 2011, Ottawa imposed a tax on distributions of income trusts. The new tax put income trusts on an equal tax footing with regular corporations.
Virtually all Canadian income trusts then converted into conventional corporations. But some are still out there: mostly real estate investment trusts (REITs).
Investing in trusts — and in particular oil and gas trusts — was risky, as the businesses that underpinned them needed steady cash flow. But that could stagnate during economic downturns. At the same time, we believed that investors should have looked for trusts with low capital expenditures and mature businesses.
More about Canadian Income Trust taxes
Canada offers special tax treatment for Canadian income trusts. When they flow their income through to their unitholders, they don’t pay much if any corporate tax. Investors pay tax on most of the distributions as ordinary income (although some distributions qualify as a tax-free return of capital).
Ottawa feels the income-trust business structure is appropriate for real estate investment trusts, or REITs, so it has exempted REITs from the income-trust tax.
Real estate investment trusts resemble Canadian income trusts, but with a key difference: REITs invest in income-producing real estate, such as office buildings, shopping centres and hotels. (We cover a number of carefully selected income trusts and real estate investment trusts in our Canadian Wealth Advisor newsletter.)
Regardless of whether or not they have converted, the basic tests we use to ferret out good investments and reject bad ones still apply, not only to Canadian income trusts, but to other types of investments, as well.
Keep “Investment Inputs” in mind when judging income trusts, or any investment
In evaluating investments, many investors focus on what we’d call “investment outputs,” such as earnings, dividends, cash flow, return on equity, sales growth and so on. These are all important, of course, but you shouldn’t focus on them to the exclusion of what you might call “investment inputs.”
Investment inputs are harder to work with than investment outputs, since it takes a judgment call to determine their risk or value. To give you a better idea of what we mean, here are 10 keys to picking the best Canadian income trusts and real estate investment trusts. We look each before recommending any income trust: Continue Reading…
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