4 ways to prepare for the coming tax on income trusts

Ottawa’s new tax on income trusts comes into effect just over a year from now, on January 1, 2011. When it does, it will put trusts on an equal footing with regular corporations.

Right now, trusts pay out a high percentage of their cash flows to their unitholders. This lets them avoid paying corporate taxes. It also gives many of them significantly higher yields than a lot of dividend-paying common stocks.

The new tax will eliminate these income-tax benefits. That will prompt some income trusts to convert to conventional corporations. Others may choose to remain as trusts. (For our latest advice on income trust investing, and how trusts should fit into your overall portfolio, be sure to download our free report, “Canadian Stock Market Basics: How to Trade Stocks and Make Good Investments in Canada.”)

If you invest in income trusts, now is a good time to start preparing for the new tax. Here are four possible strategies:

1. Look for trusts that don’t plan to cut their distributions. Regardless of whether income trusts choose to convert to conventional corporations, they will have less cash to distribute to unitholders once they begin paying corporate taxes. That will prompt some to cut their distributions.

The biggest cuts will come from trusts that now pay out a very high percentage of their cash flows as distributions. That’s often a sign that they’re struggling to remain profitable. So, when looking for income trusts to add to your portfolio, look for those with lower payout ratios (less than 75%, say). That’s a good indicator that they will be better able to maintain their distributions once the tax kicks in.

2. Hold income trusts outside of your RRSP. If you hold trusts outside of a registered plan, such as an RRSP or RRIF, you will not see a large change in your after-tax position in 2011— even though the distributions you receive will likely drop by 26.5% (based on the current corporate tax rate). That’s because distributions will be taxed as dividends, and Canadians benefit from the dividend tax credit.

However, if you hold income trusts in a registered plan, you will receive a 26.5% lower distribution, but with no offsetting tax benefits on dividends. When you eventually withdraw the distributions from your RRSP or RRIF, you’ll pay tax at the same rate as ordinary income.

So, if you want to hold your trusts past 2011, you should consider swapping them out of your registered plans for cash held in a non-registered investment account. That way you can take advantage of the dividend tax credit.

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3. REITs are exempt from the new trust tax. One way to protect your distributions from the 2011 trust tax is to look to high-quality real estate investment trusts (REITs). That’s because most REITs will remain exempt from the tax, and will likely stay in their current form. (REITs invest in income-producing real estate, such as office buildings and hotels.)

The best REITs have good management and balance sheets strong enough to weather an economic downturn. They also have high-quality tenants, and they carefully match their debt obligations with income from their leases. The best ones are still doing well, despite the economic slowdown, and are taking advantage of low interest rates to refinance long-term mortgages.

We still advise against overindulging in REITs. But high quality REITs can make attractive, low-risk additions to your portfolio.

4. Take trusts’ tax losses into account. Many of the trusts we recommend in our Canadian Wealth Advisor newsletter hold tax-loss pools that they can use to defer the new income-trust tax later in 2011 or beyond.

While this flexibility adds to these trusts’ appeal, we think factors like this should only make up part of your investment decisions. It’s far more important to look to a trust’s overall investment quality, using factors like payout ratio (see strategy #1), cash flow, profitability, industry prominence and so on.

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