These 2 royalty trusts can protect their distributions from the 2011 trust tax

Starting in 2011, Ottawa will impose a tax on distributions of income trusts, including royalty trusts. This will put trusts on an equal tax footing with regular corporations.

Many trusts are converting to corporations as a result. Some are even cutting their distributions. However, as we noted in a recent issue of Canadian Wealth Advisor, two royalty trusts have an enviable advantage when it comes to dealing with the new tax.

Oil and natural-gas producer Enerplus Resources Fund (symbol ERF.UN on Toronto) has over $2.5 billion of tax losses on its books. It can use these to defer its conversion to a dividend-paying corporation until 2013 or later. Similarly, Pengrowth Energy Trust (symbol PGF.UN on Toronto), which also produces oil and gas, has $3.0 billion in tax losses that it can use to hold off the trust tax until at least 2013.

While this flexibility adds to the appeal of these two trusts, we think factors like these should only make up part of your investment decisions. Below are 11 questions to ask yourself when you’re considering investing in royalty trusts. A trust must satisfy all of them to win our recommendation in Canadian Wealth Advisor.

Royalty trusts: Use these 11 tips to get the complete picture

1. Do you have any doubts about the integrity of the insiders?

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2. Did the royalty trust buy its assets in the midst of a recent boom, or has it owned them for some time? If it bid for assets in the midst of a boom, it may have paid too much.

3. Which of the five sectors is the royalty trust in: Manufacturing & Industry, Resources & Commodities, Consumer, Finance or Utilities? In royalty trusts, as in ordinary stocks, the first two tend to be riskier, the last two tend to be safer and Consumer is somewhere in between.

4. How much debt is the royalty trust carrying? If trusts carry too much debt in relation to their assets, their distributions can fall more sharply when their business hits a snag.

5. Is the business dominant, or at least prominent, in its industry? Royalty trusts that are not significant players in their industries face higher risks.

6. How much of its cash flow is the royalty trust paying out? Paying too much means a royalty trust may be forced to cut its distributions, especially when the 2011 trust tax kicks in. Conversely, trusts with low payouts are more likely to leave them at today’s levels, even with the new tax.

7. Has the trust’s cash flow and profitability shown acceptable performance in relation to the rest of its industry? If a royalty trust can’t make money when business is good, when can it make money?

8. Are there any special factors worth considering? With resource royalty trusts, you need to look at how long its reserves are likely to last, as well as any other special factors.

9. Is the industry stable or cyclical? If it’s cyclical, is it currently in a high or low part of the cycle?

10. Is the royalty trust (or the industry it’s in) the subject of a lot of favourable broker and public-relations attention? If so, investor expectations may be too high, and that leaves the trust vulnerable to a steep downturn when there is any hint of bad news.

11. Is the royalty trust’s current and prospective yield high enough to justify the risk? On the other hand, a very high yield may signal danger rather than a bargain.

If you’re looking for royalty trusts that are well prepared to deal with the looming 2011 trust tax, you should subscribe to Canadian Wealth Advisor. As with Enerplus and Pengrowth, the newsletter’s high-quality royalty trust selections are well prepared for 2011 and beyond. Click here to learn how you can get one month free when you subscribe today.

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