Income trusts have been in the news a lot lately. More companies are reorganizing themselves as trusts. The federal government made headlines by attempting to limit investment in trusts by pension plans, but eventually backed off. Overall prices fell by 12% in the spring before rebounding to a new high. What are income trusts, and why are they getting so much attention?

Simply put, an income trust is an alternative to incorporation as a means to organize and own a business. Companies are incorporated provincially or federally, subject to various Business Corporation Acts. They are taxed as separate entities and owned by shareholders who are protected from the losses or debts of the corporation. The liability protection is partly why the share structure has been so popular for so long.

Income trusts, which are governed by various provincial Trust Acts, allow businesses to flow taxable income through to unit holders who pay tax at their personal tax rate. This is an important difference, because personal tax rates may be lower than corporate tax rates. Furthermore, if a trust is held in an RRSP, taxation could be deferred for years. This structure not only gives investors a choice in how, and when, to pay taxes on the income, but also avoids double taxation that corporations and shareholders currently suffer (corporations pay dividends to shareholders out of after-tax income; shareholders, in turn, pay taxes on these dividends if they are greater than their personal dividend tax credit).

Trusts are also able to designate a portion of the payout as a “non-taxable return of capital,” which means that the unit holder is taxed only on the income portion. When units are sold, capital gains tax may be payable (if the sale price is higher than the adjusted cost base). Tax treatment of the payout varies with each trust and will suit each investor differently.

Investors like trusts, because they provide a stream of cash flow that can be more tax efficient than other income sources. CRA doesn’t like trusts, because it would prefer to have the tax money sooner rather than later. Businesses like trusts, because the structure can be more advantageous for investors, which leads to higher valuations and greater ease in raising capital. In particular, businesses with a long life expectancy that are earning more than they can profitably re-invest are prime candidates for the trust structure.

Income trusts come in many flavours. Utility trusts’ incomes are subject to regulation; therefore, utility trusts, like utility equities, fall when interest rates rise. Resource trusts are dependent on commodity prices and the projected life of the resource. Business trusts should be indifferent to interest rates. The real question is, “What will happen to the business?” not, “What will happen to interest rates”?

The rules that apply to investing in equities also apply to investing in income trusts. Cash flow is critical to their long-term valuation, as with any security. Management quality is also key. Diversification and fit in your personal portfolio are important, too. Talk to your advisor to find out more!