Friday, 30 January 2009

Income Trusts: a Neglected Opportunity?

Income trust investors have had a bad time in recent years. First came the 17% downward price hit from the federal government's announcement Oct.31, 2006 that henceforth such trusts, except for qualifying REITs, would be taxed like corporations. Then came the credit crunch market collapse of 2008, which has seen their price fall significantly more than the rest of the market - in the graph below compare the TSX Income Trust Index (red line) and an ETF (green line, symbol XTR) of income trusts to the TSX Composite (blue line).

The downtrodden and unpopular can provide investing opportunity! There are some enticing indicators of substantial reward too. But first ...

What are Income Trusts?
Key Features:
  • a form of equity security - distributions are not guaranteed like debt, hence riskier
  • frequent (often monthly) and substantial cash distributions - used by investors for regular income
  • traded on a stock exchange but are called units not shares and are distinguishable by the addition of the suffix UN to the symbol, e.g. BA.UN.
  • unlike investment trusts and mutual funds which own baskets of assets or shares in many companies, income trusts are confined to a single company.
  • wide variety of business types and thus differing stability or risk
Shakespeare's Primer on Trusts and the Wikipedia article on Income Trusts provide more detail.

Why the attraction now?
HIGH YIELD! At current low prices, the annual cash payout is well over 10% for many income trusts. See this handy extract table from
That's not the end of the story, however, since cash distributions can and might be suspended or reduced, unwelcome though that might be.

What are the risks to distributions?
  1. Payouts too high to sustain the business' underlying needs to service debt and make capital expenditure re-investments. Income trusts may pay out 50-90% of profits on an on-going basis; when it is over 100%, watch out, that will deplete the business if more than temporary or short-term.
  2. Leverage - if the underlying business has a lot of debt relative to revenue, downturns can be fatal.
  3. Rising interest rates - can damage two ways: a) the underlying business runs into debt servicing problems and b) the fund units lose value since the distribution is less competitive with other sources of regular income like bonds; though the distribution may not decline, its value is less.
  4. Falling commodity prices - for funds based on resource stocks, whether oil, gas, minerals or other commodities, the effect on unit prices can be rapid and dramatic as sustained drops will reduce the ability to pay distributions
  5. 2011 and Corporate Tax - expect a one-time hit to distributions of most Income Trusts when the rule kicks in
What to consider in assessing Income Trusts
  • sustainability of distributions - use DBRS Issuer Ratings and Standard & Poors who rate many (though not all) funds for stability of payouts; think how much the distribution could drop before the return would be too harmful; some businesses grow their distributions, they are not just stagnant "cash cows" though most of the expected return will be distributions, not gains on the unit price; sustainability risk is generally ranked like this:
  1. Lowest risk - Power Generation
  2. Low - Pipeline, Telephone
  3. Medium - Real Estate: office, commercial, mortgage, apartment, hotel
  4. High - Business - retailing, restaurants, trucking, cold storage etc
  5. Highest - Oil & Gas Royalty, Commodity
  • tax character of income distributed - this varies with each fund - some provide mostly dividends, others primarily interest / other income, others a mix of capital gains with dividends; this affects where the fund goes best, in a registered or taxable account
Where to find Income Trusts
Note that this post is not meant to be an investment recommendation. It is merely to illustrate current conditions.

Tuesday, 20 January 2009

ETFs and Mutual Funds - Calculating Capital Gains

The previous post on this blog explained that an investor must calculate the capital gain when he/she sells a mutual fund or ETF and must report that gain on his/her annual tax return. This post now explains how to figure out the capital gain.

Step 1: The first number to calculate the gain is the amount you receive, quite straightforwardly the net cash after deduction of fees and commissions incurred by the sale.

Step 2: The second number is the cost, or the Adjusted Cost Base (ACB) in tax parlance. The formula is:
Total Paid to Purchase Shares/Units (plus fees and commissions)
Reinvested Distributions (all of Capital Gains, Income and Dividends)
Return of Capital (ROC)
ACB of Previous Sales of Shares/Units

The ACB changes with each purchase, distribution and ROC over the years the fund is owned. The ACB is a running total for the fund. There is no selling oldest or newest shares first, they are all mixed together.

Mutual fund companies generally keep track of the ACB and you can see this on statements or obtain this information from them but they also advise to do the calculation yourself since most disclaim liability for possible inaccuracy due to situations such as deemed dispositions and incomplete return of capital deductions.

The ETF companies cannot provide the ACB of your holdings (iShares explains why in this FAQ); you must do the calculation yourself for ETFs using the data on the T3 slips and brokerage detail statements for the T3 (box 21 = capital gains; box 42 = ROC).

It is important to track ACB because if you do not, you will be paying taxes twice on reinvested distributions - once when reporting the gain on the T3 and again when you sell part or all of the holding. Remember, the higher the ACB, the less the capital gain and the less tax there is to pay.

The chart below shows examples of ACB tracking calculations for a mutual fund and for an ETF. Note especially (see yellow cell) that when an ETF reinvests capital gains distributions, no additional shares are issued or created, as explained in the iShares FAQ linked above.

The easiest way to keep track of ACB is to do an annual update when the fund companies announce their tax distributions and issue T3 slips for the previous year, sometime around the end of February. The websites of ETF and Mutual Fund companies disclose the annual distributions on a per share/unit basis, which enables the re-construction of past years if statements or T3 slips have been mislaid.

Additional Info:
Managing Taxes from iShares Canada
ETF Tax Information page at Claymore Canada

Disclaimer: this post is not to be construed as advice; it is for information purposes only. Consult a tax accountant or financial professional for proper advice.

Tuesday, 13 January 2009

The Mystery of Fund Capital Gains in 2008 Explained

Investors who own ETFs and mutual funds in taxable accounts (i.e. this does not apply to tax-protected accounts such as RRSPs) may be surprised and puzzled this year to receive T3 tax slips that show capital gains to be reported on their income tax return. After all, in 2008 stock markets had one of the worst years in living memory with the TSX down 35%. How could there be any gains one might ask?

Taxable Capital Gains When the Fund Sells: Investor Sees no Cash
Capital gains (or losses) arise when the fund sells one of its holdings and makes a profit during the year; the investor has not sold anything, the fund has. The net of all the sales during the year is calculated by the fund and the capital gains are attributed to the investor for purposes of tax reporting. Such gains are not usually paid out in cash to the investor; instead they get reinvested within the fund through new purchases.

The TSX had reached a peak in mid-June 2008, so stocks sold within a Canadian equity fund up to that point could well have made a capital gain and if few stocks were sold at a loss during the subsequent downturn before the end of the year, the fund might be reporting a net capital gain for 2008. That does turn out to be the case for instance, with the popular iShares Canadian Large Cap 60 Index ETF (symbol XIU). A press release of Dec.24th says XIU has generated a reinvested distribution of $0.14652 per share, which investors will soon see in box 21 on a T3 slip from their broker to be included on their tax return.

Taxable Capital Gains When the Investor Buys(!)
An investor who buys a fund late in the year just before the year-end capital gains distribution can end up paying tax for gains made much earlier in the year. Funds use the list of owners as of a certain date (termed the record date) to parcel out the year's gains, most often December 30th. The T3 the investor receives tells the tale. It may be better to defer the purchase till the new year. Fund companies normally publish year-end distribution estimates in advance of the record date so that investors can avoid the nasty tax surprise if a big capital gain is in the offing.

Taxable Capital Gains When the Investor Sells: Investor Sees Cash
A separate taxable capital gain (hopefully! or perhaps a loss) occurs when the investor sells all or part of a holding in a fund and the proceeds exceed the net purchase cost. The investor will NOT receive any T3 tax slips from the fund company to use on his/her tax return. It is up to the investor to calculate and report the gain.

Additional Info:
ETFs - iShares Canada Distribution History links for each fund - e.g. for XIU
Claymore Canada Tax Information Guide for 2007 (2008 tba) covering all its funds

Mutual Funds - follow links to fund companies at and look for Tax or Distribution info at each company's site; a typical handy guide is Mackenzie's Mutual Fund Tax Guide

As always, this post is not to be taken as advice. If you are unsure how to handle distributions, contact an accountant or other financial professional.