Income Trusts

An income trust is an entity created to pay out the cash flow generated by a business in the form of cash distributions to unitholders. Most income trusts are based on businesses that are stable, relatively mature, and have a generous and predictable cash flow. These traits allow much of the cash flow generated by the business to be distributed rather than reinvested. These regular cash distributions (usually monthly or quarterly) are what make income trusts so attractive to investors, especially those seeking income in their portfolios. Often, yields for income trusts can be much higher than for bonds or other fixed income investments.

Also attractive is the tax efficiency of income trusts. Income trusts do not pay corporate tax, thanks to a loophole in Canada's tax laws. Distributions from income trusts are taxed differently from dividends. Also, a portion of the distribution is often treated as a Return of Capital, and the taxes on this portion are therefore deferred. This deferral can reduce the unit holder's adjusted cost base and the amount of capital gains he or she pays when selling the units.

As with all investments, income trusts are not without risk. Although unlikely, the tax loophole could one day be eliminated. The distributions are not guaranteed and may be cut at any time. Even if distributions are maintained, the gains made from the distributions may be wiped out by a falling share price. And, not all income trusts are created equal. Make sure you understand the underlying business well before you invest.

Advantages:

• Offers a higher yields than fixed income investments (7 20%) coupled with the potential for capital appreciation.
• Income trusts can be held inside other funds as a diversified component.

Disadvantages:

• Some income trusts have depleting assets, and part of the yield investors receive is actually a return of their capital.
• Some income trusts have underlying businesses which are not suitable for the trust structure.
• Income trusts are more like equities and less like bonds, as the unit holders have a lower claim on assets, and the yields are not guaranteed, but only an estimate of the return the assets should generate.
• It is difficult to gauge when to take profit and rebalance this type of investment versus other traditional portfolio investments.