Chasing Higher Yields Up North

Canadian income trusts are attractive, but there are tax issues for U.S. investors

Unless you listen regularly to the buzz of the Canadian business press, word of the widely popular investments called Canadian income trusts will not have reached your ears. But this is a story U.S. investors will find worth listening to.

These trusts from up north raise capital through an offering of units, or shares. For the most part, trusts use that money to acquire the equity and debt of a single operating company. Because the trust is required to distribute most or all of its cash flow to investors, the trust-owned companies are managed in order to produce cash -- lots of it. Often, the original owner retains an interest in the trust and, under a management contract, will direct the operations.

Traditionally, the trusts have invested in oil, gas, and real estate. But the newer ones have been expanding into other businesses with a stable cash flow and little need for new capital investment, such as food processors, pulp mills, even casinos. Over the past three years, thanks mostly to the creation of these so-called business trusts, the number of Canadian income trusts has doubled, to nearly 200.

In fact, American investment bankers tried to import the Canadian model here in a structure called income depositary shares, or IDS. Since late 2003, a handful of companies in the U.S. have gone public with this model -- including B&G Foods, a food processor; Centerplate, a concession-stand operator; and Otelco, a telecom service provider. But investor demand for IDS never materialized, so many companies that want to do this are going public in the hot Canadian market.


Indeed, Canadian income trusts have been on a roll. They racked up a total return of 29% (in Canadian dollars) for the 12 months ended Feb. 28, 2005, according to BMO Nesbitt Burns Trust Composite Index. Add in a currency kicker, an 8% appreciation in the Canadian dollar, and the return for U.S. investors jumped to approximately 37%.

The trusts have shown their stuff over a longer period, too. The five-year total return is 202%, with another 18% currency bonus. They've become so popular that they now account for some 12% of the overall Canadian stock market. That figure is bound to grow because later this year, income trusts are slated to be included in Canada's broad market index, the S&P/TSX Composite Index. That will surely increase demand as institutional investors attempt to replicate the index.

With robust returns and yields up to 12%, there must be a catch. "These are high-yielding equities, not bonds," says John Archer, an investment adviser with RBC Dominion Securities in Montreal. "There is no protection of principal and no guarantee of the dividend payout." And complex tax rules for reporting the distributions make these investments a bit tricky to own.

Investors should consider a few criteria before investing in an income trust. Look at the ability for a trust's underlying business to continue to generate a stable cash flow. Standard & Poor's in Toronto assigns a stability rating to trusts, on an SR-1 to SR-7 scale, with SR-1 the best. It says there's strong reason to think the trust can sustain its distributions with few fluctuations. The lowest rating, SR-7, shows little confidence in the trust's ability to generate a steady flow of cash distributions. Not all trusts have ratings because they don't want to pay for them.

Since these investments are bought mainly for yield, any cut in cash can devastate the stock price. Ken Manget, managing director at BMO Nesbitt Burns in Toronto, says he has seen trust prices fall as much as 40%. Fortunately, that hasn't happened too often. Since the beginning of 2004 only 8% of the trusts have cut their distributions, while some 40% have increased them, and 52% have held them constant, according to BMO Nesbitt Burns.

Investors need to do the same research they would do before making an investment: Look at the company fundamentals, its position in the marketplace, and the general economic climate. Liquidity is important, too, so you'll "want to pick from the 35 or so companies that have a market cap of $1 billion or more (Canadian dollars) and are widely followed in the research community," says Dirk Lever, head of business trusts for RBC Capital Markets.

One such giant is Fording Canadian Coal Trust. It's the world's second-largest producer of metallurgical coal, a necessary ingredient in the production of steel. The price of this coal has doubled from $60 to $120 per tonne (metric ton) in the past year, and steel mills can't get enough of it. Currently, the trust yields 4.4%, but because of price increases that take effect next quarter, yields are expected to jump to about 14%, say analysts. Can that be sustained? That, in part, depends on continued strong demand for steel.

Superior Plus Income Trust, which yields 7.6%, is a different sort of business trust. Instead of one business, it's in three, but Superior is a market leader in each of them. As a propane distributor, Superior has a nearly 60% share of the Canadian market. It is also the world's second-largest producer of chemicals used to bleach pulp for papermaking. Finally, Superior distributes building materials.

Another business trust, the Yellow Pages Income Fund, a publisher of directories, is acquiring ADS Holdings, also a directories publisher. The deal will make Yellow Pages the nationwide leader with some $6 billion in revenues (in Canadian dollars). It also has a high payout of 97% of cash flow and a stability rating of SR-2.

Some of the largest trusts, all in the energy and natural-resources sectors, are listed and traded on both the Toronto Stock Exchange and a U.S. stock exchange. The advantage of investing in these trusts shows up at tax time. They make life a little easier for U.S. investors by reporting their distributions in line with the U.S. tax code. "The tax issues are not a question of what form to file but rather how you present the income," says Gary Gartner, the attorney who heads the U.S. tax group for Torys LLP, a law firm in New York and Toronto.

Basically, the cash distributions from trusts are made up of a taxable dividend and a nontaxable return of capital. Trusts that trade only in Canada use local accounting rules to break down the distribution. For the most part, U.S. investors in those trusts end up reporting the distributions to the Internal Revenue Service using the Canadian figures.


For the dividend, the question is whether it is qualifying -- and thus subject to a U.S. income tax of no more than 15%. The tax on nonqualifying dividends can be as high as 35%. Most dividends paid by income trusts are considered qualified dividends.

Of course, dividends earned abroad are often subject to another country's withholding tax. The Canadian government collects withholding tax on the total distribution, both the dividend and return of capital. To avoid paying taxes twice, U.S. investors can claim a foreign tax credit on IRS Form 1116. For dividends, the credit is usually dollar for dollar.

The tax on the return of capital is trickier. The U.S. doesn't tax such distributions. Instead, investors are supposed to reduce their reported cost of the investment by the amount of capital returned. Then, when they sell, they have a larger capital gain, which gets taxed at the 15% capital gains tax rate as long as the investment has been held at least one year. U.S. investors can recover the amount withheld by Canada on the return of capital. To do that, they can use the same Form 1116 to calculate and report an "excess foreign tax credit." The one drawback is that you can't use that credit until the next tax year.

Admittedly, that's a lot of work at tax time. But the hard part is doing it the first time. The benefit of earning those higher yields keeps on going.

By Toddi Gutner

    Before it's here, it's on the Bloomberg Terminal.