What is an Income Trust?

An income trust is a trust that owns businesses in order to pay most of the profits and cash to investors � generally monthly or quarterly. Traditional businesses keep most of their profits in order to expand their business. In contrast, income trust companies buy businesses and manage them with the goal of giving most of the profits and cash to investors. Units of income trust companies are traded like equities on major stock exchanges.

Types of Income Trusts

Generally, income trusts can be divided into four types: business trusts, oil and gas royalty trusts, utility trusts and real estate investment trusts (known as REITs). Income trust companies usually buy a variety of commodity-type companies and products, including real estate and oil & gas. More recently, they have branched out, buying paper mill equipment, sardines, fast food and even peat moss companies.

Some Things to Consider

Income trusts don\\\\\\\\\\\\\\\\'t guarantee returns, cash flows or capital appreciation. Payments to investors may change from period to period because these payments depend on the cash flows from the businesses that the income trust manages. If the cash flow earned from the investments is not enough to keep up the required high yields, the income trust manager may draw on your capital to make up the difference. That means even a full return of capital is not guaranteed unless clearly stated. Income trusts are sometimes viewed as having lower risk than equities, but they may actually carry equity-like risk.

Special Features

Income. Income trusts generally operate as flow-through of income to investors. Any income retained by the trust is taxed at the highest marginal tax rate, which may not be efficient to low marginal tax rate investors.

Tax Efficiency. Some income trusts pay a distribution that includes a portion of the investor\\\\\\\\\\\\\\\\'s capital investment in trust units. The return of capital is not immediately taxable to investors but reduces the original cost base of the investment. Consequently, investors will have increased capital gains when they sell the income trust units. This is a more attractive scenario since capital gains are taxed lower than both interest income and dividends. In addition, capital gains are included in income only when sold, not annually as with interest and dividends.

Are They Right For You?

Remember that income trusts may have equity-like risk. That means they may be too risky to hold as your main investment. In order to avoid making a bad investment decision, thorough research and knowledge of the companies that are supplying the cash flow is required. A safer alternative to buying income trust units directly is to take advantage of income trust units through a professionally managed mutual fund. A number of mutual funds invest in this asset class. Many have fairly unique structures that make them difficult to compare to each other and few have long track records. It is necessary to dig into the holdings of these products to pick one that is structured to meet your specific goals. As usual, it\\\\\\\\\\\\\\\\'s best to speak with an advisor before plunking your hard earned dollars down.

For more information, contact John Klotz at johnk@lms.ca or phone (416)-595-7484 ext. 305