Income Trust - Tax Characteristics

Tax Characteristics

In a typical income trust structure, the income paid to an income trust by the operating entity may take the form of interest, royalty or lease payments, which are normally deductible in computing the operating entity’s income for tax purposes. These deductions can reduce the operating entity’s tax to nil. The trust in turn, "flows" all of its income received from the operating entity out to unitholders. The distributions paid or payable to unitholders reduces a trust's taxable income, so the net result is that a trust would also pay little to no income tax. The net effect is that the interest, royalty or lease payments are taxed at the unitholder level. (Source: Department of Finance Canada.)

1. As a flow-through entity (FTE) whose income is redirected to unitholders, the trust structure avoids any possible double taxation that comes from combining corporate income tax with shareholders' dividend tax.
2. Where there is no double taxation, there can be the advantage of deferring the payment of tax. When the distributions are received by a non-taxed entity (like a pension fund), all the tax due on corporate earnings is deferred until the eventual receipt of pension income by participants of the pension fund.
3. Where the distributions are received by foreigners, the tax applied to the distributions may be at a lower rate determined by treaty, that had not considered the forfeiture of tax at the corporate level.
4. The effective tax an income trust owner could pay on earnings could actually be increased because trusts typically distribute all of their cashflow as distributions, rather than employing leverage and other tax management techniques to reduce effective corporate tax rates. Certain investors, particularly those in the highest tax brackets, could be significantly worse off investing in income trusts compared to traditionally structured corporations. While the benefits of trusts for tax-deferred and tax exempt entities are clear, trusts are clearly less attractive for other investors facing high marginal rates.