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Stocks, Bonds etc.  ->  Investing Tax Issues -> Income trusts

Tax Treatment of Income From Investments in Income Trusts

The following information is regarding investments which are held outside of RRSPs or other registered accounts.

Cash distributions from income trusts can be made up of:

bullet interest and other income
bullet 100% taxable
bullet taxable Canadian dividends
bullet more than 100% taxable, but eligible for dividend tax credit 
bullet capital gains
bullet 50% taxable
bullet return of capital (ROC)
bullet not taxable
bullet positive ROC reduces the adjusted cost basis (ACB) of the units
bullet the reduced ACB results in higher capital gain (or lower capital loss) when units are sold
bullet if the ACB is reduced below zero, the negative amount is reported as a capital gain, and the ACB is reset to zero.
bulletnegative ROC increases the ACB of the units

The tax treatment of cash distributions are reported to unitholders on T3 slips, which must be mailed by March 31 each year.  The percentages allocated to each type of income may vary over time.  The history of taxable distributions can usually be found on  the website of an income trust.

Negative Adjusted Cost Base

Return of capital (ROC) is reported in box 42 of the T3 slip, which is described as "amount resulting in cost base adjustment".  If the ROC reduces the ACB below zero, the negative ACB is reported as a capital gain on line 132 of Schedule 3 of your tax return.  Since there is no actual sale of units, line 131 (proceeds of disposition) will be zero.  The negative ACB will be shown as a negative amount in the adjusted cost base column, which results in a capital gain on line 132 (gain or loss).  The ACB of your trust units are then deemed to be zero.

Specified Investment Flow-Throughs

On October 31, 2006 the federal government announced new rules for the taxation of "specified investment flow-throughs", or SIFTs.  SIFTs will generally include publicly-traded income trusts, as well as publicly traded partnerships holding significant investments in Canadian properties.  These changes will apply in the 2007 tax year for income trusts that begin trading publicly after October 2006, but will not apply until 2011 for income trusts that were traded publicly prior to November 2006.

Under old rules, when calculating taxable income, income trusts could deduct the income and capital gains paid to unitholders.  Any remaining taxable income was taxed at the highest personal tax rate of 29%, plus applicable provincial taxes.

Under the new rules, SIFT trusts will not be able to deduct most of these amounts (non-portfolio earnings).  However, the tax rate that is applied to the "distributed non-portfolio earnings of a SIFT trust" will be reduced to a rate equivalent to the corporate tax rate (21% in 2007), plus 13% for provincial taxes.  The distributed non-portfolio earnings of the SIFT trust will be taxed in the hands of investors as Canadian dividends eligible for the enhanced dividend tax credit.

Undistributed taxable income of a SIFT trust will still be taxed at the old rates.

Return of capital (ROC) treatment will not change - distributions of ROC are not deductible to the trust, and not taxable when received by investors.  The ROC amounts reduce the cost basis of the investor's holdings of the trust.

Tax Tip:  Whether to hold income trusts inside or outside a registered account depends on the make-up of the cash distributions.  If they are mostly interest, they should be inside a registered account.  If they are mostly Canadian dividends, capital gains, or return of capital, they should be outside.

We do not recommend income trusts for the novice investor, because:

bullet the majority of them are small companies, which are riskier than large companies
bullet many are in the resource sector, which is more volatile than other sectors
bullet they pay out most or all of their earnings, leaving little or nothing to grow the company
bullet the bookkeeping can be complicated
bullet many are run by management companies which are well paid and may get large bonuses based on factors not influenced by their management ability.
bullet they usually trade at higher price/earnings, price/sales, price/book etc. multiples

Canada Revenue Agency (CRA) Resources

T4037 Capital Gains Guide:  See Chapter 3 - Special rules and other transactions

Specified investment flow-through (SIFT) trust income and distribution tax (for trust administrators)

Revised: October 26, 2023


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