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tax matters

As I look back, 2006 was a year of unexpected costs for me. Oh, these were not costs based on poor decisions on my part. No, these were the result of decisions made by others that cost me money.

First, there was my nephew, visiting from British Columbia for the summer, who got his arm stuck in a vending machine trying to get a chocolate bar after the machine stole his money. The fire department came and finally freed him using axes, crowbars, an air chisel and a rotary saw. I got stuck with the bill.

Then, in October, 2006, there was the Department of Finance, who decided to change the rules around income trusts so that the tax benefit of these investments all but disappeared. That cost me a few bucks as well.

I've got good news all around: My nephew has not been stuck in a vending machine since, and a new breed of income trust has started to appear, tax benefits and all. Let's talk about those income trusts.

The concept

You might recall how income trusts work. They were very tax efficient because it was possible to defer tax for many years. A common structure looked like this: A corporation earns business income, but fully or largely offsets that income by borrowing money from a trust (the income trust) and making large deductible interest payments to the trust. The result was that little or no tax was paid by the corporation.

The income trust would then distribute the income to the end investor, and would claim a deduction for the amount distributed. The result was little or no tax for the trust. Finally, the end investor would often pay little or no tax on the income distributed to the extent the income trust units were held in a registered plan, or the investor was non-resident. Further, some of the distributions were returns of capital, which are not taxable.

On Oct. 31, 2006, the Department of Finance changed things by introducing the Specified Investment Flow-Through (SIFT) rules. These rules levelled the playing field between income trusts and publicly traded corporations by eliminating the flow-through advantages of income trusts. Specifically, the rules cause the Canadian-source income of most income trusts to be subject to tax that is approximately equal to the combined federal and provincial corporate tax rate, and the income distributed to unit-holders of these trusts is taxed as dividends.

The SIFT rules caused a huge reduction in the number of initial public offerings by income trusts and caused many income trusts to convert to a corporate model instead. It was a disappointment for many investors.

The developments

Given that investor appetite for yield is still strong, some creative minds at some of Canada's leading law firms have been looking at ways to use the income trust structure in a manner that side-steps the SIFT rules, and in a manner that should not offend the Canada Revenue Agency.

Enter: The Cross-Border Income Trust (CBIT). You see, the SIFT rules only apply to a publicly traded Canadian trust which holds a direct or indirect interest in the assets of a business carried on in Canada, or in Canadian real estate or resource properties. So, a new generation of CBITs has emerged that are focused on acquiring productive oil and gas assets located in the U.S. or another foreign jurisdiction, avoiding the SIFT rules. It's likely only a matter of time before CBITs also start acquiring the assets of other types of businesses as well.

These CBITs can vary in how they are structured, but basically look like this: A Canadian mutual fund trust (the income trust) owns an interest in a Canadian corporation or commercial trust which in turn owns an interest in a U.S. or foreign operating partnership or corporation, which in turn owns the assets producing the income.

The Canadian income trust also lends money to the entity reporting the operating income. The entity earning the operating income reduces that income (and tax liability) through deductible interest paid to the Canadian income trust on the loan, and through other expenses. The result? Little or no tax paid by the operating business or the income trust itself, and income and capital in the income trust to distribute to investors.

The Eagle Energy Trust and Parallel Energy Trust were the first out of the gate in this new generation of income trust. I'm not going to comment on the investment merits of these, but it's good to know that, for those seeking tax-efficient cash flow, CBITs may be worth a look.