"What are the Risks of Canadian Income Trusts"
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There are 8 risks of Canadian income trusts:
1. Business risk
I don't need to go into great detail here. Basically, an income trust is a business. You won't receive income from the trust unless the business has the money with which to pay you. These businesses are subject to all the usual risks of running a business: competition, rising interest rates, the overall economy, unemployment rates, poor management, marketing failures, technological changes and so on.
Canadian royalty trusts are not magic. Trusts are business structures that are great for their investors, but they're still businesses that must make a profit. If a company with a lousy product or which is poorly managed converts itself from a corporation to a trust, it will still have a lousy product and be poorly managed (unless it goes under new management, which does happen).
In 2005, 18 trusts cut their dividends and 4 eliminated them. Heating Oil Partners became the first trust to declare bankruptcy.
Technically, risks number 2 and 3 are business risks, but they're so specific to so many Canadian trusts that it makes more sense to describe them separately.
2. Depletion of the Income-Generating Asset risk
Many Canadian income royalty funds are natural resource businesses, since Canada is rich in natural resources and commodities. Therefore, it's possible that some trusts will go out of business when their oil wells run dry or their mines are depleted. These are known as wasting assets.
Canadian income trusts are allowed by Canadian law to set aside some of their annual profits for exploration and development of new income-producing assets. Some trusts are doing a better job than others of maintaining their long term viability. Some income trusts are better able than others to expand their asset bases through generating cash flow and obtaining outside financing.
Therefore, you want to own units in trusts that are well-managed for the long term.
3. Asset Price Fluctuation risk
We all know that the price of oil is going up -- but even though, when we're filling our tanks it seems as though the price keeps going up, it does go down sometimes.
It hit a recent peak right after the Gulf hurricanes in the Fall of 2005. It gradually came down from there, but as I write is reaching that former peak again.
I don't know what it'll be when you read this. If there's a major war in the Mideast, it could go quite high. If Toyota comes out with a hydrogen-powered car that costs under $15,000, the price of oil could go quite low.
Other forms of energy such as natural gas, and commodities such as gold, silver and copper, go up and down in price as well.
Your payouts from energy trusts will rise and fall with the price of the natural resources of the business.
Some trusts own energy-related infrastructure such as pipelines and storage facilities. These companies make money as long as oil must pass through their hands. Examples include Altagas and Pembina Pipeline.
4. Legal liability risk
Remember that the major reason for businesses to incorporate is to allow people to invest in a business without incurring any legal liability for what happens in the business. This means that if you own 100 shares of General Motors stock, and someone wins a lawsuit against General Motors, the award comes out of General Motors' cash account, not out of your pocket. You do lose, but only in proportion to how much your ownership interest in General Motors is (that is, how many shares of its stock you own). The lawyers suing General Motors cannot sue you personally even though you are one of the owners of General Motors. Your personal income and assets are safe -- only your percentage of ownership interest in General Motors is at risk.
We take this for granted, but it is important. If you owned 1/100th interest in a candy store, along with 99 other partners (that is, the candy store business is a partnership NOT a corporation), and someone fell and broke their leg in front of your store, their lawyer could successfully sue all 100 of you owners. And you would each owe 100% of the total settlement award. In theory the lawyer could attempt to collect money from any and all of you, but in practice would go after the owners with the most obvious income to garnish or assets to attach.
However, oil income trusts are not corporations, and therefore in the event of lawsuits unit holders in trusts do not have the same automatic limited liability as corporate shareholders do.
To the best of my knowledge, no unit holder in a Canadian income trust has ever been sued, but it legally could have happened, and the possibility, no matter how remote, limited the popularity of these investments.
However, this risk is now over. That's because the provinces of Alberta, Quebec, Manitoba and Ontario (where most Canadian funds are based) have passed laws limiting the financial liability of trust holders to their unit shares in the trust.
Therefore, the way to avoid this risk is to not buy units in a Canadian trust that is not based in one of those three provinces.
5. Political risk
In 2005 the Liberal Party-controlled Canadian government attempted --but failed -- to impose taxation on Canadian business trusts. This became a big issue during the next election. When the Conservative Party barely won on January 23, 2006, trust investors celebrated. The Conservative Party had campaigned on a no new taxes (including on CanRoys) platform.
Then came October 31, 2006 -- the Halloween Massacre -- when Canadian Finance Minister Jim Flaherty announced that almost no Canadian businesses would be allowed to convert to trust status. Plus, beginning 2011, almost all existing trusts (except Real Estate Investment Trusts) would lose their tax exempt status. The minister filed a notice of intent to table a bill in Parliament.
The bill must actually be passed by Parliament and signed into law. About one million Canadian adults own income trusts, and therefore would find their spending power reduced if these trusts are taxed. And they make up about 5% of Canadian voters.
Therefore, it's possible that by 2011 this proposal will be forgotten and that trusts will remain tax-free.
However, nobody can guarantee what Canadian politicians will or won't do now and into the far future.
In United States, the IRS has ruled that all but a few passively managed funds and limited partnerships Canadian income funds are qualifying foreign corporations, which means their dividends are taxed at the 15% rate.
But early in 2007 Democratic Congressman Richard Neal of Massachusetts proposed a bill that would revoke this tax treatment of foreign entities, including Canadian income trusts and REITs.
6. Interest Rate risk
If interest rates in general go up, other investments such as bonds may appear relatively more attractive to investors than Canadian trusts. This could pull down their market price.
But if you're in the market to buy, not sell, CanRoys, this is not a risk, but an opportunity.
7. Over-Distribution of Dividends
Some Canadian income funds pay out to unit holders more than their net income. This is not sustainable in the long run. Therefore, it's a good idea to analyze a fund's cash flow. Compare its annual net profit per unit to its total annual dividend distribution per unit. Dividend distributions per unit should be under 100%, certainly not over.
8. Capital Gains risk
Because Canadian royalty and income trust funds can't reinvest retained earnings as corporations do, they cannot grow their capital as quickly. In theory, this limits the capital price increase in the unit shares.
Investors who want their money to grow through investing in capital gains-oriented corporations, therefore, would not find income trusts attractive. They would have to pay taxes on the money generated by their investment rather than allowing the company to grow it for them through reinvesting the cash.
In some income trusts, some distributions may constitute a return of capital, and therefore would be taxable as a realized (but not desired) capital gain.
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