Our Canadian Income Trust Plan
By Tom Dyson
March 24, 2008
A hydroelectric power plant is a slab of concrete with a generator, a turbine, and a connection to the power grid. There is no maintenance, fuel, or operating cost. You don't even need any employees. Computers control the sluice gates.
Once you've built the dam, it will provide you with dividends forever.
Revenues from dams are inert as a lead weight. You sell your power to utilities in long-term contracts. These contracts might span 30 or 50 years. You build in a provision for inflation, check the utility's credit, and then you collect your perpetuity. Revenues from hydroelectric power plants don't care about panics on Wall Street, recessions, or wars in the Middle East.
The dam rises in value, too, so your investment keeps up with inflation.
Pipeline investing is the same way. Once you've sunk the tube and attached the valves, there's nothing left to do but sit back and collect dividends. And wind farms... Hang a turbine in the wind and watch the cash pour in.
As most income investors know, Canada is in the process of scrapping its income trust structure – the rules that allow companies to avoid corporate taxes if they funnel their earnings to shareholders (or "unit holders").
This decision has created months of uncertainty in the market and made income trust unit holders among the most confused investors around... On the one hand, the income trust structure seems like a sinking ship. At the same time, many of these companies remain high-quality, stable operations paying generous dividends – some as high as 25%.
I want to collect these huge dividends. (Who doesn't?) But like a lot of investors, I'm worried about the government's new tax laws.
I have good news. Although most income trusts will suffer under the new tax regime, a few of the trusts – and their hefty dividends – will be safe. It's not easy to figure out which are safe. Here's where to start.
The details lie in the minutia of tax accounting. Distributions from income trusts come in two parts. There is return on capital. The government counts this part of the distribution as income and will tax it. Then there is return of capital. The government counts this as capital gain and does not tax this portion of the distribution.
Every income trust publishes information on how it breaks down its distributions. It's usually in the "investor relations" area of its website. You'll see a trust breaks down the dividend by nontaxable return of capital, taxable return on capital (or income), and foreign earnings.
You'll find the distribution from most Canadian income trusts is close to 100% taxable return on capital. The new tax law will reduce these distributions by a painful 29.5%.
Here's the thing: Trusts that make large investments in infrastructure – like pipelines, hydroelectric power stations, and wind farms – paid only a fraction of their earnings as taxable return on capital.
It's because of the way Canada allows infrastructure trusts to account for the depreciation of their assets. They're allowed to say their assets are "wasting away," and the government lets them label their distributions as non-taxable return of capital. Now the taxable portion of their dividend streams is small, and the new taxes won't bite as hard.
This loophole creates one of the most compelling income investments I've ever seen. You get to own high-quality infrastructure assets that produce dividends forever. And these dividends rise with inflation.
Safe infrastructure assets in the U.S. might spin off 6% dividends a year. But because of the uncertain tax situation in Canada, you can buy these same assets with double-digit yields through the Canadian income trust market.
So that's what we're looking for: Income trusts that make investments in infrastructure. If you can find these income trusts, you'll have a way to earn huge dividend yields long after the 2011 tax legislation begins...
Good investing,
Tom
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