Every once in a while, my friend James and his wife Kate visit Carolyn and I. And James always has a hot stock tip to share. Last weekend, he told me that FedEx and UPS were going to amalgamate (which is not true).
"What a dominant company that would be, eh, Tim?" he said.
"That's for sure," I replied.
"And Tim," he continued, "I've heard they're going to call the new company FedUP."
Not to be outdone, I shared a hot tip myself.
"James, bet you didn't know Polygram Records is expected to merge with Warner Bros., and Zesta Crackers," I said. "They're going to call the company Poly Warner Cracker." I'm not sure, but I think he called his broker the next day to buy a few shares.
Now, if you're looking for a real hot tip, consider a royalty trust. There are more than just a couple of tax reasons to look at them.
The example: Take my friend James again. He had $10,000, and rather than investing in Poly Warner Cracker, he invested in units of XYZ royalty trust this year. His adjusted cost base (ACB) is $10,000. XYZ trust then used the $10,000 to acquire a right to royalties from Opco Inc., a company that then uses the $10,000 to buy oil and gas properties. Follow me so far?
Opco earned $1,000 net profit (after a Crown royalty, costs of production, transportation, marketing, management fees, and other costs) from selling oil and gas this year. Opco then paid the $1,000 to XYZ trust as a royalty. XYZ trust then paid the $1,000 to James.
Is James taxed on the $1,000 distribution? Only partly. You see, when XYZ trust acquired the right to royalties from Opco, it became entitled to pools of deductions known as Canadian oil and gas property expense (COGPE) and Canadian development expense (CDE). These pools can shelter from tax the distributions made.
So, James received a $1,000 cash distribution from XYZ trust, but just $350 was taxable (varies by trust, and by year). The other $650 was sheltered from tax using the COGPE and CDE pools in the trust. For 2005, James will receive a T3 slip showing the taxable portion of $350.
The $650 tax-free portion of the distribution will reduce James' adjusted cost base dollar-for-dollar, so that his new ACB is $9,350 ($10,000 less $650). If James sells his XYZ trust units in the future for, say, $10,000, he'll trigger a capital gain of $650 ($10,000 proceeds less $9,350 ACB). That capital gain will be just 50 per cent taxable.
The benefits: Talk about multiple tax benefits. Consider these: There's a form of tax arbitrage in that distributions received from royalty trust units will be higher than you'd receive from the same investment structured as common shares, because there is little or no tax at the corporate level.
The royalty trust structure eliminates tax at the corporate (Opco) level by siphoning the profits out of the company as royalties. The structure avoids tax at the trust level because all net royalty income of the trust is distributed to the investor. The distributions from the trust can be a tax-free return of capital to the extent of COGPE or CDE in the trust.
There's a deferral and permanent reduction of tax since, when cash is paid as a return of capital, there is no tax on that amount until the trust units are sold, and then the tax is on a capital gain, at half the tax rate of royalties.
Tim Cestnick, FCA, CPA, CFP, TEP, is a tax specialist and author of Winning the Tax Game 2005 and The Tax Freedom Zone.
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