It's time for a rematch in the battle between dividend stocks and income trusts for the allegiance of investors seeking income.
Trusts have had the upper hand with seniors and other income investors because they offer the highest yields around. But dividend stocks have come on strong thanks to the federal government's announcement that it will lighten the tax load on dividends paid by public corporations starting in 2006.
Trusts are still king if you want the highest possible income, but dividend stocks will be surprisingly competitive on an after-tax basis. The appeal of dividends is all the greater when you consider that you're more likely to get a reliable, even growing, stream of dividends from the average blue-chip stock than you are to get an uninterrupted flow of cash distributions from the average income trust.
If you're investing in a registered retirement account, where taxes are deferred until you make a withdrawal, then the proposed changes aren't a consideration at all. The choice between trusts and dividend stocks must be decided strictly on the investment merits.
In taxable accounts, dividends would be more competitive with trusts than they used to be under the government's proposals despite substantially lower yields. While the monthly cash distributions paid by a trust yield anywhere from 5 to 20 per cent, depending on the riskiness and growth potential of the trust, dividends paid by public corporations typically yield 1 to 4 per cent.
The lighter tax treatment on dividends makes them worthy of consideration for income seekers, however. At a personal income tax rate of 46 per cent, $100 in distributions from income trusts would leave you with an after-tax amount of $54, assuming the trust paid out only income.
Number-crunching by TD Economics shows the federal dividend tax cut would have the effect of producing a tax rate on dividends of 26 per cent immediately, down from about 32 per cent this year. The effective tax rate on dividends would fall to something like 23 per cent if the provinces matched the federal move with dividend tax cuts of their own, and ultimately down as low as 21 per cent as a result of changes on the corporate level that will fully take effect in 2010. At the end of the process, then, $100 in dividends would produce $79 in after-tax income.
Now, let's factor taxes into the comparison of the yields from trust distributions and stock dividends. Paul Hickey, a national tax partner with KPMG, said a trust yielding 7.4 per cent before tax would produce the same after-tax income as a stock with a dividend yield of 5 per cent, assuming a 21-per-cent tax rate on dividends and a 46-per-cent rate on regular income. With a 4-per-cent dividend, you get the same after-tax benefit as a trust yielding 5.9 per cent before tax.
An underlying assumption in this comparison is that the trust distributions are considered straight income and thus taxed at an individual's maximum rate. Some trusts include a small return of your invested capital in their distributions, which would be taxed at the more favourable capital gains rate.
The bottom line here is that even with the lower tax hit on dividends, trusts are still the way to go if you want to maximize your income flow. But dividends are a lot more competitive than you'd think if you just compared the pretax yields.
If you're a senior, you'll have to balance the lighter taxation of dividends against a wrinkle that could have the effect of causing a clawback of social benefits like Old Age Security.
The explanation for this can be found in the way in which dividends are taxed. You start by "grossing up" the dividends you receive by 45 per cent starting next year, up from 25 per cent. So if you received $100 in dividends, you'll have to add $145 to your income.
A dividend tax credit is applied to the grossed up amount, so your ultimate tax hit is eased considerably. The problem is that your income is increased by $145, rather than the $100 you actually received. If you receive enough dividend income, the grossed up amount could increase your total income enough to trigger a clawback of social benefits like Old Age Security, the GST credit and the age credit.
"It's a negative for any one getting tax credits that are income-tested," said Aurele Courcelle, a tax expert with Investors Group in Winnipeg.
There are two other matters to consider if you're swayed by the dividend tax cut, one of them being the fact that this measure has not yet been passed into law by a parliamentary vote. The Canada Revenue Agency will start applying the lower rate for dividends paid in 2006, but a federal election would prevent a vote. In that case, the party forming the next government would have to decide whether to follow through or eliminate the tax reduction. If it's eliminated, then the old dividend tax rate would apply and the price of dividend stocks could fall.
Another issue concerns the provinces and their plans to introduce dividend tax cuts that piggyback on the federal cuts. In presenting the potential savings to investors from lower taxation of dividends, Ottawa assumed the provinces match its cuts.
But KPMG's Mr. Hickey said the provinces have the power to follow the federal cut to whatever extent they choose. "It could be the provinces say, this is great, we're on board and we'll reduce our provincial tax rate on dividends," he said. "But there are certain provinces on the East Coast where they have very high taxes on dividends."
For the 2005 tax year, a Newfoundlander in the top tax bracket would pay an effective 37.33-per-cent rate on dividend income, while a New Brunswick resident would pay 37.25 per cent. By comparison, the top Alberta rate would be 24.08 per cent and most other provinces would be the low 30-per-cent range.
Investors will still pay less tax on dividends if their province of residence doesn't lower its own taxes on dividend income. But the case for dividends over trust distributions is weakened.
Beyond taxes, there's risk to consider when comparing trusts and dividend stocks. In this area, blue-chip dividend-paying corporations have a decisive advantage over income trusts.
Many banks and utilities have been paying dividends for decades, often increasing them. Despite all their misadventures over the years, the big banks have not cut or suspended dividends in recent memory. Dividend cuts do happen at blue-chip corporations, as TransCanada Corp. shareholders found out several years ago. But, on the whole, they're rare.
The vast majority of trusts haven't been around long enough to establish the same level of reliability as banks and utilities in terms of their distributions. Stability ratings from Standard & Poor's Corp. and Dominion Bond Rating Service Ltd. (you can view these on Globeinvestor.com's Trust Centre) can give you an indication of how reliable a trust's monthly payout is, but there's no substitute for decades of history.
Another risk was highlighted this week in a report by Accountability Research Corp., an affiliate of Rosen and Associates forensic accountants, that said some trusts aren't generating enough cash from operations to fund their distributions. To make up the difference, they're paying back some of the investor's capital or borrowing the money. Trusts can get by temporarily without enough money coming in to fully finance distributions, but eventually they either have to cut or suspend the payout.
Where does all this leave our showdown? Let's say that trusts are the way to go if you have to maximize your income flow in a taxable investment account, if you can live with the higher risk attached to their distributions and if you're willing to do the research necessary to choose quality trusts or, alternatively, find a good mutual or closed-end fund that offers instant diversification.
Dividend stocks are the way to go for those who would sacrifice some yield for safety. Starting next year, that sacrifice will be easier to make.
Comparing two tax systems
The federal government's move to lower taxes on dividend income will make the returns from dividend stocks more attractive on an after-tax basis when compared to income trust distributions. Here are some specific examples how this would work, with an assumption that an income trust would pay out straight income that receives no special tax treatment and thus would be equivalent to interest income.
Existing dividend regime
Assume top federal provincial combined marginal tax rate on dividends of 32 per cent, and 46 per cent on interest and regular income.
3% dividend yield produces the same after-tax income as 3.8% pretax yield from a trust or interest-paying investment
4% dividend yield produces the same after-tax income as 5% pretax yield from a trust or interest-paying investment
5% dividend yield produces the same after-tax income as 6.3% pretax yield from a trust or interest-paying investment
Proposed dividend regime
Assume top federal provincial combined marginal tax rate on dividends of 20.6 per cent and 46 pre cent on interest and regular income. This assumes that the provinces will also reduce their tax on dividend income to target rate of approximately 6 per cent assumed in the federal proposal.
3% dividend yield produces the same after-tax income as 4.4% pretax yield from a trust or interest-paying investment
4% dividend yield produces the same after-tax income as 5.9% pretax yield from a trust or interest-paying investment
5% dividend yield produces the same after-tax income as 7.4% pretax yield from a trust or interest-paying investment
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