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New Income Trust Fund Gives Investors a Significant Tax Break

by Wayne Cheveldayoff, 2003-05-22

Barclays Global Investors Canada has launched a new exchange-traded index fund that gives investors a much more tax-efficient way of investing in income trusts.

The new fund, known as the Barclays Advantaged S&P/TSX Income Trust Index Fund, is designed to replicate the returns of the S&P/TSX Income Trust Index, which currently includes 40 of the largest income trusts in Canada and was recently showing an annualized cash yield of 11.74%.

The new fund had a reasonably good reception when launched in mid-May, as there were buyers for 18 million units at a price of $10 per unit.

Barclays has appropriately named the new fund “advantaged” because the tax advantages of the fund could be quite substantial to certain investors holding income trusts outside of registered plans such as RRSPs or RRIFs.

Investors in this new fund will pay lower income taxes than if they invest directly in the exact same portfolio of income trusts that is in the income trust index or, for that matter, in most regular mutual funds that focus on the income trust sector. The reason is that Barclay’s has engaged in some fancy financial engineering to ensure that the monthly cash distributions are treated only as either return of capital or capital gains.

Normally, cash distributions from income trusts are split for income tax purposes into three components: income (taxed at regular rates); capital gains (of which only half is taxed as income); and return of capital (which is not subject to income tax in the year received but lowers the adjusted cost base of the investment and is treated as a capital gain when the investment is eventually sold or redeemed).

For each income trust, and each income trust mutual fund, the amount attributed to the three categories can vary widely, but most have at least some taxable income in the cash distribution.

Barclays has found a way to get around the “income” designation. Through a complex process involving a forward agreement with the Bank of Montreal, cash distributions to investors in the Barclays Advantaged Fund (to begin in July) will be treated only in the two most favourable ways, as return of capital or capital gains. The details of this arrangement can be fully reviewed in the fund’s prospectus at www.sedar.com.

What this boils down to in practical terms is that investors will receive cash returns (less fees) equivalent to those of the S&P/TSX Canadian Income Trust Index but with a significantly lower tax liability.

The savings for some investors could be substantial. For example, investors in real estate investment trusts (REITs), which comprise one group in the income trust sector, receive a substantial amount of their cash distribution as income. Cash distributions from the Barclays index fund that invests in Canadian REITs (based on the S&P/TSX Canadian REIT Index) are split roughly into 41% income, 56% return of capital and 3% capital gains.

Of course, as with any financial engineering, there is an additional fee that investors must pay. However, in this case, it appears modest and shouldn’t completely reduce the attractiveness of the tax break to investors paying the highest marginal rates. The total management expense ratio (MER) of the Barclays Advantaged Fund is 1.1% (half to Barclays and half to the Bank of Montreal). This is higher than the 0.55% MER for the Barclays REIT index fund. But it is well below the standard 2.0% to 2.5% MERs usually charged for actively managed mutual funds.

Someone switching to the Barclays Advantaged Fund from a regular mutual fund that invests in income trusts could cut the MER approximately in half and get the added tax break as well.

Would the investor be giving up pre-tax cash return by going to an index fund? This is a hotly debated issue in the investment community. The facts, which apply in general, are that some actively managed funds do outperform the respective index they are measured against, but the historical evidence shows that few can do this consistently year by year. Also, the index usually outperforms more than 50% of funds in any given year.

In this case, taking into account both the lower MER and the tax advantages, the index option has a good chance of consistently beating, on an after-tax basis, most of the actively managed funds that focus on income trusts.


Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at wcheveldayoff@yahoo.ca.



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©2003 Wayne Cheveldayoff