You no doubt are aware of how popular income trusts became in the financial markets over the past few years. While this form of investment has been around for years, most notably in the real estate and resource sectors, it has burgeoned recently into every sector of the economy.
Taxation of trusts is a little bit tricky, more like mutual funds (which themselves are, normally, trusts) than like regular stock investments. In particular, some of the cash stream that you receive may not be taxed as income, but is instead non taxable “return of capital”. The T3 slip reporting system tells you everything you need to know for any particular year.
However, one item on that slip is a notation called “return of capital”. You need to note this for the future because it has later tax implications, either upon sale or perhaps even before! Depending upon the particular trust and how long you hold it, this can create quite a surprise later on.
Specifically, tax law says that the return of capital becomes a deduction from what you actually paid for the investment when you bought it. When you eventually sell the asset, your cost base for tax will be the original cost reduced by these returns of capital over the years, which mathematically creates a higher capital gain on the sale.
However, there may be tax implications even if you haven’t sold it yet. Once the total return of capital over the years exceeds what you originally paid, then that negative amount is supposed to be taxed as a capital gain in that year (even though you still own the asset). This has the effect of restating your cost base back up to zero. Any return of capital in that following year would again be taxed as a capital gain, and so on into the future.
From a tax compliance point of view, the interesting thing is that few tax practitioners, and even fewer taxpayers preparing their own returns, likely keep track of the accumulating returns of capital to know when the cost base has been driven below zero. Instead, they may flush out this problem only when they sell the asset and sit down to figure out the tax implications that year. Even then, when they sell the asset, they may not know to make the “return of capital” adjustments.
We recently had a client who sold an oil and gas trust unit which she had held for 11 years. She sold it for $18,296. Her original cost was $11,000 and we ascertained that her returns of capital totaled $13,842 over the 11 years. The result, as you can figure, was a capital gain of $21,138, and an unexpected tax bill including OAS clawback exposure.
In the modern digital world, you likely can research the historical “return of capital” information on the trust unit’s website, if you do not have an adequate history of T3 slips.