These Canadian Income Trusts Will Keep Paying Huge Dividends

On October 31, 2006, Canadian Finance Minister Michael Flaherty closed a loophole in Canada's tax code. The next day, $20 billion evaporated from the Canadian stock market.

Canadian accountants call companies that use this tax loophole "income trusts." An income trust is an unusual type of corporate structure that enables a business to avoid tax. When you structure a company as a trust, you give every owner direct partnership in the business. This way, any profit generated by the business flows straight to the owners before the government can tax it.

Income trusts generate tremendous dividend streams. Investors can receive 7% or 8% a year from low-risk businesses like pipelines and hydroelectric dams. High-risk oil and gas drilling projects can pay as much as 20% a year. These high yields have attracted many investors, particularly retirees.

But Flaherty's announcement surprised the market. Income trust stocks immediately crashed 12%. A year and a half later, the looming tax deadline is still holding down prices. Right now, the S&P/TSX Income Trust Index is down 18% from pre-announcement prices.

Meanwhile, many Canadian trusts have increased their dividend payouts. Here's how the stats look since 2006's Halloween shocker:

Since dividends have risen, but stock prices have fallen, yields have risen. Canadian income trusts now have the highest collection of equity yields I've ever seen. For example: The yield on the Income Trust Index is 13% right now, and dozens of high-quality Canadian companies trade with yields above 15%.

In my last column, I told you to stay away from most Canadian income trusts...

Recently, two income trusts said they were considering changing from the trust structure to the corporate structure. These companies' prices fell more than 20% in the weeks that followed.

Most Canadian income trusts will have to convert to corporations by 2011. If investors are going to react so strongly to conversions, then I don't want to own those trusts, even if they pay 15% dividends.

That said, there is one pocket of the income trust market I still want to own. Let me explain...

I spent the weekend digging through the tax data on dozens of income trusts. I found infrastructure-focused trusts have assets on their balance sheets called "capital cost allowances" or CCAs. These assets are tax shelters.

It costs billions of dollars to build a new skyscraper or lay a gas pipeline across the country, for example, and it takes years to earn a return on your initial investment. So the Canadian government gives out CCAs to these trusts as a reward for investing in Canada's infrastructure.

After the 2011 tax deadline, these trusts will still be able to pay huge dividends by shielding their cash flow with CCAs.

Canadian income trusts have huge yields right now, but I recommend you avoid most of them. Prices will fall as the trusts begin to convert to corporations. I recommend you concentrate on trusts that invest in infrastructure...

These trusts pay 8%-15% dividends. And they should be able to maintain these dividend yields long after the taxation starts in 2011.

Good investing,

Tom