Right now, Canadian income trusts pay out a high percentage of their cash flows to their unitholders. This lets them avoid paying corporate taxes. It also gives many of them significantly higher yields than a lot of dividend-paying common stocks.

Canadian income trusts face tax changes in 2011

In 2011, the Canadian government will begin taxing income trusts (with the exception of real estate investment trusts or REITs).

With the income-tax benefits of income trusts eliminated, some trusts may convert to conventional corporations — the same structure as most common stocks. Other income trusts may choose to remain as trusts.

Either way, many will likely cut their distributions. That’s because their cash available for distribution to unitholders will fall after they begin to pay corporate taxes and can’t pass it all on tax-free.

The biggest cuts will come from income trusts that now pay out a very high percentage of their cash flows as distributions. That’s typically a sign that they’re struggling to remain profitable.

Some strategies for your 2011 portfolio

If you hold income trusts outside of a registered plan, such as an RRSP or RRIF, you will not see a large change in your after-tax position in 2011– even though the distributions you receive will likely drop by 26.5% (based on the current corporate tax rate). That’s because the distributions will be taxed as dividends, and Canadians benefit from the lower tax rates provided by the dividend tax credit.

The Growing Power of Dividends Learn everything you need to know in '7 Winning Strategies for Dividend Investors' for FREE from The Successful Investor. The Best Canadian Dividend Stocks to Buy: REITS Canada and other Top Canadian Dividend Stocks.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

However, if you hold income trusts in a registered plan, you will receive a 26.5% lower distribution, but with no offsetting tax benefits on dividends. When you eventually withdraw the distributions from your RRSP or RRIF, you’ll pay tax at the same rate as ordinary income.

So, if you want to hold your trusts past 2011, you should consider swapping them out of your registered plans for cash held in a non-registered investment account. That way you can take advantage of the dividend tax credit.

Stick with our trust recommendations

Most trusts expose unitholders to a wide variety and range of risks — and most are of poor quality. That’s why we’ve recommended so few over the years — and why we’ve avoided the many income-trust disasters.

Our focus on the highest-quality Canadian income trusts has also given us some spectacular successes — including Fording Canadian Coal Trust, which generated a whopping 5,769.2% return from when we first recommended it until it was taken over by Teck Resources.

Above all, even with Ottawa’s plan to start taxing trust earnings in 2011, the best-quality trusts should continue to pay above-average yields for years to come. These are the kinds of trusts we recommend in Canadian Wealth Advisor.