Ottawa’s new tax on income trusts comes into effect just over four months from now, on January 1, 2011. When it does, it will put trusts on an equal footing with regular corporations.

Right now, 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.

Many income trusts have already converted to conventional corporations in response to the new tax, or plan to do so later in 2010 or in early 2011. Others will continue to operate as trusts.

Low payout ratios, strong cash flows are key to steady post-2011 income trust distributions

Regardless of whether they convert to conventional corporations, the tax has made many investors wary of income trusts. But many income trusts still have investment appeal, even with the new tax.

One way to spot trusts that are likely to maintain their distributions when the new tax kicks in is to focus on those that pay out a lower percentage of their cash flows as distributions (less than 75%, say). That’s because the biggest cuts will come from trusts that now pay out a very high percentage of their cash flows as distributions. By the way, that’s also often a sign that they’re struggling to remain profitable.

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As well, it’s more important than ever to focus on high-quality income trusts that operate stable businesses in growing industries. That will help them increase their cash flows and keep their payout ratios low. That further lowers the risk of a distribution cut.

In a just-published issue of Canadian Wealth Advisor, our newsletter for conservative investing, we update our buy/sell/hold advice on two oil and gas trusts with low payout ratios and rising cash flows. One of these trusts is Peyto Energy Trust (Toronto symbol PEY.UN).

Peyto produces and explores for oil and natural gas in Alberta. Its average daily production of 20,653 barrels of oil equivalent (including natural gas) is weighted 84% toward gas and 16% to oil. At current production rates, Peyto has proven oil and natural-gas reserves that should last 14 years.

Peyto’s cash flow was $0.51 a unit in the three months ended March 31, 2010. In light of its strong cash flow and exploration success, the trust is increasing its 2010 exploration spending to $225 million to $250 million. That’s up from $72.7 million in 2009.

The units yield a high 9.7%. Peyto paid out a relatively low 71% of its cash flow as distributions in the latest quarter. That will help it keep its distributions high when it converts to a conventional corporation on December 31, 2010, just before the new income-trust tax takes effect. As well, rising natural-gas prices would boost the trust’s cash flow and lower that payout ratio.

You can get our full analysis, including our clear buy/sell/hold advice, on Peyto Energy Trust and 18 other safety-conscious investments in the latest Canadian Wealth Advisor. What’s more, you get this issue free when you subscribe today. Click here to learn how.