In Canada, income trust distributions will be taxable to the level where the trust would be roughly equivalent for them to convert into a corporation and distribute dividends from after-tax income. Because a simple corporate structure is easier to understand for most investors, in addition to being cheaper to maintain, it is likely that most conventional income trusts (except for the REITs, which will still have the same tax-free exemptions as existing trusts do) will convert into corporations before the conversion deadline.
There are a whole litany of tax issues involved with conversion (which can be read in the explanatory notes in the July 2008 legislative proposal), but the salient detail is that income trusts by the end of December 2012 will have to convert to corporations in order to prevent a deemed disposition (i.e. tax consequences for unitholders).
In the meantime, trusts will have a distribution tax, both a federal and provincial component. The Federal component will be based on the large corporation tax rate (16.5% in 2011; 15% in 2012 and beyond), while the provincial component will be based on a weighted average where the trust earns its distributable income and the respective province’s large corporate tax rate. In BC, this will be 10%. So in 2011, a trust that operates in BC will have a 26.5% distribution tax put on its distributions; the way to calculate “equivalent distributable income” is by dividing the pre-2011 distribution by one plus the distribution tax.
So for example, if an income trust distributed 100 cents a year of income in 2010, the equivalent will be $1.00*(1/(1+0.265)) or $0.7905/share in 2011; in 2012 this would be $1.00*(1/(1+0.25)) or $0.80/share.
It should be noted that the income coming from trusts will be considered eligible dividends in 2011 and beyond; as a result, the tax treatment to Canadians will more than offset the loss in trust income. At the low tax bracket, the marginal rate for a BC resident for trust income will be 20.06%, while eligible dividend income will be -9.42%. So a $100 trust distribution will end up as $79.94 after taxes for a low income earner, while a $79.05 eligible distribution will yield $89.50 after taxes. At the top tax bracket, $100 of income will end up as $56.30 after taxes, while a $79.05 eligible distribution will end up as $60.15 after taxes.
The take-home message is that once 2011 rolls around, there is going to be no excuse whatsoever to keep income trusts inside the RRSP; they should be immediately removed and placed into a regular taxable account. Alternatively they can be placed inside the TFSA, but one would surrender the tax benefit of the dividend tax credit.