With oil prices high, you might consider energy investments as income-producing vehicles. A great deal of evidence suggests that higher prices for oil and natural gas will be around for quite a while. High prices, in turn, increase the likelihood that ample amounts of cash will keep flowing into investors’ pockets. Moreover, energy-linked income vehicles can provide an inflation hedge while traditional bonds, especially-term long issues, are devalued by rising prices.
Income from energy may be derived via royalty trusts. With royalty trusts, you’re buying a stream of income that’s tied to the commodities market, not to the bond market. Royalty trusts own a share of top-line revenues, unaffected by any costs, so they’ll provide cash flow from oil and gas wells, with fluctuations due to energy prices and to the current volume of production.
For several reasons (limitations on non-Canadian ownership, foreign withholding tax), Canadian royalty trusts often trade at a lower multiple of cash flow, compared with U.S. royalty trusts. Some Canadian trusts, traded on U.S. exchanges, are paying out 8 percent-10 percent. Examples include Enerplus, Pengrowth Energy, Petrofund Energy, Provident Energy, and PrimeWest.
For all types of royalty trusts, the tax treatment is favorable. If distributions are, say, 9 percent in a given year, perhaps 6 points will be considered a return of capital, sheltered by a depletion allowance, and thus not taxed until the shares (“units”) are sold.
(Tax-free distributions lower your basis in royalty trusts. This lower basis results in a higher tax upon sale. The gain attributed to previous tax-free distributions will be taxed as ordinary income, not low-taxed long-term capital gains.)
What’s more, Canadian royalty trusts typically are structured so that taxable payments to U.S. investors qualify for the special 15 percent rate on dividends.
Tax rules also dictate that such trusts be held outside of a tax-deferred account. In a taxable account, you can take a credit for foreign withholding tax. That credit is not available in an account that’s already tax-deferred. Thus Canadian royalty trusts in a tax-deferred account could wind up being taxed on the front-end, via withholding, and on the back-end, when U.S. income tax is imposed on distributions.
Royalty trusts have other risks, too. The depletion allowance that provides tax shelter is in the tax code because investors’ assets literally are depleting. Any energy investment will have a decline curve: the volume of production will decrease over time. Investors should do their homework on estimated future reserves before buying any royalty trusts.
