With income trusts rapidly vanishing from the scene as the implementation date for new tax approaches, some investors are expressing interest in U.S. master limited partnerships (MLPs).
These are the closest thing Americans have to income trusts. They are limited partnerships, mainly in the pipeline and energy sectors, which trade on stock exchanges. Many of them offer very attractive yields of the kind Canadians were receiving before Finance Minister Jim Flaherty pulled the plug on the trust sector by announcing a punitive new tax on Halloween night 2006. The tax takes effect Jan. 1, 2011 and most income trusts are planning to convert to corporations by then or have already done so.
One of the largest MLPs is Kinder Morgan Energy which trades on the New York Stock Exchange under the symbol KMP. Recently priced at $51.24, it pays a quarterly distribution of $1.05 for an annualized yield of 8.2 per cent (dollar figures in U.S. currency). Another popular choice is Energy Transfer Partners LP (NYSE: ETP) which is yielding 8.3 per cent based on a price of $43.20.
At first glance, these MLPs may seem enticing to Canadian investors desperate for revenue-producing securities to replace the vanishing income trusts. But turn away – these securities come with a couple of built-in poison pills.
The first is risk. Although the big MLPs are generally solid, some of the smaller ones (those with the highest yields, of course) can be as dangerous to the health of your portfolio as the fourth-rate issues that were being flogged during the income trust heyday. To cite one example, Rio Vista Energy Partners (NDQ: RVEP) was trading at $13 last August. After suffering heavy losses, it is now priced at $0.50 with almost no takers and Nasdaq is moving to delist it.
But even the good MLPs should be avoided because of an even greater risk: tax shock. Last week I received an e-mail arrived from a reader who had been given a warning by his broker of potential tax complications that could arise when Canadians invest in these partnerships. The broker was vague on the details so I undertook to probe more deeply by putting the question to a tax expert at a major brokerage firm. The reply was basically that Canadian residents should steer clear of MLPs.
For starters, investing in an MLP may result in a requirement to file a U.S. non-resident tax return. "The reason for this is that if the partnership is carrying on trade or business effectively connected with the U.S., each non-U.S. partner is treated as if they too carry on a trade or business located in the U.S.," the expert wrote. "This treatment results in the obligation to file a U.S. tax return."
But that's only the beginning. Payments made from MLPs to Canadians are subject to non-resident withholding tax equal to the top U.S. marginal tax rate, which is 35 per cent. "This withholding is required regardless of whether the non-U.S. person is documented or undocumented," the tax expert said.
Any excess U.S. withholding tax may be recovered on the annual non-resident U.S. tax return but that's a hassle that most Canadians would rather avoid.
Of course, any income from MLPs must also be reported on your Canadian tax return. But there is a problem with that as well, says our expert. "Unless the limited partnership is targeted towards Canadian investors, there may be difficulty obtaining adequate information to properly file a Canadian tax return. The information provided by the U.S. limited partnership, using U.S. Form 1065 (Schedule K-1) for limited partner tax reporting, typically lacks sufficient detail to allow the taxpayer to convert the income from a U.S. tax basis to a Canadian tax basis. With the cooperation of the partnership, these difficulties may be overcome, but will typically increase the complexity and cost of the client's personal tax return."
Think you can get around all this by buying MLPs for your RRSP or RRIF? Forget it. Shares of U.S. master limited partnerships may not be held in registered accounts in Canada because they do not meet the required qualification of being traded on a Canadian exchange.
The bottom line is that most Canadians should avoid U.S. limited partnerships. If you want to go ahead anyway, make sure fully understand all the tax implications and/or have a professional advisor who does.
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