Investing in Energy Assets via Royalty Trusts

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Royalty trusts are corporations that avoid double-taxation by distributing a high percentage of their profits to shareholders as dividends. Just like a real estate investment trust (REIT ), these distributions are taxed only at the personal income level, rather than at the corporate level and the personal income level, as would be the case under a standard corporation.

The majority of royalty trusts are energy-related, operating in oil and gas or mining industries in several different countries. Often times, these royalty trusts own a passive stake in these energy assets and receive a steady stream of income as a result. The corporations also have few officers and/or employees and are overseen by a trust officer at an appointed bank.

Reasons to Invest in a Royalty Trust

Investors are attracted to royalty trusts because they are forced to distribute the majority (90%+) of their profits to shareholders. In particular, income investors looking for a fixed amount each quarter benefit from unusually high dividend yields or distributions that are backed by relatively stable income streams from energy assets.

Royalty trusts also avoid double-taxation, as mentioned earlier, since they are taxed only on a personal level rather than a corporate and personal level. The result is a lower percentage of revenue headed into government coffers and more profits distributed to investors relative to the same operations contained within a standard corporate shell.

Canada’s So-Called Halloween Massacre

On Halloween of 2006, Canadian Prime Minister Jim Flaherty announced changes to the country tax regulations calling for all royalty trusts to be taxed like regular corporations at the full 31.5% rate (the rate at the time). The move followed the realization that such trusts were costing the government more than $500 million per year in lost tax revenues.

These changes went into effect in 2011, forcing many Canadian royalty trusts to convert to standard corporations or liquidate in its wake. At the same time, many of these converted royalty trusts cut their dividend payouts to reflect the new level of taxation that they were forced to pay. But as of 2012, these stocks have stabilized under the new regulations.

Royalty Trusts in the United States

While royalty trusts may have been effectively abolished for now in Canada, many U.S. royalty trusts are still thriving in today’s environment. These trusts are not allowed to acquire additional properties once they are formed and therefore tend to deplete over time, but the steady income stream makes them attractive to many income investors.

Some examples of 2012 U.S. royalty trusts include:

• BP Prudhoe Bay Royalty Trust (NYSE: BPT)
• Cross Timbers Royalty Trust (NYSE: CPT)
• Dominion Resources Black Warrior Trust (NYSE: DOM)

Paying Taxes on Royalty Trusts

Distributions made by royalty trusts are most often taxed at the dividend rate for individuals, which varies depending on the individual’s level of income. Since part of the dividend is considered a capital return because of asset depletion, investors can also take a depletion allowance as a deduction on their taxes in order to offset the dividend tax.

Finding these amounts is usually easily accomplished by looking at the issuer’s website or contacting them directly, but some unusual cases may require calculating the depreciating asset’s cash flow and coming up with the figures independently. Investors are advised to consult their accountant or tax professional for specific advice regarding their situation.

Key Points to Remember

• Royalty trusts are corporations that operate like a real estate investment trust, avoiding double-taxation in exchange for distributing a high percentage of their profits.
• Canada essentially eliminated their royalty trust structures, but they remain in the United States and parts of Europe.
• Investors that own royalty trusts often pay very little effective taxes, since they can take a depletion allowance as a deduction in not tax-deferred accounts.