What is a Royalty Trust?
A royalty trust is the type of corporation that usually operates in the energy or resource mining industries and acts as a mineral rights owner of mineral deposits, wells, and reservoirs. The main purpose of royalty trusts is to distribute the generated resource sales income to shareholders.
If the major part of the income (90% or more) is distributed as dividends, there is no income tax to be paid on the corporate level, and shareholders only need to pay personal income tax – the system effectively eliminates the double-taxation problem of corporate income.
Characteristics of Royalty Trusts
Royalty trusts are most common in the United States and Canada. A royalty trust poses as a legal owner of mining property and its resources, while the actual mining and operations are run by a third party or contractor. The trusts don’t employ anyone and are usually operated by financial institutions.
Royalty trusts usually own mature, well-developed mines or those that are past their peak. The oil and gas mines will gradually deplete, but require minimum to no investments, while producing a significant cash flow. With relatively high yields, the royalty trust share price drops when the interest rate is high and rises during low interest rate periods.
All the abovementioned factors make royalty trusts a favorable option for investors who do not wish to own an actual mine but want to be directly involved in the extraction and production of the resources while owning stocks with high-yield dividends. In addition, royalty trusts offer speculation power over commodities, without the need to acquire futures contracts.
Types of Royalty Trusts
Currently, there are two types of trusts: American and Canadian.
1. American Trusts
In the United States, royalty trusts are not legally allowed to buy any additional property or make any investments after the creation of the trust. Hence, the trusts mainly focus on maintaining existing assets, rather than expanding their operations.
With depleting resources, it makes American trusts a good short-term investment, but offer no potential in the future. Upon the full depletion of the royalty trust’s reserves, the trust will be effectively dissolved. Because of the inability of the trusts to reinvest in themselves, they do not qualify for the recent reduction of dividend income tax (15%).
2. Canadian Trusts
Canadian Royalty Trusts (“CanRoys”) are usually traded on the Toronto Stock Exchange (TSX) and provide higher yields than their American counterparts. The legal status of Canadian entities significantly differs from American trusts. In Canada, royalty trusts can be run as businesses and have their employee base.
In addition, the trusts are allowed to make investments, raise or borrow money, and expand their operations, which makes them more flexible in the long term. However, there are some implications for CanRoys:
- They are mostly only listed on TSX.
- They are affected by the prevailing exchange rate.
- Canada imposes a 15% foreign withholding tax.
With the increased interest in CanRoys in recent years, the Canadian government became worried about losing nearly $1 billion in taxation due to the loophole royalty trusts created in the system. In 2006, the Canadian government introduced Specified Investment Flow-Through (SIFT) rules that eliminated the loophole and required the trusts to pay corporate taxes on their dividend distributions at the full rate of 31.5%.
With the SIFT rule, 90% of CanRoys either transformed themselves into corporations or were simply liquidated. The incident dramatically dropped the interest in CanRoys. However, with the recent introduction of Foreign Asset Income Trusts (FAITs), which, in essence, are CanRoys that own assets abroad and, therefore, are not subjected to the SIFT rules, the industry may see some revival.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: