To trust or not to trust, that’s the question

The popularity of income trusts had been on the rise for years.  With monthly payouts and enhanced yields amid declining interest rates, many investors considered the trust attractive.  The Conservative government’s election promise to leave the taxation of income trusts alone further enhanced the popularity.

But everything changed on October 31 when Ottawa announced its “Fairness Plan,” a move to redesign the way income trusts are taxed that may investors felt was unfair.  Here’s a primer on the issue:

So what is an income trust?

An income trust is an equity investment that was designed to distribute cash flow generated from a business to unit-holders.  People requiring income from their investments were attracted to this structure as income is generally paid monthly or quarterly.  As a result of these distributions income trusts are often referred to as “flow-through” investments.  They typically fall under the following four categories:  1) royalty/energy trusts; 2) income/business trusts; 3) limited-partnerships; and 4) real estate income trusts.

Why were income trusts were created?

Investors who require income found trusts attractive as many paid out income on a monthly basis.  Over the past few years in an environment of declining interest rates, they provided an opportunity for risk tolerant investors to enhance their yield.  The majority of investment returns tend to be generated by the monthly/quarterly distribution stream while total returns may be increased or reduced by changes in the underlying unit price.  With an aging population there is no surprise that there was a strong demand for quality income trusts paying investment income.

What is the problem?

Income trusts are designed to be tax efficient.  Their tax effectiveness comes from the trust being able to distribute the pre-tax business income out to unit-holders.  Provided this income is distributed out to unit-holders then the trust has little to no tax to pay.  People receiving distributions from income trusts may or may not have been taxed immediately on these amounts.  Individuals holding these investments within registered plans, such as RRSP and RRIF accounts, were able to defer tax on this income even further.  The trust structure is considerably different than a corporate structure that must first pay tax on company profits prior to paying dividends to shareholders.  This is the primary problem that led to the recent announcement.  Ottawa may not have been too concerned in the past when trust conversions were primarily done by smaller businesses and taxation dollars were minimal.  With the recent announcements by BCE and Telus to convert to an income trust structure the Government was compelled to act in the interest of supporting their eroding tax base.  It is clear this became a greater issue when some of Canada’s largest companies began contemplating trust conversion.  As a result the Federal Government announced a new Tax Fairness Plan designed to balance the taxation of income trusts and corporations.

Tax Fairness Plan

The proposed Tax Fairness Plan has impacted income trust investors with the exception of those invested in real estate income trusts.  For the other three types of income trusts, profits within the trust will be taxed at corporate tax rates before distributions and distributions will subsequently be treated as dividend income.  These proposed changes are to take effect in the 2011 tax year for trusts that are currently publicly traded.  New income trusts that begin trading after October 31 are impacted immediately.

Political risk in Canada

Prior to investing in income trusts investors should have been aware that this recent announcement from Finance Minister James Flaherty was at least a possibility.  Just over a year ago, former Finance Minister Ralph Goodale spooked income trust investors by announcing that the Liberal Government was looking into the taxation of income trusts.

Ongoing risks

Prior to October 31, many investors may have felt the greatest risk to investing in income trusts is political uncertainty.  Another major risk is that distributions are not guaranteed.  When distribution payments are reduced, people’s income stream will be reduced and the market tends to respond negatively.  One common way to analyse income trusts is to look at the stability of distributions and the payout ratio (cash distributions dividend by available distributable income). Payout ratios greater than 100 per cent of available distributable income is generally an indicator that the trust may need to adjust the distribution level.  Volume of trading is also a concern with some income trusts.  Supply and demand has always driven the markets and some trusts are relatively illiquid.  Energy and resource related trusts are generally impacted either negatively or positively by changes in the price of the underlying commodity.  Changes in the level of interest rates have also had a significant effect on unit prices.  As with any equity investment, it is important to continually analyse the merits of the underlying business.

Coming Up

Many investors may be concluding that the existing trust market is likely to shrink considerably by 2011.  Our next column will provide a few options for investors to consider.  We will also provide an illustration of an investor with a diversified portfolio.