TORONTO (ResourceInvestor.com) — Over the past few years, the Canadian equity market has been denominated by income trusts, a business structure that eliminates taxes at the corporate level and allows net income to flow to investors, where it is taxed at the personal level.
For the 10-year period ending September 30, 2005, the Scotia Capital Income Trust Index (SCITI) has generated a total return of 18.9%, versus 11.2% for the S&P/TSX Composite equities index. Since the end of 1998, income trusts have posted an annualized total return of 24%.
In addition to cranking out regular cash distributions, income trusts also allow investors to avoid the double taxation of regular dividends from corporations.
Income trusts work on the premise that free cash flow belongs to shareholders (unit-holders) and should be returned to them, instead of being squandered by management (notable Canadian examples of such corporate boondoggles include Molson’s foray into Brazil and BCE’s purchase of Teleglobe, the latest in a long list of wealth-destroying moves by Ma Bell).
Not all companies are suited for the structure – the most important asset potential candidates should possess is the proven ability to generate strong, consistent cash flow.
According to the Investment Dealers Association of Canada, initial public offering of income trusts (including closed-end and fund-of-fund offerings) on the Toronto Stock Exchange totaled C$7.8 billion in 2004 and C$5.7 billion year-to-date. The total for common equity IPOs over the same periods were C$4.1 billion and C$1.5 billion respectively.
Companies of various stripes have converted to the trust structure, though oil and gas companies, pioneers in their development, remain the best known.
The usual path for an established petroleum company is to transfer its producing and long-life reserve assets into a trust, while spinning out the exploration assets (generally undeveloped land) into an “exploreco.” Such conversions have become the preferred exit strategy for senior officers, which can remain with either the trust or exploreco, or both, though such strategies may enrich management at the expense of shareholders.
The strong returns have garnered widespread attention throughout the corporate community, as well as with yield-hungry investors. But it has also caught the eye of the federal government.
Unofficially, the problem began in the summer when the CEO of one of the country’s largest banks hinted that his firm was open to converting part of its operations into a trust.
With thoughts of tax dollars slipping through their fingers, the bureaucrats kicked into the public sector’s version of overdrive and on September 8 the Department of Finance issued a “consultation paper” related to “publicly listed flow through entities,” including income trusts and limited partnerships.
The stated primary objective was to determine if the current tax system is appropriate for dealing with these entities. But the key sound bite was the cry that government lost an estimated C$300 million in tax revenue in 2004, due to the number of businesses structured as trusts instead of corporations.
The business community quickly noted the small size of this apparent ‘loss’ in comparison to the numbers usually dealt with by the tax authorities: in fiscal 2005, the federal government collected C$30 billion in corporate taxes, C$122 billion in total revenues and ran a C$2.6 billion surplus, down from a C$9.1 billion surplus in the previous fiscal year.
Analysts also disputed the C$300 million figure, noting it excluded deferred corporate taxes which are frequently not collected. (These taxes can be sheltered through the acquisition of tax loss carry-forwards, whereas deferred personal taxes have a 100% certainty of being collected, either through the financing of retirement or a deemed disposition at death, and most likely at the top marginal tax rate.)
Another point raised by analysts: income trusts shift most of the deferred tax burden onto individuals and matches their collection with increased government expenditures (as baby boomers begin to draw down their retirement savings, the resulting tax revenue coincides with their increased use of the health care system).
Yet the bureaucrats squealed that income trusts were limiting productivity by forcing great companies to adopt a structure focused on boring consistent cash flow.
In reality, management’s retention of earnings generally destroys shareholder wealth (see “Surprise! Higher Dividends = Higher Earnings Growth” by Clifford Asness and Robert Arnott in the January-February 2003 issue of Financial Analysts Journal).
Yet reality didn’t stop the feds from announcing on September 19 that advance tax rulings for companies looking to convert to trusts were no longer being provided, pending completion of the previously announced public consultation process.
While such rulings are not required when converting to a trust, as there are no laws per se that cover these entities, many companies still seek them for comfort (and for the board of directors to cover themselves).
Seizing upon the opportunity, the Alberta provincial government itself then decided to get in on the act. This was somewhat of a surprise given that Alberta is home to Canada’s oil patch, a large beneficiary of the popularity of income trusts, and is known politically for its fiscally conservative government.
The province said it was considering a withholding tax on income trust distributions, similar to withholding taxes on foreign investors. Why? When a corporation pays income taxes, it goes to both province and Feds. For businesses operating in more than one province, these taxes are split between the provinces. In contrast, an income trust allocates taxable income to its unit-holders, with the unit-holders paying provincial income taxes based on their residency.
Since the majority of Canada’s population, and hence unit-holders, resides in Ontario, the Alberta government couldn’t stand the thought of all its “hard-earned” tax money leaving its borders (distributions to foreigners are only subject to federal withholding taxes).
The impact of all this political interference has been to put a freeze on the sector. Trusts across the spectrum have declined, especially the so-called consumer trusts. The SCITI is down 8.4% since the end of September, while the energy and consumer sub-indexes have fallen 8% and 10.3% respectively.
Equities have also fallen as the yield curve flattened and crude oil prices have retreated from nominal record highs. But a normal pullback has been transferred into a wider sell-off as a result of the politicians.
Investors and corporations are now left to speculate as to the government’s actions.
The hope is the Feds will normalize the dividend tax credit to eliminate double taxation. Such an initiative worked fine in Australia, which has vibrant trust and equities markets. If implemented in Canada, it would be positive for dividend paying equities and not negative for trusts.
Other possibility is to limit the deductibility of interest expense, on which most trusts depend in order to avoid corporate taxes. However, such a move would seriously harm both public and private companies, as well as large foreign owned operations in Canada.
The jury will be out at least until December 31 when the consultation process is complete, though little may be done considering the likelihood of a federal election in the spring.
The stoppage of advance tax rulings will likely halt conversions currently in progress, as well as upset senior management teams looking to cash out. But for investors, there’s no reason to sell now considering market prices have generally discounted a tax hike.
Does the downturn provide a buying opportunity?
Within the energy sector, numerous oil and gas trusts are now trading at discounts to conventional corporations. Debt-adjusted cash flow multiples are below proved plus probable reserve life indexes, balance sheets are strong and payout ratios are at their lowest in decades. Investors can buy numerous oil and gas trusts at five and a half times debt-adjusted cash flow at a time when the underlying reasons for high commodity prices remain in place.
So though the government has the potential to screw-up a free market solution to high taxes, the fundamentals for energy trusts are positive.
Photo credit: US Embassy New Zealand via VisualHunt / CC BY-ND
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