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Demystifying Income Trusts 

  • In response to widespread interest and increasing relevance to Canada’s financial markets, the Certified General Accountants of Canada (CGA-Canada) has seen it timely to release “Demystifying Income Trusts”.
  • The main purpose of this paper is to:
    • Provide a general understanding of income trusts, including what an income trust is, how it is structured and how it compares to other investments; and
    • Discuss tax implications of the proposed government policy and its impact on investors, corporations and government.

Facts

  • Trust activity has reached an estimated 2004 market capitalization of $118.7 billion.
  • There are approximately 200 income trusts in Canada.
  • Income trusts represent one of the highest sources of sustainable recurring cash yield in equity and fixed income markets and therefore are the preferred structure for many investors.
  • Income trusts have become a powerful investment vehicle that has already established substantial staying power.

Key Characteristics and Appeal of Income Trusts

  • There are three main groupings of income trusts including business trusts/hybrid trusts followed by real estate investments trusts and royalty/energy trusts.
  • The income trust purchases most of the equity and debt of a successful operating business and thereby becomes entitled to receive cash flows or proceeds of that business.
  • Income trusts return 70% to 95% cash flows in the form of cash distributions and return of capital to unitholders that allows them to decide how best to reinvest those funds, as opposed to leaving them in the hands of management of income trust.
  • The principal preoccupation of an income trust is to generate consistent, constant and rewarding cash distributions for the trust’s unitholders.
  • From a business owner’s perspective, income trust structures tend to value assets at a higher conversion value than is typically experienced through corporate structured stock issuance.
  • Types of businesses most suitable for conversion to an income trust are those businesses that have mature assets that require little ongoing capital expenditure to enhance the products, face little or no competition, provide a sustained level of cash distribution with little or no variability at a higher level of yield, have more than one revenue stream containing some degree of diversification, have low interest rates on limited debt and have a management commitment that is predominantly focused on cost control. The business of an income trust that specializes in overseeing the manufacturing or sale of a particular product or service such as the sale of home furnishings may be a good candidate for trust conversion.
  • A comparison with other investment vehicles highlights that the uniqueness of income trusts stems from their tax treatment as well as the high yield cash distributions.

Challenges

  • Growth and sustainability of an income trust may be curtailed as most of the cash is distributed to unitholders and not re-invested in research and development.
  • When compared to bonds, cash distributions received from an income trust are neither guaranteed nor fixed.
  • Although income trusts follow GAAP, “distributable cash” is a non-GAAP financial measure. The Canadian provincial and territorial securities regulators would be well served to introduce a mechanism which reconciles distributable cash to GAAP reporting.

Tax Implications

  • In some foreign jurisdictions corporate and personal income tax structures are fully integrated which may contribute to the absence of distinct preference and growth for comparable income trust structures.
  • Under the current income trust regime, almost all of the cash flow is distributed to unitholders therefore the trust itself attracts and pays little corporate tax.
  • Although the monies flowed through the trust construct are fully taxed in the hands of unitholders, the government estimates that this business form has resulted in the forfeit of tax revenue to the tune of $300 million.
  • The former government estimated a forfeit of $300 million in corporate income tax revenues as an outcome of income trust investment. It is interesting to note that federal tax revenues for 2005 were $132 billion and to consider that corporate tax revenue was $6.8 billion over the 2004 forecast. When taken as a function of federal income tax revenue we can concede that this forfeit is not a considerable amount.
  • The former government proposed to increase the dividend tax credit to placate corporate investors.
  • Based on assumptions outlined in our report, CGA-Canada’s analysis shows that the previous government’s proposal to increase tax dividends would effectively dissuade top earners from investing in income trusts.
  • Having witnessed public reaction to this debate, CGA-Canada urges the government to exercise caution when introducing tax measures that could create an adverse situation in the marketplace.

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