The new income trust proposals - how will they affect you?

The announcement by the federal Finance Minister that distributions from income trusts created after October 31, 2006 would be subject to taxation at the same rate as corporate dividends was somewhat of a surprise. Since completely unexpected, it has been the primary reason for the current volatility in the Canadian stock market.

What are the new rules?

The government is proposing a new tax on the money distributed to unit holders by newly formed income trusts. The rationale is to level the playing field among trusts, income trusts and corporations.

The tax rate on trust distributions will start at 34% - to mirror federal and provincial taxes on companies - and drop to 31.5% by 2011. Ottawa will remit a 13-percentage-point share of the revenue to the provinces. These measures will apply to new income trusts that start to trade after today, beginning with the 2007 taxation year.

The Transition Period

Income trusts in existence at the end of October 2006, will be grandfathered, and continue to function as normal. Their distributions will not be subject to taxation until 2011.

Fortunately, real estate investment trusts will not be affected by the change in taxation - provided they maintain the same distribution policy. They will continue to be able to distribute their income in a tax-advantaged form.

Income trusts which distribute part of their income in the form of Return of Capital (ROC), having the effect of reducing investors' Adjusted Cost Base, will continue to have the portion of the distribution that is regarded as ROC exempted from taxation until the units are sold. ROC is essentially the process of getting your own money from the investment, which is not taxable.

What are money managers saying?

As in any period of market volatility, these events allow professional money managers to take advantage of pricing anomalies. Panic selling leads to opportunities - many income trusts have fallen below what their corporate valuations suggest is reasonable. Many managers believe it will take the markets several weeks to assimilate the news.

Most of the blow to income trust positions may well be behind us. The majority of professional money managers did not sell any positions, since they anticipate the bottom to appear within the next week. Some took advantage of the low prices to buy select opportunities - ones with stronger capital structures, less debt, better balance sheets and low payout ratios. Of course, these are the same criteria that most professional managers have favoured over the past few years.

Money managers are saying that the proposed tax changes to our positions will not take effect for four years. The recent drop has effectively integrated the future tax changes into the price of the income trusts. However, the legislation has not been passed, and there could still be some tinkering. Although it appears that it will become law with little opposition.

The Positives

The fact that future income trusts are on hold makes the existing ones more attractive since they now have a scarcity premium, and will continue to enjoy tax-advantaged status for the next four years, compared to traditional corporations. This is a huge benefit over a definite four year period.

We also believe the drop in prices will make some trusts attractive merger and acquisition candidates, especially to foreign firms.

We do not think the news is all bad, especially over three or four years. The distributable cash positions for trusts are still strong.

The Negatives

Some softness will occur in fund flows into this category over the next few weeks, as investors absorb the news, and realize that the existing trusts are still attractive.

A large number of oil and gas trusts have been held by foreign investors. They are the most affected, since they will move from a 15% to a 46% tax bracket. The announcement could motivate them to remove the trusts that have dropped in value from the Canadian market.

Existing trusts will likely lower their distributions, as they prepare to pay the tax at the end of the four year grace period.

While volatility will remain high as a result of the announcement, we believe that income trusts remain an attractive investment. They may still appeal to conservative investors looking for an asset class that provides a portion of its return in the form of income and has a low correlation to other asset classes, such as fixed income and equities, although its tax advantages may have been reduced.

Impact on the Canadian dollar

The Canadian dollar will be affected, as Canadian income trusts are popular with foreign investors. These investors might move their money elsewhere if they are forced to pay tax on their Canadian trust holdings.

However, a falling Canadian dollar can be favourable for portfolios which have a lower Canadian equity weighting.

The Future

The Minister of Finance hinted strongly that the Conservative Government would reduce personal income taxes, although he wouldn't provide details. We can expect some announcements on this proposal before the next budget.

The grace period of four years will allow income trusts to develop solutions in order to anticipate the government's next moves in this area.

While in the short term, the move will spark instability in the market and investors may sell their fund units, it could lead to companies making use of the trust structure only when appropriate for their business. As with all market place panics, as soon as the uncertainty is removed, the normal investment cycle will resume. Companies will continue to make profits, earnings will continue to rise, and dividends and distributions will remain.

We believe that a calm and rational approach based on discipline and fundamentals will lead to investment success. And why not take advantage of other investors' insecurities?

As the renowned investor John Train told us "For the investors who know what they are doing, volatility creates opportunity".