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The unitholders are the Beneficiaries of the Trust , and their units represent their right to participate in the income and capital of the trust. Income trusts generally invest funds in assets that provide a return to the trust and its beneficiaries based on the cash flows of an underlying business. This return is often achieved through the acquisition by the trust of equity and debt instruments, royalty interests or real properties. The trust can receive interest, royalty or lease payments from an operating entity carrying on a business, as well as dividends and a Return Of Capital . 1 The main attraction of income trusts (in addition to certain tax preferences for some investors) is their stated goal of paying out consistent Cash Flow s for investors, which is especially attractive when cash Yield s on Bond s are low. They are especially useful for financial requirements of Institutional Investor s such as Pension Fund s. ( ''Investment Dictionary'' ) The names ''income trust'' and '' Income Fund '' are sometimes used interchangeably, even though most trusts have a narrower scope than funds. Currently, income trusts are most commonly seen in Canada . The closest analogue in the United States to the business and royalty trusts would be the Master Limited Partnership . INVESTOR RISKS Income trusts are equity investments, not Fixed Income Securities , and they share many of the risks inherent in stock ownership, but often not the same rights and responsibilities, especially concerning Corporate Governance and Fiduciary responsibility. Investors in Canadian income trusts cannot rely upon provisions in the Canada Business Corporations Act allowing for Derivative Action s and the Oppression Remedy , and often do not even have the right to elect a board of directors. Each trust has an Operating Risk based on its underlying business; the higher the yield, the higher the risk. They also have additional risk factors, including, but not limited to, poorer access to debt markets.
Interest rate risk is also present inside the trusts themselves on their Balance Sheet s since many trusts hold very long term capital assets (pipelines, power plants, etc.), and much of the excess distributible income is derived from a Duration Mismatch between the life of the asset, and the life of the financing associated with it. In an increasing interest rate environment, not only do the attractiveness of trust distributions decrease, but quite possibly, the distributions themselves decrease, leading to a double whammy of both declining yield and substantial loss of unitholder value.
Generally, income trusts carry the same risk levels as dividend paying stocks that are traded on stock markets. And since income trusts or dividend paying stocks sometimes pay out a portion of their profits every month, investors get the equivalent of a capital gain (in the form of monthly distributions) on their investment without having to sell their stocks. TAX CHARACTERISTICS In a typical income trust structure, the income paid to an income trust by the operating entity may take the form of Interest , Royalty or Lease payments, which are normally Deductible in computing the operating entity’s income for tax purposes. These deductions can reduce the operating entity’s tax to nil. The trust in turn, "flows" all of its income received from the operating entity out to unitholders. The distributions paid or payable to unitholders reduces a trust's taxable income, so the net result is that a trust would also pay little to no income tax. The net effect is that the interest, royalty or lease payments are taxed at the unitholder level. (Source: Department of Finance Canada .) #As a Flow-through Entity (FTE) whose income is redirected to unitholders, the trust structure avoids any possible Double Taxation that comes from combining corporate Income Tax with shareholders' Dividend Tax . #Where there is no double taxation, there can be the advantage of deferring the payment of tax. When the distributions are received by a non-taxed entity (like a pension fund), all the tax due on corporate earnings is deferred until the eventual receipt of pension income by participants of the pension fund. #Where the distributions are received by foreigners, the tax applied to the distributions may be at a lower rate determined by treaty, that had not considered the forfeiture of tax at the corporate level. #The effective tax an income trust owner could pay on earnings could actually be increased because trusts typically distribute all of their cashflow as distributions, rather than employing leverage and other tax management techniques to reduce effective corporate tax rates. Certain investors, particularly those in the highest tax brackets, could be significantly worse off investing in income trusts compared to traditionally structured corporations. While the benefits of trusts for tax-deferred and tax exempt entities are clear, trusts are clearly less attractive for other investors facing high marginal rates. ISSUES Some of the following issues have not been proven: #Tax revenues for governments are reduced, deferred or reallocated between jurisdictions. Differential treatments between the same economic entities is inherently unfair. #Economic efficiency is lost when cash is endlessly raised, returned to owner, and raised again - each time involving fees. #Cash is redeployed and recycled efficiently when managers are forced to exercise more discipline in investment decisions.. #Mis-allocation of capital from its most productive use toward the enterprise with the cheapest tax structure. #Mis-pricing of investments due to incorrectly focusing on cash yield and misunderstanding Return Of Capital . #Growth is put at risk, when new shares must be continually issued to fund growth. #Damping of price volatility due to frequent cash returns. #Broad Economic Benefits from the informative value of frequent cash distributions as a changing indicator of underlying business health such that a premium valuation can be paid for trust ownership in respect to reporting transparency qualities offered in the form of cash distributions. TYPES OF INCOME TRUSTS There are four primary types of income trusts: Investment trusts Investment trusts (aka "mutual funds") are trusts established for communal investment in securities, encapsulated under the umbrella of a flow-through entity and typically managed by a 'fund sponsor', usually an investment firm, asset management firm, or investment bank. These trusts invest in a variety of investments including stocks, bonds, futures, etc., and are often marketed to the public directly when authorization has been received from provincial securities regulators to do so. This type of trust has not been affected by the recent changes concerning income trust taxation; like Canadian REITs, mutual fund investment trusts have been exempted from taxation. Some investment trusts have been specially structured with Leverage in order to amplify cash yields paid to investors, while others deplete their assets to pay distributions to investors on a regular basis. Real estate investment trusts and/or Mortgage-backed Securities . The REIT structure was designed to provide a similar structure for investment in real estate as mutual funds provide for investment in stocks. Royalty/energy trusts Royalty Trust s, "resource trusts" or "energy trusts" exploit Natural Resource s such as Oil Well s. The amount of distributions paid will vary from time to time based on production levels, commodity prices, royalty rates, costs and expenses, and deductions. Business trusts Business income trusts are individual companies that have converted some or all of their stock equity into an income trust Capital Structure for tax reasons. Business income trusts are used in many sectors, such as manufacturing, food distribution, and power generation and distribution. They are not Investment Trust s in the classic sense, since they represent a single company's assets and not a pool of investments. Among business trusts, utility trusts that invest in or operate Public Utilities such as Electricity Distribution or Telecommunication s are sometimes put in a separate category as they are inherently less growth-focused. ( ''InvestCom'' ) In the US, the business trust structure typically takes the form of (IDS) has also failed to attract investor attention due to the trust activity being focused on the Canadian market. INCOME TRUST BOOMS BY COUNTRY The tax advantages offered to trusts in certain jurisdictions have fueled income trust booms and Bubble s in the recent economic history of several countries. In each case, the growth was led by the multiplication of business income trusts. (Main source: 3) Australia See Also: Economic history of Australia Taxation in Australia Resource-rich Australia has had royalty trusts (and REITs) for a long time but in the early 1980s, a wider range of firms sought the same tax benefits and started converting into income trusts. Yield-hungry investors jumped on the bandwagon and rewarded the trusts with higher valuations. When Queensland Coal converted to a trust in 1984, its stock price tripled overnight. The Australian government, citing ever-increasing (but unquantified) losses of tax revenues, clamped down in 1985. All trusts except REITs and royalty trusts were given 3 years to find an Exit Strategy : to either keep the current structure at higher tax rates, or convert (back) to a public company. As unit prices started to collapse, the majority dropped the trust structure. It is notable, however, that the legal trust structure and the public trust structure persists in Australia to this day. As of December 2006, the Australian government was revisiting the income trust issue to consider whether further legislation was needed to address the many thousands of trusts that have been maintained and developed since taxes were imposed in the mid-1980s. United States See Also: Economic history of the United States Taxation in the United States Master limited partnership In the US, the business trust structure appeared with Publicly Traded Partnership s (PTPs) which were Limited Liability Partnership s (LLPs) with units that trade on public securities exchanges, combining the tax advantages of partnerships with the liquidity of public companies. Starting from the early 1980s all sorts of business, from manufacturers to the Boston Celtics basketball team, converted to PTPs. In 1987, conversions numbered more than 100 and Congress estimated that the trend was costing Washington $245-million a year in lost revenue. All PTPs except those categorized as "slow-growth investments" (roughly a third of them) were therefore given 10 years before they would be taxed as corporations. Just like in Australia, most of them converted back as unit prices fell, but the decade-long transition meant fewer sharp losses for investors. Others such as Cedar Fair received a special corporate tax rate on the condition that they would not be allowed to diversify outside of their core businesses. Few of the partnerships remain today as US income-focused investors favor high-yield Bond s or Debenture s instead. With the Canadian income trust market booming in the 2000s, American investment bankers have tried to import the Canadian model in a structure called Income Depositary Shares (IDS). A handful of small IPOs have used this model since late 2003; but due to lack of investor demand, interested companies have preferred to go public directly in the hot Canadian market. (4) Canada See Also: Economic history of Canada Taxation in Canada The first Canadian tax ruling enabling the income trust structure, inspired by the American PTPs, was awarded in December 1985 to the Enerplus Resources Fund royalty trust. The first corporate conversion into a proper business trust, using the 1985 ruling, was Enermark Income Fund in 1995. The move attracted little attention at the time as the vast majority of trusts were still REITs and royalty trusts (the so-called "CanRoys"). A substantial historic and status report on the Canadian income trust market was published at the end of 2006 coinciding with the announcement of new taxes on income trusts proposed by the Canadian Minister of Finance (Key reference provided by author: 5) The trust structure was "rediscovered" after the 1- Billion in the process. By 2002, trusts accounted for 79% of all money raised through IPOs in Canada, with only 38% in the traditional sectors of petroleum and real estate. By 2005, the income trust sector was worth C$160-billion (approx. US$ 135-billion at October 2005 Rate s). The mere announcement by a company of its intention of converting could add 10-20% to its Share Price . Trusts received another boost in 2004-2005 as the provinces of Ontario , Alberta and Manitoba implemented Limited Liability legislation that shields trust investors from personal liability. (Such legislation existed in Quebec since 1994). Partly as a result of this ruling, managers and institutional investors replicating the index. However the S&P, as a major bond rating agency, has expressed concerns about the sustainability and the quality of the accounting concerning many trust entities as going concerns in the future. Business trusts have come to the attention of the government. In the March, 2004 Federal Budget , Finance Minister Ralph Goodale had tried to prohibit Pension Fund s from investing more than 1% of their assets in business trusts or owning more than 5% of any one trust. Powerful funds led by the Ontario Teachers Pension Plan , which at the time had a significant stake in the Yellow Pages Income Fund, fought the proposed measure; the government backed off and suspended the restrictions. On October 31, 2006, Canadian federal Finance Minister Jim Flaherty announced a new tax on income trust distributions in a bid to stem the growing number of companies that are converting to trusts. Suspension of advance tax rulings On of the Royal Bank Of Canada , mentioned in passing that he was not opposed to Canada's largest bank converting into a trust. One week later on September 19, the Department of Finance announced that they were suspending advance tax rulings – essential for investor confidence – on future trusts. {Link without Title} The resulting uncertainty caused an immediate slump with the trust market losing approximately $9 billion in market capitalization during the following week. This caused also showed hesitation regarding its planned trust conversion. Previous plans by ACE Aviation Holdings to spin-off Air Canada Jazz into a trust were put on hold indefinitely. "Traditional" Canadian REITs, once content to ride the trust boom, tried to distance themselves from the new business trusts, to avoid regulatory "collateral damage." [http://www.globeinvestor.com/servlet/ArticleNews/trusts/GAM/20050928/RREIT28 (6) In the day following the change in working tax policy, the unit price for all income trusts and REITs on the TSX dropped by a median of more than 17% according to the iTrust Report published by TrustInvestor.com and its iTrust Index . Studies by Leslie Hayman, publisher of the Report, indicated that the change in advance tax rulings in 2005 was the most statistically significant volatility event in the history of the trust market. According to RBC Dominion Securities , yearly trust cash distributions amounted to C$16 billion in 2005, not including potential Capital Gain s taxes on trust conversions. Of that amount, $3.3 billion was collected in tax. RBC estimates that taxing trusts like regular companies could slash the market value of Canadian business trusts by as much as 30% {Link without Title} – again, not counting the loss of the share price premium of companies that had announced their conversion and would then back off. Following the announcement, Mr. Goodale and the Department of Finance declined to comment or answer questions on the future of income trusts. Intense lobbying efforts to "save the trusts" were undertaken by the business community and the Conservative Party Of Canada . They demanded that if equal treatment is to be granted to trusts and traditional companies, it should be implemented by leaving the trusts alone and cutting corporate and/or dividend tax to match the trust advantage. That solution would cost the government an additional C$1 billion, which the lobbyists claim would be a small price to pay for stabilizing the market and satisfying the public investors/voters. Since any decision was to affect the finances of an unknown proportion of the government's voting base, the trust debate turned into an important Issue In The 2006 Election . Analysts were trying to estimate the political repercussions, mostly depending on how much Retail Investor s, especially seniors saving for retirement, were involved in the market. Some analysts put this at 60-65% of the market, up to 80% when counting mutual funds. If this is the case, a pre-election decision unfavorable to income trusts would have proven hazardous to Prime Minister Paul Martin 's Minority Liberal government. {Link without Title} Dividend tax cut announcement The government found itself under increasing pressure throughout November as the opposition moved towards a Vote Of No Confidence that meant the current administration might not remain in place by the time the trust consultation and review concluded on December 31. After the close of the markets on November 23 , 2005, Mr. Goodale made a surprise announcement that the government would not tax the trusts, and would instead cut dividend taxes; the advance tax rulings were also resumed. The announcement described the proposed cut as such: :To accomplish this, the Government proposes to introduce an enhanced gross-up and dividend tax credit (DTC) for eligible dividends received by eligible shareholders. An eligible dividend will be grossed-up by 45%, meaning that the shareholder includes 145% of the dividend amount in income. The DTC in respect of eligible dividends will be 19%, based on the 2010 federal corporate tax rate as proposed in the 2005 Federal Budget . The existing gross-up and tax credit will continue to apply to other dividends. ( Canadian Department of Finance ) The markets rallied in the hours leading to the announcement (the government denies any leaks, see below) and on the following days as well, sending the S&P/TSX Composite Index to a new five-year high. The day's biggest gainers were income trusts, income-trust candidates, high dividend-paying companies, and the TSX Group itself. Former trust candidates such as Air Canada Jazz announced that they were considering a trust conversion or spinoff once again. The decision, while applauded by financial circles, was widely seen as confused and hurried (an earlier government statement on the same day had mistakenly suggested a slight tax on the trusts) and made for the sole purpose of buying votes for the January 2006 Federal Election . Since the Liberal government was defeated in that election, the proposed cuts may be short-lived; furthermore the government's calculations assume that the individual provinces will match the dividend tax credit with an equivalent one of their own, which is not certain to happen. {Link without Title} Also, the Liberal government had come under fire for the very strong stock market rally that immediately preceded the announcement, suggesting leaks from government insiders to financial circles. Opposition parties requested an official investigation on Insider Trading activity on that day. The Ontario Securities Commission has rejected the suggestion, saying it amounts to political interference; the Royal Canadian Mounted Police however, has launched an inquiry on December 28. {Link without Title} The Conservatives propose new rules for income trusts Following announcements by telecommunications giants Telus and Bell Canada Enterprises of their intentions to convert to income trusts, on October 31, 2006, Finance Minister Jim Flaherty proposed new rules that will effectively end the tax benefits of the income trust structure for most trusts. Brent Fullard of the Canadian Association of Income Trust Investors points out that at the time of the announcement Telus and Bell Canada Enterprises did not pay any corporate taxes nor would they for for several years. According to his analysis, had Bell Canada Enterprises converted to a trust it would have paid $2.6 to 3.17 billion in the next four years versus no taxes as a corporation. 7 8 Income trusts, other than real estate income trusts, and mutual fund investment trusts, that are formed after that date will be taxed in the same way as corporations:
Income trusts formed on or before that date will not be subject to the new rules until 2011 to allow a period of transition. Real estate income trusts will not be subject to the new rules on real estate income derived in Canada (the non-Canadian real estate operations of existing REITs will be subject to the same taxation as business trusts). The new rules are contrary to the Conservative Party 's Election Promise to avoid taxing income trusts. {Link without Title} Flaherty proposes to reduce the federal corporate income tax rate from 19% to 18.5% in 2011. The 34% tax on distributions will be split between the federal and provincial governments -- the federal government will consult with the provincial governments on an appropriate mechanism for allocating 13 percentage points of the new tax between the provincial governments. Flaherty also proposed a $1000 increase to the amount on which the tax credit for those over 65 (the "age amount") is based, and new rules to allow senior couples to split pension income in order to reduce the income tax they pay. These proposals are designed to mitigate the impact on seniors of the new income trust rules. Legislative amendments to implement these proposals must be passed by the Parliament Of Canada and receive Royal Assent before they become law. The legislation to implement these proposals was included in the 2007 federal budget, which was presented to Parliament by Jim Flaherty on March 19, 2007. Subsequent to the October 31 announcement by Flaherty, the TSX Capped Energy Trust Index lost 21.8% in market value and the TSX Capped Income Trust Index lost 17.6% in market value by mid November 2006. In contrast, the TSX Capped REIT Index , which is exempt from the 'Tax Fairness Plan', gained 3.2% in market value. According to the Canadian Association of Income Funds, this translates into a permanent loss in savings of $30 Billion to Canadian Income Trust Investors [http://www.caif.ca/content/CAIF_OtherChoicesAd.pdf]. In the month following the tax announcement, the unit price for all 250 income trusts and REITs on the TSX dropped by a median of almost 13% according to the iTrust Report published by TrustInvestor.com and its iTrust Index . Studies by Leslie Hayman, publisher of the Report, indicated that the tax news at the end of 2006 was the second most significant volatility event in the market following only the suspension of advance tax rulings by the Minister of Finance, Ralph Goodale in 2005. =Opposition to and criticism of new tax rules Criticism of the new tax rules has been strong, and generally based on three different types of criticism:
Economist Yves Fortin has challenged the reasons for the change in tax regime announced by Flaherty and disputes the Harper government assertion that the Trust structure has led to loss of tax revenue because of trust conversions in his research paper Income Trusts and Tax Leakage: Is there a problem? . In a January 12, 2007 paper Yves Fortin outlined his concerns regarding the claim of tax leakage. Finance Minister Jim Flaherty stated in his October 31, 2006 policy statement "If left unchecked, these corporate decisions would result in billions of dollars in less tax revenue for the federal government to invest in the priorities of Canadians, including more personal income tax relief" but Minister Flaherty has not documented the claimed losses nor the methodology used to estimate them. Mr. Fortin's paper [http://www.caif.ca/content/TaxLossRecipe.Fortin.pdf A Recipe For Tax Loss gives several examples on how the tax on income trusts could lead to a loss in government tax revenue. Analyst Gordon Tait has also raised concerns about the lack of consultation and misconceptions surrounding the change in tax policy on Trusts in The Inconvenient Truth About Trusts , although Mr. Tait also notes that he recognizes "the dilemma the Finance Minister found himself in," and that "the potential for a large number of corporate conversions to income trusts necessitated some kind of action." A December 11, 2006 Income Trust Report by PricewaterhouseCoopers reviewed the surveys and studies conducted in 2004 and 2005, the economic benefits and impact of income trusts in Canada. The report concludes that income trusts do have a place in Canadian capital markets and the 'Tax Fairness Plan' is unfair to Canadian investors who hold trusts in a tax-deferred Registered Retirement Savings Plan or a Registered Retirement Income Fund . Analyst Cameron Renkas examines the Department of Finance assertion that the United States and Australia have taken action to shut down flow-through structures. In his research paper Digging Deeper he gives a perspective on how the United States taxes publicly traded Flow-through Entities and Master Limited Partnerships , the US equivalent of Canadian income trusts. Analyst Dirk Lever wrote on January 15, 2007: "We cannot understand why any Canadians would support double taxation of retirement benefits - it affects all of us eventually". Mr. Lever also looked at the Conservative government's policy in his research paper Deep Dive into Tax Issues: Canadian Pensioners Taxed Twice on Canadian Corporate Dividends . In the report Mr. Lever questions the logic behind double taxation of dividends, and claims that foreign investors pay less tax on distributions than domestic investors. The proposed solution, however, is not to retain the existing benefits of income trusts, but to have identical tax regimes for both corporate and income trust distributions (dividends). The report does not address the benefit received from tax deferred savings plans (such as RRSPs and pensions) at the time of contribution, nor the tax-free accumulation throughout the life of these plans. |
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