Income trust expert says

(October 8, 2003) Income trusts have been the darlings of an otherwise sluggish market over the past three years, but lately they have been the target of many naysayers who are distrustful of their structure and its tax advantages.

One of the recent setbacks to the sector was caused by PricewaterhouseCoopers’s (PWC) refusal to audit the Specialty Foods Income Fund, saying it was uncertain if the trust’s accounting methods conformed to U.S. generally accepted accounting principles.

Because the underlying operation’s assets were based in the U.S., PWC worried that the trust was draining money from the U.S. economy without paying taxes on the income. The facts were never at issue: Specialty Foods was generating its revenues in the U.S.; these funds flowed through to the trust that owns the operation, thus avoiding U.S. taxation; and the cash was then distributed in Canada to be taxed in the hands of investors by Ottawa.

What remains unclear is whether America’s Internal Revenue Service (IRS) will step in to stop this drainage. The IRS has not yet issued a statement and Leslie Lundquist, portfolio manager for Bissett Income Fund, says the amount of money involved is too small for the U.S. taxman to worry about.

“Even if you waved a red flag under [the IRS’s] nose, it would have to be a big enough red flag for it to see,” says Lundquist. “The Canadian income trust phenomenon is so miniscule, I don’t think they’d spend one minute of their time looking at it.”

But it is an issue that won’t go away. There’s always a chance that the IRS will take a closer look and come after such cross-border trusts some day. Until there is some clarity on this, U.S.-based trusts will trade at a price discount.

Lundquist says it is unlikely that more of these trusts will come to market, due to the added risks.

“I don’t think it’s a bad thing for investors to realize that investing in a company that’s not in your home borders is just a riskier proposition overall.”

And it is not just south of the border that trusts’ “tax efficiencies” are coming under scrutiny. Opinions vary on the degree trusts affect the tax coffers of various levels of government, but a study conducted by the C. D. Howe Institute came to the conclusion it was around $600 million a year.

But Lundquist says this study did not include taxes garnered on capital gains made, which have been significant despite the focus on distributions, not growth. Even if the $600 million figure is accurate, she says this is insignificant when compared to Ottawa’s overall revenues.

“The Department of Finance is fully aware of the income trust phenomenon, it’s not that they haven’t noticed, it’s just that they’re not concerned about it,” she says. “So far there’s been no indication that they think anything needs to be done, so they’ve been monitoring it, but so far there hasn’t been any particular concern.”

Filed by Steven Lamb, Advisor.ca, slamb@advisor.ca