One year later: Income trusts hang tough

A year ago this week, Canada’s financial industry got a huge scare — and it had nothing to do with Halloween.

October 31 marks the first anniversary of Finance Minister Jim Flaherty’s pledge that the federal government would start taxing income trust distributions in 2011.

It was a surprise announcement that sent shockwaves through the industry. For the next two months, fund managers were dumping income trusts left and right, and the sector fell 22% in November and December. But the dust cleared soon enough, and despite doomsday prophecies, the income trust sector is still standing, at least for now.

“The initial reaction was understandable,” says Leslie Lundquist, a portfolio manager with Bissett Investment Management. “It took out all of the tax benefit the trusts have enjoyed.”

She says investors were overly negative and “not fully thinking that these companies are good businesses.” In four years, however, when the trust rules come into effect, many will still be viable investments.

Some managers recognized this and decided to buy instead of sell. “At the time, these companies were trading quite cheaply,” she explains. “Cooler heads prevailed and people picked up good assets at cheap prices.”

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John Priestman, a managing director at Guardian Capital, agrees that there were some rash sell-offs, but the industry is nowhere near extinction. In fact, 2007 is expected to produce overall returns of about 8% — not the highest returns for the sector, but not bad for an asset group that’s in turmoil.

“November and December [2006] weren’t a lot of fun,” says Priestman, “but I think the story on the trust market is that [by the end of 2007], we’ll have nine straight years of positive returns.”

An even bigger story might be the feverish M&A activity that’s occurred over the past 12 months. Since Flaherty’s announcement, 48 income trusts have been bought out. That’s almost one trust per week.

Owning trusts that are potential takeovers could make investors a lot of money, but Priestman admits that this frenzied buying spree is also a bit frustrating. “Mostly foreigners or private equity are going to end up owning the good trusts rather than people who can use them, like baby boomers or retired Canadians looking for income.”

With increased M&A activity, a lack of IPOs and other trusts converting into corporations, the number of income trusts in the sector has dropped significantly over the past year. Prior to Flaherty’s announcement, there were 245 trusts in the Scotia Capital Income Trust Index; 11 months later, that number was down to 213.

“We could safely say the number of trusts that existed prior to 2006 grew every year for the last five years,” says Les Stelmach, an analyst with Bissett Income Management. “It’s been on a general increasing trend, up until the tax announcement.”

Lundquist says a smaller trust universe is not necessarily a bad thing. She points out that it’s the weaker trusts that have disappeared, leaving a strong group of companies to dominate what’s left of the sector. “It makes the remaining trusts a bit more valuable,” she says. “If I had to characterize, we’re net negative for overall, but certainly we still have a healthy and viable market.”

“There are a lot of truly terrible trusts out there,” adds Priestman. “There are about 80 that are really good, another 80 that are bad, and about 50 that are somewhere in between.”

That means, says Priestman, that the sector is heading to a “bifurcation of performance.” Basically, the good trusts will either be taken over by private equity, or survive past 2011. The rest will fall by the wayside, either converting into a corporate structure or disbanding all together.

With many healthy trusts likely to be around after the new tax regime kicks in, both Priestman and Lundquist say investors will still benefit from holding income trusts.

“As you move toward 2011, the best trusts will be able to sustain distributions after they become taxable,” says Priestman. “Their distributions will become dividend income and that’s a pot of gold at the end of the rainbow.”

That optimism stems from the dividend tax rate, which falls somewhere between 18% and 26% depending on the province. Compare that to the 46% tax rate on interest income, and the income trust benefits are obvious. “If you get income in dividends rather than interest, it’s a huge win,” Priestman explains.

It’s clear that the income trust industry hasn’t handed in its cards yet, but that doesn’t mean it’s let Flaherty off the hook. “Certainly all is not forgiven,” says Lundquist. “We’re still angry and disappointed at how it went. It was completely unnecessary. It’s hard to stay shocked for a year, but when we speak to companies and management teams, none of them say, ‘oh well, no big deal.’ Feelings range from disappointment to anger to disgust.”

“Mr. Flaherty is in over his head as finance minister,” says Priestman. “He dropped the ball. As far as anyone can tell, it was just a personal decision that he made without consulting anybody.”

According to Priestman, the federal government hasn’t explained why it decided to tax trusts, and, more frustrating for the industry, it hasn’t issued any guidelines to tell income trusts how to operate between now and 2011.

Looking forward, Priestman says the best-case scenario for income trusts is that the Liberals win the next election. He explains that the party has promised to implement an immediate 10% tax on trusts, which is a better option than waiting four years, only to get hit with the 31% corporate tax that the Conservatives are planning to install.

But if nothing changes? “We’ll work towards 2011. Our game plan has always been to buy the biggest and best income trusts, so we think we can, even if the Liberals don’t come to power,” he says. “Our holdings will be prime takeover targets, and the ones that stay will be high-yielding dividend payers.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(10/29/07)

Bryan Borzykowski