The future of the trust structure

Federal Finance Minister Jim Flaherty’s surprise decision that he plans to tax income trusts may have been a nasty trick on All Hallow’s Eve, but tax experts say the writing was on the wall.

If tax leakage was ever an issue for the federal government than Telus’s decision to convert to a trust certainly sent a chill down the hallways of Parliament Hill. BCE’s announcement a short time later simply exacerbated the problem, and likely forced the government’s hand, experts say.

“We’re talking about a billion dollars of foregone tax revenue here, so if anyone thought that this was a shock or a surprise then clearly they have underestimated the resolve of the federal government,” says Kevin Hibbert, chief accountant for Standard & Poor’s Canada.

According to the feds, this year alone almost $70 billion in market capitalization have either converted to an income trust or have announced their intention to do so. Some have estimated the resulting tax loss at close to $1 billion a year.

Under Flaherty’s “Tax Fairness Plan” the federal government is proposing to apply a distribution tax on distributions from publicly traded income trusts. Although the new measures will not impact existing trusts until 2011, they will apply to any trusts that commence trading on or after November 1, beginning in the 2007 tax year.

While the intended targets of Flaherty’s plan are trusts that are converting to the structure for tax avoidance purposes, the fallout will be felt across the board. “Certainly there will be some casualties of this event that will be much more severe than others,” says Hibbert. “Some will require a band-aid, others are going to require open heart surgery and others break out the pine box.”

Business trusts will be amongst those impacted, as was evident on the markets Wednesday morning after the government’s announcement, but they could spring back, particularly those that turned to the trust structure as an alternative to the high-yield debt market.

The trust structure has been great for companies that don’t have strong credit ratings since it’s made it easier to access capital. While companies such as CI, GMP, Telus and the BCE will be hurt by Flaherty’s decision, Hibbert says, it will likely have little impact on business trusts. “The other guys probably had very little earnings to begin with such that even if they do get taxed it’s not going to be that meaningful.”

Still, he warns, “If your cash flows are falling off because you have to pay tax than it could result in sustained or permanent pull back in valuations.”

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• Trick or treat?: More on Ottawa’s tax changes • Funds shrug off tax • Feds hit trusts in surprise mini-budget

• TEMPLATE LETTER: Ottawa’s new "tax fairness" plan

Although tax events are never incorporated into the S&P’s stability ratings since all companies, or in this case all trusts, are impacted equally, Ron Charbon, S&P’s director of Canadian ratings says Tuesday’s announcement may affect some funds more than others.

The good news is the tax change won’t impact the operations of these funds, he says, but there certainly are implications down the road and some cases immediately for those funds that are in certain situations.

Although Flaherty said in his statement that his plan will level the playing field between trusts and corporations,” that is not really the case; the most notable exception being real estate investment trusts, which have been excluded from the new rules — although there are exceptions.

Blake, Cassels & Graydon LLP note in a bulletin that the federal government has constructed a narrow definition of REITs in its plan. As a result, the exemption “may not apply to all existing real estate based trusts.”

The law firm explains that to be a REIT for the purpose of the government’s plan, a trust must hold no “non-portfolio” properties except real estate, it must derive at least 75% of its income from rents, mortgages or gains from real property in Canada and must hold real property in Canada, cash and government debts that account for at least 75% of its equity value.

REALpac, Canada’s national industry association for owners and managers of investment real estate, issued a statement saying it feels the vast majority of REITs will be excluded from Flaherty’s plan. The ones that will be most effected are those that have active business components or significant foreign real estate holdings.

The association assures investors, “With a four-year transition until the rules come into effect, it is expected that Canadian REITs will have plenty of time to make the necessary structural and business modifications to bring themselves onside.”

Warren Pashkowich, a tax expert and a partner with Ernst & Young, notes that while the plan does a better job of leveling the playing field between trusts and corporations there are still a number of questions that need answers.

“One of the significant differences [between trusts and corporations] is that if income is retained in the trust, it is taxed at a different rate than if it was in a corporation,” he says. “The tax only applies if earnings of the trusts are distributed to the unitholders.”

Given the provinces continue to tax dividends and different rates that could be good or bad news for investors depending on where they live.

“It’s a very complex set of rules that are going to create a lot of confusion over the next few months until some clarity is gained from the actual legislation,” Pashkowich says.

Filed by Mark Brown, Advisor.ca, mark.brown@advisor.rogers.com

(11/01/06)