Trust investors left with few alternatives

With the passing of the federal income trust tax into law on June 22, it’s no longer a game of wait and see; income trusts and their investors have to make some hard decisions about what to do now. For the foreseeable future, there are few options, and none of them are as attractive as the pre-tax format.

Ross D. Freeman, a partner with Borden Ladner Gervais who heads the firm’s tax division in Calgary, says that if investors are looking for a way to duplicate the tax-efficient performance of the pre-tax trusts, they won’t find it.

Freeman expects that many of the trusts will now put in place a plan to convert into corporations. This rollover can be done with virtually no loss to the investor.

“Instead of holding trusts, investors would be holding shares of a corporation. That transaction can be done on a rollover basis using a section of the [income tax] act called section 85,” he says.

For corporations, however, he says the transfer is going to be problematic, particularly for companies that have public subsidiaries and may have income trusts and corporations existing under the proposed umbrella corporation. Freeman says this type of structure is inefficient and there will be substantial tax implications and costs associated with the conversion.

Even more problematic is that a conversion to a corporate structure does not address how investors will duplicate the combination of capital growth/yield offered by income trusts. Whether or not the trust tax is warranted, income trusts were an effective investment vehicle for retired investors, who have a unique need for capital growth and a steady flow of income.

Brent Fullard, the president of the Canadian Association of Income Trust Investors, says as the boomer generation enters retirement, the need for income yield is only going to increase.

“In the end, the common shares may provide a total return that is greater than income trusts, but that’s not the point,” he says. “I’m sure there are some companies that don’t deserve to be trusts. It was in response to a latent need that isn’t changing, that isn’t abating. People need income.”

He expects that trust investors are going to grudgingly turn to U.S. alternatives, such as master limited partnerships and the municipal bond market. “All of this money is going to leave the country. That’s where I’m taking my money. I’m not going to leave it in common shares in the TSX, forget it. That’s not why I bought income trusts,” Fullard says.

Freeman says that cashing out and going south is a real option but a very costly one.

“[The U.S. market] gives them the same kind of yield as income trusts, but they’re going to lose 20% of their investment right off the top because of the capital gains tax,” he says.

Freeman expects some Canadian companies to try to retain Canadian trust investors by offering either very large corporate dividends or direct royalty interests.

Already, he says, some corporations intend to offer large dividends as alternatives to income trust yields.

“Corporations that are raising money are now saying right in their public disclosure, they intend to declare dividends on their shares essentially equivalent to what would have been an old income trust dividend. This is something in the order of 9, 10 or 11% dividends. This is something that was previously unheard of,” he says.

The problem with dividends, Freeman says, is they are not tax-efficient. The corporation will pay tax on the income and won’t be able to deduct the dividend, and investors will then have to pay tax on the dividend they receive.

To circumvent the double-tax hit, he suspects that energy-producing companies in particular will look to resurrect direct royalty trust interests, where the company pays investors a royalty on a percentage of its product revenue.

“They could issue what was called a royalty certificate. On all of our production in the oil company, they pay the investor a royalty,” he says. “The advantage of that is that you eliminate the double tax. When the royalty is approved, that’s a deductible tax for the company.”

Freeman says it still pales in comparison to income trusts because the investor is still on the hook for tax on the income.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(07/03/07)

Mark Noble