Trusts look stable, for now

(October 14, 2005) Standard & Poor’s issued two key decisions on income trust this week. First, the ratings agency said it would go ahead as planned and add trusts to the TSX starting in December. A day later, S&P decided not to alter its stability ratings on trusts — at least not yet.

Both were important announcements, if only because they didn’t create more uncertainty in this already uneasy sector. (Billions of dollars invested in income trusts evaporated overnight when the federal government decided to suspend advanced tax rulings as part of is consultation process to limit tax leakage). But the fact that the S&P has concerns at all about the impact tax policy changes will have on the stability of some trusts isn’t very comforting.

The S&P won’t penalize the trusts now because there’s no way to know how Ottawa will proceed. That’s not to say the S&P won’t change its mind.

As S&P’s stability ratings analyst Barbara Komjathy points out, “Direct taxation of income funds, for example, could alter the current distributable cash flow levels and relative pattern of income funds, and could result in negative stability ratings actions.”

The Dominion Bond Rating Service, the other ratings agency that tracks trusts, is also sticking to its methodology. Bob Maxwell, senior vice-president of DRBS Canada, agrees that it’s still too early to say what the full impact will be from the government review.

Whatever Ottawa decides, any change to Ottawa makes to the tax treatment of trusts would cut across the entire sector, except for REITs, Maxwell expects. “I would be surprised if they didn’t get carved out in some fashion,” he says “If you look internationally at the U.S. or Australia or other markets, generally speaking the real estate sector has been carved out relative to business trusts.”

While tax policy changes won’t necessarily impact the quality of a trusts underlying cash flow, Komjathy says, it could impact yield and valuation of the entire sector. That could have a serious impact on trusts that routinely tap the equity markets to fund growth.

Komjathy likens it to a GIC. “When you buy a GIC and it pays 5% and if there is a secular shift and interest rates become 2% going forward, that will not impact the likelihood that that GIC will pay the interest but it will impact the attractiveness of that investment.”

A uniform tax increase, which is one of the options Ottawa is said to be considering, would lower valuations, making trusts less attractive and in turn, making it more difficult for companies in the sector to raise equity. Generally, if Ottawa was to tax income trusts at a rate of, say, 38%, then one can expect distributions to be cut by the same amount. This will make it most difficult for those companies that have relied on frequent access to the equity market.

“There are a number of ways that this could play out at this point,” Komjathy says. “Most likely companies would have to decide is whether to re-evaluate their capital structure if there is a direct taxation.”

They also may have to find other forms of funding, which could force a company to pass up growth strategies, or pass up on certain acquisitions altogether. If a company can’t access equity, there is a degree of concern there, says Komjathy, but that depends on the nature of the fund.

At the end of the day, the more conservative strategy a fund has, either from a payout perspective or less of a need to access the equity markets, the better it will be able to withstand potential shocks. “What was a good business will remain a good business.”

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