Funds shrug off tax

(November 2006) The federal government’s surprise announcement that it would level the playing field between income trust distributions and dividend payments has had a sudden and massive impact on the Toronto Stock Exchange.

Announced on Hallowe’en, whether the move is a trick or a treat depends on what’s in a portfolio. Canadian bonds, for example, have enjoyed an uptick as investors sought replacement income vehicles for some of their trust holdings, not to mention a refuge from the ensuing equity market volatility.

Prices for many income trusts fell, with share prices of those planning to convert to a trust structure plummeting. While the overall index has seen a huge sell-off of more than 300 points on the open, there are some investments which are bucking the trend. REITs, which the government exempted, mostly held their own on the market.

Some of the winners are the materials stocks, as investors flock to the perceived safety of the commodity market. But also standing fast are shares of some of the long-standing dividend-paying companies, which will not only see competing trust distributions taxed, but will also see their own corporate tax rates trimmed by 0.5%.

“We like those companies and income trusts that continue to increase their distributions year over year,” says Patrick Magee, vice-president, Leon Frazer and Associates and co-manager of Industrial Alliance Canadian Conservative Equity Fund.

“From what I understand, it’s only going to be on the taxable portion of the distribution, so if it’s a return of capital it won’t be taxed,” Magee says. “If it’s a return of capital, I don’t know that it’s going to be taxed at the corporate tax rate.”

If a given trust is going to see a net 15% tax levied on its total distribution, he says, it will only need to increase its distribution by that amount over the coming four years.

“We like the ones that have good operations — none of this has affected operations. If that income can continue to be increased, you have four years before there’s going to be any tax effect,” he adds. “The idea of having a four-year window gives time for some of these income trusts to make some of that up.”

He estimates his fund’s exposure to trusts was about 17% before the announcement; or 23% if he included holdings in soon-to-convert stocks, such as Manitoba Telecom and BCE. The decline in these stocks is unfortunate, he says, but his fund originally bought into these stocks before the trust speculation began.

The immediate stampede out of trusts may also benefit dividend-paying common equities in sectors such as pipelines, utilities and banks.

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“If things get really sold off, maybe even a little more than they are now, then we might start getting more involved in picking some more up,” he says. “The next few days may present some buying opportunities.”

Dean Orrico, managing director and portfolio manager at Middlefield Capital Corp. agrees.

“You could very well see a number of businesses getting oversold here, which would make them attractive to private equity players,” he says. “There would be many players who will look to the trust market to buy some very attractive companies at lower prices than they were yesterday.”

Middlefield recently closed a new fund offering and have not yet invested the proceeds and Orrico says he is sitting on top of a “pile of cash.”

“You see a lot of panic selling right now, and that creates a lot of opportunities for buyers, like us, to take advantage of these kinds of prices.”

He can accept that his existing funds may take a short-term dip, but says they are relatively well-insulated from the government’s new tax plan.

“Our closed-end funds will be affected, certainly, because we own income trusts in our portfolios,” Orrico says. “They’re typically diversified portfolios, and REITs are really the anchors. I think they’ll perform better than the index because virtually across all our funds we’ve got double market-weight positions in REITs.

“Between now and 2011 we’ll review our portfolios and make the necessary changes to ensure we meet our objectives on the income side,” he says.

Orrico says there may be a few trusts which will convert once again, this time into income-participating securities, corporate structures which mimic the tax effectiveness of the trust, with investors holding a combined unit of debt and equity. But he warns that the government may step in to prevent this strategy as well.

“The individual investor who owns trusts in their cash account, not only are they unaffected for four years like anybody else, but even after that, his distribution is going to be treated as a dividend and he’ll get the dividend gross-up,” Orrico says. “He’ll be no worse off than owning a corporation.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(11/01/06)

Steven Lamb