July 20, 2010, 5:00 am

Everything you need to know about Income Trusts

by: The Financial Blogger    Category: Canadian Dividend Stocks,Investment, Market and Risk,Trading
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For years, any top dividend list has had many income trusts at the very top. If you look at the most recent one that was published, the top 5 stocks were in fact trust units. But the Canadian government announced changes to this structure that will affect those companies as well as the investors involved in these funds. We have received many comments and emails about Trust Units, the upcoming changes and how it will impact the investments in those companies. So we did some research and will do our best to answer these and additional questions as well.

What are Income Trusts?

Income trusts are capital structures that are designed to pass on cash flows to their investors. This differs from traditional businesses because corporations generally do not keep much capital.  Income trusts also avoid taxation since the taxes are paid by the investors who will receive the dividends. Because of that structure, trust units generally pay high dividends. They avoid the “double taxation” that affects almost any other company. Double taxation represents the fact that a company will be taxed on its profits and then the individual receiving the dividend will also pay income tax on those gains. They were created mainly to spur growth in Canada’s energy sector as this helped give shareholders an incentive to invest in these funds. Since the Federal government saw natural resources as an important driver for Canada’s economy, getting capital investments was a key to accelerating the development. It’s safe to say that these measures have been a huge success. Not only did these funds attract capital but many other companies realized they could increase their company’s value by 15-20% simply by converting to an Income Trust.

What is happening to these trust units?

Because of the favourable tax treatment, an increasing number of Canadian corporations started converting their structures to become “Income Trusts”. This of course had a major impact on the revenues of the Canadian government as it was an efficient way to diminish taxes paid out. That attracted attention from the government. But when BCE, one of largest telecommunications companies in Canada announced its intention to convert, it became too much for the government. Finance minister John Flaherty announced changes in the treatments of trust units that would be rolled out over 4 years. These changes applied to any company that became a trust unit after 2007 but others had 4 years to adapt to the new rules. As the January 1st 2011 deadline gets closer, many of the Income Trusts are converting to more traditional structures.

How big of a problem were these Income Trusts?

In 2002, 79% of the money raised in IPOs in Canada was for Income Trusts. All of these corporations would end up paying little to no taxes to the federal government. It is easy to understand why this could not continue for very long. The federal government estimated it had lost $300 million in the previous year in taxes and the amount lost by provincial governments was similar.

Are the changes a mistake by Ottawa?

Of course many would say that they are but in the end, every Canadian would have been affected if the government had left the rules as is. With larger companies such as Air Canada & BCE converting, the government was going to receive less income and would need to add or increase other taxes to compensate. In my opinion, this was not a mistake. It’s sad for all of us Income Trust investors but still right.

Are all trusts affected by these changes?

No, real estate income trusts and mutual fund income trusts are not affected.

Do all trusts have to convert into a traditional structure?

No, they can remain as is. The main objective of these changes is to eliminate the tax benefits. Thus, income sent out to shareholders will be taxed at a 34% rate (31.5% starting in 2011) at the corporate level. Individuals will also be eligible for dividend tax credits, which is the same as with regular dividends. Many income trusts have confirmed they would remain in that structure.

Will the dividends change?

It really depends on each corporation. In general, corporations are simply reducing their payout to account for these taxes. For example, Daylight Energy Ltd (DAY-U) recently convered into a non Income Trust, its new ticker is DAY. It also reduced its payout from 0.08$ to 0.05$ per month. But is far from the majority. Of the 33 trusts that initially announced they would convert into a traditional corporation, 23 confirmed they would not diminish their payouts.

Will the prices of these securities dip?

That is very unlikely. Why? Because the rules are known and most of these securities already have the new rules priced in. In the month following the announcements, the trust index dropped by 17.8%. That is when it was dangerous to hold them. These days, you will simply see your monthly inflows take a hit.

Is there anything good for the Income Trusts?

Yes, it is far from being terrible news. One of the reasons why many income trusts converted into a corporation early is that as Income Trusts, they were very restricted when they wanted to issue shares. That made it difficult to increase their size even when good opportunities existed. As corporations, the trusts will have more flexibility.

What do I need to do as a shareholder?

Nothing. No matter if the trust unit converts or not, you can hold on to that security. The corporation is the one that needs to take action to pay the proper amount of taxes.

Conclusion

In conclusion, you should expect the dividends from these corporations to drop when the new rules take effect or earlier if the company changes to a traditional model. However, the stock price should not be affected.

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Comments

Very interesting. Still have hopes that somehow they will bring back a measure similar to this one back… it was great while it lasted

Good post. Question: What trusts > high-yield dividend corporations are you considering buying? Do you hold any right now?

Would love to hear that as well TFB? Are you invested in any trust units right now?

by: The Financial Blogger | July 20th, 2010 (11:01 am)

I will actually take a closer look at trust and high yield dividend corporation in a near future as I will restart my Smith Manoeuvre probably in August or September.

I really like banks in general (who don’t?) and Canadian Oil Sand (which I made a review in my latest newsletter) seems interesting to me.

What about you FC?

Hey FB! I’m also a fan of the banks. I own 3 to date. You’re right, who doesn’t love them? :)

COS.UN seems good, but I like JE.UN even more. I’m looking forward to them converting in 2011 and will probably put that into my TFSA for 2011. I’m staying away from any trusts until they convert; only 5 months away anyhow and there are likely good deals to be had this fall with some bigger blue-chips.

I do like the REIT still. I have two so far (REI.UN & CUF.UN) but I also have CPG which converted late last year and like Financial Cents, JE.UN looks to be in a good market with the deregulations of energy in some states and provinces.

I have been watching LIQ.UN (15%), KEG.UN (11%) and CGX.UN (6.5%) and I am just baffled by how the alcohol, a restaurant chain and a movie theatre chains have paid high yield for quite a while.

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