Income Trusts

September 26th, 2008 by Potato

The Liberals have made one of their election promises to reverse the damage Harper & Flaherty have done to income trusts, and set a new tax of 10% which should bring them back to something approaching fair (it might just swing back too far towards benefiting trusts with the rebate, but it’s a hell of a lot closer than 31.5% was). This has brought the whole issue back to the forefront for a surprisingly small amount of people — most people never knew what an income trust was to begin with, or have written the sector off for dead and couldn’t care less about a Liberal promise. From a political point of view, it’s a brilliant promise because it points out to burned trust investors that the Cons broke their promise (flagrantly) at the same time that it talks about what the Libs will do. It’s negative campaigning at it’s best, because the negative part is fairly subtle. “They’re bad, and we’re better than them and have a plan to fix things.” vs. the usual Con rhetoric of “They’re bad, and we’re not them” which just doesn’t motivate me.

Anyhow, I know most of my readers won’t care, and in fact probably don’t know what an income trust is. Being an income trust investor myself, I’m going to do a post on the matter.

So for starters, what is an income trust? Well, it’s a special kind of company, a corporate structure. Like public corporations, you have shares (units) traded on an exchange such as the Toronto Stock Exchange, that represent ownership of the company. Unlike a regular public corporation, the money the trust makes is not taxed by the government in the hands of the company — instead, the company distributes the money every month to its owners (you, the unit holders), and it’s taxed there. There are various rules about how much a trust is allowed to grow and whatnot, but that’s the basic idea. The first wrinkle comes in that some of the distributions are (often) not interest, or employment income or even dividends when they go to the unitholders to be taxed, but rather are (or can be — some parts can be interest, income, or dividends) “return of capital”. This means they’re not taxed right away when you get them, but can be deferred until you sell your units (it affects your adjusted cost base*), and then at half your marginal rate.

So far, it’s looking about the same from the investor’s point of view: they can make the same money from either capital gains on a corporation’s shares or an income trust, and only pay capital gains tax (at half their marginal rate) when they sell. Then you consider that there’s a time advantage to getting the money up front but deferring the tax, which the income trust investor can do, and on top of that that the corporation was taxed on its money that it reinvested in itself, whereas the income trust was not taxed on its money. Then things start to look pretty rosy for the income trust setup, even with the other rules. They’re fantastic for people like seniors and students: you can get some cash flow up front, to keep the pizza and coke fund afloat while you’re still working a little, then when you’re finally in school full time (or retired), you can sell your trusts, and not pay much (any) tax since you’re in a lower tax bracket. The restrictions on growth were easily met by mature companies, and indeed it’s a pretty optimal structure for a company that has plateaued in its growth and capital expenditure and is now just churning out cash.

Of course, the deal seemed a little too good to be true, and there were ever more companies deciding that they would convert. There were accusations of “tax leakage” — that less tax overall was being returned to the government with trusts than with corporations. It’s kind of a difficult thing to figure out: yes, there almost certainly was less tax being paid by trusts**, but how much? Some of it was being taxed in investors hands, and while regular corporations faced double-taxation, that was only on their profit whereas income trusts get taxed on their cash flow (in the hands of investors). Was it worth bothering with, especially given the other benefits trusts offered (when you’re not taxed “expensing” something has a different meaning — I haven’t conducted a thorough survey, but obscene salaries, perks, and bonuses are seemingly less common in income trusts; stability in returns; regular cash flow vs. having to regularly sell when you’re in say, retirement)?

When behemoths Bell and Telus decided to join in the fun it started to become clear that there might be a problem, that the trust structure was clearly more lucrative than was fair. (Though according to CAITI Bell and Telus hadn’t paid any corporate taxes anyway, so converting to a trust would increase government revenues — again that point about taxing net income vs cash flow).

To “fix” this problem, the Cons, Flaherty and Harper made a surprise announcement, apparently having done no research on the subject, imposing a punative 31.5% tax, to come into effect in 2011. Now the evidence is clearly showing that this tax is too much to be fair because there is a torrent of companies converting back into regular corporations. Indeed, it doesn’t look like the government will collect anything from it’s 31.5% tax, because there won’t be any profitable trusts left. When asked to prove how they got to their figures on tax leakage, they released 18 pages of blacked-out documents, which tells us that they probably were wrong and are just too bone-headed to admit it and fix their error, or, as they have done before, they ignored the advice of their experts and just did whatever the hell they felt like anyway.

This was a hugely bad move not just from the point of view of killing the whole trust sector, but it also put the government on a bad foot because they were rash and impulsive. This was an election promise that they flagrantly broke, with no evidence provided that it was necessary. Moreover, this was not introduced gradually, there was no study. They didn’t halt new conversions and invite testimony from the corporate world, they just leaped out of a dark corner and sprung this on the market, and let me tell you, the market fucking hates that shit. It’s very difficult to do business in an environment where the government is pulling the rug out from under you and changing the rules all the time. Not just trust investors, but everyone suddenly had to be on Harper/Flaherty watch: what if a golf buddy of his complained about the favourable tax treatment solar water heaters were getting, would he jump in on that “crisis” and start taxing the sun to level the playing field with natural gas? If someone in the grocery line complained that cheese didn’t have GST but Coke did, would he run off to “fix” that, and add a cheese surcharge and tank that industry? What if he suddenly started believing in global warming?! Oh, the damage he could do in a brash unresearched move***. I’m all for fairness, and an income trust tax was probably necessary. But if you’re going to do that to the market, you’ve got to show up with a binder the size of the Yellow Pages documenting how you came to that conclusion, and showing that your new tax would be fair but not punitive, and moreover, showing that you’re taking this move as part of a well-researched plan, and aren’t just jerking the business world around on a whim.

And, as has been pointed out numerous times, the surprise announcement lead to a sell-off, which foreign and private companies/pension funds took advantage of to snap up trusts, and hey: now the tax leakage just got way, way worse.

So the Liberals have promised to put the tax at 10%, which to me seems more like where fairness should be (though rebating that might swing the pendulum back a bit too far in favour of the trusts). It should remove any tremendous tax advantage from either side, and will let companies pick the structure that best suits their investors based on other factors — are they mature, more suited to spinning out cash in a predictable fashion? Or do they still have potential for growth? Are they majority owned by crotchety old seniors and pension funds who want stability and cash flow from their mature industries, or hot-shots with blackberries trying for a two-bagger? Should they take on incredible amounts of debt to become highly leveraged, or would they benefit from being more stable with modest debt levels? I’m a trust investor, and I like having options, so I think the trust structure should remain a viable option, but yes, it shouldn’t be a privileged one.

My idea is that if the big symptom of a problem, the indicator of a preferred tax setup, is that too many companies are trying to convert; but that it just takes too much studying to try to determine the tax leakage and a fair tax rate from the government’s side… then let the market determine the fair tax rate for trusts. Let one and only one company convert to trust status each year, and let them bid on the tax rate they’re willing to pay to make it worth their while. Whoever is willing to take on the most tax burden gets to switch, the others can try again next year/quarter/whatever.

* – ok, for the technical stuff: when you buy some stock, you hope it will go up. Say you buy at $10, then sell at $11. That gives you a capital gain of $1: you sold for $11, and your cost was $10. Now, what if you bought in over time, say one unit at $9, one at $10, and two at $10.10? In that case, your cost base is (9 + 10 + 2*10.10)/4 = $9.80, so you’d make $1.20 per share, and would have to pay capital gains tax on that. Still with me? Good. Now, What if you had to wait 3 years for that capital appreciation to take place? What if you didn’t want to wait 3 years, but wanted some of the money now? You could sell on the way up, and pay capital gains tax (and commission) at each sale, or, if this was an income trust, the company could give you some of the capital appreciation in the form of a return of capital distribution. You would have cash come into your account, and it wouldn’t be taxed — yet. Instead, that return of capital would come off of what you paid for the stock, and, in theory, the unit price wouldn’t change. So let’s say you bought that stock income trust for $10, and it paid $0.33 every year for 3 years, and is still worth $10. You still have $11 at the end of those 3 years: $1 from the distributions, and $10 worth of stock… and, so far, haven’t paid any tax. Now if you sell your units, what happens is that all those distributions you received come off your “cost base”, so even though you paid $10 for the income trust, and are selling it for $10, your cost for tax reasons is $9 and so you have a capital gain of $1 that you have to pay tax on. Phew! Still with me?

** The average corporate tax rate is ostensibly~31% (something like 16% for small businesses; ~6% after all the corporate deductions are taken into account), the average Canadian’s marginal tax rate is ~31%, the average tax rate on RRSP withdrawls is ~20%, and dividends are favourably taxed in the hands of investors, anywhere from a negative tax rate up to 30(?)%. So it’s hard to say, but in the hands of a rich person (highest tax bracket) in a non-registered account, a trust’s income cash flow would be taxed at about 25%, about 16% in the hands of an average Canadian (though honestly, I think the average investor is probably in a higher tax bracket than the average Canadian), about 20% after deferral in an RRSP, and 0% in my hands. If a corporation chose to act like a trust and spit out dividends, those would be taxed at ~31% [or 6%] in the hands of the corporation, and then again in the hands of the investor (at anywhere from -15% to 30% — yes, at just the right income, you can have a negative dividend tax). However, for a regular corporation non-cash expenses like depreciation count against income, so if you have a building that yields 6% rents and that you can depreciate by 2% every year, a corporation pays 31% tax on that 4% net difference — an income trust pays nothing, but then that 6% is taxed fully in the investors hands at some rate, probably in the 20% range. So it’s pretty clear to see that there is some tax advantage to being an income trust, which is part of the point, and that there is probably some measure of tax leakage. However, determining how much is a tricky issue, one that requires careful study. From what I can see of the plan, the Tory tax is going to hit the distributions, not the net income… and if I’m reading it wrong, then the other interpretation means essentially there is no trust structure any more, since they can only distribute dividends (like a corporation) and pay tax (like a corporation)… When the tax rate is the same, and the distributions are dividends rather than income/interest/RoC, then income trusts really have ceased to be, and they’re just regular corporations with a funny ticker. This hurts seniors in particular, because things like old age security benefits are taken away based on your investment income — and dividend income is much worse for this than income trust income was, even if the other tax issues were the same; now income trusts won’t be an option.

*** – hell, he risked nuking Chalk River/Ottawa because those damned “Liberal” safety people wouldn’t turn the 50-year old reactor back on without, scoff, backups. Oh, but he had it on good authority that it wouldn’t blow up, but he couldn’t share his evidence… but that’s a rant for another day.

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