The Certainty of Life: Death and Taxes

This week, the Liberal Party of Canada announced that they would reverse the Conservative Party's plan to tax income trusts. Clearly, our nation’s largest political parties don’t see eye to eye on this issue. So what ever happened to income trusts following the Conservative’s initial announcement to tax income trusts in the first place?

On October 31, 2006, Jim Flaherty proclaimed to Canadians that the government would be implementing new taxes on income trusts in 2011. In essence, the income tax structure benefits which allowed trusts to distribute a very high percentage of their cash flow – in some cases, nearly 100% – would end. The following day, income trusts in Canada lost roughly one-fifth of their market capitalization – a huge loss for a company in one or two years, let alone one day. As the clock starting ticking, the management and directors of income trusts had to start contemplating what move was best for the funds. Should they cut distributions when they ran out of cash? Should they restructure? Should they refinance? Should they convert into an entirely new entity? Should they sell off some or all of the trust?

Two of these options become the most widely feasible for most income trusts: either cut distributions to the extent of the proposed tax increases, or convert into a corporate structure.

The logic for converting to a corporation (from a trust) is generally “short-term pain for long-term gain.” A conversion would:
a) Reduce the distribution expectations – many corporations have no dividend or one below 3%; and
b) Allow management to re-allocate funds to invest in growth opportunities.

The immediate reaction to the distribution cut would be for existing unitholders – aka “yield pigs” (investors who are looking for trusts distributing cash for a 10% or higher yield) – to sell off their units in large blocks (short-term pain). Many Canadian income trusts followed this route: Aeroplan Income Fund, TransForce Income Fund, Fairborne Energy Trust, High Arctic Energy Services, Trinidad Energy Service Income Trust, and Keystone North America. 90-days following the announcement that they would convert, these trusts traded on average down 17%.

The second option available in income trusts is to cut distributions to unitholders. Two Canadian trusts have taken this route: Primary Energy Recycling Corporation and Boralex Power Income Fund, which cut distributions by 31% and 22%, respectively. 90-days following the announcements they would cut distributions, they traded on average down 24%.

What can we learn from this? Firstly, the fundamental reason why people invest in any income trust is for its stability: predictable cash flows, tangible assets with easy-to-understand valuation procedures, tax benefits, and steady distributions. Income trusts also have significantly higher yields than bonds, bank dividends, preferred shares, and almost all other securities that one could name. Thus, when income trusts announce distribution cuts – especially when the market does not expect them – the unit price is at risk.

And yet, it would seem that management is stuck between a rock and a hard place: converting to a corporation results in a negative outcome for shareholders, as evidenced from their double-digit decline since conversion. Moreover, one’s entire shareholder base will be replaced with more aggressive, growth-focused investors which could take a more active role in their growth-development phase.

The conventional wisdom suggests that there are two certainties in life: death and taxes. But, if it’s up to Liberal leader Stephane Dion, perhaps income trusts will get a tax break after all. How unconventional.