The Truth About Trusts

By JoAnne Sommers

Finance Minister Jim Flaherty delivered an unexpected – and for many investors a highly unpalatable – Halloween trick with his October 31 announcement of sweeping changes to the tax treatment of income trusts. The proposed measures, which have already cleared their first hurdle in the House of Commons, mean that profits from trusts – excluding REITs (Real Estate Investment Trusts) – and limited partnerships will in future be taxed like corporations.

Trusts and partnerships already in existence at the end of October 2006 will be grandfathered and will not have their distributions taxed until 2011. Those created after November 1 will be taxed, starting January 1, 2007.

The proposals would also cut corporate taxes by half a percentage point as of January 1, 2011 and change tax policy for pensioners: the age credit will increase by $1,000 to $5,066, effective January 1, 2006, while income splitting for pensioners will be permitted, beginning in 2007.

The likely trigger for the move was the announcement earlier this Fall that telecom giants BCE Inc. and Telus Corporation planned to convert to income trusts. There were concerns that banks, broadcasters, cable TV operators and other cash cows might follow suit. 2006 has already seen $70 billion in new trust conversions, pushing the sector’s value to $200 billion.

While income trusts have been around for two decades, they got a real boost when the “dot com” bubble burst in 2000. With the markets heading south and interest rates falling, investors were looking for steady income. And trusts, which promised high yields relative to stocks and bonds, looked mighty attractive.

The appeal of the income trust structure is that it pays very little, if any tax, provided it pays out all of its net income each year to unitholders. Thus, unitholders pay the tax, which enables the business to distribute more cash than it could if structured as a corporation. It's mainly for this reason that income trusts tend to have much higher yields than common shares.

A further advantage is that, although unitholders are in theory fully taxed on the distributions they receive, they can use basic personal exemptions and RRSP contributions to reduce or even eliminate that tax. So the net after-tax return from an income trust can be significantly higher than the dividend yield from a similar-risk common share.

While there had been calls from some quarters for the government to level the taxation playing field for trusts and corporations, most observers were caught off guard by Flaherty’s announcement.

“It certainly surprised me,” admits Clay Gillespie, vice-president, financial advisor and portfolio manager with Rogers Group Financial in Vancouver. “I didn’t think the government would tackle it, given their minority status and their campaign promise to leave trusts alone. Plus, they were dealing with large budget surpluses.”

But in hindsight, Gillespie says the government probably chose a good time to make the announcement. “The reaction could have been much worse than it was: I thought this would drive the entire market into a correction but it didn’t.”

The market did lose more than $30 billion in the two days following the announcement, its biggest loss in more than two years. Since then, however, it has rebounded, recouping nearly all of the losses.

As for those who lost $100,000 or more in the aftermath of the “Halloween Massacre”, Gillespie isn’t overly sympathetic. “Anyone who suffered big losses was overweight in the income trust sector. This situation really underlines the importance of diversification.”

Flaherty’s announcement did not sound the death knell for trusts, according to Adrian Mastracci, portfolio manager with KCM Wealth Management Inc. In fact, good trusts – those with solid underlying fundamentals – have already started to come back, he says. On the other hand, he predicts that weaker trusts will be weeded out.

Mastracci advises investors to be patient, noting that he hasn’t added or sold any income trust positions since October 31. “Don’t make any long-term plans yet. After the minister hears from all the interested parties I think there will be some changes, either to the rate or the dates. So wait until you have more information and then consider your options.”

On the other hand, Mastracci thinks it’s unlikely that efforts by a coalition of oil and gas trusts to obtain an exemption will bear fruit.

Gillespie agrees. “As important as the energy sector is to Canada’s economy, I don’t think the government can be seen to play favourites,” he says.

The proposed changes will likely derail plans by Telus and BCE to convert to trusts, he adds. At the same time, existing trusts may decide to re-convert. CI Financial, which became an income trust earlier this year, has already announced plans to convert back. “I think that some businesses will re-convert to corporations and increase their dividends. And that’s good for investors.”