Death to Income Trusts; Or Is It Really!

Well, Canadian’s got hit last week with a huge tax hammer. In spite of Conservatives singing a different tune during the elections, Finance Minister Jim Flaherty came out with a different taxation structure for income trusts. The one where income trusts will no longer enjoy tax exemptions, but actually have to chip in as everyone else to federal coffers.

The fallout from this decision was devastating for Canada’s stock markets, which took a severe beating. Every single business news venue was reporting about the tax changes, important income trust analysts were generously spreading investment opinions, more or less advising ordinary investors of the same–seek advice from an investment advisor.

So, what actually happened to cause such a reaction? Well, the federal government decided that it didn’t like more and more Canadian corporations restructuring into income trusts because they were shrinking its tax haul. I suppose the last straw were announcements from BCE Inc. and Telus that they would restructure into income trusts.

So, the government thought if it cannot stop them, it can join them, so to speak. If corporations want to be income trusts, so be it, but they’ll have to pay taxes on distributions from now on. And things just got a lot uglier in the previously idyllic income trust landscape.

Taxed distributions mean less income to income trust holders, and even less money going back into the underlying businesses. That further snowballed into slaughter on the stock markets, since trust units traded on regular exchanges as common stocks. Sure, there is a four-year grace period, but it doesn’t apply to new income trusts. This immediately served as an icy shower to BCE Inc. and Telus, which are currently rethinking the whole idea.

But, are all income trusts doomed to despair? Well, no! I have to say I always had a huge problem with income trusts because of the CAPEX loophole, whereby capital expenditures could be anything that management decides it to be, leaving so much wiggle room for manipulation.

The way Bay Street is buzzing right now, all income trusts have received a serious blow, but not all are doomed to failure. We can already see two distinct groups forming: Income trusts that can revert to regular common share structure and those that became income trusts only to take advantage of tax exemptions.

For example, Sleep Country Canada, a mattress retailer, is an income trust. It is also a niche department store chain; it has steady revenues and fiscally prudent management. So, if and when it decides to revert back to a corporation status within the next four years, which is how long the grace period is, Sleep Country is not likely to have any problems doing so.

However, income trusts with a huge pile of debt, practicing the high payout ratio, and with a growth strategy based solely on the sale of new units are in an entirely different kind of jam, including the one not having enough money to pay taxes.

What should income trust investors do? Well, the Street is right, people should seek expert advice of their investment advisors. Together, they should go over their income trust holdings and examine the underlying entities in great detail. Watch for the debt structure, if and why the payout ratio is high, how much money is available for near-term cash needs, if any profits are going back into the business, is there a viable market for the company’s products or services, is the balance sheet healthy, etc. In other words, do one more thorough company analysis, as if you were buying regular stocks.

Panic is clearly the worst possible choice. Arbitrarily selling the units after they have depreciated so much is the worst possible thing you could do, because such a move finalizes your capital loss. If you have to sell, at least base that decision on reasons that your income trust doesn’t have much chance to survive once the new tax regime kicks in. You have four years to come up with that decision.

That will take care of your portfolio. But, there is still one more visit you’ll have to make, and that is to your tax specialist. New tax on income trust distributions is favorable to some unit holders and not so favorable to others. You must educate yourself on consequences of the new investment income taxation concerning trusts.