Dispelling the myths on the effect of Tax Changes to Income Trusts

This is an e-mail that I sent out to those on my e-mail distribution list on November 1, 2006. However, there is still much talk and confusion surrounding the change of tax structure of income trusts, thus I have reprinted in this “Your Best Interest” edition.

Those who are expecting a further grandfather period should not hold their breath. This change in tax structure for income trusts does not come as a complete surprise. A few years ago the income trust market lobbied the Government for Investor Exemption from Personal Liability. Once this was granted, the structure of Income Trusts was no different from a corporation, except for the tax exemption on the distributions. Thus, as the old saying goes “If it looks like a Duck, and it walks like a Duck…..” and alas, the tax exemption was removed.

Taxable Accounts

There are no after tax effects to investors in their taxable account. Investors currently pay tax at the income tax rate on distributions. Going forward, the distributions will be cut by 31.50% (the corporate tax that the income trust must pay prior to distributing income), thus instead of receiving $100, investors will receive $68.50. Investors will be paid dividends rather than income, thus will be eligible for the dividend tax credit. After that is accounted for, investors will have the same after tax income, or the same “$ in your pocket”.

Non-Taxable Accounts (RRSPs, Pension plans etc..)

These accounts were the most impacted by this change. The frustration for Canadian investors is that these accounts contribute significantly to the Canadian Government tax base. The Government, taking into account the future stream of tax flows from these accounts, comes out significantly ahead by earning tax revenues on not only the amount contributed to the RRSP, but all of the growth as well, upon withdrawal. In fact, on average, the Government will collect ten times the tax revenue from a non-taxable account upon withdrawal, than they would have collected on the initial contribution.

For these accounts, as the distributions are cut by 31.50% to pay the tax, holders of income trusts in non-taxable accounts will have their cash flow cut from 100% to 68.50%

Foreign Residents

For our non-residents, there is a large impact as well. They normally have 15% tax withheld at source and no other tax owed. Going forward they will receive $68.50 for every $100 and then have the 15% withheld. Thus, foreign residents will end up with 56% of distributions instead of 85% which is almost a 35% reduction in income.

Outlook

It is four years before these changes will take effect. As we have seen, there will certainly not be any more income trust conversions. Income trusts may have trouble raising funds going forward in the equity market thus we may see more high yield bonds as a result as they choose to raise funds in that manner. That certainly would bode well for non-taxable accounts and pensions.

As Income Trusts will only be taxed on the distributions, they may start cutting their distributions and reinvest the proceeds turning themselves into a more traditional common stock. They may also cut distributions to maintain a tax pool to remit to the Government.

Finally, many of the income trusts that have sold off significantly may remain at these levels as investors seek value elsewhere knowing that not only may the income trust cut the distribution at some point in time but now, more importantly, the growth of the income trust is significantly limited.

This event allows us to emphasize that a well diversified portfolio is the best approach. There are many other high yielding investments such as: High Dividend Paying Equities, Preferred Shares, and Corporate Bonds, that should be included in a properly balanced portfolio.