Too much trust placed in income trusts?

If you are an investor, you ought to be interested in this topic. This is complex, so pour yourself a cup of coffee, and then lock the door so as to bear no interruptions. This topic probably has earned more column inches in the country’s newspapers through 2005 than any other newsworthy topic.

The stock market meltdown after the dot-com bust turned off investors, resulting in companies and their underwriters encountering no taste for primary stock issues. Enter trust units. These have been around for a long time. They started as a structure for real estate investing (REITS) and in the ‘80s expanded successfully to the resource sector. Trust units have risen from the dot-com wasteland of capital-raising and companies have been flocking to “convert” their activities into trust structures. The market capitalization of trusts has grown from $15B in 1999 to $40B in 2001 and more recently to $160B in mid 2004. The number of trusts listed has increased from 73 in 2000 to 175 in 2004.

The classic trust is a slow-growth, cash-certain business, typically collecting real estate or resource rents. But the recent growth in trusts has derived primarily from conversion in other industries, which unrealistically seek to emulate the sustainability and predictability of cash flows delivered by REITs and the oil and gas sector. While resource and real estate units comprised 90% of the listings in 1995, they were only 50% in 2003.

The “conversion” process is that a new trust is created and raises capital by issuing units. That money is used indirectly to buy the operations from the company by way of lending it money. The interest payments are deductible to the company, thus reducing its taxable profit. Sometimes the trust directly acquires the operating assets and leases them back to the company, collecting a lease payment as income.

The payment to trust unit-holders is some combination of interest income, dividend income, lease payments, capital gains and even return of capital. Individual unit-holders pay personal tax on some of the classifications of cash received. Corporate unit-holders do likewise but do not enjoy their existing, normal tax-free treatment from receiving dividends. Sheltered accounts pay no tax at the time of course but the investor will pay at full personal rates upon withdrawal. Foreign owners pay at international withholding rates on some classifications of cash received.

The problem

The popularity of trust units can be attributed to a tax system that fails to “integrate” personal and corporate tax systems. An absence of “perfect” integration causes some degree of double-, or over-, taxation of company profits. “Integration” is a foggy term, but it simply refers to the issue of coordinating the corporate taxation of profits with the personal taxation of shareholders receiving those profits as dividends. The mechanism for integration is referred to as “gross-up-and-credit”.

The matter of integration was topical in the famous White Paper of 1969, which supported perfect integration through a gross-up of one half and dividend tax credit of 33 1/3%. This was not enacted in the Budget of 1971 but was adopted later in the Budget of 1977. A problem was that the system applied to both private and public companies. Given that each of them bears significantly different corporate tax rates, “perfect” integration requires different systems for each. When one system is applied to both, it either favours one of them or hurts the other, depending on the system chosen.

The 1977 Budget significantly favoured private business, with the unanticipated result that hordes of small businesses rushed to incorporate. The Budget of 1981 fixed this by adding a “distribution tax” to private business, effectively creating two systems. However, this lasted only briefly and there have been several changes to the integration system in 1982, 1986 and 1987, resulting in today’s integration system that treats private companies fairly at the expense of hurting public companies, whose income is insufficiently integrated. In fact, for high-income investors, public company dividends are severely over-taxed, bearing combined corporate and personal tax of 67%!

Trusts on the other hand are flow-through entities that transfer all of their income to their unit-holders, leaving no income to be taxed in the trust. Therefore, the total tax is the personal tax, thus avoiding the dividend problem of insufficient integration. Trust unit-holders gain back the under-integration that the government takes from corporations, and this gives trusts their current market popularity, called the “trust premium”. This premium can increase the value of trust units over conventional shares by as much as 15-50%! One company recently saw its share price increase 14% overnight on the day it announced its intention to convert to a trust.

Rotman School professor Jack Mintz should get some credit for banging the gong on this topic with a paper he released in 2003. He estimated the total net tax loss to government treasuries from trust conversions to be approx $600M annually, all things measured. The Finance Department released a consultation paper in September, in which they countered with a number of $300M in 2003. The Royal Bank recently weighed in, saying that, given the on-going proliferation of conversions, that number has likely climbed to $600M, with no end in sight. Yet another unattributed source estimated the cost at $300M for Alberta alone!

Trust units also are popular because they provide higher cash payouts which are considered more attractive to investors who, in the wake of Enron etc, prefer to see the corporate profits paid out to them to spend, rather than relying on CEO’s bright ideas of how that money should be reinvested in the company. However, full distribution of corporate profit flies in the face of conventional textbook wisdom. Corporate profits benefit from the concept of financial leverage, which, simply said, says that capital can be borrowed (from creditors or shareholders) and applied to a business opportunity. When the rate of return on the business idea is greater than the cost of that capital, then financial leverage has occurred, creating profits for the shareholders. This of course presumes some proficiency in the company to identify profitable business opportunities. The pressure for higher cash payouts from trusts estops this process.

The economics of taxation acknowledges three fundamental principles of efficiency, neutrality and equity. Efficiency requires that the tax regime ought not to distort the market forces of supply and demand allocating financial resources to their best use. Neutrality says that the tax regime ought not to effect business decisions. Equity says that equals ought to be treated equally. The existing situation runs afoul of all of these fundamental economic principles. When only certain companies and industries function as trusts, the trust premium creates a distortion in the capital markets by the allocation of funds to those entities.

The solutions

The government’s September consultation paper acknowledges two broad choices to restore the fundamental economic principles: enhance integration of stocks or tax trusts. What is good about enhancing integration is that this could be a very simple piece of language in the next budget. What is bad about enhancing integration is the same problem as 40 years ago. The public company problem is solved but you throw a major goodie to private companies, as in 1977. The answer might require what the 1969 White Paper sought, or the 1981 Budget attained, which was some means of specific law applying to private companies to take away their undeserved goodie.

A further problem is that the dividend tax credit never benefits shareholdings in sheltered pension accounts. So, enhancing the credit has no effect. Also, taxation of foreign ownership of Canadian trust units needs separate consideration.

What is bad about hitting the trust sector with a new tax is that no doubt hundreds of pages of new compliance rules would be required, keeping the Ottawa mandarins on heavy overtime for the next 12 months drafting all of this, not to mention the cost of the legal and accounting professions investing time to understand it, explain it to clients and figuring out ways to circumvent it anyway.

The repercussions

It is being said that widows and retirees will be financially punished if trusts are taxed. The Royal Bank weighed in with an analysis which said that adding a trust tax would slash trust values by 30%. The truth is there is NO solution that will not effect trust investors’ portfolio values. Obviously the impact of a tax on trusts will have a negative effect on these investors. BUT a carrot of dividend relief on stocks does not leave trust investors untouched. Either solution mitigates the tax difference between trusts and stocks, and thus the trust premium has to reduce, closing the gap in the pricing of stocks vs trusts. The gap-closing likely would see some degree of meeting in the middle: stocks are driven up and trusts are driven down.

The players

What also is needed here is more education of the citizenry about saving and investing. Investors themselves are guilty of not understanding what they are investing in and assessing what the risks were. The high trust returns are not a matter of right, any more than was a $100 share price in the BCE spinoff called Nortel, that so many Canadians held in their portfolios. Business trusts are akin to equity, not fixed income. The return on investment equals the sum of the cash payouts plus or minus the change in value. A hamburger business that has converted to a trust is still a hamburger business, and its value can be clobbered by strategic competition from McDonalds or Wendy’s.

In finance circles, the return on investment equals the “risk-free rate” plus a risk premium. The risk free rate has been estimated at circa 3%, so if you are earning 10%, you are carrying a risk premium of 7%. While higher returns come with risk, risk doesn’t necessarily come with higher returns! That’s the risk!

The whole conversion process is a distraction to senior executives who will need to dedicate 6-9 months of their fulltime endeavours to dancing with the underwriters and lawyers and analysts to stick handle towards a trust conversion. In the meantime, forget about running the company. Forget about addressing how Canadian productivity can avoid the China economic tsunami sweeping over the entire globe, with a fair share aimed at Canadian industrial output. Don’t forget this cost in the analysis, which will drive down Canadian business indices, whether they are on the TSX 300 index or disguised in the trust index. The real winners are the investment bankers and lawyers: can you spell fees fees fees! Some CEOs are not enamoured with the current trust mania, but have no choice but to follow the herd to meet their responsibility to deliver shareholder value.

Financial advisors also are as culpable in this fiasco of the month as they were in taking their clients too deep into technology in the late ‘90s. They should be compensated for managing risk through diversification, and seeing the broader horizon.

Provincial governments also joined the party. Not so long ago, trust units – an unincorporated business entity – were precluded from the hallowed and sacred ground of limited liability, and many investors avoided buying them for this specific reason. However, recently many provincial governments have introducing parallel legislation to level the liability playing field.

Conclusion

Some perspective is needed here. First, we have to remember that “them” is “us”, ie a win for the government coffers ought to translate into lower taxes (I know… don’t hold your breath!) Second, don’t feel too sorry for this recent loss of revenue to trust units – the government coffers have filled with the over-taxing of dividends for years.

Trust mania is the current era’s investment flavour of the month. Do you remember the last one: it was called the tech bubble. The trust premium is no more nor no less than a tax shelter, like all of the tax shelters that we have had over the decades, including thoroughbreds and feature films, etc. Recall that most of those were bludgeoned out of existence many years ago. Nature abhors the proverbial vacuum and seeks rebalancing. It was entirely obvious that the trust premium could not continue forever. It is lunacy to have and keep a business environment in which every company is forced to draw into this trust phenomenon to preserve shareholder value. To do nothing merely promises that, with the passing of enough time, there will be no shares on the TSX anymore, only trust units.

There were tens of billions of dollars of such conversions in the pipeline when Finance dropped its little ticking bomb in September, and all of these are temporarily iced. The government’s request for comments and timeline for action (likely well into Winter) are not satisfactory because our domestic capital markets are effectively put on hold.

Its time for a Fall mini-Budget!