Income trust
An income trust is an investment that may hold equities, debt instruments, royalty interests or real properties. It is especially useful for financial requirements of institutional investors such as pension funds, and for investors such as retired individuals seeking yield. The main attraction of income trusts, in addition to certain tax preferences for some investors, is their stated goal of paying out consistent cash flows for investors, which is especially attractive when cash yields on bonds are low. Many investors are attracted by the fact that income trusts are not allowed to make forays into unrelated businesses; if a trust is in the oil and gas business, it cannot buy casinos or motion picture studios.
The names income trust and income fund are sometimes used interchangeably even though most trusts have a narrower scope than funds. Income trusts are most commonly seen in Canada. The closest analogue in the United States to the business and royalty trusts would be the master limited partnership. The trust can receive interest, royalty or lease payments from an operating entity carrying on a business, as well as dividends and a return of capital.
Types
There are four primary types of income trusts:Investment
s are trusts established for communal investment in securities, encapsulated under the umbrella of a flow-through entity and typically managed by a 'fund sponsor', usually an investment firm, asset management firm, or investment bank. These trusts invest in a variety of investments including stocks, bonds, futures, etc., and are often marketed to the public directly when authorization has been received from provincial securities regulators to do so. This type of trust has not been affected by the recent changes in Canada concerning income trust taxation; like Canadian REITs, mutual fund investment trusts have been exempted from taxation. Some investment trusts have been specially structured with leverage in order to amplify cash yields paid to investors, while others deplete their assets to pay distributions to investors on a regular basis.Real estate investment
s invest in real estate: income-producing properties and/or mortgage-backed securities. The REIT structure was designed to provide a similar structure for investment in real estate as mutual funds provide for investment in stocks.Royalty/energy
s, "resource trusts" or "energy trusts" exploit natural resources such as oil wells. The amount of distributions paid will vary from time to time based on production levels, commodity prices, royalty rates, costs and expenses, and deductions.Business
Business income trusts are individual companies that have converted some or all of their stock equity into an income trust capital structure for tax reasons. Business income trusts are used in many sectors, such as manufacturing, food distribution, and power generation and distribution. They are not investment trusts in the classic sense, since they represent a single company's assets and not a pool of investments.Among business trusts, utility trusts that invest in or operate public utilities such as electricity distribution or telecommunications are sometimes put in a separate category as they are inherently less growth-focused.
In the US, the business trust structure typically takes the form of publicly traded partnerships or master limited partnerships, essentially limited partnerships with units that trade on public securities exchanges. Those were very popular in the mid-1980s but are rare today. Revised IRS tax treatment of MLPs made the structure inefficient and infeasible, in light of the special tax that is levied on MLP owners who hold them in tax-deferred or exempt accounts such as 401s, IRAs, and Roth IRAs. A more recent alternative called income depositary shares has also failed to attract investor attention due to the trust activity being focused on the Canadian market.
By country
The tax advantages offered to trusts in certain jurisdictions have fueled investor interest in this type of investment vehicle.Australia
Resource-rich Australia has had royalty trusts for a long time but in the early 1980s, a wider range of firms sought the same tax benefits and started converting into income trusts. Yield-hungry investors jumped on the bandwagon and rewarded the trusts with higher valuations. When Queensland Coal converted to a trust in 1984, its stock price tripled overnight.The Australian government, citing ever-increasing losses of tax revenues, clamped down in 1985. All trusts except REITs and royalty trusts were given 3 years to find an exit strategy: to either keep the current structure at higher tax rates, or convert to a public company. As unit prices started to collapse, the majority dropped the trust structure.
It is notable, however, that the legal trust structure and the public trust structure persists in Australia to this day. As of December 2006, the Australian government was revisiting the income trust issue to consider whether further legislation was needed to address the many thousands of trusts that have been maintained and developed since taxes were imposed in the mid-1980s.
Canada
The first Canadian tax ruling enabling the income trust structure, inspired by the American PTPs, was awarded in December 1985 to the Enerplus Resources Fund royalty trust. The first corporate conversion into a proper business trust, using the 1985 ruling, was Enermark Income Fund in 1995. The move attracted little attention at the time as the vast majority of trusts were still REITs and royalty trusts.A substantial historic and status report on the Canadian income trust market was published at the end of 2006 coinciding with the announcement of new taxes on income trusts proposed by the Canadian Minister of Finance
The trust structure was "rediscovered" after the dot-com crash of 2000, as investment banks were searching for new sources of fees after the initial public offering market had dried up. The first high-profile conversion was former Bell Canada Enterprises unit Yellow Pages Group becoming the Yellow Pages Income Fund and raising Can$1 billion in the process. By 2002, trusts accounted for 79% of all money raised through IPOs in Canada, with only 38% in the traditional sectors of petroleum and real estate. By 2005, the income trust sector was worth Can$160 billion. The mere announcement by a company of its intention of converting could add 10-20% to its share price.
Trusts received another boost in 2004-2005 as the provinces of Ontario, Alberta and Manitoba implemented limited liability legislation that shields trust investors from personal liability.
Partly as a result of this ruling, Standard & Poor's then announced plans to add the largest income trusts to the S&P/TSX Composite Index, starting with a 50% weighting and gaining full representation on March 17, 2006. A new equity-only composite index would be created that will resemble the present structure without trusts. This move is seen as a strong gesture of support for the trusts, who would see increased demand from index fund managers and institutional investors replicating the index. However, the S&P, as a major bond rating agency, has expressed concerns about the sustainability and the quality of the accounting concerning many trust entities as going concerns in the future.
Business trusts came to the attention of the government. In the March 2004 federal budget, Liberal Finance Minister Ralph Goodale had tried to prohibit pension funds from investing more than 1% of their assets in business trusts or owning more than 5% of any one trust. Powerful funds led by the Ontario Teachers Pension Plan, which at the time had a significant stake in the Yellow Pages Income Fund, fought the proposed measure; the government backed off and suspended the restrictions.
On October 31, 2006, Goodale's successor, Conservative Jim Flaherty announced a new 34% tax on income trust distributions in a bid to stem the growing number of companies that were converting to trusts. Since January 2011, all Canadian income trusts are considered as Specified Investment Flow-Through entities that are subject to double taxation at a rate approximately equal to corporate income tax rates.
Suspension of advance tax rulings
On September 8, 2005, the Canadian Department of Finance issued a white paper suggesting that the trusts had cost it at least Can$300 million in tax losses the preceding year, with provincial governments possibly losing another $300 million. The markets barely reacted and on September 13, Gordon Nixon, CEO of the Royal Bank of Canada, mentioned in passing that he was not opposed to Canada's largest bank converting into a trust. One week later on September 19, the Department of Finance announced that it was suspending advance tax rulings - essential for investor confidence - on future trusts.The resulting uncertainty caused an immediate slump with the trust market losing approximately $9 billion in market capitalization during the following week. This caused CanWest Global Communications to reduce its proposed $700 million IPO spin-off to $550 million. CI Fund Management also showed hesitation regarding its planned trust conversion. Previous plans by ACE Aviation Holdings to spin off Air Canada Jazz into a trust were suspended indefinitely. "Traditional" Canadian REITs, once content to ride the trust boom, tried to distance themselves from the new business trusts, to avoid regulatory "collateral damage".
In the day following the change in working tax policy, the unit price for all income trusts and REITs on the TSX dropped by a median of more than 17% according to the iTrust Report published by TrustInvestor.com and its iTrust Index. Studies by Leslie Hayman, publisher of the Report, indicated that the change in advance tax rulings in 2005 was the most statistically significant volatility event in the history of the trust market.
According to RBC Dominion Securities, yearly trust cash distributions amounted to Can$16 billion in 2005, not including potential capital gains taxes on trust conversions. Of that amount, $3.3 billion was collected in tax. RBC estimates that taxing trusts like regular companies could slash the market value of Canadian business trusts by as much as 30% - again, not counting the loss of the share price premium of companies that had announced their conversion and would then back off.
Following the announcement, Goodale and the Department of Finance declined to comment or answer questions on the future of income trusts. Intense lobbying efforts to "save the trusts" were undertaken by the business community and the Conservative Party. They demanded that if equal treatment is to be granted to trusts and traditional companies, it should be implemented by leaving the trusts alone and cutting corporate and/or dividend tax to match the trust advantage. That solution would cost the government an additional Can$1 billion, which the lobbyists claim would be a small price to pay for stabilizing the market and satisfying the public investors/voters.
Since any decision was to affect the finances of an unknown proportion of the government's voting base, the trust debate turned into an important issue in the 2006 election. Analysts were trying to estimate the political repercussions, mostly depending on how much retail investors, especially seniors saving for retirement, were involved in the market. Some analysts put this at 60-65% of the market, up to 80% when counting mutual funds. If this is the case, a pre-election decision unfavorable to income trusts would have proven hazardous to Prime Minister Paul Martin's minority Liberal government.