Investment Planning Counsel sets out the key information you need to have.
What are the new rules?
The government is proposing a new tax on the money distributed to unit holders by newly formed income trusts. The rationale is to level the playing field among trusts, income trusts and corporations.
The tax rate on trust distributions will start at 34% — to mirror federal and provincial taxes on companies — and drop to 31.5% by 2011. Ottawa will remit a 13-percentage-point share of the revenue to the provinces. These measures will apply to new income trusts that start to trade after today, beginning with the 2007 taxation year.
The Transition Period
Income trusts in existence at the end of October 2006, will be grandfathered, and continue to function as normal. Their distributions will not be subject to taxation until 2011.
Fortunately, real estate investment trusts will not be affected by the change in taxation – provided they maintain the same distribution policy. They will continue to be able to distribute their income in a tax-advantaged form.
Income trusts which distribute part of their income in the form of Return of Capital (ROC), having the effect of reducing investors’ Adjusted Cost Base, will continue to have the portion of the distribution that is regarded as ROC exempted from taxation until the units are sold. ROC is essentially the process of getting your own money from the investment, which is not taxable.
What are money managers saying?
As in any period of market volatility, these events allow professional money managers to take advantage of pricing anomalies. Panic selling leads to opportunities – many income trusts have fallen below what their corporate valuations suggest is reasonable. Many managers believe it will take the markets several weeks to assimilate the news.
Most of the blow to income trust positions may well be behind us. The majority of professional money managers did not sell any positions, since they anticipate the bottom to appear within the next week. Some took advantage of the low prices to buy select opportunities – ones with stronger capital structures, less debt, better balance sheets and low payout ratios. Of course, these are the same criteria that most professional managers have favoured over the past few years.
Money managers are saying that the proposed tax changes to our positions will not take effect for four years. The recent drop has effectively integrated the future tax changes into the price of the income trusts. However, the legislation has not been passed, and there could still be some tinkering. Although it appears that it will become law with little opposition.
The fact that future income trusts are on hold makes the existing ones more attractive since they now have a scarcity premium, and will continue to enjoy tax-advantaged status for the next four years, compared to traditional corporations. This is a huge benefit over a definite four year period.
We also believe the drop in prices will make some trusts attractive merger and acquisition candidates, especially to foreign firms.