The Certified General Accountants of Canada released a useful report, “Demystifying Income Trusts”. It’s an official “response to widespread interest and increasing relevance [of trusts] to Canada’s financial markets”. Some media and brokers are twisting observations from the report into frightening news about trusts. But the report is more informative and useful than that.

The report aims to “provide a general understanding of income trusts, including what an income trust is, how it is structured and how it compares to other investments”. The intent of the report was also to take a look at the tax implications of proposed government policy and its impact on investors, corporations and government.

A link to the CGA Web site and to the report will be maintained in our Resources section.

The Nature of Income Trusts and Their Market

What are trusts and how do trusts work? The report describes the overall market in rough terms and then generally categorizes trusts in terms of three basic types:
- Business trusts/hybrid trusts;
- Real estate investments trusts; and
- Royalty/energy trusts.

It explains that, “The income trust purchases most of the equity and debt of a successful operating business and thereby becomes entitled to receive cash flows or proceeds of that business.” And to this end, they say that income trusts, “return 70% to 95% cash flows in the form of cash distributions and return of capital to unitholders that allows them to decide how best to reinvest those funds, as opposed to leaving them in the hands of management of income trust.”

Do income trusts really offer value? According to the CGAs’, “Income trusts represent one of the highest sources of sustainable recurring cash yield in equity and fixed income markets and therefore are the preferred structure for many investors....Income trusts have become a powerful investment vehicle that has already established substantial staying power.”

In terms of business practices, the accountants suggest that “The principal preoccupation of an income trust is to generate consistent, constant and rewarding cash distributions for the trust’s unitholders...From a business owner’s perspective, income trust structures tend to value assets at a higher conversion value than is typically experienced through corporate structured stock issuance.”

By these definitions, the CGA-Canada report proposes that the types of businesses that are most “suitable” for structuring as an income trust include businesses that:
- have mature assets that require little ongoing need for capital expenditure;
- require little cash to develop or enhance products;
- face little or no competition;
- provide a sustained level of cash distribution;
- provide cash with little or no variability;
- provide cash at a higher level of yield;
- have more than one revenue stream and some diversification;
- operate with low interest rates on limited debt;
- have managers focused on cost control.

In short, the report could have described income trusts in terms of “ideal” management practices for purposes of reducing the risks of returns to investors and owners.  Focus on cost control could have been more generally described as focus on increasing operating margins and cash flow, as some trusts do as well or better than well-run public companies.

The report also offers a few kinds of cautions about income trusts for the benefit of operators and investors. The “challenges” of trusts:
- Growth may be curtailed if most cash is distributed rather than re-invested;
- Compared to bonds, cash distributions are neither guaranteed nor fixed;
- Some trusts follow GAAP rules, but other use non-GAAP terms like “distributable cash”.

One might observe: The first fact is true in common equities in the same way as it’s true of trusts.  The second caution is useful for the most inexperienced of investors who need help to undersand different class of securities and the confusingly common language used to describe different dimensions of them in similar ways.  And the third challenge touches on more general policy concerns for those who ensure that public companies and securities provide accurate and meaningful information to investors.

Policy Implications

The CGA’s have used the report to suggest that, “provincial regulators would be well served to introduce a mechanism which reconciles distributable cash to GAAP reporting.”

Furthermore, the report looks at tax policy and implications. It suggests that income trusts exist in Canada in a unique tax regime.  The Canadian tax system with our various provincial taxes and forms of corporate, personal and other taxes create an environment that is not as fully integrated as the systems in other countries.  In other words, it’s not that relevant to make a comparison of tax policies in Canada where income trusts exist with policies of other countries where trusts do not exist.

The stage is set for policy discussion by reporting that “almost all of the cash flow is distributed to unitholders”, the trust itself attracts or pays little corporate tax. Money that flows through the trust is fully taxed in the hands of unitholders.”

And the accountants directly address the Department of Finance claim that income trusts cause it to “forfeit tax revenue to the tune of $300 million”. The CGAs characterize it as “interesting” that the government had federal tax revenues in 2005 of $132 billion. Corporate tax revenue was $6.8 billion higher in the year than the estimate made in 2004.

They go on to say that they “concede that this forfeit is not a considerable amount.” They are of the opinion that the, “former government proposed policy to increase the dividend tax credit to placate corporate investors.”

The group research and analysis, “shows that the previous government’s proposal to increase tax dividends would effectively dissuade top earners from investing in income trusts.”

As many have said all along, CGA-Canada “urges the government to exercise caution when introducing tax measures that could create an adverse situation in the marketplace.”

Conclusion

The policy positions in this document are relevant and worthy of coverage that can be defined as news. So too, the background information on trusts and reminders of general cautions for investors can only be seen as potentially useful by a range of audiences and so very welcome.

Given the intent of the report, it should be no surprise that ultimately it offers little fresh insight into the nature of trusts.  Rather it reiterates general perspective saying that from an accounting perspective, “the uniqueness of income trusts stems from their tax treatment as well as the high yield cash distributions.”

And given the intent and useful information offered in the report, the way it is portrayed by some members of the media and the financial trade may be typical. But it’s disappointing. One must beware of business and market risks while investing.  One might also beware of the journalists and advisors who twist and refocus the accountants’ words to attract attention by delivering frightening news about the extraordinary dangers of investing in income trusts.