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What you can trust about income trusts

This income trust expert gives us five reasons trusts will survive, eight trusts to like and one last lament on how the government got it wrong.

Back on Halloween, we looked at the first anniversary of the infamous income trust tax through the eyes of Mr. Gordon Pape, who is convinced that trusts will survive.

Income trust investors can take further reinforcement from another expert on the subject, Mr. David West. Writing in The MoneyLetter, he has five firm reasons why income trusts will be with us well beyond the tax deadline of January 1, 2011.

He also has some telling — and acerbic — observations about the tax structure of trusts. The tax losses that frightened the government into action were more apparent than real, he claims. He may just be crying over spilt milk, Mr. West admits, but it’s worth one final protest.

On a more constructive note, he identifies his eight favourite trusts for investors. We’ll begin with those.

These guys are good

First the bad news. Mr. West finds that there is “nothing special” among the power generation trusts just now.

The rest is good news. Here are Mr. West’s eight picks among income trusts, with his comments:

RioCan REIT (TSX-REI.UN), specialists in retail properties. “Talk about smooth operators. These guys are good.”

Canadian Oil Sands Trust (TSX-COS.UN). “A ridiculously long reserve life index puts nuisances like the Alberta royalty review in perspective.”

Fort Chicago Energy Partners (TSX-FCE.UN), pipelines. “Consider the growing supply of product in Alberta, and the growing demand in the U.S. Midwest and South, and the connection is clear: the pipelines.”

Bell Aliant Regional Communications Income Fund (TSX-BA.UN). “This could be a refuge for ex-BCE holders to pile their money into.”

Consumers’ Waterheater Income Fund (TSX-CWI.UN). “I like Consumers’ because of its growth, its income, and its status as a takeover candidate.”

Davis + Henderson Income Fund (TSX-DHF.UN), who print chequebooks and provide an electronic network for real estate transactions. “Buy this one for the same reasons as Consumers’ Waterheater.”

Energy Savings Income Fund (TSX-SIF.UN), gas and electrical utilities. “I like it for distribution increases more than growth, and because management’s interests are aligned with unitholders.”

Yellow Pages Income Fund (TSX-YLO.UN). “For its very smart business model.”

The tax is on the books

Now here are five reasons investors should consider these eight income trusts. Reasons, in fact, why investors should have a very healthy collection of income trusts to choose from in the years ahead.

The first two reasons have to do with the fact that the trust tax has, in a manner of speaking, already been paid.

First, the tax is effectively on the books of the trusts themselves, asserts Mr. West. The tax on income trust distributions may not fall due until 2011, but it became the law of the land this past June 22.

Accordingly, income trusts were forced to reflect the future impact of the tax in their financial statements. Most did this by means of an adjustment in their fiscal second quarter.

This means that “we can make judgments now about how these companies will fare under the new regime; we don’t have to wait until 2011 to do so.”

Second, the tax has already been built into the price of the units. (It’s everywhere!) “The investment markets are a fascinatingly efficient theatre,” says the analyst, “where future known events are quickly discounted into new present values.”

Prices were adjusted to reflect the expected tax on November 1, the day after the tax announcement, and again before Christmas, 2006. “Today, unit prices go up and down on anything but the trust tax issue.”

It’s not just about the taxes

The third reason trusts have a future is simply a matter of merit: good operators will survive.

“Some businesses had no business being trusts,” says Mr. West, “because they lacked the fundamental discipline and prudent management to survive under the trust structure.” Some of these are already gone. Others will be leaving shortly, and a few may linger on. But well-run trusts will thrive, no matter what structure they are obliged to adopt.

The fourth reason is a slightly subtler one, and flies in the face of much of the conventional wisdom about income trusts. Income trusts were not just formed to save on corporate taxes.

“There is more to an income trust than a tax structure,” states Mr. West firmly. An income trust “is a method of running a business to maximize current and future cash flow, rather than accumulating assets for the sake of size over substance.” Thus there are very successful, cash-rich businesses suited to the structure, and other successful businesses that are not.

Finally, income trusts will survive because there is a need for them. By 2011, says Mr. West, “income trusts may still be called that, or high-yield corporations, or something else. But there is no other asset class that can take its place in a portfolio context. It will survive.”

In conclusion, Mr. West points out that he has made each of his eight income trust picks on the merits of the company itself, with no thought of the tax structure and its temporary advantages.

It boggles the mind

The government got it wrong anyway, Mr. West tells his readers in The MoneyLetter. He has one last lament over the myth that still gets trotted out in the financial media — that income trusts produced tax-free income.

They didn’t.

No sir, says the analyst. Look at the financial statements for any income trust before October 31, 2006 and there is a clear provision for current and deferred taxes.

The analyst declines to debate whether or not deferred taxes represent a future tax liability, something that accountants and analysts fight over constantly (and who wants to get into a scrap with accountants and analysts?).

But there is no dispute about current taxes. Real cheques were written to pay those taxes. “So income taxes did, and do, pay some amount of income tax at the trust level.” Not to mention huge revenue royalty taxes paid by oil and gas trusts and other compulsory fees and levies.

What’s more, taxes not paid by the trust were passed on to the investor. And since an investor’s marginal rate might be considerably higher than that of any given trust, “more overall net tax, not less, might have been payable under the trust structure than the corporate structure.”

So why was it claimed that the government was being deprived of these taxes? Perhaps the income was funneled into a tax-sheltered RRSP, or a tax-sheltered pension fund. But that only defers the tax. It will be paid. The government in power may not be around to enjoy the spoils, but there will always be willing hands at Revenue Canada ready to rake it in when the time comes.

And anyway, adds Mr. West, why should sheltered stock dividends be considered any less damaging to the Canada’s tax revenues than sheltered distributions? “It boggles the mind.”

The government may have been deprived of revenue in one way, he concedes. Non-Canadian investors were off the hook with a 15 per cent withholding tax on their distributions, and nothing more. “If that is the problem,” Mr. West “then that is where to focus the solution.” Attacking the whole trust structure to plug one leak, he adds, seems like overkill.

But it’s too late, admits our analyst in The MoneyLetter. The trust tax is here to stay. Fortunately, so are income trusts. Apparently even overkill can’t keep a good trust down.