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A fresh look at the profits and pitfalls of income trusts

Although tax rulings are complicating things for income trusts, they’re still performing well, says this advisory, which has three best buys.

We have the impression that the income trust market is turning into a sort of game show. The host — who bears a strong resemblance to the finance minister — keeps adding new challenges for those who are chasing the big prize.

With over two and a half years to go before the final challenge — the income trust distribution tax of 2011 — yet another obstacle has been added.

The latest comes from the adjustment in the corporate tax rate that will actually wind up costing individual shareholders more. This in turn poses some challenging decisions for income trust themselves.

If things are getting this complicated, the blunt question must be asked: why stay with income trusts at all?

Well, for one thing, income trusts are outperforming equities. That’s the word we get from one of the leading authorities in the field, the Income Trust Guide published by the Money Reporter.

First we’ll see why trusts are beating their corporate counterparts on the market, then we’ll double back and consider the implications of a higher tax on dividends. We’ll finish with the advisory’s best buys.

Fewer financials, more resources

Income trusts have been outperforming Canadian equities virtually since the beginning of the year, says this advisory. Even with a flurry of recent gains, the S&P/TSX Composite Index has been trailing the main trust index by several percentage points.

There are three reasons for this gap. A rather obvious one is that the Composite index contains a lot more financial stocks than does the trust index, and we scarcely need tell you that financials are not in favour.

On the other hand, more trusts than stocks are concentrated in the resource industry, and we scarcely need tell you that resources are thriving.

A third and more subtle reason is that more stocks than trusts have international exposure. As the U.S. flirts with recession, says the advisory, “income trusts that do most of their business here at home are more sheltered from that eventuality.” They are also sheltered from some of the more damaging affects of the high Canadian dollar.

Still, the government keeps throwing sharp curves at the trust market, creating some tough decisions for trusts and their unitholders.

Three options

To illustrate the knotty problems introduced by the government’s various tax rulings, the Income Trust Guide turns to a specific case. TransForce Income Fund (TSX-TIF.UN) is shedding its trust status and turning itself back into a corporation.

Here’s what this means to unitholders. TransForce is currently paying $1.59 per year in distributions, a yield of 18.9 per cent. As a corporation, it will pay a dividend of $0.40, which would work out to a yield of some 5 per cent. A high yield for common shares, but a long way from 18 per cent.

“This is a decision that all income trusts will have to grapple with by the time 2011 rolls around,” says the advisory. One option is to remain a trust and adjust the payout to give unitholders the same after-tax income.

Option number two is to remain a trust, keep the same payout ratio, and let unitholders absorb the difference. By then, unitholders will be able to treat the distribution as a dividend, grossing it up and claiming the tax credit, but after-tax income will still be lower.

Option number three is to revert to corporate status and pay dividends at the normal corporate rate of 4 per cent or so. The latest tax ruling has complicated all of these options.

Paying the extra tax

The original trust tax of October 2006 implied that by 2011 investors would not really care whether they were getting $1.00 worth of distributions or $1.00 worth of dividends. But that was based on the dividend tax rate remaining the same. It has not.

The government has done a nifty two-step (or is it a shell game?). First in the 2007 Economic Statement, it proposed to reduce the corporate tax rate: from 19 per cent it would gradually fall to 15 per cent in 2012. That promised a lower tax on dividends for shareholders as well.

But then came step number two. Budget 2008 stipulated that the dividend tax rate will also change, so that “individual investors will pay in extra tax all the money the corporation will save,” explains the advisory. “The overall tax burden will be the same, but the individual shareholder will be paying more, and the corporation proportionately less.”

It’s one thing, adds the advisory, to impose a tax on income trust unitholders in the name of fair and equal tax treatment between equities and trusts. And it’s understandable that in the name of fairness, distributions should be treated the same as dividends for tax purposes.

“It’s quite another to then ramp up the tax on dividends which, for all intents and purposes, also applies to distributions once 2011 arrives,” concludes the advisory. Ernst & Young has calculated that while corporate rates will fall from 19 per cent to 14 per cent over the next four years, taxpayers in the top tax bracket will be headed in precisely the opposite direction, with their dividend rate rising from 15 to 19 per cent.

Profits to be made

While those issues get sorted out over the next few years, there are still profits to be made in the market. The advisory illustrates with its three best buys for the month.

Yellow Pages Income Fund (TSX-YLO.UN) has been out of favour through no fault of its own. The advisory thinks it is undervalued and management agrees: it has launched a 5 per cent unit buyback that will immediately raise distributable cash.

CI Financial Income Fund (TSX-CIX.UN) is also down so far this year. But it still yields 8.3 per cent, has no exposure to the dreaded commercial paper and has bright prospects for the future as the mutual fund industry consolidates.

Series S-1 Income Fund (TSX-SRC.UN) has been doing well. As a fund of trusts, it reflects the strong returns in the trust market in general. If you want to add to your trust allocation without disturbing the trusts you already own, this is the way to go, says the Income Trust Guide.

Most game shows end in a half an hour. This one goes on for about 32 months and if this advisory is right, there is more than enough time to hit the jackpot. And hit it more than once.