INCOME TRUSTS ARE A GOOD THING!

THE REAL TRUTH ABOUT INCOME TRUSTS

The Rodney Dangerfields Of Canadian Investing

Pity the poor income trust, the popular income-producing investment vehicle that just can’t get “no respect” from Canadian politicians or the media. Income trusts are held in about as high esteem, by Canadian politicos and journalists, as the idea of Belinda Stronach attending a Mensa convention. And unfortunately investment vehicles can’t change their hair colour or date a hockey player to try and change their public image.

But what is the real truth about income trusts -- still simultaneously hailed as the next best financial thing by income-starved retirees and GIC refugees, but politically maligned by two successive Canadian governments misled by ill-informed Finance Department bureaucrats?

In fact, like most things in life -- including flavoured latte confections and an underwear-challenged Britney Spears -- income trusts have their good and bad sides.

Fortunately, when it comes to income trusts, the good outweighs the bad by a long shot -- contrary to what you’ve heard from Canada’s misguided Finance Minister, or from ambitious would-be financial “experts” looking for their fifteen minutes of media notoriety.

The Good, The Bad & The Sometimes Ugly

Income trusts have been good for Canada. They have been good for investors who understood the risk involved in investing in these financial entities. And despite the bad rap trusts have been getting lately, they are superior generators of tax revenues to government -- it’s just that the tax is paid by the individual investors who receive income-trust income, rather than by the trusts themselves.

First off, it’s important to understand that there are several kinds of income trusts, including the original royalty trusts (energy trusts), real-estate investment trusts (REITs), infrastructure trusts (eg., pipelines and power generators) and today’s varied business trusts.

The very first form of income trusts, sanctioned by federal legislation, were royalty energy trusts. Talk about being good for Canada. By way of a unique confluence of economic factors, the first energy trusts sparked a productive wave of increased energy production, job creation, resource optimization, and government tax royalties for Canada’s Western provinces, particularly Alberta.

And along the way, this unique investment structure for generating investment capital and income -- an unprecedented fruition of the meeting of minds of government and the free market -- managed to provide individual investors (such as retirees and self-employed RSP contributors) with the enhanced income they needed to cope with inflationary pressures in today’s low-interest-rate income environment.

In other words, in an emerging new economic era -- in which five-year bank GICs paid under 4% per annum, and electricity, heating, real-estate tax and other costs of living soared -- investing in royalty (and later all) income trusts provided millions of Canadians with the income required to “scrape by” in retirement, or to save up for their future retirement.

This is an economic fact of life which today’s pampered Finance Department bureaucrats -- with their inflated six-figure salaries and guaranteed indexed pensions -- have never been able to grasp. But then again, when your work life revolves around indulgent expense-account lunches -- dedicated to finding new ways of squeezing hard-earned dollars out of taxpayers to pay for the excesses and perks of government -- why would you be aware of the struggle by ordinary Canadians to simply survive?

Oops! Business Trusts!

But speaking of the bad (and we certainly believe revenue-hungry federal bureaucrats are bad for the country), let’s get back to the history of income trust themselves. Because after the success of energy trusts, and then real-estate investment trusts, Bay Street came up with a new twist on trusts -- business trusts.

Not that there aren’t some good business trusts. There are in fact a lot of them. But in the rush to “cash in” on the trust “golden cow,” Bay Street financiers, brokerage houses and corporate lawyers were not unwilling to take loser businesses, dress up their spreadsheets, and present them to the investing public as the newest and best thing in income trusts.

Not that these same Bay Street interests haven’t followed that same greedy and unethical M.O. in taking lame private businesses and converting them into conventional corporate stocks (the kind our current Finance Minister reveres, even if these businesses are total turkeys, lose most of their investors’ money, and pay little tax to the government).

There have been, and still are, plenty of rotten apples like these in the conventional stock market. But unlike with income trusts, accounting experts and government bureaucrats don’t seem to mind, even if the Bay Street denizens have long been getting filthy rich sponsoring this kind of stock-market flim flam.

Regardless, welcome to the world of bad business trusts, the poster boys for what can go wrong, but usually doesn’t, with income trusts. These are the bad trust apples that have been used by critics to misrepresent the true nature of income trusts in general -- without ever mentioning the bad apples among conventional stock-market equities.

As for the ugly, would you buy a used car from a Bay Street paper pusher who garnered millions of dollars in fees, bonuses and commissions from churning out business lemons? It may not be a bad way for these guys (and gals) to help pay for a new Porsche, Muskoka vacation home or Rosedale mansion, but it still has the ugly whiff of greed gone wild.

But let us emphasize one key point. This is the exception not the rule when it comes to income trusts. Most income trusts are well-run, money-making enterprises that benefit their unitholders and the geographic locales in which they are situated.

Yet, when today’s panic-stricken government leaders have stumbled and succumbed to the mistaken advice of their bureaucratic advisors on trusts, it is usually because our politicians have bought this exaggerated stereotype of trusts, hook, line and sinker. And consequently, they believe that all income trusts operate this way.

Nor do they usually have any idea that income trusts have become an essential income source for millions of ordinary Canadian retirees and savers who are struggling to keep up with increasing costs of living in Canada. But after taking bad advice from bureaucrats with a hidden agenda, government leaders would prefer to believe that any damage created by their mistaken actions on trusts has only impacted the rich.

Then there’s the issue of “tax leakage” -- taxes which income trusts allegedly don’t pay to the government, in contrast allegedly to conventional business corporations like Telus (which incidentally has paid no tax to the Canadian government since 2000). Unfortunately, the myth of tax leakage is a complex and nuanced subject which we’ll have to leave for a subsequent blog. But be assured that there is more tax leakage from many celebrated non-trust, large-cap stocks (such as Telus and BCE) than from almost any income trust.

Final Thoughts

In the meantime, please remember that it’s not wealthy “coupon clippers” who primarily benefited, and still benefit, from the income-generating capabilities of income trusts. It’s the millions of ordinary Canadians (particularly pensionless retirees) who have had trouble living on reduced income from G.I.C.’s, bonds and other conventional savings instruments in today’s high-cost world.

And contrary to what your favourite Finance Minister has been mistakenly telling you, income trusts (and particularly energy trusts) have been good for Canada. Without them, much of the thriving energy bonanza in the Western oil patch, and profitable real estate developments right across Canada, would not have happened.

Thousands of jobs would not have been created, local economies would not have been invigorated, trust investors themselves would not have paid billions of dollars in taxes to various governments, and the nation would have been poorer for it had trusts not existed -- a few rotten apples notwithstanding.

That’s the truth about income trusts. And the whole truth (though condensed somewhat).

Not what you usually hear or read these days. But then again, if you were a politician, and if -- for political expediency -- you cynically broke a promise to the electorate for the wrong reasons, would you be telling the truth?

Not likely.


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SOME BONUS INCOME TRUST READING:
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TAXING TRUSTS NOT THE ONLY OPTION:
HARPER COULD HAVE CUT CORPORATE TAXES & SHRUNK HIS BIG GOVERNMENT BUDGET

The Edmonton Journal
Sun 05 Nov 2006
Page: A18 Section
Opinion Byline: Lorne Gunter


On Friday, I wrote that the federal Conservatives had made a necessary decision regarding income trusts.

Imposing the same taxes on companies that convert to trusts, as are currently imposed on corporations, was not their only option.

To be sure, they needed to equalize the two tax rates. But equity could have been achieved just as well -- or better -- by lowering the taxes on corporations rather than raising the taxes on trusts.

The way trusts are taxed gets around the double taxation inherent in the taxation of corporate dividends.

Corporations pay dividends to shareholders on after-tax profits. And shareholders pay taxes on the dividends they receive. A tax double-hit on the same money.

Income trusts and other "cash-flow entities" get around this by paying out income as it is earned by the company. The company "flows through" its income to trust holders and pays no tax since it never retains the income. Trust holders pay tax on the monies they receive, but often at a lower rate than on earned income. As such, trusts are very attractive to investors and corporations alike.

The Conservatives could have eliminated most corporate income tax rather than imposing new income taxes on income trusts. That would have made Canada the one of the most attractive investment destinations in the industrialized world.

Rather than slashing billions from the value of trusts, it would have added billions to the value of corporations.

But the tax inequity was becoming a political, if not an economic problem. It didn't have to be solved by imposing the same double taxation on trusts as is imposed on corporations. Yet at least the Conservatives did something.

My Friday piece, though, prompted several thoughtful, informed replies offering alternative viewpoints.

"You're simply wrong that the trust option was exploited only or even mainly by very large companies," wrote one analyst from Calgary. Sleep Country, small breweries, Atlas Cold Storage are all trusts and none of them (with the possible exception of Sleep Country) is a huge company. I stand corrected.

"Oil companies with production of 10,000 barrels per day? Come on. The trust market was almost entirely medium-sized companies. Literally none of the large energy producers or giant pipeline companies had converted. The largest two trusts produce about 100,000 barrels per day, far less than even the smallest of the integrated producers."

This second point reveals the one miscalculation the Conservatives may have made in their decision to tax trusts: They forgot about trusts' role in the recent oil and gas boom in Alberta.

They anticipated well the reaction of seniors to the trust change by permitting income splitting on retirement income and extending other deductions. And they knew they would take a serious hit from near-retirees who would see some of their investments diminished and for whom little compensatory action was possible.

So the government resolved to brace themselves against that storm.

But they seem not to have recalled that many oil and gas producers in Alberta were income trusts. With a prime minister -- an economist -- from Calgary, you might imagine this would not have escaped their notice. Yet it appears it did.

A director of one of the trusts wrote to Prime Minister Stephen Harper: "Brilliant. With the stroke of a pen you have wiped out $35 billion in market value and ripped the heart out of the number one growth industry in Canada." He claimed to have torn up his Conservative membership card and promised to vote Liberal in the next election.

Another reader asked why I thought the Conservatives' action was courageous, since it was the predictable, big-government option? It increased the tax revenues flowing to Ottawa. It preserved the lifeblood of the state.

"Don't we want government to have less revenue," he chided, "so they have less money to spend? Any argument for why we needed the revenue is just an argument for more big government."

And he's right.

The truly courageous thing for the Conservatives would have been to lower all corporate taxes, take the risk that the increased economic activity that resulted would have replaced the foregone tax revenues and be prepared to make government smaller if the new revenues never materialized.

That would have been the bold -- and conservative -- thing to do.

Finally, to all those readers who wrote or called and asked whether I knew that the federal finance minister is Jim Flaherty and not Joe (as I mistakenly wrote Friday)? Yes, thanks. I do know Canada's public finances are in the hands of the former Ontario cabinet minister Jim Flaherty rather than Joe Flaherty, the zany comedic talent of SCTV fame (Count Floyd, anchorman Floyd Robertson, smarmy talk show host Sammy Maudlin).

As Dave from St. Albert pointed out, "At least if Joe Flaherty, rather than Jim, had wiped out $40,000 in my retirement account overnight, he might have made me laugh about it."