“A little government and a little luck are necessary in life, but only a fool trusts either of them.”
– P. J. O’Rourke
US humorist & political commentator (1947 – )
Well, well, well. I am sure many Canadians have a lot of different names they wish to call our finance minister Jim Flaherty after he blindsided income trusts with a new tax regime.
Mr. Flaherty (who only last year graduated from the George Bush, Sr. school of political rhetoric, i.e.: “Read my lips – no new taxes”) was faced with a true Hobson’s choice. He could keep his pre-election promise not to tax trusts and allow BCE, Telus, and Encana to open the floodgates to a corporate environment where no public company paid tax — or he could pull the punchbowl from the party and ride out the inevitable storm of protest.
As we all know, he chose the latter and provided some table scraps of income splitting on pensions to hopefully placate trust investors.
It will take some time to determine if this turns out to be a good economic move. For today, what we hope to do is provide information to our clients which will:
Summarize what happened
Look at the immediate and long-term impact on our clients
Analyze what we believe to be the positives and negatives of these changes
Look at how this will affect future investment strategies we will recommend to our clients
First, as a general comment, I would like to tell our clients and other readers that this week’s debacle is not (as much of the media would have you believe) the end of income trust investing as we know it. It is not even the end of high-yield assets that incomestarved Canadian investors have come to expect. Overall, I feel the long-term impact will be slight and even this week’s significant correction is minor when compared to the overall returns generated by income trusts over the last 5-6 years, as we shall see.
Starting with the 2011 tax year, income trusts will be subject to tax on their net income at the same rate as corporations. The tax rate will be 31.5%, which is an average of federal and provincial tax rates (in BC, for example, the 2011 corporate tax rate will be 30.5%). Real estate trusts will be exempt from this tax. Any companies that want to change their corporate structure into trusts and have not yet done so would have to pay the new tax from 2007. As such, companies such as BCE and Telus will almost certainly shelve their plans to become trusts.
Based on this new tax, most trusts (which do not pay tax now) would have to reduce their distributions. As an example, Pengrowth (PGF.UN) pays a current distribution per trust unit of $3, and, as of November 3, 2006, the units were trading at just under $20 for a 15% cash yield. If Pengrowth has to pay tax in 2011 at 31.5%, then that distribution would fall to just over $2, since $0.95 would now be paid by Pengrowth in tax. The yield would drop to 10% and our intrepid investor would see their annual income drop by almost 1/3rd.
It almost makes you wish Jean Chretien was still running things.
There is, however, a little more to the story.
In 2005, 20% of Pengrowth’s distribution was a return of capital and, as such, we presume (hopefully) that this will not be taxed. In that case, the original tax estimate of $0.95 per unit would drop to $0.75.
For taxable accounts (essentially non-registered personal and corporate accounts), the investor will receive a tax credit that will be equivalent to the new higher dividend tax credit that applies for 2006 and later years. This new credit reduces the maximum tax on an “eligible dividend” for a BC individual to 18.4% (vs. 31.6% previously and 43.7% on interest income). Dividends from public companies are eligible dividends, and non-capital distributions from income trusts that are subject to the new rules will also be treated as eligible dividends. Let’s see how this affects our Pengrowth investor. After 2011, the investor will now receive $2.25 and be required to pay an additional tax of up to 18.4%, or $0.41. That would leave $1.84 in after-tax distributions. Under the old system, $2.40 of the $3.00 distribution is taxable (remember 80% of PGF distributions are taxable now and 20% are return of capital). Assuming a 43.7% tax rate on $2.40 we get a tax of $1.05. When we subtract that from $3.00, the net is $1.95. The future net is projected to be $1.84, or a reduction of about 4% in the cash flow. Not too much to get excited about. Furthermore there will be no change in the tax status for another four years. By itself this would not justify the 13% drop in Pengrowth’s price last week.
The situation for tax-free, tax-deferred accounts (RRSP’s, pensions, IPP’s and charitable foundations), and offshore investors, is quite different. These investors have been receiving their trust distributions tax-free (or at a 15% withholding rate in the case of most offshore investors). Starting in 2011, they will see an immediate drop in distributions and no offsetting tax credits will be available for them to recover the new trust tax they’ve paid. It is this market that has been primarily responsible for the sell off in trusts and the current price correction.
How our clients were affected:
We have been strong proponents of investment vehicles that generate cash flow for many years and that included income trusts. However, trusts overall have performed exceptionally well for many years and many of them were getting to be quite expensive. As a result, we have been slowly reducing our clients’ overall exposure to trusts. As of last week our typical client portfolio had between 4% – 10% of their overall assets in trusts with the average being just under 6%. As a result of that, the 14% drop in trust prices reduced our average client account by less than 1% (0.85%) and most clients have higher balances now then they did on September 30th 2006. Very few if any clients should feel the need to make any significant changes in their portfolios. That is the benefit of being truly diversified over many asset classes and still retaining a strong focus on cash flow.
Analysis and where to from here:
I am a numbers guy so let’s start there.
Many trusts have dropped by 15% or more in the last week, but in most cases, they are currently where they were a year ago and have been paying out their distributions.
Funds that specialize in trusts (such as Guardian’s Monthly High Income Fund) have a five-year compound rate of return of 17.5% after the sell off in trusts last week – far better than blue chip stocks.
Most of the energy trusts have been dropping since both oil and gas prices peaked earlier this year. Pengrowth, as mentioned above, dropped about 13% last week. Before that, however, it had gone from $27 to $22.50 per share since July (a drop of 17%). Overall, it is off about 27% from its July peak. Yet this has also caused its yield to increase to 15% from about 11%. If Pengrowth drops its distribution, it will be because of the drop in energy prices and not because of this new trust tax.
Companies such as Telus, which were going to become trusts, also took a beating, dropping about 13% last week. Nevertheless, Telus is still up about 20% over the last twelve months. Furthermore, when one factors in the cash flow investors have received from current Telus dividends and share buybacks, the annual yield on Telus is over 6%. Under the new dividend tax credit, that equates to an interest yield of about 9% for a taxable investor. Had Telus converted to a trust, its distribution might have been in the 7% range and likely fully taxable. Hard to see how investors are worse off with Telus as a dividend paying company.
As some of you know we employ a technique called “covered writing” in our pooled fund. This involves buying what we feel is a good dividend paying company (or trust) and selling calls (options) to create additional cash flow which enhances the income we earn on the stock or trust. This additional income has the benefit of being taxed at capital gains rates, and so attracts only half the tax that income from interest would. A good example of how this can be combined with trusts is Canadian Oil Sands (COS.UN). As of Friday, we can acquire COS at a price of about $28 per share and earn a current dividend of 4.3%. In addition, by writing calls, we can increase the cash flow we earn on that position by a further 6% (for a 6 month position). When we combine these two, we are able to create an annualized cash flow in excess of 15% per year with much of it taxed at capital gains rates. While there are many other factors we consider before we write calls, it can be an effective way to increase cash flow while maintaining a position in publicly traded companies and trusts.
In the future, both companies and trusts have the option to consider using vehicles such as convertible debentures to provide interest income for tax-free accounts, while simultaneously allowing the investor to participate in the upside of the stock or trust. Currently, interest on such debentures is paid from pre-tax corporate or trust income.
Consider acquiring more high quality income trusts directly or through our pooled fund for taxable accounts.
For those who have some income trust exposure in their registered accounts, they should be left unchanged for now. There will be no tax changes in effect for four years. If we want to, we can do a swap at that time with other non-registered accounts.
The new dividend tax credit makes ownership of companies with high growth in dividends more attractive.
We can combine some of the above with a covered writing strategy to enhance tax-efficient cash flow.
This past week has been a good reminder of why we need to be diversified. It is also important to remember that in order to be able to acquire assets at good prices, we need to have times when they are on sale or available at a discount. Not all trusts are cheap by any stretch of the imagination, but some good quality opportunities do exist and we need to be shopping. I would not say that blood is running in the streets, but perhaps the market experienced a migraine last week. Time will tell.
Please note that in the coming days we will be sending out an invitation to a series of small client seminars regarding the impact of these taxation changes. The first session will be on Friday, November 10th at 7.30am in our office boardroom. Please contact Lanie Collins at 604.739.6450 or by e-mail at [email protected] to reserve a spot, as space is limited.