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Canadian Business
November 6-19, 2006 Issue
lncome trusts have made headlines lately, with the announcements that BCE Inc. and Telus Corporation plan to convert to a trust structure.
Adrian Mastracci, fee-only portfolio manager at Vancouver’s KCM Wealth Management, says, "Investor due diligence typically stops at the cash yield. They have to appreciate that income trusts behave like equities, not fixed income products, so don’t replace your GICs and bonds with them."
They join a lengthy list of companies that have taken this route in recent years. There are now almost 200 income trusts in Canada —currently 72 in the TSX composite index alone.
Although they’ve been around for two decades, income trusts got their real boost from the “tech wreck” of 2000 and the subsequent market downturn. Interest rates fell and investors were longing for steady income, and business operations they could easily grasp. And with easy-to-understand businesses — such’ as peat moss, coal and root beer — and their promise of high yields compared to stocks and bonds, income trusts filled the bill.
Income trusts are neither stocks nor bonds, although they share some of their characteristics. They’re an alternate form of business organization that pays very little, if any tax, provided they distribute all of their net income annually to unitholders. The unitholders pay the tax, which allows the business to distribute more of its cash flow than it could if structured as a corporation. It’s primarily for this reason that trusts tend to have much higher yields than common shares.
Another advantage is that, while unitholders nominally are fully taxed on distributions, they can use various measures to reduce or eliminate that tax. For example, the basic personal exemption, plus RRSP contributions, can be used to offset distribution income.
So the net after-tax return from an income trust can be significantly higher than the dividend yield from a similar-risk common share.
Income trusts represent such a significant part of the market that investors who want a properly diversified portfolio would be foolish to overlook them, says Clay Gillespie, vice-president, financial advisor.
But before purchasing trusts, make sure you. understand what you’re getting into, he adds. ‘Trusts were originally created as cash cows by companies with a steady income stream and no need to reinvest profits for growth. That’s why the Telus announcement surprised me: they need to reinvest some of their earnings to survive.”
Adrian Mastracci, portfolio manager with KCM Wealth Management Inc. in Vancouver, is concerned that many investors who own income, trusts don’t fully understand them.
“Investor due diligence typically stops at the cash yield. They have to appreciate that income trusts behave like equities, not fixed income products, so don’t replace your GICs and bonds with them.”
Of course, like any investment, income trusts carry some risk. FMF Income Fund went bankrupt last year and there have been other “hiccups” along the way.
“Higher yields mean greater risk,” says Mastracci. "if income trusts fit your risk proflle, fine, but if not, look elsewhere."
Mastracci recommends diversification across the various types of income trusts — REITs (Real Estate Investment Trust), resource or oil and gas trusts and business trusts — as well as by geographical distribution.
The possibility that the Canadian government might decide to start taxing income trusts is back in the news, thanks to the Telus and BCE conversion proposals. Clay Gillespie doubts whether the current minority government will tackle it, “especially when they’re dealing with large budget surpluses. And as even more large companies convert to trusts, that likelihood diminishes even further.”
But while Adrian Mastracci believes that many more companies, including Canadian Pacific and perhaps some divisions of the banks could become trusts he’s far from sure that the taxation issue is dead.
“Sooner or later someone will look at it,” he says. “The government always wants its pound of flesh.”
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