The Union newspaper in Grass Valley, Calif., reported on June 25 that a man called the police, after hearing someone screaming and discovering a woman lying in the street. When the man asked the woman if she was all right, she started yelling at him, ran inside a residence, and appeared to be smashing things. When the police contacted the woman, she said that she was just having an argument with herself.
Now, I have no idea what the argument was about, but it could very well have been about income trusts. And if you're like many, you may have debated with yourself over the merits of investing in these things. Are the high valuations really justified? In many cases, the answer may be "yes." Let me explain.
Income trusts commonly work this way: The income trust uses about 25 per cent of the capital raised to invest in the shares of an operating company (the underlying business). The other 75 per cent is lent to the operating company at a high rate of interest. The interest expense to the company is designed to virtually eliminate any profits in the operating company and flow that income to the trust. Further, some dividends may be paid by the operating company to the income trust. Investors will receive the income of the trust, and will face tax accordingly.
The real benefit of income trusts is a form of tax arbitrage. You see, when you invest in the shares of an operating company, there can be a double-tax problem (first, the profits are taxed in the company, then the profits are taxed in your hands when dividends are paid out to you as a shareholder). The income trust structure substitutes a mutual fund trust for a corporation to avoid this problem.
Consider these tax advantages of income trusts:
1. A significant deferral or elimination of tax at the operating company level through the use of high-yield debt owing to the mutual fund trust.
2. An elimination of tax at the income trust level as a result of the availability of deductions for any income distributions by the trust to the unit holders of the trust.
3. A deferral of tax on the income distributed by the trust to the unit holders of the trust to the extent the units are held inside such plans as Registered Retirement Savings Plans, Registered Retirement Income Funds and Registered Pension Plans.
4. Where the units are not held in registered plans, a deferral of tax on the income distributed to unitholders of the trust is available to the extent the distributions are characterized as a return of capital.
Don't forget, these income trusts are simply businesses that may have otherwise raised capital as corporations issuing shares on the stock market. Are higher valuations justified simply because an income trust structure is chosen rather than a corporate structure? Isn't the underlying business still the same?
In fact, additional value can be "squeezed" out of an income trust structure over a conventional equity offering primarily because of the tax benefits. To the extent that those savings are passed on to investors in the form of bigger distributions, a higher valuation may be justified.
How much higher? It's open for debate, and will vary based on the underlying business. I'm not suggesting that every income trust on the market is fairly valued, but let's recognize that higher valuations for income trusts over shares should be expected.
Tim Cestnick, FCA, CPA, CFP, TEP, is author of Winning the Tax Game 2004, and The Tax Freedom Zone. He is managing director, Tax and Estate Planning, at AIC Ltd.
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