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Messing with grandma's income trusts

In an era of low interest rates and far fewer defined benefit pension plans, trusts promising to pay out 9 per cent have found plenty of fans in the over-50 crowd. But thousands of older investors are worried Ottawa is about to send their 'golden goose' to the chopping block, ANDY HOFFMAN writes

With files from reporter Steven Chase in Ottawa

A change in the way Ottawa taxes income trusts could have a big impact on the lives of Ed and Caroline White. Recently retired and without a pension, the couple subsists almost entirely on the cash distributions from their portfolio of trusts.

"If we put all our money in bonds, we wouldn't be able to live," Mr. White said at his home in Toronto. "I'd have to go to Wal-Mart and be a greeter."

Yield-addicted grannies and grandpas are the face of Canada's one-million-strong income trust nation. In an era of historically low interest rates and dramatic declines in the number of defined benefit pension plans, trusts promising to pay out 9 per cent have found plenty of fans in the over-50 crowd. With guaranteed investment certificates offering around 2 per cent and savings accounts even less, many of these so-called "GIC refugees" are using trust distributions to pay for the basic necessities of life. Today, small retail investors control well over half of the more than $160-billion income trust market.

Mr. White calls trusts "the golden goose." Now he and thousands of other trust investors are worried the federal government is readying the chopping block and sharpening its axe.

Faced with an explosion of business trust conversions, the government has put its foot down. Citing concerns about tax leakage and a possible drain on productivity, Ottawa is considering a number of policy measures to level the playing field between trusts and traditional businesses. Among them, taxing trusts more like corporations or limiting the amount of interest expenses a trust can deduct.

Done in isolation, either action would hurt unit prices and presumably trust unitholders such as the Whites. Whatever the government does, it will have to balance its economic concerns and desire for tax revenue against the army of grey power mobilizing over the issue. Letter writing campaigns and on-line discussion groups have formed with a simple message for Finance Minister Ralph Goodale: Keep your hands off my income trusts.

The federal government appears only slightly fazed, so far. But anxiety appears to be growing. Mr. Goodale has refused to answer further media questions about the future of income trusts, and one senior Liberal Party member says the political risks of the file are slowly dawning on Ottawa.

For every business that converts to a trust, federal tax losses mount -- $300-million in 2004 and growing, according to the Department of Finance. Add provincial losses and some estimate the leakage at more than $600-million. Trusts pay little if any corporate income tax. Instead, a trust's cash flow is distributed to investors who are then taxed on the income.

It's a lot of tax. At current market levels, $12.7-billion in distributions paid to domestic and foreign trust investors would be taxable in fiscal 2005. According to research conducted by RBC Dominion Securities analyst Dirk Lever, trust unitholders will contribute $3.3-billion to tax coffers this year. The figure would be considerably higher if 30 per cent of the distributions were not in registered retirement savings plans or other tax-deferred vehicles.

Those who are taxed don't seem to mind. "I'd rather pay taxes than look for handouts," Mr. White said.

More than a fifth of trust investors live outside Canada and pay only a 15-per-cent withholding tax on their distributions. Raising the withholding tax to levels more in line with what Canadians pay is another option for Ottawa to consider, although such a move could have an impact on unit prices, especially in trusts with a high concentration of foreign ownership.

The solution preferred by domestic investors like the Whites is to reduce corporate dividend taxes. They suggest curbing so-called double taxation on traditional stock payouts to make business trust conversions less attractive.

Although the Prime Minister's Office has begun monitoring the issue, Liberal government members still dismiss the possibility that a backlash against Ottawa's handling of the file will shift to Main Street from Bay Street.

Opinions among Liberals vary, but the few who are acutely aware of the file appear to believe that trust unitholders are not a major political threat; that they still represent a small minority of the Canadian electorate, a relatively well-off group that has already profited handsomely from several years of income trust gains. Several have mused privately that trust investors are probably more likely to vote Conservative than Liberal anyway.

Weighing the political considerations won't be easy. Despite their popularity, there is a conspicuous lack of data concerning the economic effects of trusts or their shareholder base. However, the research that does exist, coupled with anecdotal evidence, suggests trusts are a phenomenon overwhelmingly driven by retail investors.

Analysts who cover the sector peg retail holdings at between 60 and 65 per cent of the more than $160-billion trust market. Institutional holders make up the rest, but the bulk of that is held in mutual funds. Some fund managers believe individual investors -- either through direct ownership or by mutual funds -- hold up to 80 per cent of the trust market.

Privately, Liberals display little worry over angry income trust investors. They believe the market is now excessively nervous about possible changes to the tax treatment of trusts. MPs are feeling some heat via letters, e-mails and phone calls but not enough to make it a priority issue.

TSX statistics indicate trust investors are far less likely to sell their units than stockholders. Trust turnover averaged 47 per cent year to -date until August, compared with 62.4 per cent for equities.

"It tells you [income trusts] are more buy and hold, which fits the profile of a retail investor," said TSX senior manager, Janis Koyanagi.

Average trust holdings of $67,400 are also smaller than the average stock holding of $76,100.

Some federal officials are defensive, saying investors should not have assumed Ottawa had abandoned its desire to rethink this investment vehicle when it suspended 2004 budget measures to restrict pension fund purchases of business income trusts.

Powerful funds led by the Ontario Teachers Pension Plan, which at the time had a significant stake in the Yellow Pages Income Fund, fought the proposed measure. Within weeks, the government had backed off.

But expectations that pension funds would pour into the trust market appear to have been unfounded. Pensions remain relatively small players, accounting for roughly 8 per cent of the institutional holdings, or slightly more than 1 per cent of the trust market over all. Simply put, large pensions have little need for the trust middleman. Teachers, for example, has its own portfolio of real estate holdings and can bypass the real estate investment trust sector altogether.

Even so, institutional interest in income trusts is on the rise. Index fund managers are buying trusts ahead of their inclusion in the S&P TSX composite beginning in December. Hedge funds are believed to rival pensions in terms of their holdings. Most analysts say large, more liquid trusts such as Penn West Energy are held over 50 per cent by institutions.

The trend has carried forward into the approximately $15.5-billion worth of income trust deals brought to market so far this year. Investment banking sources say 55 per cent were sold to retail investors and 45 per cent institutional.

A sample of 10 income trust holdings provided by Georgeson Shareholder Canada found retail and institutional ownership levels at 55 and 45 per cent respectively, similar to what bankers estimate. Georgeson officials say the split for traditional equities is the reverse.

Institutions held just 20 per cent of the trust market as recently as 1998, according to CIBC World Markets analyst, Alice Sun Dunning. "So it's grown substantially," she said.

Lobby efforts by the Canadian Association of Income Funds (CAIF) tend to portray the typical trust investor at or near retirement age. CAIF claims 48 per cent of income trust investors are over 50 years old, but reliable research is lacking.

According to CAIF chairman Steve Probyn, "a wall of worry" has developed among seniors over possible government action on trusts. Indeed, the Canadian Association of Retired Persons has taken up the issue on behalf of its more than 400,000 members, citing "letters of panic and desperation" pouring in to the national office.

One Liberal source in Ottawa who's not involved in the file suggests the federal government may be starting to get nervous.

"Nobody realized there was a political downside to this and I think they are just starting now to realize that there is some political risk here because of the number of seniors that are looking for [good] returns. The world has changed. People that you wouldn't have thought could tell you what an income trust was -- own them. I think that political calculation is now going on," he said.

William Barrowclough says he's not the best poster child for the average trust investor. A retired teacher living in Peterborough, Ont., he's a widower with a good pension and "not dependent on trusts to keep me out of the cat-food aisle." Nonetheless, he has moved 90 per cent of his portfolio into trusts. So far, he has done "embarrassingly well."

He's also eager to point out he's now paying more in annual income tax than he ever earned from a yearly teaching salary.

"These trusts are one of the best financial creations Canada has ever created," he said. "Now Ottawa is trying to slaughter them."

Mr. Barrowclough says his political allegiance is currently for sale. "This is more than a ballot box issue. This hits me right in the wallet."

Trust tradeoff

Retail investors hold most of the trust units in Canada, which puts them squarely on the frontlines in any battle over trusts. As Ottawa seeks input on whether trusts should continue to be tax-free, many investors say they are happy with the status quo. They pay income tax on all cash distributions, which they say is a fine exchange for average yields of 9 per cent.

11.3 MILLION: NUMBER OF SHAREHOLDERS WHO OWN STOCKS DIRECTLY OR INDIRECTLY

$76,100: AVERAGE SIZE OF A STOCK PORTFOLIO

1 MILLION: NUMBER WHO OWN INCOME TRUSTS DIRECTLY OR INDIRECTLY

$67,400: AVERAGE SIZE OF AN INCOME TRUST PORTFOLIO

Buy and hold

Income trust units do not trade as frequently as common shares, which suggests that investors are happy to hold them and collect the cash distributions. Below is a list of some of the country's biggest trusts, and how much of their outstanding unit float traded in the first eight months of the year.

Yellow Pages: 38%

Aeroplan: 128

Riocan: 35

Canadian Oil Sands: 50

Fording: 45

Penn West: 89

Pengrowth: 44

Superior Plus: 31

Average trust turn over: 47%

Average stock turn over: 62.4%

Trust unit ownership

Ontario, 49.2%

Quebec, 16.9%

British Columbia, 14.7%

Alberta, 12.5%

Atlantic provinces, 2.8%

Manitoba, 2%

Saskatchewan, 1.8%

Yukon, Northwest Territories, 0.1%

'If we put all our money in bonds, we wouldn't be able to live. I'd have to go to Wal-Mart and be a greeter.'

ED WHITE, WITH HIS WIFE CAROLINE, SUBSISTS ON CASH DISTRIBUTIONS FROM THEIR PORTFOLIO OF INCOME TRUSTS.

SOURCES: TSX GROUP, CANADIAN ASSOCIATION OF INCOME FUND ENERGY TRUST SURVEY, CANADIAN UNITHOLDER GEOGRAPHIC ANALYSIS AT OCTOBER, 2004

In Canada we trust

A four-part Report on Business special investigation.

Yesterday: Why Ottawa turned its back on income trusts

Today: Retail investors dominate the trust market

Tomorrow: Why does Canada have income trusts?

Friday: Can trusts be good for the economy?

© The Globe and Mail

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