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Fund dealers, hedge funds board income trust gravy train

Date: Monday, September 26, 2005
Author: David Clarke, Investmentnews.com

OTTAWA - Income trusts are all the rage in Canada, and that has captured the attention of the tax man and hedge funds.

On Sept. 8, Minister of Finance Ralph Goodale launched consultations on income trusts, saying: "We need to do so quickly so we can get public policy right as early as possible."

Last Monday, he said that he has asked Minister of National Revenue John McCallum to postpone providing advance rulings related to flow-through-entity structures, effective immediately.

The Finance Department estimated the trust sector costs Ottawa $280 million (U.S.) a year in taxes, or 1% of corporate income tax collected in the past fiscal year.

That amount of lost revenue due to trusts potentially could hit the $900 million mark under certain conditions, according to the department.

The consultation document, inviting submissions until Dec. 31, was released the same day that CI Fund Management Inc., Canada's second-biggest independent seller of mutual funds, said that it plans to convert to an income trust. Such investments are structured in a manner similar to that of U.S. real estate investment trusts.

A conversion of Toronto-based CI Financial to an income trust likely would be effected by way of a statutory plan of arrangement and would be subject to, among other things, regulatory and court approvals.

"Tax rulings are generally not required for transactions of this nature. But we feel it is prudent given the size of CI - even though the structure we are contemplating is similar to existing income trust structures," said William T. Holland, the company's chief executive.

'This is nuts'

Marketers of trusts felt blindsided by the government's moratorium on advance rulings.

"This is nuts," Mr. Holland said in an interview with the Toronto Globe and Mail.

"How do you run a business? It creates uncertainty for the whole structure of income trusts. I never saw this coming at all," he said.

CI Fund's $5.8 billion market value would make it the third-biggest income trust behind Canadian Oil Sands Trust and Yellow Pages Income Fund. On the day of the announcement, CI Fund's stock had its biggest gain in more than five years.

CI Fund joins the list of companies converting to income trusts.

More than 200 income trusts are listed on the Standard & Poor's/TSX (Toronto Stock Exchange), more than double the number three years ago. And S&P began a six-month transition Sept. 14 that eventually will add 68 more trusts to a new provisional index.

The reason for the popularity?

Income trust unit holders pay income tax on distributions they receive, but most trusts pay no corporate income tax themselves. By contrast, corporate dividends are taxed at both the personal and corporate levels.

The worrisome downside is that income trusts pay out almost all their operating cash flow to investors and retain little capital.

No sweat

That doesn't worry hedge funds, according to Derek DeCloet, a columnist for the Toronto Globe and Mail.

"By 'consulting' until year's end, before a likely election next February or March, Mr. Goodale has signaled Ottawa will do nothing to halt the trust boom for at least eight months, probably longer. So it's game on for the hedgies, who have been presented with a unique (and probably short-lived) opportunity to use their boldness to beg, browbeat and bully CEOs into turning their firms into trusts," Mr. DeCloet wrote recently.

The response from George Kesteven, president of the Canadian Association of Income Funds in Toronto, was curt.

"The column indulged in rather speculative comments about what the hedge funds might do about companies wishing to transform themselves into income trusts," he said.

"Any company considering this switch should do due diligence. This is quite a bit of hype and isn't very instructive," Mr. Kesteven added.

"That's one writer's opinion," said Tristram Lett, deputy chairman of the Toronto-based Alternative Investment Management Association of Canada.

"We cannot predict what hedge funds will or will not do, but if they followed such a strategy, they will be the first to short them as well if they become overpriced."

Unique value seen

AIMA Canada has more than 70 corporate members, including hedge fund managers, institutional investors, pension fund managers and consultants, administrators, auditors, lawyers, prime brokers and other service providers.

Income trusts offer unique value to both issuers and investors, according to Leslie Hayman, editor and publisher of TrustInvestor.com.

"The kind of [equity] model that we're talking about [with income trusts], in terms of efficient distribution of cash flow from business profits back through to the owners, is similar to what was common 40 to 50 years ago at the time Benjamin Graham was talking about the virtues of common stock ... What we're actually seeing with income trusts [in this] post tech-bubble, is a re-emphasis on cash flow and responsibility to unit holders," she said.