What it means
The structure worked by separating ownership from corporate form. Investors held trust units rather than shares, the trust held the underlying business, and the business's cash flow was passed up and then out to unitholders, who were taxed personally on what they received.
One layer of tax was therefore avoided, which was the whole point. That extra yield made the structure popular with income-focused investors, especially retirees, and by the mid 2000s a large part of the Canadian market value sat in income trusts across energy, pipelines, restaurants, retail and manufacturing.
The attraction created a problem for government revenue, because every conversion from company to trust reduced corporate tax collected. Large telecommunications companies announcing conversion plans is what brought the issue to a head.
In late 2006 the federal government announced the Tax Fairness Plan, which applied a tax at the entity level to distributions from what it called specified investment flow-through entities, with a transition period before the rules bit. Unit prices fell sharply on the announcement because the yield advantage was being removed.
Over the following years most trusts converted into corporations and replaced distributions with ordinary dividends. Not everything disappeared.
Real estate investment trusts meeting defined conditions were excluded from the new rules and remain a flow-through structure in Canada, which is why REITs are often described as the surviving branch of the family. Some royalty and resource structures also persisted in modified form.
For a non-specialist the lasting lessons are about analysis rather than history. A high distribution yield is not the same as a high return, because distributions can include a return of your own capital, and a structure whose advantage comes from tax treatment carries policy risk that no financial model of the business will show.
Both lessons still apply to any high-yield listed vehicle.
In practice
Real-world examples.
Example
A retired investor holds units yielding 9% and treats the distributions as safe income. An analyst points out that the payout ratio exceeds 100%, so part of each payment is funded from borrowing rather than earnings. The investor reduces the position before the distribution is cut.
Example
A corporate development team at a pipeline business models converting to trust form in the mid 2000s to lower its tax cost and raise its market value. After the Tax Fairness Plan announcement the model is abandoned. The team keeps the corporate structure and increases its ordinary dividend instead.
Example
A pension analyst comparing two Canadian property vehicles finds one is a REIT taxed as a flow-through and the other a taxable corporation. She adjusts the forecast cash flows for the different tax treatment before comparing the yields. The apparent yield gap of 2% narrows to almost nothing.
Formula
Calculation
Distribution yield = Annual distribution per unit / Unit price. Payout ratio = Distributions paid / Distributable cash.
A trust pays $1.44 per unit a year and its units trade at $18.00.
Distribution yield = $1.44 / $18.00 = 0.08, or 8%.
Assume the trust generates distributable cash of $1.60 per unit, so the payout ratio = $1.44 / $1.60 = 0.90, or 90%, leaving only 10% of cash retained for reinvestment.
The effect of entity-level tax can be shown simply. If the trust distributes $100 of operating cash with no entity tax, unitholders receive $100 before their own personal tax. Apply a 30% entity-level tax and they receive $100 - $30 = $70, a fall of 30% in cash received, which is why unit prices dropped when the rules changed.Case study
Seen in the real world.
Northbridge Royalty Trust is an illustrative income trust created for this example and is not a real entity. It held royalty interests in mature oil wells, paid monthly distributions of $0.12 per unit, and marketed itself to income investors on a yield of about 9%. Nearly all of its distributable cash was paid out.
In this fictional scenario the trust had two separate vulnerabilities that its yield disguised. The underlying wells were declining, so distributable cash per unit was falling by a few per cent a year, and the structure's tax advantage depended entirely on policy that could change. When the entity-level tax on distributions was announced, both weaknesses arrived together.
Northbridge cut its monthly distribution to $0.08 and converted to a corporation within two years, and unitholders who had bought for yield took a capital loss as well as an income cut. The illustrative lesson is to ask what the yield depends on: the business, the balance sheet, or a tax rule someone else controls.
Watch out
Common mistakes.
- Reading a high distribution yield as a high total return, when distributions can include a return of the investor's own capital rather than profit.
- Ignoring the payout ratio, when a trust paying out more than its distributable cash is funding distributions from debt or asset sales.
- Assuming Canadian income trusts no longer exist in any form, when REITs meeting defined conditions were excluded from the 2006 rules and continue as flow-through vehicles.
Questions
People also ask.
Why were income trusts taxed differently after 2006?
Because the structure avoided corporate tax on distributed income, and widespread conversions were reducing federal and provincial tax revenue.
Were unitholders free of tax on their distributions?
No, they paid personal tax on what they received, and the structure removed the corporate layer rather than all tax.
What replaced the structure for most businesses?
Conversion back to a corporation paying ordinary dividends, which are taxed at the company level and then in the investor's hands with a dividend credit.
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