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Doubts Cast On Canada's Burgeoning Income Trust Sector

by Mike Godfrey,, New York

02 December 2002

An influx of US issuers to the red-hot Canadian income trust market has worried local investment gurus, especially after the Toronto Stock Exchange decided last week not to make income trusts part of the S&P/TSX composite index, and several pending issues were cancelled or postponed on fears that high valuations had attracted some less-than-solid issuers.

Income trusts have dominated the Candian IPO market during the three years of the bear market in equities. Almost $50-billion worth of income trusts and their twins, energy trusts and real estate investment trusts (REITs), have been launched onto the Toronto Stock Exchange. In the first half of 2002, 90% of IPOs were for income trusts.

In the Canadian market-place, income trusts are one of the only investment sectors in which it's possible to get reasonably high returns on a 'pass-through' (untaxed) basis without taking too much risk. Classically, an income trust was an investment trust used by a company with a static income stream and tax deferrals on its balance sheet to return cash to shareholders in a tax-efficient way. This description particularly fits oil and gas companies after their exploration phase has finished, and also real estate companies with fully-let properties. The company with such assets sells them to a trust, similar to a mutual fund, which under Canadian tax law can distribute its income and assets to shareholders (unit-holders) on a pre-tax basis. The distributions are taxed in the hands of the recipient as income or capital, as the case may be. The units or shares of the trust are traded on a stock exchange, and valuations tend to follow distribution patterns, rather than necessarily reflecting the underlying economic health of the parent company.

As companies have found it increasingly difficult to raise capital directly on the equity or bond markets, more and more of them have used income trust IPOs as a way of capitalising on their current cash flows. A wide range of Canadian companies have launched income trusts in this way, and in 2002 the fashion has spread to US companies. Of course, they have the IRS to contend with as well as the Canadian revenue, and it is a tricky process to structure the Canadian income trust so that the transfer of income and deferred tax assets from the US corporation escapes withholding tax. A lucrative business has sprung up among the Canadian tax firms which help US companies through the minefield.

Initially, US companies launching Canadian income trusts were those with Canadian income streams, which are reasonably safe from the IRS, but more recent IPOs have been braver, and have begun to involve weaker US companies for whom the Canadian capital market in its current income trust frenzy may appear as a last resort, regardless of the tax problems that may loom ahead.

The future of the income trust market as a whole is probably not in doubt, although current double-digit returns may not last. But valuations may need to take more account of the underlying economic health of the issuer; and the corporate governance of the income trust itself is another area in which closer inspection is likely to lead to some sheep-and-goat sorting.

For some, the income trust phenomenon is a sign that investors have switched from a capital-growth bias to an income bias, returning thus to the situation that obtained in the 1950s and 1960s before the 'go-go' years began. If that's true, then the income trust bubble (as some describe it) can be seen as a kind of growing pain of the new era. Better to stay away?

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