Income trusts: Trust temptation

The income-trust tax kicks in soon. Get in now and you could score a deal.

Leslie Lundquist will never forget where she was the day Finance Minister Jim Flaherty announced the federal government would tax income trusts. It was a Halloween afternoon in 2006, and the fund manager at Calgary’s Bissett Investment Management was sitting in a colleague’s office, having a casual, late-day chat. “Then my phone started ringing off the hook,” she says. When she heard the news, Lundquist, then the lead manager on the Bissett Income Fund, couldn’t believe her ears.

At the time, trusts were incredibly popular because they were exempt from paying taxes on the income they flowed to unitholders. Because they were designed to spin off regular cash payments, they had been embraced by seniors, who used them as a source of income for their golden years. Just a few months earlier, in the midst of an election campaign, the Harper government had promised not to touch income trusts. So when Flaherty announced that trusts would be taxed starting Jan. 1, 2011, Lundquist thought there had to be some kind of mistake. She wondered if her job — managing a fund that entirely consisted of trusts — was in jeopardy.

It’s now 3? years later, with less than nine months to go before the trust tax deadline kicks in, and Lundquist is much calmer. She says she’s “already gone through the various stages of the grieving process,” and she’s feeling much more bullish about the sector. She will not only continue to manage her fund next year, she says now is actually a great time for investors to get into the income trust market.

The reason? Ever since Flaherty made his announcement, Canadians have been wary about investing in the sector, and that wariness, says Lundquist, has made for some bargain-basement deals. Investors fear that when the new trust tax kicks in this January, distributions will be slashed and prices will tumble. But that’s not necessarily the case, because the market has had lots of time to price in the new tax already. The biggest opportunities, she says, lie in undervalued trusts that have not yet announced whether they will remain trusts or convert to corporations and maintain their current distribution levels. “Once the announcement gets out, the uncertainty won’t be in the market,” she says. “If the price needs to adjust, it will, but from then on you’ll be owning a company for its own merits.”

It’s likely that almost all income trusts (except real estate investment trusts, which aren’t generally subject to the tax) will convert to a corporate structure some time in the next two years, says Lundquist. While trusts will have to pay tax on their income come 2011, they have until 2013 to convert into a corporation without having to cough up the taxes associated with the transfer. Remaining a trust without the tax benefit is costly, as it’s more expensive to operate as a trust than as a corporation. But despite the expected exodus from the trust sector, her fund will continue to operate — she’ll just hold many of the same high-yielding businesses as corporations in her portfolio instead.

Martin Ferguson, a director and portfolio manager at Calgary-based Mawer Investment Management, says that for those investors holding trusts when the tax comes into effect, the transition should be fairly smooth. Beginning on Jan. 1, non-REIT trusts will be subject to a tax of approximately 30% of theirpre-tax income. This tax will reduce the cash available to flow out to investors by a like amount, thus ending the tax advantage they had over corporations. But at the same time, regardless of whether they remain a trust or convert to a corporation, their distributions will be considered dividends for tax purposes. In other words, depending on their income bracket, investors may not notice a big difference in the annual income they get after tax. The end result could be that investors will get less cash out of the company, but it will be taxed at a lower rate as dividend income in their hands.

Many investors have been scared out of the trust sector by the impending tax changes, but Ferguson says there are opportunities for investors who focus on the quality of the underlying businesses. He says he looks for trusts with a strong business model, a unique competitive advantage and healthy cash flows. “If they have all that, the only thing that should change is the tax situation,” he says, which the market has already factored in. Nick Dedes, a fund analyst with Morningstar Canada, agrees, adding good companies are good companies no matter how they’re structured. He says investors should look at whether or not the business will take a different strategic direction and how crucial the tax savings were to its operations.

Still, while many of the weaker trusts have already folded or merged out of existence, there’s no guarantee that a trust won’t wind up being a dud after the January deadline. The riskiest bets are the companies that switched to the trust structure just to take advantage of the tax savings — it’s those operations that may get rid of their distributions altogether. Another red flag would be a sudden, major shift in the underlying business model. Generally, good trusts are those with a predictable, regular stream of income. If one of these steady operations decides to go on an acquisition spree, using its cash to grow the company rather than flowing it out to investors, you should ask whether that shift in strategy will increase shareholder value. “Those changes have not been met well by the market,” Lundquist says. “They’ll reduce their distribution down to zero, and there’s usually a period of extreme price weakness until they prove they can grow again.”

In the end, finding a good trust is similar to finding a good corporation to invest in. “We look at the future,” Lundquist says. “If it has a very bright future, but because of the uncertainty the trading price is down, that’s attractive.” As long as a trust has some growth potential, pays a high yield and continues to execute its business plan soundly, it’s possible that it may even decide to increase its distribution down the road.

Best bets

There are now about 150 Canadian income trusts on the market — down from a high of 248 in 2006 — but there are still plenty to choose from. Here are four trusts that investors may want to consider:

Morneau Sobeco Income Fund [ MSI.UN]
‘We really like this business,’ says Leslie Lundquist, co-manager of the Bissett Income Fund. Toronto-based Morneau is Canada’s largest HR services firm, with 2,300 employees in North America. On March 10, the fund announced it would convert to a corporation on Jan. 1, 2011, and continue to pay a distribution. Currently, the fund’s annual yield is 9.17% — next year investors will get about 7.6%, assuming its price doesn’t change when it converts. Because the distribution will be taxed as dividend income in investor’s hands after the conversion, management says distributions will actually increase 10.6% on an after-tax basis for unitholders paying the highest marginal tax rate.

Badger Income Fund [ BAD.UN]
Badger Income Fund has been in the trust market for several years now, becoming a flow-through entity in 2004. It has a smaller market cap, but Lundquist thinks it has potential. The company is North America’s largest provider of ‘non-destructive’ excavating services. It digs unobtrusive holes for energy companies, infrastructure projects and other industries. Its annual yield is about 8%, and thanks to its low debt level and strong balance sheet, the company says it will keep paying dividends of between 75% and 100% of the current annual distribution when it converts in 2011. ‘If you buy Badger today, you’re getting a well-managed company that will continue to succeed many years into the future,’ Lundquist says.

First National Financial LP [ FN.UN]
According to Martin Ferguson, a director and portfolio manager at Calgary-based Mawer Investment Management, First National has a solid business model, with high recurring revenues and low risk. The Toronto-based operation is the largest nonbank player in the mortgage market. After the company originates a mortgage, it sells it to an institution, retaining the servicing contract. It also securitizes packages of mortgages, again keeping the service contracts. Currently, the trust is yielding about 7% per year and trading at about $21 a unit. When it converts at the end of the year, the yield is expected to drop to 5% a year, or $1.10 per share annually.

Altus Group [ AIF.UN]
Altus Group, based in Newmarket, Ont., is another favourite of Ferguson’s. The income fund is one of the country’s largest independent real estate valuation organizations, with more than 50 offices in 11 countries. It has a wide range of clients, but pensions, REITs and other commercial property owners are its main clients. With a strong and focused business, Ferguson expects its annual yield of 8% to stay in place after January. The fund had not announced its conversion plans at press time.