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Business Income Trusts—Tax-effective Investment Vehicles
Income trusts have been popular investment vehicles
in Canada. The income trust structure has been in use
for many years in the real estate and oil and gas
sectors. However, many of the income trusts to hit the
stock market recently are in less traditional sectors.
These so-called “business income trusts” have been
used for a wide variety of businesses, including
restaurant chains, manufacturers, printing, and
warehousing and distribution.
What is an income trust?
An income trust is a public investment vehicle that achieves a tax
advantage through the use of a mutual fund trust. Taxable income
earned in the mutual fund trust is allocated to the trust unitholders and
is not subject to tax at the trust level. This is substantially different from
a corporation, where the income is subject to tax at the corporate level.
When a mutual fund trust is interposed between the investing public
and the operating business, it may be possible to greatly reduce or
eliminate the tax that a corporation would normally pay and allow the
tax benefits to be passed on, through higher distributions, to the
investors. These anticipated higher distributions are the main feature
of income trusts. Therefore, income trusts generally involve businesses
that provide a stable and predictable source of income and cash flow.
The goal is to provide the investors with maximum cash flows,
translating into regular, high-yield investment returns.
Since income trusts are typically based upon distributable cash, they
are generally priced on the quality and consistency of the cash flow and
the risks inherent in the business. For example, $10 million of cash flow
at a 10 per cent yield would give a value for the income trust assets of
$100 million. A lower yield of 8 per cent would increase the value to
$125 million. Lower yields and higher valuations will generally apply to
more stable, mature businesses; however, the yield is also a function of
many other factors, including current market conditions and interest rates.
Profile of a business suitable for an
income trust
Income trusts are generally used for mature businesses that have
moderate growth. The business must have a steady, predictable
distributable cash flow since income trusts distribute all or most of
their cash flow, and the market value of the business is based on this
distribution. The business should also have low capital expenditure
requirements since the income trust will generally maintain very little
capital to stimulate growth or fund these requirements. Growth is
typically funded through new unit issues or third-party debt.
Corporation tax inefficiencies
A typical public corporation structure is inefficient and subjects the
investors to double taxation, once at the corporate level and again at the
investor level. As a result, an individual investor often pays direct and
indirect income taxes that are approximately 10 per cent higher than what
he or she would pay if earning the income directly. The tax inefficiency
inherent in the typical corporate investment is the primary motivation for
the income trust structure. Inefficiency is even greater where the investor
is a tax-deferred vehicle such as an RRSP or a non-taxable entity such as a
pension plan.
Since capital taxes are paid by corporations but not by partnerships or
trusts, they also contribute to the corporate tax inefficiency that the
income trust structures seek to eliminate.
Income trust structure
While there are different variations, the current income trust structure
of choice will generally utilize a combination of trusts and partnerships
to ensure to the extent possible the full flow-through of taxable income
to the investors.
Generally, the income trust will invest in
an intermediary trust that will use the
proceeds to acquire units in a limited
partnership. The limited partnership will
acquire the business assets from the
vendors on a full or partial tax-deferred
basis, in exchange for the cash received
from the trust and units of the
partnership. The partnership, which is
itself a flow-through vehicle and is not
subject to income or capital taxes, will
directly or indirectly conduct the vendor’s
business.
Typically, the vendor will retain an interest
in the operating business in the form of
partnership units that are exchangeable
into units of the income trust. The
exchange of these limited partnership
units for units of the income trust will be
a taxable event.
The future of income
trusts
In the 2004 federal budget, the
government identified a risk to the tax
revenue base due to the increase in the
number of business trusts. The budget
proposed to limit the potential
investments by pension plans (nontaxable
entities) in income trusts. Even
though, at the time, pension funds were
not significant players in the business
income trust sector, this proposal was
expected to have a significant impact on
the future of business income trusts.
However, the government reversed this
position in the 2005 federal budget. In a
related proposal, the government also
made it easier for registered plans to hold
interests in publicly traded limited
partnerships, which are flow-through
entities much like income trusts. In
September 2005 the Department of
Finance released its long-awaited
consultation paper entitled “Tax and Other
Issues Related to Publicly Listed Flow-
Through Entities (Income Trusts and
Limited Partnerships)”. The paper is a
starting point for upcoming consultations
on the tax issues related to income trusts.
A clear focus of the paper is the
discussion of the revenue loss due to
flow-through entities. Less than two
weeks after the release of the
consultation paper, the Canada Revenue
Agency announced that it would
postpone providing advance income tax
rulings for income trusts and other flowthrough
entities pending measures that
may be proposed after the consultation.
This development will significantly slow
the creation of new income trusts while
the industry awaits the government’s
ultimate conclusion on their status.
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