Income Trusts - A Taxing Issue
Everything goes in cycles. We saw a similar situation in Australia 20 years ago. Their listed structures were like ours before income trusts came on the scene, and a group of talented lawyers and investment bankers converted Queensland Coal from a corporation to an income trust – it tripled the next day.
During the following year a not-so-cottage industry of converting corporations to income trusts sprouted up and took root. This rampant growth was stamped out in 1985 when the Australian government changed the rules: higher tax rates on all new income trusts and current listings could take up to 3 years to decide whether to keep their structure or convert back to a corporation – the majority flipped back to being corporations because the tax advantage simply was not there. This rule, however, did not extend to REITs or royalty trusts/flow-through shares.
New Rules Introduced
Yesterday, the Canadian government announced new rules for income trusts: For existing Income Trusts, by 2011, there will be no appreciable difference between all-in income trust and corporate tax rates, allowing 5 years for companies to convert back to corporations. Beginning immediately, new conversions will face the new tax structure from the get-go.
A difference between the Canada and Australian government's implementation of the changes is the lead-time: Australia gave 3 years to decide, while Canada has given 5 years – with the bonus of a 0.5% drop in the corporate tax rate by that time.
As at close of day November 1, 2006 the S&P/TSX Capped Income Trust Index is down roughly 12.5% and the S&P/TSX Composite Index is down almost 300 points (income trusts make up 10% of the QMV, or Quoted Market Value, of the S&P/TSX Composite Index). It's uncertain how much of this drop is a knee-jerk reaction (some investors selling on panic signals as liquidity has dried up because of the recent news) and how much will be sustained losses.
Notes on Protection and Tax Efficiency
Although investments in notes are generally considered for their primary benefit of principal protection, notes can also provide a number of other benefits.
For investors who want exposure to businesses structured as income trusts, notes continue to provide indefinite tax efficient exposure to income trusts, both now and beyond the governments 2011 deadline. Many notes provide a return of capital feature where income received through the note's underlying investment portfolio is automatically converted to return of capital, thereby deferring investors' tax liability to maturity. Other notes also internally reinvest distributions received from income trusts held in the note's underlying portfolio, thereby compounding returns and deferring all tax liabilities until maturity.
Notes of course can also provide investors with multiple other benefits, including a minimum of 100% principal guarantee, leveraged growth and income from up to 200% exposure, and protection of NAV in down markets.
Impact on LEADERS methodology
The ONE Financial Profit Lock-In & Cashflow Notes, Income Trust LEADERS™ Class was designed to invest in the largest, most liquid company shares and income trusts in Canada to deliver high, tax-efficient income to our investors.
The changes outlined yesterday do not affect the tax treatment of the Profit Lock-In & Cashflow Notes, Income Trust LEADERS Class RoC distributions, but yields of Income Trusts underlying the notes may be affected. Investors in the Income Trust LEADERS™ Notes will continue to benefit from full downside protection, profit lock-in, and return of capital distributions.
Markets reacted immediately to the tax news with Income Trusts incurring a one day drop of 12.5% on November 1st. By comparison, the Income Trust LEADERS Notes (which utilize a dynamic asset allocation, or "CPPI", structure designed to protect the NAV in falling markets) dropped by only 6.8% the same day – and continues to provide investors with both principal and profit protection.
Innovation in Action - Switchability
The ONE Financial Profit Lock-In & Cashflow Notes are designed to be responsive to changing market conditions or personal investment objectives. The notes offer investors the unique ability to switch between the different classes within the family at any time, for any reason.
Investors may choose to switch out of the Income Trust LEADERS Notes and into the Global Dividend LEADERS Notes (or any other note within the family). As of November 1st, they would receive approximately 0.8 units of Global Dividend LEADERS Notes for each unit of Income Trust LEADERS Notes. The new yield would be approximately 3.5% with a Guaranteed Amount of at least $10.39 by Maturity.