The news is pretty much all bad for trusts these days

ROB CARRICK

The one-year anniversary of the great income trust debacle of 2005 has arrived with trusts once again looking like the investing world's problem child.

The news is pretty much all bad for trusts these days -- returns in 2006 have been disappointing, and last fall's debate about whether trusts are costing the federal government too much in taxes has returned with a vengeance. Even some seniors, a prime market for trusts, have turned against them.

So what should investors do about income trusts? This edition of the Portfolio Strategy column makes the case for holding onto them and ignoring all the noise about how bad they are.

Let's look at some of the criticisms being levelled at trusts these days. One is that they're bleeding the federal government of tax revenue. In fact, the severity of the tax loss is in such dispute that Ottawa doesn't have anything close to a clear cause for acting against trusts. The major risk for people who currently own trusts is that the government will try to wring more tax revenue out of these investments, which in contrast to corporations, pay little or no tax. In a worst case, trusts would be hit with a tax that reduces the amount of cash they can pay out to unitholders. Trust prices would then plunge, leaving investors shattered.

We've already had a taste of what fear of a trust tax can do. A year ago, the broad trust market lost about $23-billion when the Liberal government of the moment clumsily announced a review of its trust policy. Then, just as a decision was made to spare trusts, the market recovered in a lightening-quick rally that sparked an RCMP investigation into whether insider information had been available to some investors. The tax debate surrounding trusts was recently reignited with the news that telecommunications giants BCE Inc. and Telus Corp. plan to convert themselves into income trusts. Earlier this week, University of Toronto finance professor Jack Mintz estimated that with BCE and Telus included, trusts will cost Ottawa and the provinces $1.1-billion in taxes a year. Prof. Mintz is an eminent scholar, but his numbers have produced all kinds of rebuttals.

"I see no impetus for the federal government to do anything about trusts," said Leslie Lundquist, who runs more than $1-billion in income trusts for Franklin Templeton Investments. "We keep hearing they have to do something, but why?"

First off, Ms. Lundquist noted that the previous Liberal government's own tally of taxes lost to trusts was $300-million. That was the number cited by then finance minister Ralph Goodale last November when he announced that taxes on dividends would decline in order to draw investor interest away from trusts.

True, this figure was issued before the announcement that BCE and Telus would convert into trusts. But Ms. Lundquist said it's overly simplistic to look at these conversions strictly as a drain on taxes.

BCE currently pays $1.32 a year in dividends, but after it converts to a trust it will pay $2.55 a year in distributions. Ottawa's ability to tax the $1.32 is limited by the dividend tax credit. Meanwhile, distributions from the new Bell Canada Income Fund will primarily be taxed as straight income, which essentially means the government will get a bigger slice of a bigger pie of taxable income.

Prof. Mintz said that Ottawa's tax-loss problems are exacerbated by the fact that an estimated 39 per cent of trust assets are sheltered from income tax because they're in pension or registered retirement plans. But the federal government will eventually get its hands on this money when money is withdrawn from these plans by retirees.

"This deferral of taxes is a very good planning technique to deal with the aging population," said Sandy McIntyre, senior vice-president and senior portfolio manager with Sentry Select Capital Corp. "You tax the income when you need the tax revenue."

The point investors should take away here is not that trusts have zero effect on federal government tax revenues, but rather that the problem may not be as severe as it's sometimes billed. "The tax argument, as far as I can tell, sure isn't enough to make a minority government come out and do something," Ms. Lundquist said.

Let's say that federal Finance Minister Jim Flaherty can live with trusts as they are now. After all, he had a $13-billion budget surplus last year, and his party promised not to introduce any new trust taxes in the last election. The counterargument here is that so many companies are converting into trusts that Ottawa must defend its corporate tax base against future erosion.

The question is, how many more companies are going to turn themselves into trusts? Dirk Lever, chief income trust strategist at RBC Dominion Securities, said there's simply not enough appetite from investors for unlimited trust conversions.

Retail investors have already started backing away from trusts, he said. The Investment Funds Institute of Canada reports that sales of dividend and income funds -- income trusts would be a major component of these funds -- are off 50 per cent this year on a net basis that subtracts redemptions from new purchases.

Disillusionment with trusts was on public display in Ottawa this week when seniors group National Pensioners and Senior Citizens Federation called for a moratorium on companies converting into trusts. The group argued that lost taxes will squeeze funding for social programs, and it also believes that regulation is needed to protect people from trusts that fail to make their expected distributions.

Mr. Lever said the aging of Canada's population actually suggests that people will increasingly turn to trusts to help generate income in retirement. Still, he believes that money managers and individual investors will continue to want to own the shares of companies like Research In Motion that offer growth, as well as income-generating trusts.

"There's not an insatiable appetite for trusts," Mr. Lever said. "Not everyone who owns a corporation wants to own a trust." Investor demand for trusts has no doubt been slipping this year because of the sector's disappointing performance. The S&P/TSX capped income trust index was off 0.9 per cent for the year through Oct. 19, a real comedown for investors who watched the index gain a cumulative 78.5 per cent in the past five years.

This year's slump in the trust index suggests another reason to get out of trusts -- their glory days are over.

If you're investing for capital gains rather than yield, income trusts may not provide much excitement looking forward. But don't interpret this year's slump as a sign of malaise across the trust universe. In fact, energy and business trusts have been weak, while real estate investment trusts have been on a roll.

"My REITs have done really well," said Mr. McIntyre, of Sentry Select. "The market for large-cap REITs has been hotter than a pistol." Mr. McIntyre said energy trusts have been hurt by slumping oil and gas prices, while business trusts have been troubled by concern about an economic slowdown. Several business trusts have already had to cut or reduce their cash payouts and there's concern that slower economic growth would cause more of these trusts to disappoint investors.

"Investors have taken down good, bad and indifferent business trusts, irrespective of the quality," he said. "We are seeing some opportunities developing on trusts where people are ignoring what aren't bad businesses." Two examples are Data Group Income Fund, a printer, and KCP Income Fund, a producer of household laundry, cleaning and pharmaceutical products for brand-name companies such as Gillette, Unilever and Johnson & Johnson.

The safest thing to do if you're worried about your income trusts would be to sell them now and try to find something else that offers the same high yields and potential for capital gains. Good luck to you on that.

Or, you can hang onto your trusts and accept the risk that the federal government will listen to the critics and ignore the very reasonable arguments for leaving trusts alone.

Investor FAQ

What are income trusts, anyway?
Trusts are entities that pay all or virtually all of their earnings to unitholders through monthly or quarterly cash distributions. Trusts, which are considered to be a type of stock, can be based on oil wells, office buildings and malls, power-generating plants and a wide range of businesses that include fast-food restaurants, trucking outfits, garbage hauling and construction.

Why own trusts?
The cash distributions can yield anywhere from 5 to 15 per cent on an annual basis, with higher yields coming from riskier trusts. Plus, there's the opportunity for trusts to rise in price.

What are the risks associated with trusts?
Like stocks, trusts can rise and fall in value. They can also reduce or suspend their cash distributions if their businesses are weak.

What's the current fuss over trusts all about?
Mainly, it's concern that too many corporations are turning themselves into trusts and thus taking tax revenue away from the federal government. Unlike corporations, trusts pay little or no tax to governments. Trust unitholders must pay tax on their distributions, but many trusts are held in pensions or RRSPs and are thus tax-sheltered.