Income Trusts | The Canadian Encyclopedia

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Income Trusts

Income trusts present an opportunity for investors to participate in a cash-flow stream generated by certain assets of an operating company.

Income Trusts

Income trusts present an opportunity for investors to participate in a cash-flow stream generated by certain assets of an operating company. This type of investment became popular with investors and corporations alike in the early 2000s and increased in popularity until, in the fall of 2006, the federal government introduced tax measures with a view to ending the practice of income trust conversions.

In 2002, Initial Public Offerings (IPO - the first time a corporation offers shares to the public) of income trusts accounted for 94 percent of all IPOs that year, when measured by value. At the end of 2003, there were a total of 123 income trusts with a total market capitalization (shares outstanding times unit price) of more than $74 billion or about six percent of the total market capitalization of the TORONTO STOCK EXCHANGE (TSX).

Typically, income trusts are established by companies wishing to consolidate mature, steadily performing assets that face little competition under one legal structure, taking advantage of the tax savings as any income is now taxed at the investor level, or not at all, in the case of tax-exempt investment vehicles such as Registered Retirement Savings Plans. Additionally, any Canadian taxes to be paid are now paid in the province where the investor resides rather than where the company is located, leading to a shift in provincial tax revenues. Income trusts can be found in virtually all industries with real estate investment trusts (REITs) and energy trusts being the more popular ones due to the relatively stable nature of their business.

Under the typical structure of an income trust, a separate legal entity, the "income trust," is inserted between the investors, called "unitholders," and the operating company. Income trust unitholders provide the funds that allow the income trust to purchase debt and equity from the operating company in exchange for the cash flow from the company's operations less any capital required to keep the company running. The income trust can own up to 100 percent of the operating company, and nearly all the cash flow from the operating company is distributed to the unitholders as interest income, dividend payments, or return of equity. A trustee or a board of trustees oversees the income trust, while the management of the operating company can be external or internal.

Following their appearance on the investment front, income trusts posted significant returns, especially when compared against an underperforming STOCK MARKET as was the case following the bursting of the "dot com bubble." This popularity did not go unnoticed by the federal government, faced with the prospect of losing hundreds of millions of dollars in corporate tax revenues as more and more companies announced that they would convert. In 2006, companies representing more than $200 billion in market capitalization had converted to income trusts and the provincial government of Alberta estimated its corporate tax losses at $400 million annually.

In October 2006, two of Canada's largest telecom companies, TELUS Corporation and BELL CANADA ENTERPRISES, announced that they would convert to an income trust structure, prompting the federal government to announce new tax measures (subject to parliamentary approval). Under the new rules, once fully effective in 2011, income trust distributions (other than those of REITs) will be treated like dividends both at the investor and the corporate level, thus eliminating any motivation for corporations to convert to an income trust or for investors to choose income trusts over other forms of equity investments.

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