How much will they cut my income trust distribution by?

Posted by on August 25, 2008 in Investment Information

As part of the much-maligned decision of the Canadian government, the income trust industry (except for real estate investment trusts) will be part of the newly phased in income tax regime by 2011 which is specific to the income trust industry. Given that the oil and gas industry has been bought up by everyone, Canadian and non-Canadians alike, this move has global implications given that many income trusts are oil and gas trust. As the title of this post suggest, the results will not be pretty.

The Cole’s Notes version of the taxation of income trusts is as follows: prior to 2007, Canadian income trusts could distribute their profits (or cash since some income trusts were not profitable and basically eating into cash) tax-free to the investors (this is a simplified review so, armchair tax lawyers, please bear with me) this resulted in some alarmingly high yields since income trusts had a huge advantage over dividend-paying corporations by not having had to factor in tax in its distribution policy. For political and economic reasons which is not the subject of this post, the government implemented an income trust tax which taxes income trusts 31.5% tax on all distributions paid to investors by the end of the phase-in period of 2011 (31.5% being the average tax rate which corporations pay in Canada). In other words, an income trust now has less money to distribute since it has to pay 31.5 cents on every dollar to the tax authorities. I can’t speak for the tax implications if you are a non-Canadian purchasing income trust to ride the oil and gas boom so please speak to your advisor.

In anticipation of 2011, income trusts have already started converting back into corporations- some public and others fully privatized which has begun to give us a sample size of income trust distributions post-2011.

One would think, that after conversion, an income trust would simply take a 31.5% reduction on distribution to account for the tax. Right?  Well… the issue is that many businesses who had no business converting into income trusts became trusts anyways lured by the siren song of the greedy investment banker (and remember what happens to sailors who heed the call of mermaids in tales of old). Income trusts are supposed to be structures for mature businesses that were not going to grow that much or all their capital expenditures were substantially completed (think of a landlord who can eat off of long term rental revenue, an oil company extracting oil at a consistent rate year over year from an oil-field or an infrastructure company collecting tolls off a busy highway). But too many businesses that are growing jumped on the bandwagon.

These businesses are, in a sense, using the conversion of trusts back into corporations as a smoke-screen to cover up the fact they should have never been trusts and slashing their distributions dramatically as a result.  The business reasoning is quite legitimately- they are cutting back distributions to grow the business- but the hard question remains why did you do it in the first place? The easy money and greed over-took them and now investors are going to pay on the back-end: first they took our money on the IPO now they are going to slash the distribution converting back to a corporation (which could be used for expansion but a cynic thinks, in this age of willful blindness to corporate malfeasance, that this extra money may end in the board’s pockets some how). The easy blame will be to look at the government but there were also a lot of greedy business people who were the harbingers of this mess

(…its pretty obvious I think the income trust saga is nothing more than another huge debacle that is becoming frightfully more common- people got greedy in a manner that would make Gordon Gecko blush, people got stinkin’ rich peddling generally bad or mediocre products (with some notable expectations) to the investor,  government had to step-in with their usual heavy-handedness after things got out of control, the investor loses again and the people who created the debacle walk away richer and legally blameless with an appropriate scape-goat in the government. Makes you want to go back to a barter economy but I digress….)

How bad are the cuts in distribution? Andrew Willis of the Globe and Mail summarized the following cuts or proposed cuts:

  • BFI Income Trust: 73% reduction in distributions annually (proposed)
  • Trinidad Drilling : 57% reduction; now paying dividends (converted)
  • Transforce Income Fund:75% reduction; now paying dividends (converted)
  • Aeroplan: 40% reduction; now paying dividends (converted)

In summary, based on a small sample size, expect a 40% cut in distribution in a best case scenario and 75% in the worse. The general trend being the more acquisitions the income trust undertook during the glory days, the bigger the acquisition (the reasoning being these types of trusts need to save money to service the loans to acquire companies given that the government also barred the issuance of new shares by a trust).

What can you do? You can wait until they announce the conversion and collect the distribution in the meantime or you can convert to other vehicles which distribute cash. As mentioned, real esate investment trusts are generally not subject to the new tax regime and have been suggested by some as a good alternative. Most of all, consult someone about your options. There will be a flood of conversions next year which may cause a panic and a drop in share price so the early worm gets the worm.

The larger lesson? At the end of the day, it always comes back to the Buffet rules. Buy businesses with large economic moats. Buy something easy to understand (if you boil it down, how were people sold income trusts? Its advantage was tax-driven and, in most cases, not a fundamental business edge- in other words, in assessing most trusts, we didn’t buy on the fundamentals; we bought on a tax loop-hole which most of us did not understand). Buy something you know.

As an administrative note, I moved to a new WP template last week- hence, the lack of posts as I sorted out the technical issues. If you have subscribe to this blog on the site, kindly subscribe to the RSS feed since the only subscription option will soon be the RSS feed. Thank you.

12 Comments on How much will they cut my income trust distribution by?

By moneygardener on August 25, 2008 at 1:57 pm

Don’t forget that some trusts like YLO.UN and IPL.UN have stated that they will continue to pay distributions at current levels through 2011. While I am not certain if this means literally ‘current level’ or current percentages of net income, the reduction should be minimal compared with other trusts. Read Yellow Pages investor relations for more information.

By moneygardener on August 25, 2008 at 2:06 pm

“We believe our continuing strong performance and prospects for 2009 support this seventh increase in cash distributions since our IPO in August 2003,” mentioned Christian M. Paupe, Executive Vice President and Chief Financial Officer. “YPG continues to be well positioned for a successful transition from an income trust to a corporation on or about December 31, 2010. We are confident that the growth in our Distributable cash will allow us to progressively reduce our payout ratio over the 2008-2010 period taking into account future expected cash income taxes while sustaining cash distributions.”

By admin on August 25, 2008 at 3:27 pm

MG: I guess I am from Missouri. These trusts have to show me after they convert that they can maintain the distribution at current levels (not yield but hard cash).

The YPG statement really says a lot without saying anything. It never commits to sustaining cash distributions AT CURRENT LEVELS. It only promises to sustain cash distributions so, technically, if they pay a dividend post conversion they have not made a false representation since the distribution is sustaining in that you are getting something.

At what levels? They refuse to say (nor should they). Maybe I am being a lawyer and word-smithing but if I was YPG lawyer that’s how I would defend the release if push came to shove.

By moneygardener on August 25, 2008 at 4:19 pm

I agree that the quote I attached was not the best, and I apologize for that. Here is a better version:

We intend to continue to increase cash distributions during the transition period, but at a more moderate pace than in the past. With Distributable Cash per unit expected to grow at sustainable growth rates in excess of cash distributions, the payout ratio is expected to decline to the low 70% range by 2010, which will provide the necessary flexibility to fund cash taxes starting in 2011.

Our objective is to be in a position to maintain the 2010 level of cash distributions to our shareholders in 2011, after a conversion to a corporate structure, despite the cash taxes that will then be payable by YPG. These distributions will then be treated as dividends, providing an additional advantage to taxable investors. Therefore, our ability to generate growing free cash flow from operations will provide the necessary flexibility to fund cash income taxes, which will position us well for a successful transition from an income trust to a corporation on or about December 31, 2010.

Distribution turns into a dividend after December 31, 2008. Currently yielding 12%. No bones about it, they are saying that their objective is to change distributions into dividends and proceed post 2011 without ever cutting.

By admin on August 25, 2008 at 4:51 pm

Thanks. The way I read this release then is that YPG can set out to maintain the cash distribution (hard cash and not the yield) as you do. The assumption is that their cash flow from operations can increase at no less than a 31.5% clip by 2011 (in reality more to factor inflation). If they falter between now and then, then all bets are off. That is a very aggressive cash flow growth strategy. You know the stock better than I do, do you think it can be done?

By moneygardener on August 25, 2008 at 7:59 pm

I don’t make the same assumption as you do based on that. The way I understand it is that by 2011 their pay out ratio will be down to a point (low 70% range) where they will be able to pay the same distribution as they did in 2010 while paying the new tax rate. They have given investors no reason to think that they can not pull this off. It almost seems to good to be true though; that a Canadian company can be bought today at an eventual 12% dividend yield rate on cost.

By Potato on August 25, 2008 at 8:58 pm

MG, that’s my understanding as well…

Right now, YLO is paying out $1.17/unit per year and estimated to make $1.45/unit per year (DCPU 2008E), for a payout ratio of about 81%. So for 2011, they’re hoping to still pay out $1.17 and make ~$1.67 pre-tax so that they still have $1.17/unit after-tax (pre-tax payout ratio of ~70%, after-tax payout ratio of ~100%). Between now and then they have to increase their revenues/cash flow by about 15%, or about 4-5% per year.

By David on August 25, 2008 at 10:02 pm

Great post, I’ve just gotten into this investing thing, and YLO is my first foray. I appreciate your comments MG (& Potato). Thanks!

By Canadian Capitalist on August 26, 2008 at 1:41 pm

Thanks for the link.

As YLO is one of my handful of holdings, my guess is that it is one of the few holdings that is likely to maintain its payout. As Potato points out, their payout ratio is already in the 80% range (78% in the latest quarter) and they seem to be on track to bring it down to 70% range fairly easily.

MG: I don’t find it unbelievable that YLO is sporting such a juicy yield. P/E on comparable businesses (mostly in the US) is down to 7.5 or an earnings yield of 13.33%. YLO pays out all its earnings, so the earnings yield is slightly lower. I personally think it is a good business, that’s why I’m holding it.

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By Thicken My Wallet » Blog Archive » Will income trust conversions lead to yield chasing? on January 19, 2010 at 5:03 am

[...] of a 31.5% tax on previously tax exempt Canadian issued income trust would force many income trusts to convert to corporations before January 1, 2011 (the day the new tax regime is effective) and lead to distribution cuts in [...]

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