Canadian income trusts brace for 2011 tax hit
In their heyday, Canada’s income trusts boasted over C$200 bn ($170 bn) in stock market capitalization. Yet by 2011, when their ‘tax holiday’ expires, the sector (sans real estate) is set to become virtually extinct. In the interim, trusts face the prospect of being consumed or reborn.
For a variety of idiosyncratic reasons, several dozen have already transitioned via M&A, privatization or corporatization. Most of the roughly 195 remaining trusts are expected to hang on to the bitter end. As an anxious investor base looks on, managements are now fleshing out the genetic code of the corporatized animal they are about to become.
Some have definitively shown their spots; others are still hiding in the grass. All are aware that some early conversions have stumbled. Growth stories, for example, have seen major stock price drops and significant investor churn amid the financial crisis.
Take BFI Canada, for example: back in August 2008, when the garbage collection company announced a conversion coupled with a distribution cut, its units got hammered. Other early converters like Superior Plus and Bonterra Oil & Gas have held up well on the decision to keep their distributions – now dividends – in place.
Preaching to the converting
The number one question facing an income trust IRO (who is frequently the chief financial officer) is: ‘What will the new entity’s operating strategy be and, more importantly, will it cut income distribution? If so, by how much?’
‘The more detail in terms of internal assumptions about 2011, the better,’ says Patrick Kenny, an analyst at National Bank Financial. ‘If, for example, a trust states it can sustain its payout, it should provide the numbers to back up that assertion.’
Even Kenny admits that giving guidance that far out has finite value, however, and many trusts are feeling a little cagey on the subject anyway. ‘What you want to communicate is that you offer the potential of sustainability, but don’t promise it,’ asserts one prominent bank analyst. ‘For now, few trusts are providing much guidance on what they will be after they convert.’
‘It’s especially hard to formulate a plan given uncertain economic conditions and debt markets,’ adds Michael Lough, vice president and director at TD Asset Management. ‘Overall, however, management teams indicate their strong preference is to maintain the dividend. Hopefully they have enough growth in their business plans to be able to cover taxes and maintain payouts at the existing level, but most trusts will have to cut to some extent.’
‘It’s not going to be all good news for investors hooked on income,’ agrees Philip Koven, a senior IR consultant with Bryan Mills Group. ‘It will be a big challenge for IROs. In some cases, they will preside over a major changing of hands of the entity’s shares. It may be devastating.’
Roy Shanks, president of Georgeson’s Canadian business, says potentially avoiding such disagreeable calamities means ‘knowing who your unit holders are and being able to communicate a message clearly and promptly.’
Currently, that message often remains unspoken – and when it is uttered, investors remain skeptical. ‘It will be easier for companies that stick with yield,’ comments Gordon Tait, managing director in equity research at BMO Capital Markets. ‘Their investor base is already there. Saying you will become a growth story is tougher; just saying it doesn’t mean it’s going to happen.’
Trust but verify
Overall, Tait, who specializes in the oil and gas royalty trust sector, believes 2011 won’t turn out to be such a bitter pill. He points out that corporate taxes are being cut and, at the same time, many royalty trusts have tax shelters so ‘it will be years and years before they will ever be faced with corporate tax.’ Not that it would make much difference. ‘For a lot of these royalty trusts, commodity prices, not tax, will be the biggest influence on the payout,’ Tait adds.
For some trusts, though, a payout slash is inevitable. Even then, some might not have a long-term, sustainable future. How do investors know who these ‘zombie’ companies are? ‘You can see it in their yields,’ says one analyst. ‘The higher the yield, the more suspect the company.’
And while a high-dividend policy post-conversion may encourage a premium valuation, the retail hordes are probing deeper than ever. ‘Investors have been burned so badly, they may not be buying any story you tell them,’ says independent income trust analyst Harry Levant. ‘They are getting more educated and will demand as much data as possible surrounding the reliability of yield.’
Effectively communicating to an audience of varying sophistication promises to be among the toughest challenges faced by investor relations practitioners during the transition. If, for example, the size of the distribution cut precisely reflects changes in taxation, then the arithmetic is fairly universally understandable.
‘That’s the approach many will take,’ predicts Bill Procter, senior vice president of investments at Mackenzie Financial Corp. ‘In that case, it’s important to communicate that the fundamentals of the business aren’t going to change as a result of the transition. You’ve still got the same strategy and the same cash flow.’
The tricky part is when there is a gap between the tax hit and the payout cut. Procter says explaining this situation can be complex. ‘For example, the reporting differences in earnings as a corporation and distributions as a trust can greatly affect payouts, depending on circumstance,’ he explains. ‘That’s also vital for the company to properly communicate.’
Brave new world
Ultimately, as Procter points out, that communication may soon be going to an entirely new set of investors. ‘Unit trust funds will become dividend funds or will be rolled into others,’ he explains.
While there will doubtlessly be retail churn, Procter concludes that ‘IROs may have to address a whole new group of portfolio managers as well.’
Of course, all this might be moot if somehow the federal opposition Liberals take power and fulfill their most recent campaign promise of restoring the income trust system, although this is a faint hope indeed.
RiskMetrics has revamped its 2009 Canadian proxy voting policies with ‘specific guidelines’ highlighting unacceptable proposals. Least hunky-dory is any conversion triggering change-in-control payments or acceleration of options vesting. ‘The successive equity compensation plan for the corporation needs to be carved out as a separate item so that both elements can be reviewed and voted on their own merits,’ says Debra Sisti, RiskMetrics’ director of Canadian research. ‘Basically, we don’t want to see companies trying to get something over on investors.’
Hybrids too efficient
In the fall of 2006, Canada’s Conservative government, arguing that income trusts cause ‘tax leakage’, broke a campaign promise and announced a 31.5 percent tax on distributions to take effect in 2011. The move outraged many yield-loving investors, including Brent Fullard, former head of equity capital markets for BMO Nesbitt Burns and founder of the Canadian Association of Income Trust Investors. Fullard says the government’s tax-leakage argument has been proven ‘a total crock’, and its solution just makes things worse.
‘The government has contrived an analysis that gives rise to an outcome it was seeking in order to justify a policy that serves the purposes of all the people who lobbied for it,’ Fullard says. He believes, in effect, that income trusts had become too popular with both the providers and receivers of capital. ‘Insurance companies found they were selling less product in the face of income trusts, while banks feared the competitive threat on their debt-selling business,’ he suggests.