One of the greatest fibs to ever roll off the Bay Street assembly line was that the income-trust boom of the early 2000s didn't cost the federal treasury anything. Trust promoters assured Ottawa of that. Of course, they also bragged to underwriting clients about how much more their companies would be worth if they converted them from corporations to trusts, which essentially paid no corporate income tax.
It's basic math that if the value of the company went up upon conversion, the increase in value had to come from somewhere. That somewhere was the government-cash that used to flow to the silent partner in Ottawa was now paid out to investors as distributions. So investors were willing to pay more for a trust unit than for a share of dividend-paying stock.
On Oct. 31, 2006, however, Finance Minister Jim Flaherty announced that income trusts would be taxed like corporations, starting Jan. 1, 2011. As many trusts prepare to convert back before then, it stands to reason that their value will fall. Many have taken a beating since Flaherty's announcement. But there could still be more surprises and wrinkles for investors before the deadline.
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One potential pitfall is a trust's management. A lot of trusts operated in mature industries such as conventional oil extraction and utilities, in which many companies generated steady cash flow, but had few growth opportunities. That meant that a trust could ladle out almost all of its profits to unitholders, rather than keeping them to finance new projects. In fact, it pretty much had to, or risk paying income tax.
Managers, however, generally prefer having money at their disposal. They like to hire lots of people, do deals and play big shot. They're usually paid very well for doing that successfully, and not punished much for failing, so they tend to go for it.
Investors should watch very carefully what management says when they announce that a trust is converting back to a corporation. Be particularly wary if they say it will become a "growth-oriented" dividend-paying corporation. Growth, by definition, means investing in possibly risky new ventures with your money.
Insider ownership-the lack of it-could be another red flag. When some entrepreneurs converted their businesses to trusts, they also sold some or all of their stock. Hank Swartout, CEO of Calgary-based Precision Drilling, used conversion as an exit strategy to unload most of his stake in the company in 2006. It is now converting back to a corporation, but its managers don't have large holdings. They won't have a lot of their own skin in the game if they play with retained earnings.
Growth by acquisition will also be more difficult. Income trusts had a relatively low cost of capital, because their units sold for a high price compared to their earnings. That made it easier to buy rivals. But the prices of many trusts have declined, and could drop even more upon conversion, depending on their dividend policies.
Finally, a word on the subject that matters most: the size of your distributions and dividends. Once the taxman reappears, companies will have about 30% less income left over to pay out to investors. But if you own your shares outside a tax-exempt account, you may not be much worse off because of the favourable tax treatment of dividend income. Canaccord Adams says that a $1 dividend could net you the same amount after tax as a trust distribution of $1.22 to $1.43.
Corporations and corporate taxes may not be that bad after all.
THE ART OF CONVERSION As income trusts reinvent themselves as corporations, investors should pay attention to what management plans to do afterward
› STRONGCO INCOME FUND When Strongco announced that it will convert itself back to a corporation this July, it also said it will not be paying any dividends. The company, which sells and leases heavy construction equipment, was worth little before converting to a trust in 2005. Its unit price surged to around $22, but then skidded when investors looked more closely at its finances. Strongco eventually cut its distributions, and units have slid back to about $3.75 recently. It should never have been an income trust in the first place.
› JAZZ AIR INCOME FUND Jazz Air CEO Joseph Randell recently said that he saw no reason to cut payouts to investors when the fund becomes a corporation later this year. That should raise eyebrows. Over the past two years, the airline has used up 93% of its cash flow to pay distributions and to replace or maintain equipment and planes.
› SECOND CUP INCOME FUND Second Cup will convert to a corporation next January. The fund currently pays distributions of 92 cents per unit per year. After conversion, it will pay a dividend of 60 cents. After taxes, however, that won't make too much of a difference to investors. Also, the company plans to pay out 75% to 85% of its profits as dividends. That means little money for management to play with, which is good news for income investors.