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Budget impact on trusts
Proposed changes impact some investors

Federal Finance Minister Ralph Goodale tabled his first budget on March 23. The investment community had highly anticipated his comments on the income trust sector given the conflicting reports of their impact on government tax revenues. For the most part, the proposed changes were not as bad as feared for most retail investors, but some institutions are up in arms.

Proposed changes for trusts

The government does not currently view the tax issue as significant. However, they obviously see a future risk since they proposed investment limits on the extent of pension plan ownership. Registered pension plans may invest in business trusts in amounts up to 1 percent of a plan's total book value or 5 percent of a trust's outstanding units.

Recall that income trusts, like mutual funds, avoid income tax at the trust level by flowing through enough taxable income to unitholders. But if those unitholders are not taxable (i.e. pension funds), the government doesn't receive any immediate tax revenues. By contrast, a corporation paying dividends to shareholders have already paid tax on that money at the corporate level - so the government has already received tax revenues on such shareholder distributions.

The pension ownership limits don't apply to real estate investment trusts (REITs) or royalty trusts since pensions have been known to simply take direct ownership in the same underlying assets found in these types of trusts. Plus, those two classes of trusts tend to have the largest amounts of tax-deferred cash flow so there is little tax revenue to be lost with these trusts.

Also, trust distributions that are otherwise not taxable when paid (i.e. return of capital or RoC) will now be taxed (15 percent at source) if paid out to non-resident unitholders. Many royalty trusts - particularly the larger ones - have significant numbers of non-Canadian unitholders. For instance, Pengrowth Energy Trust recently announced that non-residents of Canada hold approximately 53 percent of its units.

Investor impact

There are both direct and indirect consequences for retail investors. Small business owners who have set up individual pension plans (IPPs) will be impacted by the pension ownership rules. Since IPPs are registered pension plans, the proposed ownership limits will also apply to such plans.

Also, those Canadians invested in royalty trusts with a significant foreign ownership contingent have already begun to see some downward price pressure. In effect, the 15 percent withholding tax now makes the distributions that much less valuable - which is mirrored in how non-resident investors value the trust unit prices. Expect affected trusts to respond promptly. Pengrowth, for instance, has already planned to split their units into two classes - one for Canadian residents and one for non-residents. Hence, the ultimate impact may be negligible.

Similar downward price pressure may occur where pension plans already own significant stakes in trusts in excess of the new limits - which come into effect after this year and allow for a phase in period after its introduction. Ontario Teachers (OTPPB) says it ownership in Yellow Pages Income Fund is above both the book value and percentage of total units limits.

In this instance, brokerage firms may play a key role in softening the price pressure resulting from such sales to the extent that they can directly provide liquidity to investors like OTPPB to allow them to unload big chunks of shares without the resulting downward price pressure. As an aside, neither pension plans nor the income trust industry is happy about the proposed rules, so expect a great deal of lobbying prior to the finalization of these new limits.

Note: The second instalment on the deductibility of advisory fees is being delayed briefly but will be posted soon.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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