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CI as a trust
Growth and maturity don't mix

Mutual fund companies' corporate finance is the theme again this week. CI Fund Management has noted in press releases that a planned hike in corporate tax has prompted them to investigate the merits of converting from a corporation to a trust legal structure. However, the characteristics that make a trust a good idea conflict with the market's apparent view of CI's future.

Income trust suitability

The appeal of the income trust structure lies in its ability to flow through income to stakeholders in a tax efficient manner. Dividends paid from a corporation are paid with after-tax dollars - i.e. dividends are not deductible from a corporation's taxable income. Generally, a trust incurs a tax bill at the top marginal rate for individuals on any income retained in the trust. It can avoid tax liability at the trust level by distributing a sufficient amount of income, thereby shifting the tax burden to its unitholders.

Since unitholders are unlikely to all be taxed at the top marginal rate (not to mention that some trusts are held in tax deferred accounts), the overall tax burden is much lower - as compared to incurring a tax bill at the trust or corporate level.

Avoiding trust tax means distributing the bulk of a business' profits, which creates a tradeoff. Paying more cash out means keeping less in the business to finance growth plans.

Valuations and market expectations

According to globeinvestor, CI Fund Management is trading at a price equal to more than 38 times its trailing year's profit. That valuation level assumes that the company has many years of consistently strong double-digit profit growth ahead. Even for CI, an industry leader, that's a stretch in Canada's mature mutual fund industry.

There are two possible motivations for converting to a trust: a) to save tax or b) the company feels that shareholders can reinvest its earnings more profitably than the firm. Based on CI's financials, its effective tax rate is under 40 percent. Trusts must pay tax at the highest marginal rate - more than 46 percent in Ontario. Planned increases in corporate taxes will narrow this 6 percentage point gap.

It's unlikely that tax savings can result from such a conversion since trust taxes will likely still exceed corporate tax rates. Actually, this can reduce the total tax bill, but the firm would have to pay out the bulk of its earnings, leaving individual shareholders to pay tax on distributed earnings.

The problem is that this high payout strategy leaves CI with little to finance its growth plans. Plus, fund company earnings are subject to the wild swings of global stock markets so paying out most of the earnings leaves little wiggle room to cushion leaner times.

Will the market's continuing infatuation with income trusts drive CI's stock price higher if such a conversion takes place? Recent media reports suggest this was in fact behind recent strength in the stock's price. However, logic dictates that this can't be sustained since a conversion to an income trust may be an admission that future growth is limited.

In other words, it doesn't make sense that a business trading at a price reflecting big future growth rates would rise higher if converted to a structure suited to mature, low growth businesses. However, this analysis is a bit superficial and CI's senior management has proven savvy in the past so only time will tell if this happens at all and the specific motivations if it does.

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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