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Thursday, November 09, 2006

Income Trusts: Why Should you Care?

Well that was quite the hullabaloo wasn't it?

Last week, Finance Minister Jim Flaherty changed the rules on Canadian income trusts, going back on a campaign promise to leave them alone. Much wailing and gnashing of teeth followed. So what's the deal, and why should you care?

What the hell is an income trust anyway?
An income trust is a way of structuring a company; you can be a public corporation, a limited partnership, an income trust and so on. The idea of an income trust is pretty simple. Instead of re-investing profits back into your company to increase growth, you pay the money out to unit holders. They get a nice income stream and the company gets a big break on taxes. Basically, instead of the company paying tax on all those profits, the individual unit holders pay the taxes, at a rate lower than the company likely would have paid. It can be a win-win.

So what's the problem with income trusts?
Income trusts were designed to be used by certain kinds of companies. These are companies that have significant up-front capital investments and then a fairly steady stream of profits with little need for further capital investment. Think of a real estate company - you buy some land, pay a ton of money to develop it, and then it sits there generating revenue at very low on-going cost to you. Income trusts were particularly designed to address companies that generated more on-going profit than they could logically reinvest - it makes sense for a company in this situation to pay out the cash to shareholders. Sounds good so far. Here's the problem: because of the tax regulations, it became very, very attractive for companies to become income trusts -even companies that did not fit the high-initial-investment, low-on-going-capx criteria. Companies that wanted to save on corporate taxes - which are pretty damn high in Canada - could convert to trusts. This was likely to cost the federal government hundreds of millions of dollars in taxes (due to that personal/corporate tax differential). Plus, most companies need to reinvest in order to grow and remain competitive. An income trust structure has the potential to stifle research and development and actually hurt companies in the long run.

Why now?
Flaherty had to act because the problem was getting bigger, not smaller. Telus announced a move to the income trust model. Once they did so, BCE really had no choice but to do the same thing. And BCE is one of the most widely held stocks - and biggest companies - in Canada. The impact would be huge. Then EnCana started making income trust noises. The dominoes were falling. Flaherty simply couldn't let it go on. He made a tough but, ultimately right, call. Could he have left the tax incentives in place for those companies that had already converted to trusts? Probably, but no-one's perfect. Trust me, it pains me to praise a Tory, but I'm doing it! He just had to do it.

What about all those pensioners who lost tens of thousands of dollars?
Give me a break!!! Anyone who is retired or near retirement who had a portfolio over-weighted on income trusts is a moron. Balanced investing - ever heard of it? Changes to trusts were going to come eventually, and these folks were gambling big time. But the Tories promised, say the pensioners. Hmm... trusting your retirement on a campaign promise. Interesting choice there. How did these people ever earn enough money to retire if they are this dim?!? Payments shouldn't be affected for 5 more years - ride it out and a lot of the trusts (if they were fundamentally good trusts to begin with) will rebound just fine. And to those crying pensioners? Suck up the loss and buy some bonds for Pete's sake.


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