Financial System Review
Income Trusts: Understanding the Issues Michael R. King*
n income trust is an investment vehicle year-end 1994. The exceptional growth of this that distributes cash generated by a set asset class has been driven by appreciation in of operating assets in a tax-efficient the value of outstanding income trusts, the issu- A manner. The sharp rise of income-trust ance of units through initial public offerings, valuations, the large supply of new issues, and and the subsequent sale of additional units by the complexity of their legal structure have led existing income trusts. to increased scrutiny of this asset class. To ex- An income trust is designed to maximize the plore whether the cash returns from income cash distributions from a set of revenue-generat- trusts are in line with the risks, the structure of a ing assets, with these distributions typically typical income trust is compared with that of a paid to unitholders on a monthly basis. The typical corporate entity. The legal, regulatory, cash distributions from an income trust are and governance issues introduced by these dif- maximized by minimizing or eliminating the ferences are then raised. Finally, business and corporate tax paid by the operating company market-related issues are discussed. that holds these assets. In other words, an in- come trust is a “flow-through” vehicle that Structure and Valuation allows income to flow through it and be taxed at the investor level. An income trust is a special-purpose entity that sells equity to the public in the form of units The valuation of an income trust is similar to and uses the proceeds to purchase an operating the valuation of any other equity security. Inves- company that holds a set of income-generating tors discount the future stream of cash flows assets. Legally, income trusts are a subset of the that are expected to accrue to unitholders using broader category of “mutual fund trusts” within a discount rate that reflects the uncertainty of the meaning of the Income Tax Act (Canada). the business and the capital structure. Three The term “income trust” may be used broadly to steps are fundamental to the valuation of an in- cover a variety of businesses and models, or nar- come trust: an analysis of the distributable cash, rowly to refer to a segment of this asset class. an understanding of the capital structure, and a Here, it refers to royalty trusts, real estate invest- comparison of one income trust with others in ment trusts, and trusts based on various busi- the same industry sector or business. To get an nesses (also called hybrid trusts or business- accurate picture of risks and returns, existing in- income trusts). come trusts must be valued relative to others in the same industry, using multiples of cash flow As an asset class, income trusts have experienced that take into account the leverage in the capital phenomenal growth over the past two years. In- structure, the uncertainty of the business, and come trusts had a total market capitalization of the tax treatment of different types of distribu- $45 billion at the end of 2002 and represented tions. about 6 per cent of the stock market capitaliza- tion of the Toronto Stock Exchange. This total Firms and investors have benefited from the de- represents a dramatic rate of growth when com- velopment of income trusts. Firms have been pared with the $29.5 billion of total market cap- able to realize significant gains on the sale of as- italization at year-end 2001 and $2 billion at sets through this market. They have therefore been able to raise significant amounts of capital by selling off mature assets and either returning * This note summarizes a recently published Bank of Canada working paper (King 2003). the proceeds to shareholders or investing them
77 Research Summaries in potentially more profitable growth opportu- potential conflicts of interest. Unitholders nities. This avenue of raising capital has particu- should also be aware that their legal rights are larly benefited small firms or firms that did not more limited than those of shareholders in a have access to Canadian equity markets on corporate entity. attractive terms. For their part, investors have Operational issues relate to the subordination earned high cash returns from income trusts of the unitholder’s claim on the operating assets over the past few years—a period when Canadi- to secured bank loans or other debts, the sus- an stock markets suffered significant losses, and tainability of expected cash flows from these as- interest rates declined to historically low levels. sets, and the degree of leverage in the operating Higher cash payouts reduce the need to monitor company’s capital structure. Not every business management, because investors make the deci- model is viable as an income trust. For example, sion on how to reinvest the earnings rather than this structure is suited to businesses that gener- leaving these funds in the hands of manage- ate a steady stream of cash distributions and re- ment. quire minimal capital expenditure to maintain the productivity of the assets. Given the prolif- Issues Raised by Income eration of income trusts in various business Trusts sectors, investors need to question the key assumptions regarding cash distributions to Investors should consider several issues when ensure that these distributions are sustainable valuing an income trust. These issues can be in the long run. classified into four broad categories—legal and regulatory issues, corporate governance issues, Finally, market issues involve the sensitivity of operational issues, and market issues. income-trust valuations to changes in the level of interest rates, the level of risk premiums, and Legal and regulatory issues include the potential secondary market liquidity. While market con- personal liability of unitholders, the possibility ditions have been favourable for income trusts of a change in tax treatment, and the treatment over the past two years, the change in the exter- of unitholders in the event of bankruptcy. The nal environment in the fourth quarter of 2002 issue of unitholder liability is being addressed led to a decline in their valuation. In 2003, the in some provinces. For example, the Ontario wide variation in the performance of different government has introduced legislation that income trusts reflects a greater differentiation by would limit the liability of Ontario-based investors concerning their future prospects. unitholders under the Trust Beneficiaries’ Lia- bility Act 2003 (Government of Ontario 2003).1 These investment issues led Standard & Poor’s Hayward (2002) addresses the tax implications to introduce a new product in 1999 called sta- of this asset class. bility ratings. These ratings are intended to re- flect the “sustainability and variability in While they resemble corporate entities, income distributable cash flow generation in the medi- trusts fall under a different code of law with dif- um to long term” (Standard & Poor’s 2002). A ferent requirements for corporate governance. stability rating is voluntary, and income trusts Unitholders in an income trust are represented must pay Standard & Poor’s to receive one. As of by a trustee, whose responsibilities are laid out year-end 2002, only 25 Canadian income trusts in a trust indenture. The assets owned by the in- had been rated. come trust may be managed by full-time inter- nal managers similar to a corporation, but this task may also be contracted to a management Conclusion company under a management agreement. In- A better understanding of the issues raised by vestors need to scrutinize these documents in income trusts will allow investors to seek the order to understand the staffing of these posi- appropriate return for a given level of risk. The tions, the incentives for the trustee and manag- mixed performance of this asset class over 2003 ers, their compensation arrangements, and the suggests that income trusts are evolving and level of disclosure required for factors such as have reached a new phase of consolidation with slower growth expected in the future. 1. Passage of this legislation was delayed by the Ontario election.
78 Financial System Review
References Government of Ontario. 2003. “The Right Choices Act (Budget Measures), 2003.” March. Photocopy. Available at
79