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Acuity Investment Management's Submission in Response to Finance Canada's Tax and Other Issues Related to Publicly Listed Flow-Through Entities (Income Trusts and Limited Partnerships) consultation:
November 17, 2005
The Honourable Ralph Goodale
Federal Minister of Finance
House of Commons
Ottawa, Ontario K1A 0A6
Dear Mr. Goodale:
RE: Consultations on Income Trust Portion of Flow-Through Entities
It was a pleasure to meet with you last Monday, October 31. I appreciated the opportunity to provide you with Acuity Investment Management's views concerning the vital role that income trusts play in our economy and our financial markets.
In response to your Consultation Paper of September 2005, we are submitting our analysis to the Department of Finance. We are focusing our comments on a few key topics for which we believe we can add value:
- Benefits to productivity
- Retail investor dependency on income trust distributions
- Professional portfolio management perspective.
Please find attached a paper addressing these items, and do not hesitate to contact us if you require further input or clarification on the issues we have highlighted.
Acuity Investment Management Inc.
Ian O. Ihnatowycz
President and Chief Executive Officer
cc Rt. Hon. Paul Martin, Prime Minister
Hon. David Emerson, Industry Minister
Mr. Mark Carney, Assistant Deputy Minister of Finance
Mr. Borys Wzresnewsky, M.P. Etobicoke Centre
Mr. Will Adams, Assistant to The Hon. Ralph Goodale
The recent announcements from the Finance Ministry have caused instability in the income trust asset class. This uncertainty has had real economic repercussions over and above the impact on the capital markets. Due to a marked decline in investor appetite for trusts caused by fear of potentially adverse Finance Ministry actions, access to capital has virtually ground to a halt. This situation is affecting the strategic actions of many trusts, effectively causing them to freeze such decisions pending the outcome of this review.
While there are a broad range of issues with respect to integrating the taxation of various legal entities and foreign jurisdictions, we have focused our comments on a few key topics. These issues include productivity, the benefits of distributions to taxpayers and the economy, and the portfolio management benefits to investors of income trusts.
Benefits to Productivity
Access to capital through trust structure critical for many small and medium sized companies
The importance of the trust asset class to the capital markets cannot be overstated. Virtually 80 percent (177 of 223) of income trusts are small to mid sized businesses with capitalizations of under $1 billion. Almost half (105 of 223) have capitalizations of under $250 million. Access to capital for many of these businesses would be prohibitively expensive if not for the trust structure. Bank debt and other forms of lending are often severely curtailed or simply unavailable to businesses of this size, while equity issuance must frequently be done, if at all, at materially discounted valuations compared to established public or foreign comparables. In the past, this lack of liquidity put many Canadian businesses at a disadvantage, and likely contributed to sub-par productivity.
The trust structure, however, has generally eliminated this handicap by providing easier access to capital at more attractive valuations, and contributed untold benefits to the Canadian economy. In fact, since 2001, 141 of 704 initial public offerings on the Toronto Stock Exchange (20%) have utilized the trust structure. Trusts, which represent a broad cross-section of small and medium sized corporate Canada, are now a vibrant and growing sector of the capital markets and economy. As of Oct. 31, the 223 income trusts listed on the TSX had an aggregate net worth of $158 billion (almost 10% of the market capitalization of the TSX), generated approximately $15 billion of annualized distributions and employed on the order of 250,000 workers. This employee base represents approximately 1.5% of the total Canadian work force of 16.3 million people, and almost 2% of the private sector work force of 13.3 million people. Any materially adverse adjustment to the status of income trusts would significantly curtail economic activity and potentially stall employment growth.
Long term benefits
The owners of many small, mature, cash cow businesses, as well as divisions of large public corporations, have often been reluctant to sell their businesses and trigger substantial tax liabilities. They have often extracted value from the business and avoided taxation by periodically borrowing against the firm's assets and cash flows, and then using the cash flows to pay down this debt before repeating the cycle. This approach produced few productivity benefits to society.
However, the trust model allows these businesses to realize a much higher percentage of the true value of these assets by selling them at much more attractive valuations than could be achieved through debt refinancing or a conventional sale. Not only do these initial public offerings (IPOs) or stock conversions to trusts increase tax collections, but they also allow the previous owners to redeploy the proceeds to new, more productive ventures. The combination of higher tax revenues and greater productivity is vastly superior to the prior alternative, which was inefficient and generated less tax.
Benefits to Canadian GDP
Canada has ranked at the forefront of the G7 in economic performance over the past decade: from 1996 to 2004, our 3.5% real GDP growth rate exceeded that of every other G7 nation. While many factors have contributed to this performance, we believe income trusts have definitely played a part. Beyond the immediate and tangible benefits of providing access to capital for many Canadian businesses, income trusts have also provided ancillary benefits. For instance, consumer spending has been bolstered by the flow of distributions to unit holders. These distributions have significantly exceeded the cash flows that these businesses would have been able to deliver under an alternative structure. In addition, trusts have been a key pillar of the investment banking and brokerage businesses at the nation's major banks. During a time of significant turmoil in the global economy and banking industry, our banks have been among the strongest financial institutions in the world, and the burgeoning income trust asset class has contributed materially to their success. A stable and healthy financial industry is a critical component of any vibrant economy.
Capital investment decisions – trust model equivalent to corporate model
Contrary to popular opinion, income trusts do not distribute all the operating cash flow they generate. Rather, trusts generally distribute free cash flow, or cash flow from operations less cash flow from investments such as maintenance capital expenditures. In order to remain competitive and maximize shareholder value, businesses must allocate capital efficiently regardless of their legal structure. Most businesses have maintained a consistent capital investment profile or actually increased such spending even after converting to trust status or conducting a trust IPO. Examples include BFI Canada Income Fund, CCS Income Fund, Energy Savings Income Fund, Peyto Energy Trust, Sleep Country Canada Income Fund, and Transforce Income Fund, among many others. In fact, the trust structure imposes an additional financial discipline on any capital investment decision. Trusts must typically ensure that such decisions are accretive since they do not wish to disrupt distributions. Any adverse impact on cash flows due to poor investment strategies would therefore quickly become apparent. Corporations do not face this hurdle to the same degree.
Trust model not appropriate for all businesses
The notion that all companies may convert to trusts is not valid. There are many businesses for which the trust model is not optimal, such as research-intensive businesses. Such early stage enterprises usually generate negative free cash flow and would be unable to support distribution payments. Innovative technology-oriented businesses represent a completely different sector of the economy and need to be supported by venture capital or alternative means, not by trust structure capital. Indeed, technology is the only global industry classification sector (GICS) with no income trust representation, for precisely this reason. Therefore, any adjustment to the current trust model would have no effect whatsoever on productivity gains from innovative R&D. There are numerous examples of other businesses that are unlikely to convert to trusts, such as businesses with negative cash flows, highly seasonal or cyclical businesses, businesses with infrequent but sizable capital expenditure requirements, banks (given their regulatory requirements), etc.
International examples of productivity benefits of reduced corporate taxes
Canada taxes business investment at the second highest rate among 36 major countries. If we are to boost our productivity and global competitiveness, these taxes need to be reduced, not increased. There are numerous examples of jurisdictions that have actually increased tax receipts due to the economic stimulus of lowering corporate tax rates, including Ireland, Spain, eastern Europe, and the United States. We should consider lowering corporate and dividend taxes, not raising trust taxes. Corporate Canada is already at a tax (and therefore productivity) disadvantage as it is; the trust model helps reduce this disadvantage.
Trust model has attracted foreign businesses to Canada and increased tax revenue from foreign sources
The trust structure has drawn foreign businesses into Canadian jurisdictions in at least two ways. First, many Canadian trusts have used their more attractive capital structure to purchase foreign companies. There are over 40 income trusts with at least 20% of their revenue based in the U.S. These cash flows are generally taxed in Canada in the hands of Canadian unit holders. Second, at latest count, 16 foreign companies had set up head offices in Canada and chosen to list as trusts on the TSX. Again, these businesses generate productivity benefits for Canada through banking fees, listing fees, head office and operations employment, and taxes paid by Canadian unit holders on distributions and capital gains.
Unit holders reinvest in economy –significant multiplier effect
Finally, unit holders tend to reinvest their distributions in the economy, either through the capital markets or through consumer spending. Both of these activities have an expansionary impact on the economy. These distributions, currently approximately $15 billion on an annualized basis, represent over 1.2% of GDP. Taxing these distributions at the corporate level would clearly have a negative impact on GDP, even net of the benefit to government spending (it is generally accepted that private sector spending is more productive than public sector spending). Alternatively, forcing trusts to revert to the corporate model would eliminate perhaps 80% of these distributions, as dividend payments would most likely be substantially lower (assuming a 1.5% yield vs. the current average trust yield of 9.5%). Also, since corporate and dividend taxes would apply, the impact would be greater still. As a result, the vast majority of the $15 billion in distributions would be shifted from investors to government and corporations. This measure would likely result in a net reduction to GDP, as consumer spending and reinvestment would likely have a more immediate and favourable impact on GDP than government spending and corporate reinvestment over and above the levels corporate management teams have already deemed optimal. In essence, we believe there is ample economic proof that unit holders allocate capital more efficiently than governments.
Retail Investor Dependency on Income Trust Distributions
No viable high yield alternative in Canada
Most investment vehicles in Canada do not currently provide very attractive yields. GIC's yield 2-3%, bonds 4-5%, preferred stocks 3-5%, and common stocks approximately 1.5%. Furthermore, there is no viable equivalent in Canada to the $3 trillion high yield bond market in the United States. We believe it unlikely that a market such as the one in the U. S. will develop in Canada, leaving investors with no other option than income trusts, which currently yield approximately 9.5% on average. Many older, conservative investors are unwilling to hold equities, but have swapped GIC's or bonds for income trusts. Not only are the yields much more attractive, but this form of investment is more productive for the economy than investing in GIC's.
Retail participation very high, both directly and indirectly through funds and pensions
We believe that retail investor participation in the income trust market is very significant, and that taxation is a major consideration for this constituency. There are approximately 1 million retail income trust investors in Canada. Assuming 2.5 people per household, that represents 2.5 million Canadians who have invested in trusts for income and/or savings purposes. When one considers indirect ownership through mutual funds, closed end funds, pension plans, etc., it is probable that well over 10% of the Canadian population owns trusts. It is likely that an even higher proportion of adult Canadians owns trusts, since a larger percentage of seniors are believed to hold trusts than young families with children.
The vast majority of these individuals are middle class investors who in many cases are approaching retirement or are already retirees. Many of these investors focus heavily on trust yields since they rely on monthly distributions to supplement their incomes. Any material taxation of income trusts could have a devastating impact on their ability to meet their spending needs. In fact, it is conceivable that social security supplements could be required for some individuals to offset the decline in income and retirement assets. Such a requirement could undermine any supposed gain to the fiscal balance achieved by taxing trusts.
The current era of 50-year low interest rates has driven many pension plans into substantial deficits, while reducing their ability to match long term liabilities with attractively yielding fixed income assets. We believe that trusts offer a unique solution to this dilemma given their high yields and long implied durations.
Professional Portfolio Management Perspective
Income trusts provide important diversification benefits – enhanced returns with lower risk
At Acuity, we have been incorporating income trusts into multi-asset class portfolios since 1996. Such a strategy has consistently generated higher returns with lower risk profiles than traditional balanced solutions. The reason is that income trusts have fairly low correlations with both stocks and bonds (in other words, the three asset classes tend not to move in tandem in the markets), thus providing diversification benefits and lowering portfolio volatility. We believe these results prove that having an additional asset class from which to choose can potentially confer material investment benefits to all Canadian investors.
Best performing trusts have substantial growth prospects and low payout ratios
As discussed earlier (see Capital investment decisions section), a business's underlying business model is consistent regardless of its capital structure. For trusts, just as for corporations, good management, fiscal responsibility and strategic insight win. We believe that the trust structure is a very efficient model. Trusts invest what they need to maintain the business and pay out much of the excess cash flow. However, they usually retain a portion of this free cash flow to reinvest in growth opportunities such as expanding facilities or distribution capabilities, or making acquisitions. The perception that income trusts pay out all their cash flow is a fallacy.
In our experience, trusts whose payout ratio is substantially below 100% have a sufficiently prudent model to be able to maintain operating expenses, capital expenses, and distributions even during periods of turmoil. By the same token, only trusts with sub-100% payout ratios have excess cash flow which they may deploy to generate growth through expansion or acquisition. We believe these trusts have the best return/risk characteristics because they have the most productive and capital efficient structures. Indeed, many trusts have been among the fastest growing businesses in Canada over the past five years.
Conclusions and Recommendations
Recent Instability in Market Place
Recent press releases from the Minister of Finance have caused considerable fear and consternation on the part of income trust investors. The situation has extended beyond the capital markets and is having a real economic impact on the businesses in this asset class. Since investors have virtually ceased to provide further capital to this asset class pending clarity on the government's intentions, many trusts have witnessed a reduced ability to raise additional funds for business purposes. As a result, many businesses have been forced to curtail or freeze corporate activities, and have cut spending drastically. We urge the government to act quickly in deciding on and implementing a course of action so that these businesses may resume their normal activities as soon as possible.
From our perspective, for the reasons discussed above, we strongly believe that any move to tax income trusts would not be in the best interest of Canadians. We recommend adopting a solution that provides the most favourable outcome for all stakeholders. In our view, this approach would entail maintaining the status quo for the existing trust structure. In addition, such a solution should include some element of corporate and dividend tax reductions, which would result in approximately equal tax rates for investors in both corporations and income trusts. As a result, businesses would be indifferent between the two structures. We believe this approach would enhance Canadian corporate competitiveness globally, increase the attractiveness of doing business in Canada for foreign companies, reduce the incentive for corporations to convert to a trust structure, and have a net positive impact on tax revenues, based on historical precedents in other jurisdictions. At the same time, it would result in no adverse impact on the one million plus investors who rely on trust distributions, and would preserve the current multi-asset class capital market structure to the benefit of Canadian investors.
Mr. Ian O. Ihnatowycz
President and Chief Executive Officer
Acuity Investment Management Inc.
Mr. David Stonehouse
Acuity Investment Management Inc.
Acuity Investment Management Inc.
65 Queen Street West, 18th Floor