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Normandin Beaudry

Income trusts


There, in black and white

Bulletin NB Vol. 7 N. 6, June 2004


On March 23 in its 2004 budget, the government of Canada proposed special measures limiting pension funds’ investments in income trusts. The purpose of these measures, which were supposed to take effect on January 1, 2005, was to prevent potential loss of government income tax revenues should pension funds invest massively in income trusts. Some large pension funds, including the Ontario Teachers’ Pension Plan, as well as provincial governments and other organizations in the investment industry, expressed concerns about these proposed measures. As a result, on May 18, 2004, federal Finance Minister Ralph Goodale announced the suspension of the proposed measures while public consultations are held.

What is an income trust?

Often considered a hybrid instrument combining some of the characteristics of both stocks and bonds, income trusts are a type of business structure where, instead of issuing shares, a company creates a trust in which the public can invest.

The main objective of the company creating the trust is to provide unitholders with a stable income flow (like bond coupons). Thus, whereas companies that issue shares distribute a small part of their after-tax earnings in the form of dividends, income trusts distribute a large part (usually over 85%) of their pre-tax earnings. Although the objective is to provide a constant income flow, there is no guarantee that the distribution of the trust’s revenues will remain at a given level. This explains why the price of income trust units varies with economic conditions and the company’s profits, just as stock prices do.

In short, income trusts are not fixed income investments but a subcategory of equity securities, similar to mutual funds but traded on the stock exchange.

Unlike stocks, however, where shareholders’ liability is limited to their initial investment, there is no law limiting the liability of income trust unitholders to their initial investment. This unlimited liability, and the fact that there are no income trusts in the S&P/TSX Composite Index, are the main reasons why the majority of pension funds have steered clear of income trust securities.

The problem of unlimited liability, however, could be resolved in the near future. In its 2004 budget presentation, the Ontario government included a proposal to amend the Trust Beneficiaries’ Liability Act and eliminate the unlimited liability associated with income trusts. If this proposal is adopted, it would considerably increase pension funds’ investments in income trusts, especially since it is likely that some income trust securities will be added to the S&P/TSX Composite Index. This possibility is clearly related to the special measures outlined in the 2004 federal budget to limit investments by pension funds in income trusts.

2004 federal budget

The 2004 federal budget proposed to limit investments by pension funds in income trusts as follows:

  • No more than 1% of the book value of a pension fund’s assets could be invested in income trusts;
  • A pension fund could not hold more than 5% of the units in any given income trust.

While the limit of 5% of the units in any given income fund could significantly affect the large pension funds, the cap of 1% of the book value of a pension fund’s total assets invested in income trusts could have a considerable impact on all pension funds. In concrete terms, if a pension fund’s investment policy calls for an investment of 30% of its assets in Canadian equities, its investment in income trusts would be limited to 3.3% of its Canadian equities portfolio. This cap would be particularly restrictive for pension funds that favour indexed management of Canadian equities, since it is estimated that the weight of income trusts would be between 7% and 10% if they were included in the S&P/TSX Composite Index.

Finance Minister suspends income trust measures

Following concerns expressed by some pension funds, financial market participants and provincial governments and given the context of a looming election campaign, Finance Minister Ralph Goodale decided to delay application of the measures proposed in the 2004 federal budget. However, Mr. Goodale stressed that the government’s "[...] overarching goal remains to ensure that funding for priorities such as health care and education is not jeopardized by the erosion of the corporate tax base [...]". The indefinite delay will allow the Canadian government to consult with interested parties and then submit new legislation, which hopefully can accommodate the concerns of both the government and the investment industry.


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