Kevin Hall was as surprised as anyone by the federal announcement last fall that a new tax will be levied on income trusts. But despite the uncertainty that has followed, the pending change does not signal the demise of trusts as an asset class, according to Hall, a portfolio manager with Guardian Capital LP.
Hall, who is part of the three-member team that oversees the firm's income trust mandates, says trusts will continue to be valuable investments for yield-seeking investors after 2011, when the change is scheduled to take effect. The immediate aftermath of the tax announcement was dramatic, with the benchmark S&P/TSX Income Trust Index plunging 12.4% by the end of the first day of trading after after-hours Oct. 31 announcement.
But trusts collectively suffered little lasting damage. The median Canadian High Income fund gained 3.1% in the six months to April 30, and 5.5% in the first four months of this year.
Hall is quick to point out that, while the new tax of 31.5% imposed at the trust level will reduce pre-tax income levels for investors, that reduction will be offset by distributions that take the form of tax-advantaged dividend income.
"[Dividend income] is taxed much lower than the majority of income coming out of income trusts today," says Hall. "One of the big things we're trying to determine today is how each trust, on a case-by-case basis, can mitigate that 31.5% per cent tax rate," says Hall, who is lead manager of GGOF Monthly Dividend (Classic andMutual), and co-manager of GGOF Monthly High Income (Mutual andII).
What's more, a mass reversion of income trusts to corporations - which some predict will occur - won't matter all that much when it comes to levels of distributions. That's because most existing trusts chose the trust structure because their business models suit high payouts, and they would have difficulty converting back to high-growth common stocks, says Hall.
A native of Sarnia, Ont., and graduate of McMaster University in Hamilton, Ont., Hall has spent his entire career in Toronto. After working on the sales side of the fund industry, he earned his CFA designation in 1999.
He joined Toronto-based Guardian Capital LP in 2000, around the time that wary investors were seeking alternatives to deflated technology stocks. "There was a good opportunity to get away from the tech craze of the previous number of years. [Income trust investing] had a nice combination of being on the equity side as well as providing an attractive income yield," says Hall.
Now, with income trusts seemingly about to lose their best-known advantage, Hall sees at least one positive impact from the looming changes. "It's more and more difficult for poor businesses to hide behind the tax efficient structure," he says. "They can no longer use that as a crutch to sustain their business model, so I think a lot of those companies will disappear."
Indeed, the proposed elimination of the tax advantage enjoyed by income trusts may already be accelerating the trend in mergers and acquisitions in equity markets, says Hall. As an example, he cites the private equity takeover of UE Waterheater Income Fund ( UWH.UN/TSX) that's currently under way. "That whole process will have an impact on the sector, and the liquidity and the size of the market," he says.
As well, the valuation premium on income trusts is shrinking because of the pending tax, says Hall. "We believe once you get to 2009, 2010, whether you're a trust or a corporate entity will not determine the valuation you get in the capital markets - that's already being priced in." Post-2011 trusts may continue to enjoy a premium, however, because of the continuing demand for yield, according to Hall.
On the income trust team, Hall works with Guardian Capital's managing director and veteran portfolio manager, John Priestman, and portfolio manager Michele Robitaille. While the team members are self-described "generalists," each has specific sector responsibilities.
Hall points out that the new legislation will have little effect on real estate investment trusts (REITs), part of his focus on the team. (REITS are generally expected to be exempt from the new tax if they derive 95% of income from properties in general and 75% of income from properties in Canada.) Hall also oversees trust investments in the pipeline/power and infrastructure sectors.
For Hall, finding income trusts that will prosper under the new tax rules is a matter of identifying good businesses. "We think that the trusts with lower payout ratios today - and lower debt levels and conservative balance sheets - will have a much easier time come 2011 to maintain their distributions," he says.
Currently, the payout ratio of business trusts held by the fund averages approximately 80%. "As you start to see that creep up to 90, 95, 100%-certainly that's a warning sign."
While a lot can happen in four years, according to Hall, new rules won't lessen the importance of income trusts. "For taxable Canadian investors looking for high equity yield and high dividend or distribution yield from 2011 forward, income trusts are still going to be a very attractive place to be."
