CIBC on Ottawa's Review of Trusts --
Some Preliminary Thoughts On The Government's
Forthcoming Consultation
While recent months have appeared to follow the standard script - low rates,
rising distributions and strong trust returns - a more secular perspective
suggests that the trust structure is rapidly approaching a crossroads. There is
little doubt in our mind that left unhindered by structural or governmental
obstacles, such as re-introduction of tax-motivated ownership restrictions of
income trusts, that within a period of several years the trust market would reach
proportions that even with the hindsight of the past 10 years are difficult for
most today to imagine. There is also no question in our mind that companies
which even now dismiss any notion of conversion would ultimately be forced by
the market to convert. Much will depend on Canada Revenue Agency policy
direction with regard to trusts in the days, months and years ahead, beginning
with the long-awaited consultation paper that we now hear is imminent.
Even though we might wish for it, we have long held that any expectation for
the government to turn its back on the trust issue for good, in our opinion, is
overly optimistic. On the other hand, a complete overhaul of Canada's tax code,
to the tune of U.S.-style earnings stripping rules, might just be too radical for
Canadian governmental authorities. We are therefore left with a middle-of-theroad
approach as the most probable course, an approach that must be designed
to appease, as much as it can, both sides (the government versus proponents of
the trust structure), an approach that therefore must leave room for the trust
market to develop significantly from here, but nevertheless prevents the
ultimate conversion of everything into a trust.
This is an extremely complex issue. It is made even more so by various, what
some may consider, red-herring issues likely to gain prominence as public
consultations proceed. One such issue is that of the suspected misallocation of
capital that arises due to the popularity (tax-motivated or otherwise) of the trust
structure. That is, the misallocation of capital into businesses, which are low
growth and low profit, thereby creating inefficiencies that are detrimental to the
Canadian economy. While we would not argue with the notion that the trust
structure is tax efficient, in our opinion, the entire premise of capital
misallocation is unsound from a number of perspectives.
From a theoretical perspective (tax issues aside), the market should be indifferent
between whether a company pays out internally generated cash flow versus reinvestment
of that cash flow, to the extent that a company's decision to invest is
not materially affected by its distribution policy. Higher growth companies with
more investment opportunities can maintain a high distribution level and fund
expansion capital by tapping the equity markets. The notion, therefore, that
"appropriate" income trusts are those with no growth opportunities is on shaky
theoretical ground, and incidentally, not supported by empirical fact - the trust
structure has attracted more than its fair share of high capital/high growth
companies, and these companies have been among the most successful of income
trusts. Furthermore, if we accept that the trust structure has a relative tax
advantage, it is precisely profitable companies that have most to gain by the trust
structure - companies with no profit are typically companies that do not pay tax
to begin with. From this angle, we might even argue that the desire to reduce tax
via the income trust actually results in a more efficient allocation of capital
because capital is channeled into profitable ventures.
We would go even further and suggest that the requirement to pay a high
distribution actually increases the efficiency of management and economic
returns through several mechanisms. First, the discipline required to pay a
distribution is likely to reduce the likelihood of investments in marginally
unattractive enterprises. Second, that same discipline, along with the tax-related
inefficiency of third-party debt in the trust structure, requires that managers
take a more conservative approach to debt. This saves the economy significant
costs associated with bankruptcy and financial distress, the likelihood of which
are reduced by the trust structure.
The reason we have decided at this point to remind investors of this topic relates
to what we suspect is going to be a significant component of the federal
government's angle in the forthcoming consultation process - the notion that the
income trust structure has a negative impact on an economy's productivity. We
would hold that the conventional wisdom in this regard must be firmly challenged.
Stay tuned, this is going to get interesting.
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