|
Is it true that Income Trusts paid no tax before the
creation of the Distribution Tax on 31st October 2006?
Yes! But they had to distribute nearly all of their
earnings and therefore the recipients would bear the tax.
Under the old tax regime would the overall tax be less in
the year 2011?
Yes! But only about two percentage points if received by
an individual paying tax at the top marginal rate of tax in
Ontario. However, this percentage point
increases for lower income investors.
At an income level of around $60,000 the overall increase in taxation
will be close to five percentage points.
So you can say the lower income groups who probably hold more of this
type investments are hit harder.
Compare the two tables below.
What if the recipient of distributions was tax exempt
such as a RRSP or a Pension Plan?
Then, there would be
no tax to pay at all. For now! But,
remember the tax would have only been deferred. When the investments in the
plan are ultimately paid out to the recipient, tax would be payable. All such payments would be taxed as income
regardless of whether some were capital
gains. Not a fair result for plans with
a short life as capital gains are taxed at half the rate of other income.
In comparing publicly traded corporations to Income
Trusts before the new distribution tax, would the government’s tax loss be
limited to the deferral of the tax otherwise payable on the income and gains in
RRSP’s and Pension Plans?
No. It would probably be more. Because, some individuals would be in a
lower tax bracket when receiving payment from their registered plans than the
current corporate tax rate of approximately 36% in Ontario.
Since the Minister of Finance’s announcement, the
price of Income Trusts on the TSX has dropped anywhere between 10% and
20%. Why have the prices of ALL Income
Trusts not dropped by the same amount?
Aside from the usual
market factors, there might be one other MAIN reason. Income Trusts have a different mix of taxable and non-taxable (often
referred to as Return of Capital)
amounts in their distributions.
What is the nature of Return of Capital?
Return of Capital is
really the difference between the earnings after the deduction of amortization
(Capital Cost Allowance; a term used by the tax department for allowable
amortization) and earnings before deduction of amortization. In other words it is more or less equal to
the amount of amortization that is being returned as capital.
If Income Trusts are continuously paying out amounts equal
to the amortization and not retaining it, how are they going to get the funds
to replace their amortized or depleted assets?
Good question! For now they are issuing more units and
using them to replace the amortized or depleted assets.
So in other words Income Trusts are getting back from new
investors what they paid out earlier as Return of Capital. If so, their units are increasing while
their income would probably stay the same.
That is correct in
most cases. And therefore, resulting in
a possible drop in the per unit distribution.
Why does the Return of Capital have an effect on
the price of Income Trusts?
This may be because
there is a perception of more income, but in fact it is more like a mix of
principal and interest, similar to an investment in mortgages or annuities.
Is it true to say the more amortization write off, the
less the effect of the new tax on the drop in the share price?
Yes, this may be true
in some cases!
Given the effect of the new tax in four years is it
possible to calculate the expected drop today in the price of Income Trusts?
I have an example (EnerVest Diversified
Income Trust) of such a calculation on the next two pages. This income trust holds other Income Trusts
as investments, like a mutual fund.
You will find two tables. One assumes ownership of trusts by individuals
in the middle marginal tax rate and the other by Individuals in the top
marginal tax rate.
What are your assumptions?
The assumptions are as
follows:
1)
Holders of EnerVest Diversified Income Trust will value
their investment with reference to both distributions and earnings.
2)
The earnings and distributions per unit are going to
stay the same (at 7.08% per annum) over the next four years.
3)
The tax rate on Income Trusts, which is almost the same
as the rate for public corporations, will be 31.5% in 2012.
4)
Tax on individuals at the $55,000-67,000 tax bracket
will be 33% (in Table 1) and the top marginal rate will be 46.4% (in Table 2)
5)
Marginal tax rate for individuals (at $55,000-67,000)
on the taxable portion of distributions from Income Trusts will be 15%, (in
Table 1) and 25% (in Table 2) which is the same as
tax on eligible dividends from public corporations.
6)
Two thirds of issued units are held by individuals and
one third by non-taxable entities.
7)
Return of Capital is assumed to be 40% of distribution.
Based on the calculations in the tables below, is the
Specified Investment Flow- Through (SWIFT) as referred to by the department of
finance, which includes Income Trusts, overvalued or undervalued?
Based on the one
calculated below and on the assumptions made they seem to be fairly
valued. EnerVest Diversified Income
Trust, as at 13th November 2006 was trading about 16.67% below its
net asset value per unit, which comprise of several other income trusts.
EnerVest closed at $5.45 while its net asset value per unit was reported
on its website (http://www.enervest.com/DiversifiedIncomeTrust.asp) to be $6.54.
One would assume that the market value of EnerVest would be closer to
its net asset value per unit and it is difficult to explain the reason for such
a big difference. In fact EnerVest
announced on the 14th of November that it would repurchase a number
of its units.
So do think EnerVest must be a good buy?
It definitely is a good arbitrage.
NOTICE TO READER
THE AUTHOR OWNS SHARES OF ENERVEST DIVERSIFIED INCOME
TRUST
FOR INVESTMENTS IN THIS SECURITY MAKE SURE TO CONSULT
WITH YOUR INVESTMENT ADVISOR
TABLE 1
ENERVEST
DIVERSIFIED INCOME TRUST -At 13th
November 2006
Using a Midrange
Marginal Tax Rate
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Distribution to an Individual
|
|
Tax Sheltered Distribution
|
|
|
|
|
Tax Rate
|
Earning
|
Capital
|
Total
|
|
Tax Rate
|
Earning
|
Capital
|
Total
|
|
|
|
Distribution
in 2006
|
|
$
0.50
|
$
0.34
|
$
0.84
|
|
|
$
0.50
|
$
0.34
|
$
0.84
|
|
|
|
Tax at the
trust level
|
0.00%
|
0.00
|
|
0.00
|
|
0.00
|
0.00
|
|
0.00
|
|
|
|
Net
available for distribution
|
|
0.50
|
0.34
|
0.84
|
|
|
0.50
|
0.34
|
0.84
|
|
|
|
Tax rate
on income - $55,000 to $67,000
|
33.00%
|
(0.17)
|
|
(0.17)
|
|
0.00
|
|
|
0.00
|
|
|
|
|
|
0.34
|
0.34
|
0.67
|
|
|
0.50
|
0.34
|
0.84
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Distribution
in 2012
|
|
$
0.50
|
$
0.34
|
$
0.84
|
|
|
$
0.50
|
$
0.34
|
$
0.84
|
|
|
|
Tax at the
trust level
|
31.50%
|
(0.16)
|
|
(0.16)
|
|
31.50
|
(0.16)
|
|
(0.16)
|
|
|
|
Net
available for distribution
|
|
0.35
|
0.34
|
0.68
|
|
|
0.35
|
0.34
|
0.68
|
|
|
|
Tax for
dividends - $55,000 to 67,000
|
15.00%
|
(0.05)
|
|
(0.05)
|
|
0.00
|
0.00
|
|
0.00
|
|
|
|
|
|
$
0.29
|
$
0.34
|
$
0.63
|
|
|
$
0.35
|
$
0.34
|
$
0.68
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Percentage
drop based on earning & distribution
|
|
13.10%
|
|
6.56%
|
|
|
31.50%
|
|
18.90%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average
Percentage drop based on distribution I
|
|
|
9.83%
|
|
|
|
|
25.20%
|
|
|
|
Market
price 31st October 2006
|
|
|
|
$
7.12
|
|
|
|
|
$
7.12
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Estimated Unit Price of EnerVest
Diversified Income Trust - Based on
drop in earnings only
|
|
|
|
|
|
|
|
|
|
|
Unit Price
|
Earning %
|
Future Value
|
|
|
|
Future
value based on current earning rate
|
|
|
|
|
|
$
7.12
|
7.08%
|
$
9.36
|
|
|
|
Weighted
average (2:1) % drop in unit price as result of the new tax kicking in 2011
|
|
|
19.23%
|
|
|
|
Future
value of price after the tax effect
|
|
|
|
|
|
|
|
|
$
7.56
|
|
|
|
Present
value of estimated future price of units discounted at 4.20%
|
|
|
$
6.41
|
4.20%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Estimated Unit Price of EnerVest
Diversified Income Trust - Based on
drop in distribution
|
|
|
|
|
|
|
|
|
|
|
Unit Price
|
Earning %
|
Future Value
|
|
|
|
Future
value based on current earning rate
|
|
|
|
|
|
$
7.12
|
7.08%
|
$
9.36
|
|
|
|
Weighted
average (2:1) % drop in unit price as result of the new tax kicking in 2011
|
|
|
14.95%
|
|
|
|
Future
value of price after the tax effect
|
|
|
|
|
|
|
|
|
$
7.96
|
|
|
|
Present
value of estimated future price of units discounted at 4.20%
|
|
|
$
6.75
|
4.20%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
TABLE 2
ENERVEST
DIVERSIFIED INCOME TRUST -At 13th
November 2006
Using the Top
Marginal Tax Rate
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Distribution to an Individual
|
|
Tax Sheltered Distribution
|
|
|
|
|
Tax Rate
|
Earning
|
Capital
|
Total
|
|
Tax Rate
|
Earning
|
Capital
|
Total
|
|
|
|
Distribution
in 2006
|
|
$
0.50
|
$
0.34
|
$
0.84
|
|
|
$
0.50
|
$
0.34
|
$
0.84
|
|
|
|
Tax at the
trust level
|
0.00%
|
0.00
|
|
0.00
|
|
0.00
|
0.00
|
|
0.00
|
|
|
|
Net
available for distribution
|
|
0.50
|
0.34
|
0.84
|
|
|
0.50
|
0.34
|
0.84
|
|
|
|
Tax rate
on income $119,000+
|
46.41%
|
(0.23)
|
|
(0.23)
|
|
0.00
|
|
|
0.00
|
|
|
|
|
|
0.27
|
0.34
|
0.61
|
|
|
0.50
|
0.34
|
0.84
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Distribution
in 2012
|
|
$
0.50
|
$
0.34
|
$
0.84
|
|
|
$
0.50
|
$
0.34
|
$
0.84
|
|
|
|
Tax at the
trust level
|
31.50%
|
(0.16)
|
|
(0.16)
|
|
31.50%
|
(0.16)
|
|
(0.16)
|
|
|
|
Net
available for distribution
|
|
0.35
|
0.34
|
0.68
|
|
|
0.35
|
0.34
|
0.68
|
|
|
|
Tax for
dividends $119,000 +
|
25.04%
|
(0.09)
|
|
(0.09)
|
|
0.00
|
0.00
|
|
0.00
|
|
|
|
|
|
$
0.26
|
$
0.34
|
$
0.59
|
|
|
$
0.35
|
$
0.34
|
$
0.68
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Percentage
drop based on earning & distribution
|
|
4.18%
|
|
1.86%
|
|
|
31.50%
|
|
18.90%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average
Percentage drop based on distribution
|
|
|
3.02%
|
|
|
|
|
25.20%
|
|
|
|
Market
price 31stst October 2006
|
|
|
|
$
7.12
|
|
|
|
|
$
7.12
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Estimated Unit Price of EnerVest
Diversified Income Trust - Based on
drop in earning only
|
|
|
|
|
|
|
|
|
|
|
Unit Price
|
Earning %
|
Future Value
|
|
|
|
Future
value (year 2011) based on current earning rate
|
|
|
|
|
|
$
7.12
|
7.08%
|
$
9.36
|
|
|
|
Weighted
average (2:1) % drop in unit price as result of the new tax kicking in 2011
|
|
|
13.29%
|
|
|
|
Future
value of price after the tax effect
|
|
|
|
|
|
|
|
|
$
8.12
|
|
|
|
Present
value of estimated future price of units discounted at 4.20%
|
|
|
$
6.89
|
4.20%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Estimated Unit Price of EnerVest
Diversified Income Trust - Based on
drop in distribution
|
|
|
|
|
|
|
|
|
|
|
Unit Price
|
Earning %
|
Future Value
|
|
|
|
Future
value (year 2011) based on current earning rate
|
|
|
|
|
|
$
7.12
|
7.08%
|
$
9.36
|
|
|
|
Weighted
average (2:1) % drop in unit price as result of the new tax kicking in 2011
|
|
|
10.42%
|
|
|
|
Future
value of price after the tax effect
|
|
|
|
|
|
|
|
|
$
8.39
|
|
|
|
Present
value of estimated future price of units discounted at 4.20%
|
|
|
$
7.11
|
4.20%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Check our older
Newsletter about REIT’s
http://www.tavana.ca/newsletter/newsletter.asp?iddetail=7
|
