Thursday, November 2

Canadian market plunged from proposed income trust taxation

Yesterday the Canadian government gave a nasty surprise to the market by imposing a new tax on income trusts. Existing trust will be taxed starting from 2011, for new one the effective date is as early as 2007.

TSX (Toronto stock exchange) dropped 2.6% and the S&P/TSX income trust index plunged 12%.

What is Income Trust?
It is an entity that is required by law to distribute almost all its income to shareholders as dividends. Because of this the entity pays almost no income tax to the government. This tax-efficient structure is becoming more and more popular in Canada, at the expense of the government (decreasing tax revenue).

REIT, the structure we discussed before, is a major form of income trusts.

Immediate impact
  • Energy and Telecom among biggest hit: Many of the biggest income trusts are in the energy mining sector (e.g. Canada Oil Sand Trust. Penn West Energy Trust). For telecom, stock price of two big trust-conversion candidates, Telus and BCE, had double digit drop leading to an overall 9% drop in the telecom subindex.
  • Foreign investors may be scared away: As income trusts are very popular among foreign investors, the surprise announcement may trigger an exodus of capital away from Canada. This will affect both the stock market and foreign exchange. (CAD/USD dropped >1% yesterday).
  • Bank/insurance sector benefits: Investors will likely reshuffle the capital towards banks and insurance companies, which give relatively high dividends and do not usually have trust structure.
  • Canadian market may lose momentum: With falling oil price and a possible slowdown of US economy, there are already signs of the Canadian stock market reaching the top (after several years of impressive growth). The negative news will likely take away the remaining momentum going forward.

Long-term impact

  • Only slightly negative to investors: Apparently the Canadian government is closing a loophole as the Australians have done in the 1980s. While losing the tax-free advantage, the income trust companies are not worse off than their non-trust counterparts.

Further reading

  • There is a good summary and background information on income trust at Wikipedia.

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