Canadians paid a high price for Flaherty's income trust reversal

September 16, 2008
Al Coates
Kitchener Waterloo Record

Remember the income-trust Alamo, the Halloween-night massacre of October 2006? Sure you do, and you got slaughtered.

The capital value of any income trusts is, almost assuredly, well down from 23 months ago when Finance Minister Jim Flaherty shocked the nation with his declaration to have the trust structure killed off by 2011.

Your trust-related income may be well down, too, because many trusts have either died, or cut their distributions or killed distributions outright.

You will recall the Flaherty rationale: Hundreds of millions of dollars, he said, were subject to "tax leakage" because the trusts paid no corporate tax. Instead, the profit/free cash doled out by trusts fell directly into the hands of investors.

Those investors who held trusts outside registered pension plans did pay tax -- at the income level -- on the proceeds; those who held them inside registered plans (such as RRSPs) paid tax on trust proceeds only as they chose to take income from their plans.

So, here we are, nearly two years later -- and smack in the middle of an election campaign -- and what hath Flaherty wrought?

Well, for starters, he continues to have older Canadian investors in a lather because he has hurt them badly. These are not necessarily wealthy people we're talking about here, although, of course, there are wealthy individuals (and wealthy institutions) heavily invested in trusts.

But these folk are, by and large, ordinary Canadians, people who invest to supplement their pensions, people who use the trusts' high payouts to offset low bank interest rates, such as those paid out in GICs and the like.

So, that's the start of it, but it is not the end. Prior to Flaherty's announcement, a number of giant corporate concerns, such as BCE and Telus and Manulife and Power Financial began to muse publicly about the prospect of converting from corporately-structured entities to trust-styled ones.

That, ultimately, is why Flaherty made his decision; he didn't want corporate Canada to go the way of the dodo via wholesale trust conversion. He feared two things: a growing "tax leakage" and the so-called "hollowing-out'' of corporate Canada.

That is fair enough, but look what has happened since as the unanticipated consequences of his decision -- many of those trusts have become takeover targets by giant private-equity players. They are being taken off the map and the radar, folded internally into big pension plans, never again to be seen as income-producing opportunities for Canadians.

I'll cite just two of many, many examples in an attempt to make the point. I will also note this, to be fair and clear: Our family owns the entities we are about to discuss here; and I will vote Conservative in the forthcoming election, as I typically do, Flaherty's actions notwithstanding.

The examples are these: BCE, the giant telecom outfit that once contemplated trust conversion, is soon to be purchased by a group of private-equity players fronted by the Ontario Teachers Pension Plan. At a $52-billion buyout price, $42.75 per share, it's the largest leveraged (debt-financed) takeout in global corporate history.

The buyout will be financed through borrowing and BCE will be taken private, dismantled, chopped into pieces and perhaps sold off in parts. Already, thousands of BCE mid-level jobs have been whacked and there will be more to come.

BCE is a cash-flow machine and its free cash will be used to finance the debt. The new owners of BCE -- teachers and its American partners -- will pay no corporate tax because, in the first place, pension plans don't pay tax, and for the other buyout partners, there also are offsetting cash-flow and debt-service factors at work. Ottawa will be lucky to see a wooden nickel in ongoing corporate tax proceeds.

The deal should close in December -- and Canadians will have lost a huge corporate entity, an investment staple, a giant, dividend-producing icon. Ontario's teachers, meanwhile, will benefit long-term because their pension operator is smart, rich and opportunistic.

Now, on to Teranet, an Ontario-based, real-estate-related trust that electronically records the details of every real-estate transaction in Ontario. Teranet has a locked-in contract with Queen's Park that runs through 2017 and it makes its money by taking a small slice from those transaction proceeds.

Teranet, until recently, was trading under $9 per unit, more than a dollar beneath its initial-offering price of $10 a unit. It, like so many other trusts, had been hurt by Flaherty's Halloween-night scare.

A few weeks back, a company called Borealis Infrastructure Management stepped up with an offer of $1.75 billion ($11 per unit) to take Teranet private, just like BCE. Borealis is an investment arm of OMERS, the pension operator of Ontario's civic employees, and its biggest recent move, until the Teranet bid, had been its buyout/privatization of the Golf Town Income Fund.

Before the Teranet deal is done, we may see three or four other bidders for the company, such is its stability and appeal. One potential bidder, announced just last week, is HOOPP, the pension fund that looks after the interests of Ontario's hospital workers.

Here's what I believe to be an interesting irony, a thread that runs through so much of this: The federal government kills a business/investment structure known as income trusts. Canadian investors, dependent upon them as income supplements, are taken by surprise and get whacked in the wallet.

Some trusts die as a result. Some lose huge chunks of their value. Some reduce their distributions. Some kill their distributions. Income trusts, faced with a 2011 guillotine, become, to a large degree, investment pariahs. And their holders get hurt.

And now, in the case of BCE and Teranet, and others past and yet to come, enter the opportunists -- the powerful, wealthy pension arms of public-service employees, to take advantage of a moment in time, to buy the companies, take them out of play, and reap the anticipated rewards no longer available to the rest of us.

There is no criticism intended here of those civil-service pension funds. They are doing exactly as they should: buying great assets at great prices. You cannot fault them for being smart, rich and ready.

Flaherty is a different story. When he knee-jerked on the trust decision, he clearly had no idea where his decision might ultimately lead. In his zeal to protect Canada's corporate structure -- and Ottawa's hefty tax take from same -- he forgot to look into the future; he failed to envision the private-equity-takeout tsunami that is now washing over the shores of the Canadian public markets.

Flaherty created this climate. His decision to kill trusts has hurt ordinary Canadians -- and hasn't done a thing to protect either corporate Canada or Ottawa's taxation interests. The nation and its citizens are paying a price for his haste and his myopia.

Al Coates is The Record's sports editor. He is also a private investor with 30 years of involvement in the Canadian public investment markets.