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Canadian income trusts caught in U.S. tax-avoidance net

by Wayne Cheveldayoff, 2005-09-01

Income-trust investing has become more complicated with the recent revelation that U.S. tax authorities are not allowing U.S. firms to deduct high interest payments going to foreign parent companies.

While not all Canadian trusts with U.S operations will be affected, some with a particular inter-company debt structure are vulnerable, with the likely end result being lower distributable cash for unitholders.

The U.S. Internal Revenue Service (IRS) has already caught one Canadian income trust in its anti-tax-avoidance net – Sun Gro Horticultural Income Fund, a peat moss producer with operations on both sides of the border. It is not known if this is a one-off incident or part of a larger IRS campaign.

Sun Gro reported on August 4 in the notes to its second-quarter financial statements that the IRS has challenged the 13-per-cent interest rate that Sun Gro’s U.S. subsidiary pays on debt owed to the Canadian-based income-trust parent. The IRS said a 7-per-cent interest rate would be acceptable in Sun Gro’s case and anything above 7 per cent would not be tax deductible.

Of course, this threw a huge monkey wrench into Sun Gro’s cash-distribution engine and puts at risk the inter-company debt structure the fund established at the time of its 2002 IPO to flow cash to the fund’s unitholders while eliminating, or at least minimizing, the income taxes it pays to Canadian and U.S. governments. The inter-company debt is worth $18.2 million U.S.

If Sun Gro is unable to fight off the IRS, it will have to pay U.S. income taxes that it didn’t plan on paying and that will cut into the cash available for distribution to Canadian unitholders.

In highlighting this development, Sprott Securities Inc. analyst Aleem Israel identified three other income trusts that may be similarly confronted by the IRS. They include KCP Income Fund, which has a 14-per-cent interest rate on inter-company debt, BFI Canada Income Fund (12 per cent), and Associated Brands (10 per cent).

It is important to note that Mr. Israel only looked at those income trusts that he covers and not the entire universe of business income trusts with similar inter-company debt structures and U.S. operations.

The IRS thrust may not be aimed solely at Canadian income trusts. Instead, it could be aimed at all foreign-based entities with U.S. operating subsidiaries – as an extension of its focus on inter-company transfer pricing. The U.S. tax authorities regularly monitor the prices parent companies and subsidiaries charge each other for traded goods and services so that taxable income is not sucked out of the United States to low-tax or no-tax countries. Canadian tax authorities do the same thing.

Mr. Israel thinks that only certain older income trusts with the specific type of inter-company debt are likely to be challenged along these lines by the IRS. A CIBC research report identifies Custom Direct Income Fund and Heating Oil Partners Income Fund as possibly vulnerable. There could be others.

Some of the newer trusts using the Income Participating Securities (IPS) approach could be unaffected because the high-interest debt is held directly by the unitholder.

For example, Keystone North America Inc., which operates a U.S. chain of funeral homes, issued an IPS unit earlier this year that consists of a dividend-paying common share and a subordinated note paying 14.5-per-cent interest.

Student Transportation of America Ltd., a U.S. school-bus operator, pays 14 per cent interest on the debt that was part of its IPS issue.

The common share and subordinated note can be kept together in the IPS unit or split off and traded and owned separately.

Accounting firms have stated that the IPS type of high-interest debt should satisfy IRS rules.

What’s clear for Canadian investors is that they now must include inter-company debt as part of their due diligence on income trusts with U.S. operations, along with such other factors as foreign currency exposure, capital expenditure plans, and pay-out ratios.

The Sun Gro disclosure didn’t get much publicity. It may be that the unit prices of other trusts that are vulnerable to the IRS attack, which could be just be getting started, have not yet adjusted to reflect the potential rise in U.S. income taxes and decline in distributable cash. Investors, therefore, should consider taking action now to identify and possibly sell any vulnerable trusts they have in their portfolios.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2005 Wayne Cheveldayoff