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Income deposit securities may be a replacement for income trusts

by Wayne Cheveldayoff, 2005-11-10

Income deposit securities may soon be as common as income trusts in Canada.

The early November decision by Cinram International Inc. to adopt the income deposit security structure instead of becoming an income trust is likely the beginning of trend that presents a new level of complexity for income trust investors.

Income deposit securities (IDSs) were invented by the corporate finance specialists of Bay Street as a way for U.S. firms to raise money in Canada’s burgeoning trust market.

IDSs are just another way for companies to transfer profits to investors without paying income tax at the corporate level. Income trusts set up as limited partnerships do this extremely well, but the income trust structure hasn’t been suitable for U.S. firms.

While income trust units are one security with a monthly cash payment, IDSs combine two securities – a common share paying a monthly dividend and a note (bond) paying a monthly interest payment – into one unit.

The common share and note are linked together in one unit that is traded on the Toronto Stock Exchange but some time after they are issued, investors allowed to split up the units and trade the common share and note separately.

Cinram, a Toronto-based, $1-billion-a-year maker of CDs, DVDs, and other physical entertainment media, is not the first Canadian company to be attracted to the IDS structure.

New Flyer Industries Inc., a Winnipeg-based manufacturer of heavy duty transit buses in Canada and the United States, issued 20 million IDSs at $10 each last August.

Each New Flyer IDS, trading under the symbol NFI.UN, consists of one common share and $5.53 principal amount of 14% subordinated notes issued by New Flyer. It is the high interest rate that mainly transfers taxable income to unitholders and minimizes the income tax paid by the company.

For October, the company paid a total cash distribution of 9.167 cents per IDS unit, reflecting a cash dividend of 2.715 cents on each common share and an interest payment of 6.452 cents on each note.

For investors getting the 9.167 cents per IDS unit, this may not look much different than a monthly distribution from an income trust, and there are many similarities.

Take, for example, the October distribution by Superior Plus Income Fund, trading under the symbol SPF.UN. Superior’s units represent an ownership interest in the fund and cannot be split into two securities like IDSs.

Superior said its 20-cents-per-unit monthly distribution in October would be treated for income tax purposes as a dividend of 4.7 cents per unit and other business income of 15.3 cents per unit, which is almost identical from a tax point of view as the IDS since interest payments and other business income are taxed at the same marginal rate.

However, the cash distributions from many other income trusts include not only dividend and other income components but also a return of capital component (on which income tax is deferred and when it is finally paid it is paid at the reduced rate for capital gains).

There would not be a return of capital with an IDS unit, an IDS unit may be more suitable for a registered plan like an RRSP than would an income trust unit that has a return of capital component.

Income deposit securities are identical in practical terms to income participating securities (IPSs), such as the kind issued by Student Transportation of America Ltd., the fifth-largest school bus transportation company in North America.

The IPS units, trading under the symbol STB.UN, consist of one common share of Student Transportation and $3.847 principal amount of 14 per cent subordinated notes issued by one of the company’s subsidiaries.

Cinram stated its reason for choosing the IDS structure was that it worked better in minimizing corporate income taxes because 95 per cent of the company’s earnings come from outside of Canada. .

But depending on how the Canadian government’s review of income trust taxation turns out, lawyers may be recommending it more often for Canadian companies.

What works to minimize corporate income taxes for a company with significant U.S. operations, may also end up working just as well for those with mainly Canadian operations.

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