Recent chatter on the Street is that more U.S. public companies are studying the mechanics to convert to income trust structures. This news made me start thinking about a few high-level questions:
(1) Will the IRS allow this?
(2) Is there a “search for yield” bubble forming?
(3) Would the U.S. government want to stop conversions?
Historically, public companies with income trust structures in the U.S. typically operate within just a few industries, as publicly traded partnerships (or “PTP”s) can only be treated as such if they derive 90% of their income from so-called “passive sources”. This is why PTPs (also commonly known as MLPs in energy or REITs in real estate) are the main contributors of income trusts in the U.S.
In October of last year, LyondellBasell’s CEO commented that management was studying the MLP structure for some of its assets. This comment coincided with the IRS issuing a Private Letter Ruling in response to an unnamed company essentially stating that ethane crackers would constitute qualifying within the MLP structure (http://www.icis.com/Articles/2012/10/17/9604914/us-olefins-may-see-tax-breaks-in-master-limited-partnerships.html). MLP’ing a chemical asset is rather inconsistent with the traditional MLP structures ranging from oil & gas to fertilizer companies. This ruling by the IRS could lead the way for many other companies that operate within “fringe” MLP industries to start looking into income trust structures. Other companies that have announced during 2012 intentions to convert to (or at least look into) MLP or REIT status include American Tower (wireless and broadcast communications infrastructure), Equinix (data center), and even Corrections Corporation of America (prison operator).
Income trust structures essentially allow companies to distribute more cash to shareholders (or “unitholders”), as the payout structure allows the firms to distribute 90% of income tax-free, and such distributions only get taxed once at the investors level. This compares to traditional corporate structures which pay out dividends on an after-tax basis, and then those distributions get taxed again at the investor level. Income trusts are popular among investors as this structure yields more income to them (due to less tax), which is important during low-yield environments like we’re experiencing today. In addition, stocks usually pop once the intention to convert to an MLP structure is announced, hence investors get the benefit of capital appreciation as well. This is all great news for the investor who is seeing U.S. GDP grow in the ~2% range and fed funds rate close to zero. This is evidenced by REITs and MLPs trading at peak multiples and low yields, as investors are buying up current income assets. Clearly this is a crowded trade, however, with interest rates currently at zero through 2015, there is no structural reason (yet) to disrupt the elevated multiples at which these trusts are trading.
The U.S. government, however, loses out on important tax revenue when traditional corporations convert to income trust structures. This is an important point as we are currently in the midst of a political environment where politicians are fighting tooth and nail over tax revenue. The real question is: Can (or will) the U.S. government do anything to stop this tax revenue-draining conversion? If so, then what happens to the stock prices of these income trusts? Judging by what happened in the Canadian investment community during the 2000s, this leads us to believe that the answer is politicians may act, and this would not be good for the income trust industry. The question then becomes: when might this chatter begin…
Canada’s Income Trust Historical Summary:
After the dot-com crash in 2001, the Canadian investment community was in search for high-returning assets during a low rate environment, and investment banks were in search of new sources of fees during a quiet IPO market. The first major income trust conversion was Yellow Pages Group, previously owned by Bell Canada Enterprises, which raised C$1 billion. By 2002, 79% of all IPOs in Canada were derived from income trust structures. The slew of new income trust conversions drifted away from traditional energy and real estate assets, as only 38% of these new income trusts operated within the traditional MLP and REIT structures. This boom lasted over the next few years with more and more conversions occurring (and performing well), leading to the income trust sector being worth ~C$160 billion by 2005. Government contention began to arrive during 2005 when the Canadian Department of Finance suggested that these trusts cost the Canadian government C$300 million in tax losses during 2004. Much political contention occurred over the following year, and trust equities experienced severe volatility in the face of a potential distribution tax to offset declining government tax revenue. This all came to a head during October 2006 following Telus and Bell Canada Enterprises announcement of their intentions to convert to income trusts. The Canadian finance minister subsequently announced new rules that would tax the trusts 34% on distributions paid out, starting in 2007. TSX income trust indexes lost anywhere from 15-25% of their values over the following month. The wave of conversions had ended, and political action was finally taken.