Tax changes to income trusts announced by the federal government increase the need for income trusts to provide investors with more standardized and transparent information about management practices affecting cash distributions, say Canada’s Chartered Accountants.
The Canadian Institute of Chartered Accountants (CICA) today issued guidance for income trusts that recommends standardized reporting of distributable cash in Management’s Discussion and Analysis (MD&A). The guidance calls for enhanced disclosure of the management strategies used to determine what percentage of a trust’s cash is distributable to investors. The guidance is important for the millions of Canadians who own units of existing income trusts that are exempt from the new tax until 2011 or who are considering buying trust units.
Currently there is no standard practice governing the calculation of distributable cash or the disclosure of management strategies dealing with factors that affect distributable cash. The CICA, through the Canadian Performance Reporting Board (CPRB), is taking the lead in closing this gap in the financial reporting by trusts that puts investors at risk.
“While Canadians last year received close to $11 billion in cash distributions from income trusts, the lack of consistent disclosure practices across the industry made it difficult for investors to know what they were buying, to compare one income trust to another and to assess whether or not current cash distributions from the trusts were sustainable,” said Kevin Dancey, president and CEO of CICA.
Prior to the federal government’s announcement, the promise of consistent, steady income and comparatively high yields was increasingly drawing investors to income trusts. In 2005, for example, yields from income trusts averaged 9% compared with less than 2% for dividends from corporate issuers. This is why income trusts grew from a market value of $20 billion six years ago to about $170 billion today. Based on the federal government’s decision to grandfather existing trusts from paying the new tax on distributions until 2011, investors in these existing income trusts could continue to benefit from higher yields during the transition period.
“Investors in income trusts need better information about cash distributions and management processes,” said Dancey. “CICA’s recommendations fill a gap in financial reporting and go a long way to providing essential information to investors who own income trusts directly or through pension and mutual funds. They will help increase transparency in how management determines cash available for distribution and provides for maintaining operating capacity, debt covenants and other obligations as part of its calculation of distributable cash. All of these elements could be affected by the trust’s strategy for dealing with the proposed new tax on distribution.”
Dancey said “income trusts that follow the recommendations in the guidance will help ensure investors have access to the information they need to assess the ability of these investments to pay future cash distributions and should help investors determine the relative value of income trust units – both of which will reduce risk to income trust investors.”
The term ‘distributable cash’ generally refers to the cash from operations that an income trust could potentially distribute to unit holders. Investors use this information to assess the entity’s ability to fund future distributions and to help value their investments. Lack of consistency in terminology and methods of calculation across the industry have raised concerns.
Two studies by Standard and Poor’s (S&P) and a report by the Canadian Securities Administrators this year helped highlight the problems. The S&P studies cited an average two-year reporting distortion of 26% in the calculation of distributable cash by the 40 income trusts examined in the study. For energy funds it was even higher at 37% distortion. S&P found that even the basic term was unclear with 19 different names for the concept of distributable cash used by those studied.
While the recent change in taxation policy for income trusts will dramatically curtail the recent rapid growth in income trusts, the income trust business model will continue to exist. In addition, more than 250 existing income trusts listed on the Toronto Stock Exchange will be grandfathered from paying the new tax on distributions for the next four years. Real estate investment trusts (REITs) account for close to 11 percent of the income trust market. Some of these trusts will not be required to pay the new tax on distributions.
@page_break@The CICA recommends that income trust management addresses five key questions with the MD&A. They are:
- How much cash was generated in the period and where did it come from?
- What is the entity’s strategy for maintaining productive capacity and managing debt? This is particularly important in light of the recent federal government announcement of a new tax on income trusts.
- Is sufficient cash being retained to provide for all long-term unfunded contractual liabilities, such as pension plans?
- Is sufficient cash being retained within the income trust to maintain productive capacity?
- If distributable cash were to be distributed, is it likely that the entity will meet its financial commitments, such as loan covenants, for the foreseeable future?
The CICA developed the recommendations after considering the views of the income trust community, regulators and investors. The guidance is being published for comment until March 2007 to give all stakeholders sufficient time to understand the recommendations and respond.