Thursday, November 02, 2006

Goodbye, sweet corporate structure arbitrage... oh Caaaanada

You know, income trusts are pretty sweet--until today that is, when the finance minister of Canada Jim Flaherty took the markets by surprise (if not the market, then definitely little old me) by announcing plans to effectively end the tax-free benefits enjoyed by companies that opt to structure themselves legally as an "income trust status". This move cost me an alpha of 2%... my first reaction was, of course, THAT BASTARD!

You know, it's really funny because this thing happend september of last year too when the guy came out and basically said the same thing that he has said today, except he repudiated it later by saying that the government actually has no intention of revoking the tax-free structure of income trusts (the markets were relieved, but proceeded still with some suspicion still). I bet he only revoked it because his friends begged him to too... haha

"Hey jim, buddy, can you help us out? Can you just tell the market 'nevermind' until next year, at least after we get rid of all of our own income trust holdings?"

Conspiracy theory? I hate politics.

While I still think he's a bastard, this sort of thing was probably too good to be true in the first place. It was a good thing, income trusts, but sometimes all good things must end. I know of no other developed country with a business structure like that of Canadian income trusts--simple, elegant, and sweet sweet cash flow to shareholder absent of tax on the corporate level. Canadian income trusts are like REITs, except they can be virtually any business that any normal company can engage in. From frozen food distribution and medical supplies distribution, to matress manufacturing, or air cargo services... sounds pretty sweet, and yes, it was indeed too good to last.

When a business is structured as an income trust, it usually means that despite inability to reinvest more than 10% of free cash flow to the underlying business and grow organically, it could still take on leverage to grow from acquisitions. When an income trust acquires another entity that have to otherwise pay 35% in tax to the Canadian federal government, and if these acquirees are valued solely on its ability to generate bottom-line to shareholders, then income trusts can effectively pay the market (assuming market price is a function of after-tax earnings) and pocket the spread between free-cash-flow after tax, and free-cash-flow before tax for free... which claims value (at the marginal tax rate) from the government and gives it to investors.

This is a sort of "corporate structure" arbitrage opportunity that has existed for a while... until today. Maybe the government realized that, maybe the government just wanted more tax revenue. Whatever the reason, the conservative government completely broke the election promise of leaving the income trust status alone. 10-15% losses across the board on income trusts today, and the hardest hit were seniors retirement funds.

Shit happens.

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