BCE's October 2006 announcement that it would join the most popular financial club in town by turning Bell Canada into an income trust was a watershed moment for the burgeoning trust industry. With a market worth north of $25 billion and a stock that is among the widest held in Canada, BCE's move would create the biggest income trust in the country.

It also seems likely to raise new questions about the proliferation of a business entity that was a relatively minor player on the TSX just a few years ago. After all, if BCE can do it, what's stopping the big banks and almost every other big cap company? What are the financial implications for investors, federal and provincial tax revenues, and the markets?

What is an income trust?

In the arcane vernacular of tax-speak, they're known as flow-through entities (FTEs). But most people call their FTEs by their other name: income trusts.

An income trust allows a company to avoid the double taxation that now applies to its income — first, the corporate taxes it pays and then the personal taxes on dividends it pays out to its shareholders. Trusts manage to pay little or no corporate tax because they aren't corporations. Income trusts are simply vehicles that "flow through" interest, dividends and capital gains directly to their investors (called unitholders) as distributions.

The unitholders, who then pay tax at a preferential rate on the income that is distributed to them (usually) every quarter.

Some income trusts (like oil, gas and real estate investment trusts) have been around for quite a few years. Many others — the business trusts — are more recent creations. There are now income trusts that flow through income from sales of everything from mattresses to peat moss. Some trusts get their juice from Yellow Pages advertising, hamburger sales, newspaper advertising, customs brokerage fees, even coffee and jam. Any business with a strong and steady cash flow is a potential candidate.

About a million Canadians own income trusts now. Retail investors have snapped them up for those rich payouts. But it's not just the investing public that likes them. Pension plans have been heavy buyers, too. Investment banks have made many millions bringing new income trust issues to market. And companies that hadn't even thought about going public found an easy way to join the party.

Why become an income trust?

There are several reasons why companies have been jumping on the income trust bandwagon. First, there are the tax benefits for the corporation. By flowing through income directly to unitholders, it can avoid paying corporate tax at rates of up to 35 per cent. BCE estimates that, had it not converted to an income trust, it would face corporate taxes of $800 million in 2008.

Secondly, the value of the company gets an instant lift when the trust conversion is announced. When Telus, Canada's second biggest phone company, announced its intention to "go trust" in August 2006, its stock price jumped almost 14 per cent to an all-time high. That boosted the stock market capitalization of Telus by $2.5 billion.

Nowadays, it seems a company CEO has merely to mumble in his sleep about converting to a trust and his firm's stock vaults higher.

What's in it for investors?

In one word — yield. That's the return investors get from placing their money in a particular investment.

Let's look at the current investment climate. Guaranteed investment certificates now pay three or four per cent at the big banks. There's no risk. But for many people who count on their nest egg to generate a monthly income, that just doesn't cut it.

There are stocks that generate dividends: banks, utilities, pipelines, that type of thing. Those dividends are typically two to four per cent. And while dividend payments face less tax than interest, they're still not the gravy train some have been looking for.

The yields on income trusts, on the other hand, can be six per cent, eight per cent, 10 per cent, often more. A few of the riskier ones yield more than 20 per cent.

"Tax-exempt" investors, like RRSPs and pension funds, like investing in income trusts because the company they're investing in doesn't pay corporate taxes and, as tax-exempt investors, they don't pay tax themselves on the distributions. The federal Liberals tried to limit pension plans' ability to invest in trusts, but backed off when the industry complained.

All other things being equal, investors will take home more income from an income trust, rather than as a dividend from a tax-paying corporation, because the distribution will tend to be larger. For instance, BCE says Bell Canada's annual distribution as an income trust will be $2.55 a unit. BCE's dividend is just $1.32 per share.

It's all made for a trust boom. Where there were just 70 income trusts and similar products listed on the Toronto Stock Exchange in 2000, there are almost 250 today. Total market value is over $200 billion.

Are there risks?

Some investor advocates are worried that many holders of income trusts aren't fully aware of the risks. Income trusts, after all, are all about the income. Their unit prices rise and fall on the health of that distribution. And when they fall, they can fall hard.

Several trusts have suspended distributions entirely when the cash available to distribute has shrunk. Others have cut their distributions. Predictably, the unit prices of those trusts have fallen dramatically. And they haven't revived.

There are other concerns. Some accountants say the current system encourages excessive distributions. There are also questions about the financial reporting, the valuations and the aggressive marketing of many trusts.

Accountability Research Corp. looked at the 50 biggest business trusts in 2005 and found that, on average, a significant portion of their cash distributions (more than a third) were not actual income from the business, but were simply a return of the investors' own money.

The bond rating agency, Standard & Poor's, looked at 40 large Canadian income trusts this year and found that there were 19 different ways companies calculated cash available for distribution to their unitholders. The Ontario Securities Commission is promising new rules by the end of 2006 on how trusts should calculate and report distributable cash.

The future

When former federal finance minister Ralph Goodale announced a review of the income trust sector in 2005, the finance department estimated that trust conversions cost the federal treasury $300 million in tax revenue in 2004. That figure is sure to have grown since then. A study by Jack Mintz of the Rotman School of Management estimates that the federal and provincial governments will lose a total of $1.1 billion annually in tax revenue once both Bell Canada and Telus complete their trust conversions.

When Goodale put an end to the review by announcing no new tax on income trusts and a lowering of the effective tax rate on dividends to try to "level the playing field" between corporations and income trusts, the investment community applauded.

But the end of the trust policy review left other questions still unresolved. Is the no-tax treatment given to income trusts "legalized tax evasion," as the Canadian Auto Workers union has put it? Are income trusts pressured to pay out too much of their income as distributions instead of reinvesting in the business? And is the whole sector an accounting nightmare just waiting to explode?

There's no question that income trusts have made a lot of investors very happy. In most cases, valuations have risen and distributions have been healthy. But there are no guarantees. One big collapse could make a lot of investors take a second look at a sector that's become a fixture in many portfolios.