Valuation of Income Trusts: A Test of Clienteles and Implicit Taxes

Kenneth Klassenkklassen@uwaterloo.ca

Devan Mescalldmescall@artsmail.uwaterloo.ca

School of Accountancy

University of Waterloo

Abstract

September 2005

The authors that the participants at the 2005 Canadian Tax Foundation Policy Symposium for helpfulcomment and the Deloitte Centre for Tax Education and Research at the University of Waterloo forfunding assistance.

Introduction

Implicit taxes and the related concept of tax clienteles arise when two assets of similar

economic characteristics are taxed differently. With two such assets, each security has a

natural investor, or clientele. Typically, heavily taxed investors own the more lightly taxed

security and lower tax-rate investors own the more heavily taxed security. The relative

pricing of the securities equates the after-tax return to the marginal investor. While these

theoretical relations, described in, for example, Scholes et al. 2005, have been widely cited,

documenting reliable empirical evidence has been restricted generally to a limited settings.

For example, past studies that have explored implicit taxes include the study of ESOPs

(Shackelford, 1991), yield spreads (Guenther, 1994; and Plesko 2005), TRUPS (Engel et al.,

1999), acquisitions (Erickson and Wang, 1999; and Ayers et al., 2003), the small business

capital gains rate reduction (Guenther and Willenborg, 1999), and the QSSP share rules in

Quebec (Bédard, et al., 2005). Erickson and Maydew (1998) are the only authors of which

we are aware who explore implicit taxes in a broader equity market setting. Their evidence is

somewhat mixed: they are able to demonstrate the effects of implicit taxes for preferred stock

but not for high dividend yield common stock.

This paper explores a recent innovation in the Canadian equity market that permits a

broad test implicit taxes in equity pricing. The income trust hybrid organizational structure

burst onto the Canadian equity market in 2001. While income trusts have been available for

many years, particularly in the form of real estate investment trusts (REITs) and oil and gas

royalty trusts, the trust structure is now used in a diverse set of industries, including utilities,

telecommunications, industrials, consumer products, and financial services. As many

businesses explore the benefits of this structure, trusts in business sectors (i.e., industries other

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than resources, utilities and financial) have become the fastest growing sector of income

trusts. REITs still make up 15% of the trusts, with oil and gas royalty trusts accounting for an

additional 39%. Infrastructure (i.e., pipe and power) trusts add another 11% with the

remaining 35% being other types of business trusts.

In the three years from the end of 2001 to the end of 2004, the total market

capitalization increased by a factor of four, and by June 2005, the market capitalization of

these entities on the Toronto Stock Exchange, or TSX, exceeded $140 billion. This represents

12% of the domestic capital market (Langton, 2005). As of June 30, 2005, there were 214

traded income trusts. With this continued growth, the income trust structure has become an

important, but largely unexplored, subject of research. As one evidence of the acceptance and

importance of income trusts in Canada, on January 26, 2005, Standard and Poors announced

that it would be including income trusts in the S&P/TSX Composite Index beginning in the

fourth quarter of 2005 (Chrispin, 2005).

In addition to the importance of this structure to the Canadian equity market, it also

provides a unique opportunity to study the effects of taxation on equity valuation. Income

trusts, like REITs, do not face corporate taxation as long as the taxable income is distributed

to shareholders each year. The typical corporation pays income tax and then distributes a

small proportion of its income through dividends or share repurchases, allowing the investor

to defer much of the shareholder level tax until the securities’ future sale. In Canada, both

dividends and capital gains are afforded preferential tax rates. Income trusts do not pay

corporate taxes but instead distribute their taxable income to the unitholders each period in the

form of interest.

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Thus, there is a trade off between current corporate taxes and (possibly deferred)

shareholder level taxes on dividends and/or capital gains for traditional corporate investments,

and no corporate taxes but immediate taxation at the investor level on income at regular rates

for income trust investments. We demonstrate that there is little benefit for the income trust if

the investor is a high tax-rate individual, and for long-term investments there may be a higher

tax cost with this structure. However, as the investor’s tax rate falls, the benefit of the income

trust structure increases. If the investor has a zero tax rate, the income trust structure allows

the business’ income to escape taxation entirely. Investment theory (e.g., Scholes et al., 2005)

would suggest that low tax-rate investors are the natural clientele for income trusts and

therefore should be the marginal investors in these securities.

Because income trusts operate in a variety of industries, not just real estate, there is an

opportunity to explore more general stock price relations by comparing income trusts to

regular corporations. This setting allows for a new opportunity to explore the joint effect of

shareholder and corporate taxes on market prices.1 We exploit these unique institutional

features to explore the effect of investor level taxes on equity valuation and to provide some

evidence on the shareholder clientele theory.

Based on a valuation model described below, we determine the theoretical effect of

investor tax rates on the value of the income trust units relative to corporate shares. We adapt

the model of Dempsey (2001) to the setting of income trusts. Our model demonstrates that,

relative to that on corporations, the coefficient on earnings for income trusts will increase as

the price-setting investor’s tax rate falls. If the tax rate on the marginal investor is zero (that

1 See reviews such as Shackelford and Shevlin (2001) and Graham (2003).

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is, the investor is a tax exempt organization), the coefficient on earnings for an income trust

should be almost twice that of comparable corporations’ shares.

The empirical tests reveal that the coefficient for regular corporations is 1.4 whereas

the coefficient for income trusts is 6.3. Thus, the income trust coefficient is considerably

higher, which is consistent with the marginal investor in an income trust having a tax rate of

zero (that is, being an exempt institution). Since income trusts must report to investors the

distributions that are taxable, versus the distributions that are non-taxable returns of capital,

we can determine if the investors value these two components differently. Analysis of these

two types of distributions reveals that taxable distributions receive a higher coefficient that

earnings before interest and taxes whereas the coefficient on returns of capital is much lower.

Furthermore, the difference becomes more pronounced over our sample period, suggesting a

growing sophistication among market participants in these securities.

This research contributes to our understanding of equity valuation in several ways.

First, it provides the first evidence on the valuation of income trusts in Canada. In spite of the

significant presence of this organizational structure, we are aware of no systematic empirical

research has addressed the valuation of the traded units. Second, given the unique taxation

applicable to these businesses and the broad set of industries in which they operate, we are

able to address the effects of investor level taxation, and the characteristics of the marginal

investor, in this powerful setting. Thus, our evidence provides a new element to this

extensive literature.

In the next section, we describe the income trust structure in more detail and use a

simple example to demonstrate the effect of typical tax rates on the after-tax earnings by

investors. In section three, we develop the theoretical model that guides our hypotheses,

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empirical specification and the interpretation of our results. The fourth and fifth sections,

present the research design and the results, respectively.

Income Trust Structure

An income trust is a hybrid structure that inserts a trust between the operating

corporation and the investors. Figure 1 provides a summary of the basic structure and how it

has evolved. Early income trusts were structured with the trust holding all the shares of the

corporation plus a significant amount of debt in the corporation. Interest payments on the

debt reduce the corporation’s taxable income to zero, allowing it to avoid paying income

taxes. The interest paid to the trust is distributed to the unit holders monthly, with additional

payments made at the end of the year as needed to achieve the goal of distributing all taxable

income for the year. In some cases, the distributions exceed the taxable income of the

business. These excess distributions are treated as a tax-free return of capital to the investor.

Over time, the structure was improved to avoid the use of a corporation. This provides

additional benefits by avoiding capital taxes and any inefficiency that arose from the inability

to predict the business’ taxable income. Since the investor receives a distribution that

effectively represents interest payments, the distribution is taxed at regular rates: 46% in

Ontario in 2004, and ranging from 39% in Alberta to almost 49% in Newfoundland and

Labrador.

Regular corporations in Canada are taxed at various rates depending on whether they

are a Canadian-controlled private corporation, the type of income they earn, and the province

in which the income is earned. Publicly traded corporations, operating exclusively in Ontario,

face a tax rate of approximately 36% in 2004. The rates across provinces vary from 31% in

Quebec to 39% in Saskatchewan. To provide partial relief for the corporate level tax,

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dividends and capital gains are not fully taxed. The individual taxation of dividends in

Canada attempts to integrate the corporate and personal tax systems at a theoretical corporate

rate of 20%. Thus, dividends received are included in income at 125% and a tax credit is

given that theoretically equals 20% of the grossed-up dividend, though the actual rate varies

by province. The effect of these rules is to tax dividends at a maximum rate of 31% in

Ontario, and maxima range from 24% in Alberta to 37% in Nova Scotia, and Newfoundland

and Labrador. For public corporations that own shares, dividends are tax exempt (i.e.,

corporations receive a 100% dividends received deduction). Only half of realized capital

gains are included in income for both individuals and corporations. Thus, for example, the

tax rate for capital gains in Ontario for individuals is 23%.

Based on these features of the tax system, the overall tax rate applicable to a corporate

form depends not only on the tax rate of the investor, but also on when the investor realizes

the dividend or capital gains. If the investor has a one-year horizon, then if the company and

investor reside in Ontario and all after-tax income is retained, so the investor receives a

capital gain, the after-tax value to a maximum-tax-rate individual investor is $0.49 for each

dollar of pre-tax income of the corporation. The dollar of pre-tax earnings is taxed at 36% in

the corporation. Assuming the remaining $0.64 is passed to the shareholder through

appreciation, it is taxed at a rate of 23%, or $0.147 more tax. Thus, the after-tax amount is

$0.493. If the $0.64 of earnings are distributed as a dividend, rather than retained and taxed

as a capital gain, then the tax on the dividend is 31%, or $0.198, leaving only $0.442.

However, if the business had be operated in an income trust form, the individual would have

received $0.54 since the trust pays no tax and the individual pays tax at 46% on the full $1

received. As the investor’s horizon increases, the cost of the tax on the capital gain falls. At a

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10% after-tax discount rate, the after-tax return on the corporation is the same as the income

trust if the investor does not sell the stock for 4 years.

Another method of comparing the organizational forms and payout policy is to

compute the after-tax wealth of the investments. Table 1 specifies the after-tax value to an

investor across a variety of scenarios. In panel A, the assumed 20% pre-tax return is earned

entirely as taxable income to the corporation (which is distributed to the unitholders in the

case of the trust). In Panel B, the 20% pre-tax return is earned as 5% taxable income and 15%

appreciation in value (e.g., non-taxable creation of value through R&D activities). In Panel A

the investors’ tax rates are 46%, 25% or 0%; in panel B, the returns for rates of 46% and 0%

are displayed.

Comparing the values between the income trust and the corporation, it is clear that for

a high tax rate investor, the after-tax accumulated value (and tax burden) is similar from

investing in an income trust or investing in a corporation that pays no dividends. For the high

tax rate individual, a dividend-paying corporation provides the lowest after-tax return. As the

investor’s tax rate falls, the income trust organizational form provides a greater after-tax

value. When all the business income is earned in a form that is currently taxable to the

corporation (i.e., value businesses), the benefit of the income trust is maximized. For growth

businesses like those represented in Panel B, the benefit of the income trust is substantially

reduced, with little if any benefit accruing to the high tax rate investor. Exempt investors

receive a higher return under the income trust structure, but the advantage is much less than

when no return is earned through capital gains.

Based on this analysis, the tax clientele for an income trust enterprise would be a tax-

exempt organization or a low tax-rate individual. From the business side, the benefit of re-

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organizing into an income trust is largest for businesses that are mature and stable, rather than

growing through internally generated value.

A Theoretical Model of Income Trust Valuation

To understand the effect of the income trust structure on valuation we employ the

model of Dempsey (1996, 2001), which is based on the model of Auerbach (1979). We chose

this model because it incorporates explicitly both leverage, and corporate and investor level

taxes. Further, it includes separately investor taxes on dividends and capital gains. At its

heart, the model is a discounted cash flows model and so differs significantly from more

common models in accounting research based on Feltham and Ohlsen (1995). However,

efforts to incorporate taxes into the Feltham and Ohlsen model have proven to be

controversial.2

Dempsey’s model values the firm based on its value without debt and then adds the

change in valuation that is due to its leverage. The basis of firm value, then, is equation (8)

from Dempsey

V0=V

0U + ΔV

0(1)

where V is the value of the firm at the subscript date and the superscript U denote unlevered

values.

While Dempsey’s model assumes all cash earnings are distributed as dividends, he

notes that his results flow through with an assumption of some retained earnings. In our

context, where corporations retain significant earnings while income trusts do not, explicitly

2 Papers attempting to incorporate taxes using the Feltham Ohlsen model include a series of papers (Harris andKemsley, 1999; Collins and Kemsley, 2000; and Harris et al, 2001). However, the application of taxes in thismodel has been challenged by papers such as Hanlon et al (2003) and Dhaliwal et al (2003).

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modeling the distributed portion of earnings becomes important. Thus, we modify the

equations presented by Dempsey to permit retained earnings. Thus, equation (9) from

Dempsey (2001) becomes

V0U =

EBITt(1− τ

c) − I

t( ) ⋅q1+ RU( )t

+I

t⋅ (1+ RU )N − t

(1+ RU )N

⎡

⎣

⎢⎢⎢

⎤

⎦

⎥⎥⎥t=1

N

∑ +V

NU

(1+ RU )N(2)

where EBIT is the earnings before interest and taxes,

q =1− τ

d

1− τg

, τ is the tax rate for various

forms of income (c for corporations, d for dividends, g for capital gains, and later, b for bond

interest), I is the income retained in the corporation, R is the required return on the firm’s

equity. As is evident from the equation, the valuation is based on the distributed earnings

taxed as dividends plus the value at arbitrary period N. The model is silent on how this value

is determined, and in particular, the extent to which investor taxes are relevant to this

valuation. We return to this issue below.

If the business operates as a corporation, then It= (EBIT

t− INT

t)(1− τ

c) − DIV

t, and

equation (2) becomes

V0U =

INTt(1− τ

c) + DIV

t( ) ⋅ (q −1)

1+ RU( )t+

EBITt(1− τ

c)

1+ RU( )t

⎡

⎣

⎢⎢⎢

⎤

⎦

⎥⎥⎥t=1

N

∑ +V

NU

1+ RU( )N(3)

From equation (20) in Dempsey, ΔV0 is defined as follows:

ΔV0=

α ⋅qB ⋅ INT

1+ RU( )t+1t=0

N −1

∑ (4)

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where α = 1−

1− τc

qB and

qB =1− τ

b

1− τg

. Equations (3) and (4) can then be added as per

equation (1). To eliminate the summations, we assume that EBIT, INT and DIV are constant

over time. This assumption does not alter the conclusions drawn (that is, it could be assumed

that these values grow at a constant rate and the implications would be the same). Thus,

adding equations (3) and (4) and using standard annuity formulae yields the following:

V0= INT (1− τ

c) + DIV( )(q −1) + EBIT (1− τ

c) + α ⋅qB INT⎡⎣ ⎤⎦

1

RU1−

1

(1+ RU )N

⎛⎝⎜

⎞⎠⎟+

VNU

(1+ RU )N

= (1− τc) ⋅ φ ⋅ EBIT +

1− τb

1− τg

− (1− τc)

⎛

⎝⎜

⎞

⎠⎟ ⋅φ ⋅ INT +

τg− τ

d

1− τg

⋅ φ ⋅ DIV +V

NU

(1+ RU )N

(5)

Equation (5) specifies the manner in which interest, dividends and earnings before

interest and taxes each affect firm value. If these amounts grow at a constant rate, the value(s)

of φ would be different, but the tax component of each factor would be the same.

Equation (5) holds for corporations; however, for an income trust, the value of I in

equation (2) is always zero. In addition, the earnings before interest and taxes are not subject

to the corporate tax, but instead the distributions are subject to the tax rate on bonds. Thus,

equation (4) can be added directly to equation (2), using the same simplifying assumptions

used to generate equation (5), setting I = 0, and altering the tax treatments, the value of the

firm is given by

V0= EBIT ⋅qB + α ⋅qB INT⎡⎣ ⎤⎦

1

RU1−

1

(1+ RU )N

⎛⎝⎜

⎞⎠⎟+

VNU

(1+ RU )N

=1− τ

b

1− τg

⋅ φ ⋅ EBIT +1− τ

b

1− τg

− (1− τc)

⎛

⎝⎜

⎞

⎠⎟ ⋅φ ⋅ INT +

VNU

(1+ RU )N

(6)

Equation (6) reveals that the value resulting from EBIT depends on the ratio of the tax

rate on interest to the tax rate on capital gains. The fact that the tax rate on capital gains in

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Canada is always half that on interest causes this ratio to have a maximum of 1. Furthermore,

the lower the marginal investor’s tax rate, the closer to 1 this ratio becomes. Finally, for

realistic tax rates, the value of (1 – τc) is always lower than the ratio in equation (6). These

comparisons require that the firm operate in a similar manner (implicit in the assumption that

φ is the same in equation (5) and (6)). This would require that the income trust to raise

additional capital as its payouts out its earnings and the corporation retains much of its

earnings.

Based on this simple model, we form the following hypothesis (stated in alternative

form):

Hypothesis 1: The valuation coefficient on earnings before interest and

taxes will be larger for income trusts than it is for matched corporations.

If we are able to reject the null form of the hypothesis, the coefficients on EBIT will

imply a tax rate for the marginal investor in income trusts. Note that multiple on earnings in

equation (5) do not vary with investor level taxes. This result arises in this model for three

reasons. First, the current dividends are explicitly included in the valuation equation so the

current effect of dividend taxes is explicitly captured in this term. Second, the model of

Dempsey (2001) uses the tax term q, rather than (1 – τd) to explicitly adjust for the effect of

current distributions on future capital gains. Finally, the value of the future investor-level

taxes on appreciation not affected by current distributions is left to the terminal value term.

This term is unmodeled here but we assume that it will not differ by organizational structure

(consistent with our assumption that φ is constant across the two structures). We leave to

future work to explore explicitly the implications of violating this strong assumption.

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Research Design

To test the hypothesis, we employ a standard price model, but include both interest

and dividends as specified in equation (5):

Pt= α

0+ α

1EBIT

t+ α

2INT

t+ α

3DIV

t+ ε

t(7)

where P is firm price, EBIT is earnings before interest and taxes, INT is interest expense and

DIV is dividends paid. All values are computed on a per-share basis. Since we are interested

in the difference between income trusts and other corporations, we include an indicator

variable for income trusts, IT. Interactions of IT and EBIT and INT are also included because

the theoretical coefficients on these variables differ across organizational structures, as

specified in equations (5) and (6). Thus, our empirical model becomes

Pt= α

0+ α

1EBIT

t+ α

2INT

t+ α

3DIV

t+ β

0IT + β

1EBIT

tiIT + β

2INT

tiIT + ε

t(8)

The coefficient on the EBIT • IT interaction is used to test the hypothesis; it is

expected to be positive. EBIT is estimated in two ways for income trusts. Firstly, the income

statement value of EBIT is used, consistent with the value used for the control sample of

corporations.

Based on the theoretical equations (5) and (6), the coefficient on INT should be

smaller than the coefficient on EBIT and should not differ across corporations versus income

trusts.3 The coefficient on DIV is based on the sign of (τg – τd). For high tax rate individuals,

this value is approximately –0.10, for low tax-rate individuals, this value is approximately

zero, and for taxable corporations, this value is 0.18 (since dividends are generally tax exempt

3 This assumes that the value of φ is the same for INT and EBIT. For corporate tax rates of 36%, the tax factoron interest from equation (5) ranges between 0.06 and 0.36 for tax rates ranging between the top individual rateand zero, respectively. The value for taxable corporations would lie in this range as well. The tax factor onEBIT from equation (5) is 0.64. Thus, the coefficient on INT should be, at most, half of that on EBIT.

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to corporations). Thus, the sign of the coefficient on DIV cannot be predicted, but is

suggestive of the type and tax position of investors. However, there is a vast literature on the

valuation implications to paying dividends. While the tax stream of this literature is based on

U.S. tax rules, which have traditionally made dividend payments very expensive from a tax

perspective, there is also considerable literature on the signaling value of paying dividends.

In a second set of tests, we explore the unique data available for income trusts.

Income trusts disclose the tax treatment of their distributions to investors. Distributions are

generally either taxable distributions (arising from the trusts taxable income) or return of

capital (distributions made in excess of taxable income). By adding the interest expense to

the taxable distribution, a tax version of EBIT is produced. We use this second version of

EBIT, TDIT (taxable distributions before interest), in our empirical tests.

When we estimate equation (7) using TDIT, we also include the return of capital

distributions. The theoretical coefficient on a return of capital distribution is 1 because it has

no tax implications for the corporation or the investor and it has should have a pricing

multiple of 1. However, the cross-sectional magnitude of the return of capital distribution

may have signaling value. One argument is that distributing capital is seen as a positive move

because it increases the cash return from the investment in the income trust, a positive

element from the investor’s perspective. However, it is also indicative of a lower taxable

income, so management is returning capital to maintain a pre-set level of distributions (that is,

they return capital rather than lower the distribution rate). Investors may view negatively

taxable income that is lower than expected. Finally, there may be cross-sectional differences

in the type of cash flows generated by the sample of income trusts such that very stable

income trusts have high tax depreciation, but do not require the level of re-investment implied

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by this high depreciation. If these types of income trusts are valued more highly, then the

coefficient on the return of capital variable may capture this positive difference. Thus, while

the coefficient on this variable should be informative, we are unable to predict its direction or

magnitude.

To estimate equation (8), we collect data on income trusts in Canada. From the

population of 175 income trusts as of December 31, 2004, we eliminated REITs due to their

unique asset mix and operating characteristics. Since the number of income trusts is growing,

there are 56 observations for 2002, 79 for 2003 and 109 for 2004. The total sample is 244.

To create a control sample, we matched these 244 with the same number of publicly

traded corporations. Matching was done based on industry, total sales and sales growth. The

only measure of size that is not dependent on the organizational structure is sales and so we

use this as our size measure. Sales growth was also included to try to match sample firms on

other aspects that affect pricing. There is a trade-off by using lagged values since requiring

more years of data decreases the number of observations; therefore, we use only a one-year

growth measure rather than a multi-year growth value. These three factors were combined

using a propensity scoring technique and then matches were identified by selecting companies

that had propensity scores closest to each income trust.

Summary statistics for the 244 income trusts and 244 matched companies is provided

in Table 2. In spite of including size in our matching procedure, the mean value of sales for

the corporations is larger than for the income trusts. In particular, while the distribution is

similar to the 75th percentile, the last quartile is noticeably larger for the companies than the

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trusts.4 The difference between EBIT and net income is much smaller for income trusts than

for corporations which would be expected since income trusts generally have little if any tax

expense. Income trusts are also more profitable, as measured by EBIT/sales, with mean and

median values of 15% and 12% for income trusts versus 10% and 7% for corporations,

respectively. On a per-share basis, EBIT across income trusts has a much tighter distribution

than is evident for the corporations. The median EBIT per share is higher for income trusts.

The distribution of taxable EBIT per share generally exceeds the financial statement value of

EBIT per share. Mean value of taxable EBIT is $0.98 versus the mean value of financial

statement EBIT of $0.88. The two variables have a correlation of 0.41. Non-taxable returns

of capital have a mean value of $0.25 with a median of only $0.07. Twenty-four percent of

income trusts had no return of capital and a further 6% had a return of capital that was less

than $0.01.5

Results

The results of estimating equation (8) using the data on income trusts and the control

companies are found in Table 3. The coefficient for the main effect of EBIT (that for

corporations) is 1.43. If the theoretical valuation model of equation (5) is representative of

the pricing of these corporations, and the corporate tax rate is approximately 36%, then the

estimated value of φ is 2.23. Since φ is basically the price-(pre-tax) earnings multiple

applicable to an unlevered company and ignoring the price effect of investor taxes. Inverting,

this would suggest a pre-tax required rate of return of approximately 45%.

4 Removing the companies that are larger than the largest trust does not alter conclusion from the reportedresults.5 A small return of capital is sometimes unavoidable because income trusts make monthly distributions and theseare often set in whole cents (no fractional cents per unit).

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Contrary to the theoretical prediction, the coefficient on INT (for corporations) is

negative with an estimated value of –7.0. This is a puzzling result and bears further

investigation. Our current speculation is that the negative coefficient is the result of industry

differences for which we have not explicitly controlled.

The coefficient on dividends is significantly positive, with an estimated value of 13.6.

To be positive, the tax rate on capital gains must exceed that on dividends. Thus, the positive

estimate is consistent with the marginal investor in corporate shares either being a taxable

corporation, or the coefficient is capturing the positive signaling effect of dividends.

Turning to the coefficients for the income trusts. The intercept indicator is positive

and significantly different from zero. This suggests that controlling for the variables captured

in the model, income trusts are more highly valued, on average. The interaction with EBIT is

positive, consistent with the predictions of the theoretical model when the marginal investor

in income trusts faces a zero or low tax rate. The coefficient is 3.88, implying that the

coefficient on EBIT for income trusts is estimated to be 5.30. This estimate is 3.7 times the

size of the coefficient on EBIT for the sample of corporations. If the marginal investor in the

sample of income trusts is tax exempt, the coefficient estimate of 5.30 becomes the estimate

of φ. This estimate produces a reasonable pre-tax, unlevered required rate of return of 19%.

If the marginal investor is taxable, the estimate of φ implied by the regression increases,

causing the implied required rate of return to fall.

The coefficient for the interaction IT*INT is estimated to be positive and of magnitude

approximately equal to that on INT. The coefficient is not significant, suggesting a very large

standard error on the estimate.

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Table 4 provides estimates for the coefficients using the distribution data for the

income trusts only. The coefficients for the income trusts’ taxable distributions before

interest is 9.2. The fact that the coefficient almost doubles relative to the coefficient for

income trusts when EBIT is used, while the mean of this variable is slightly higher, suggests

that income trusts may be valued more closely as a multiple of taxable distributions. The

coefficient on the return of capital is 2.33. While it is twice the theoretical value of 1, it is

only marginally statistically different from zero. The size of the coefficient on the taxable

distributions variable grows over time, while the statistical significance of the return of capital

variable become insignificant in 2003. This suggests that over the three years when income

trusts become more widespread and the market had more experience with them, the

sophistication of the market has improved to the point where valuation is driven strongly by

the taxable distributions.

Conclusions

The paper explores the valuation of a unique hybrid security in Canada, the income

trust. This security allows the operating business to avoid corporate level taxes. In exchange

the business’ income is taxed immediately in the investors hands, and at normal income rates.

Thus, avoiding corporate taxes accelerates the investors’ tax payments and requires a higher

tax rate to be used. Based on this trade-off, we expect that the natural clientele for an income

trust would be a tax-exempt investor or a low tax-rate individual investor.

We apply the valuation model of Dempsey (2001) to this setting to gain insights into

the effect of the two tax structures on the valuation of the business. This model predicts that

the income trust should be valued such that the earnings before income and taxes will be more

valuable to the income trust investors, and the relation should increase as the marginal

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investor’s tax rate falls. Similarly, the coefficients on the interest and dividend variables

imply something about the relevant investors.

Using this model and data form 223 income trusts over the years 2002 – 2004, we

estimate the pricing equation. We find that the coefficient on earnings is higher for income

trusts, suggesting that the marginal investor is a low tax-rate investor or an exempt institution.

The magnitude of the coefficient is somewhat larger than the model would imply which

suggests that there may be additional factors affecting the relative value of the two

organizational forms.

To explore the valuation of income trusts further, we employ data on the tax

characteristics of the distributions made by income trusts. While most distributions are

taxable because the trust distributes taxable income, some of the distributions are non-taxable

returns of capital. Using these values in place of EBIT, we discover that the coefficient on the

taxable distributions is approximately 10, while the coefficient on the non-taxable

distributions is much smaller and only marginally statistically significant. This continues to

be true if the proportion of distributions that are non-taxable is used in place of the value.

Furthermore, we find that the multiple applicable to the taxable distributions is increasing

over the three years studied, while the coefficient on the return of capital declines and then

loses statistical significance over the time period of our data.

This research is a first exploration into the valuation of this unique security. While

research has been conducted on REITs in the U.S., the valuation of other types of businesses

is quite different from these real estate enterprises. Thus, this research contributes to the

understanding of this growing from of business activity but also contributes to our

understanding of the effect of investors’ tax rates and their investment choices. The empirical

– 19 –

results are consistent with the clientele theory for this security because they are priced in a

way that is consistent with the marginal investor in an income trust being a very low tax rate

investor.

References

Collins, J., and D. Kemsley, 2000, “Capital gains and dividend taxes in firm valuation:

evidence of triple taxation,” The Accounting Review, 75: 405-427.

Dhaliwal, D., M. Erickson, M.M. Frank, and M. Banyi, 2003, “Are shareholder dividend

taxes on corporate retained earnings impounded in equity prices? Additional evidence

and analysis,” Journal of Accounting and Economics, 35(2): 179–200.

Feltham, G., and J. Olhson, 1995, “Valuation and clean surplus accounting for operating and

financing activities,” Contemporary Accounting Research. 12: 689-731.

Graham, J., 2003, “Taxes and corporate finance,” Review of Financial Studies 16(4):

1075–129.

Hanlon, M., J.M. Myers and T. Shevlin, 2003, “Dividend taxes and firm valuation: a re-

examination,” Journal of Accounting and Economics, 35(2): 119–154.

Harris, T., G. Hubbard, and D. Kemsley, 2001, “The share price effects of dividend taxes and

tax imputation credits,” Journal of Public Economics, 79: 569-596.

Harris, T., and D. Kemsley, 1999, “Dividend taxation in firm valuation: new evidence.”

Journal of Accounting Research. 37: 275-291.

Shackelford, D., and T. Shevlin, 2001, “Empirical tax research in accounting,” Journal of

Accounting and Economics 31: 321-87.

– 20 –

Figure 1: Basic structure of an income trust

– 21 –

Table 1: After-tax accumulation to shareholder

1 Year 2 Years 5 Years 10 YearsPanel A: All income earned as taxableincomeAfter-tax accumulation at top individual taxrates (46%)

Income trust 1.11 1.23 1.67 2.79Corporation paying all taxable income asdividends each year.

1.09 1.18 1.53 2.33

Corporation paying no dividends 1.10 1.21 1.64 2.80

After-tax accumulation at low individual taxrates (25%)

Income trust 1.15 1.32 2.01 4.05Corporation paying all taxable income asdividends each year.

1.12 1.25 1.75 3.05

Corporation paying no dividends 1.11 1.24 1.72 3.04

After-tax accumulation at zero tax rateIncome trust 1.20 1.44 2.49 6.19Corporation paying all taxable income asdividends each year.

1.13 1.27 1.83 3.34

Corporation paying no dividends 1.13 1.27 1.83 3.34

Panel B: Income partly earned as taxableincome and partly through capital gainsAfter-tax accumulation at top individual taxrates (46%)

Income trust 1.14 1.31 2.01 4.30Corporation paying all taxable income asdividends each year.

1.14 1.30 1.97 4.11

Corporation paying no dividends 1.14 1.31 2.01 4.33

After-tax accumulation at zero tax rateIncome trust 1.20 1.44 2.49 6.19Corporation paying all taxable income asdividends each year.

1.18 1.40 2.31 5.32

Corporation paying no dividends 1.18 1.40 2.31 5.32

Assumptions: After-tax income that is distributed is re-invested in the same security; pre-tax businessreturn is 20%; retained earnings in the corporate form increases the value of the investment by thesame amount and the investment is sold at the end of the time period; the corporation pays dividendsas indicated. In Panel A, all income is assumed to be earned as taxable income, so no capital gainsaccrue to the income trust units; in Panel B, the taxable income is assumed to be 5% of the investmentwith the remaining 15% being earned through capital appreciation, leading to a capital gain for allinvestments.

– 22 –

Table 2: Summary statistics

Std. PercentileVariable Mean Dev. 5 25 50 75 95

Panel A: Income trusts

Sales 221.75 258.04 4.10 46.15 138.28 295.99 753.67Net income 30.14 58.71 2.04 5.52 13.08 34.47 115.88EBIT 32.59 62.43 -2.26 5.86 16.29 37.46 122.41Interest 5.91 10.58 -29.90 -2.01 0.00 1.01 8.73Dividends 0.00 0.00 0.00 0.00 0.00 0.00 0.00EBIT/Sales 0.15 0.24 -0.55 0.13 0.12 0.13 0.16Price 14.38 9.88 3.94 9.80 12.00 16.14 28.95EBIT per share 0.88 1.09 -0.08 0.42 0.77 1.23 2.47Interest per share 0.16 0.22 0.00 0.05 0.10 0.17 0.56Dividends per share n/aTaxable

Distributions0.98 0.64 0.14 0.58 0.97 1.19 2.09

Return of capital 0.25 0.40 0.00 0.00 0.07 0.30 1.02

Panel B: Matched corporations

Sales 326.82 829.84 0.23 20.21 57.97 280.14 1530.23Net income 16.73 98.51 -37.65 -1.01 2.06 11.85 99.03EBIT 32.65 153.56 -27.49 -0.86 4.04 21.53 137.83Interest 7.39 18.89 0 0.08 0.98 3.49 47.78Dividends 4.46 18.63 0 0 0 9.41 20.64EBIT/Sales 0.10 0.19 -119.52 -0.04 0.07 0.08 0.09Price 9.48 14.57 0.1 0.935 3.67 11.33 39.45EBIT per share 2.04 15.3 -0.87 -0.04 0.15 0.97 5.98Interest per share 0.35 2.97 0 0 0.04 0.16 0.8Dividends per share 0.13 0.38 0 0 0 0 0.71Taxable

Distributionsn/a

Return of capital n/a

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Table 3: Regression of price on valuation variables with a control sample

Variable Coefficient t-statisticEBIT 1.427 2.18*INT -7.022 -2.14*DIV 13.620 2.71**IT indicator 2.451 2.05*IT * EBIT 3.877 3.06**IT * INT 7.561 1.46Intercept 7.203 10.21**R2 33%

These regressions are estimated using 488 firm-years using OLS. EBIT is the earnings before interestand taxes using values from the financial statements. INT is interest expense. DIV is dividends paid inthe year. IT indicator takes on a value of 1 if the observation is an income trust, zero otherwise.* denotes statistical significance at a 5% level; ** denoted statistical significance at a 1% level.Coefficients on EBIT, INT and IT*EBIT are tested using a one-sided test consistent with the relatedhypotheses.

Table 4: Regression of price on valuation variables

All years 2002 2003 2004Variable Coefficient (t-statistic)TDIT 9.189 6.476 8.014 9.736

(4.58)** (5.59)** (7.73)** (2.96)**INT 4.837 1.110 11.750 5.244

(1.04) (0.17) (1.37) (0.73)RC 2.330 3.029 2.668 4.288

(1.68) (2.22)* (1.69) (1.76)Intercept 4.028 4.943 3.489 4.245

(2.49)** (3.98)** (2.16)** (1.42)R2 41% 43% 49% 38%N 244 56 79 109

These regressions are estimated using 244 firm-years using OLS. TDIT is the taxable distributionsbefore interest and taxes. INT is interest expense. RC it the return of capital distributed to income trustunitholders during the year. * denotes statistical significance at a 5% level; ** denoted statisticalsignificance at a 1% level. Coefficients on TDIT, INT, and RC are tested using a one-sided testconsistent with the related hypotheses.