Valuation of Income Trusts: A Test of Clienteles and Implicit Taxes
Kenneth [email protected]
Devan [email protected]
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
– 23 –
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.
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