The most remarkable trend to emerge during the most recent quarterly reporting period for Canadian income trusts was the preponderance of “swings to losses” or precipitous declines in net income.

Why did trusts book present liabilities based on a tax that won’t effect until 2011?

The simple answer is that that’s what generally accepted accounting principles (GAAP) tell them to do.  

The enabling legislation for the 2007 Canadian federal budget, Bill C-52, passed third reading in Canada’s House of Commons on June 12, 2007, and received royal assent on June 22, 2007. The new tax requires no further action to come into force. As such, it is “substantively enacted” for purposes of Canadian GAAP and “enacted” for purposes of US GAAP.

The Tax Fairness Plan is considered enacted in the second quarter of 2007. This triggers a requirement under GAAP for trusts to determine their temporary differences, the periods over which those temporary differences are expected to reverse and apply the current substantively enacted tax rates that will apply in those periods according to standards established by the Canadian Institute of Chartered Accountants.

The legislation gave rise to changes in estimated future income tax liability during the reporting period, so the recognition of the additional liability is accounted for prospectively in the period.

Because financial statements rely on GAAP while tax returns are based on tax law, certain events may affect financial accounting income in one period and affect taxable income in another period. Recording deferred tax assets or liabilities on the financial statements for the period that an event occurs closes this gap. Deferred taxes represent the future tax effects of existing differences between books and tax.

Differences normally arise between pretax financial income and taxable income because GAAP are used to measure pretax financial income while the Canadian federal and provincial tax laws are used to determine taxable income for purposes of paying income taxes.

The differences in income stem from the differences between the objectives of generally accepted accounting principles and those of tax laws. The goal of GAAP is to provide information useful for making investment, credit or other, similar decisions. The goals of the Canada Revenue Agency (the north-of-the-border equivalent of the Internal Revenue Service) and provincial tax authorities are to raise revenue to operate the government and to meet social or economic objectives.

The Tax Fairness Plan first introduced October 31, 2006, included a provision to eliminate the deduction of distributions from taxable income for publicly traded trusts and partnerships that meet the definition of a specified investment flow-through entity (SIFT). As of January 1, 2011, amounts distributed to unitholders will be taxed at the SIFT rate rather than the rate applicable to income not so distributed.

Beginning in 2011, distributions will be subject to a 31.5 percent tax at the trust level, and then investors will be subject to tax on the distribution as if it were a taxable dividend paid by a taxable Canadian corporation.

The status quo is that distributions paid to unitholders, other than returns of capital, are claimed as a deduction in arriving at taxable income; tax is eliminated at the trust level and is paid by unitholders.

Prior to June 2007, trusts estimated the future income tax on certain temporary differences between amounts recorded on its balance sheet for book and tax purposes at a nil effective tax rate. Under the legislation, the estimated effective tax rate on post-2010 reversal of temporary differences is 31.5 percent. Temporary differences at the trust level reversing before 2011 will still give rise to nil future income taxes.

Taxable temporary differences for energy trusts, for example, relate principally to the excess of net book value of oil and gas properties over the remaining tax pools attributable thereto.

For SIFTs that commenced trading prior to November 2006, a tax rate of nil applies to those existing differences that will reverse prior to January 1, 2011. For differences that will reverse subsequent to January 1, 2011, the SIFT applies the appropriate rate.

A temporary difference is a difference between the tax basis of an asset or liability for income tax purposes and the reported amount of the asset or liability in its financial statements. A taxable temporary difference is one that will result in an increase in taxable income in future years as compared to the financial statements.

A deferred tax liability represents the increase in taxes payable in future years as a result of taxable temporary differences.

Another way to look at it: Temporary differences are the differences in an entity’s pretax financial income and taxable income resulting from reporting revenues and expenses in one period for income tax purposes and in another for financial reporting reasons. The temporary differences normally originate in one or more years and reverse in later years.

Temporary differences in the year of origination may result in either future pretax financial income exceeding future taxable income or future taxable income exceeding future pretax financial income in the year of reversal

Serious judgments are required in establishing deferred tax allowances and liabilities. The estimated effective tax rate on temporary difference reversals after 2011 may change in future periods. And because the legislation is new, future technical interpretations of the legislation could occur and materially affect estimates of the future income tax liability.

Trusts have estimated future income taxes based on estimates of results of operations, tax deductions and distributions in the future. Future income taxes will be recorded each quarter in the future based on the changes to temporary timing differences and related assumptions. Estimates of future income tax liability will vary, as do assumptions pertaining to the factors described above, and such variations may be material.

The preceding two paragraphs are highly legalistic ways of saying tax lawyers for income trusts will be busy. But the bottom line is the “temporary differences giving rise to future tax liabilities” don’t impact trusts’ ability to pay distributions–there’s no drag on cash flow. 

Penn West Energy Trust’s  first quarterly loss in 15 years is based more on dry technicalities than dry holes. The trust’s second quarter cash flow was up to CD326 million from CD265 million a year ago. Production was up 36 percent on the Petrofund merger. Penn West’s operations are still sound. RioCan REIT is still the top real investment trust in Canada; its occupancy rate for the second quarter increased to 97.7 percent, rental revenue rose by 12 percent and funds from operations were up 17 percent.