Shareholder Taxation and Valuation: The Case of the Canadian REIT Sector

The income trust is a legal entity that stands between equity holders and corporations, and can own up to one hundred percent of the operating entity that holds the income earnings assets. Most of the cash flow generated by the operating entity is distributed to trust unitholders. In Canada, until recently, the income earned was not subject to corporate income taxes, but, rather, flowed through to investors and taxed at the personal level. On November 23, 2005, the Canadian government announced a reduction in the tax on dividends in an effort to neutralize the tax system’s bias in favour of income trusts. Eleven months later, on October 31, 2006, a new government changed direction by eliminating the tax-deductibility of income trust distributions altogether. Exempted from this change in policy was the real estate investment trust (REIT) sector.

            The present study examines the valuation impacts of the government’s announcement on REITS. Specifically, it examines, first, the 2005 reduction in the tax on dividend income and, second, the 2006 exemption of REITs from the decision to eliminate the deduction of distributions from income tax income. The question addressed is whether and, if so, how these events affected REIT growth opportunities and their ability to raise capital and undertake new investments.

            The first step in the analysis is to test the effect of the tax change announcements on REITs. For this purpose an equally weighted portfolio of Canadian REITs as of each announcement date was constructed. Daily trust return data were obtained from the Canadian Financial Markets Research Center. Abnormal returns based on the market model were calculated for the period September 04, 2004 to November 21, 2006. Because the S&P/TSX Composite Index contained a number of REITs during this period, the S&P/TSX 60 was used to control for shifts in the market.

            The second step involves conducting cross-sectional tests in an attempt to identify non-tax factors that might have had an impact on abnormal returns identified around the time of the announcements. Among factors considered are those identified by both market observers and academics as explaining the popularity of REITs: REIT size, distribution yield, effective tax rate paid on undistributed income, and profitability (measured as rate of return on REIT assets).

Beyond the REIT industry, these tax changes provide a laboratory for testing the effects of taxes on asset pricing in general. The effects of tax changes on asset prices is a controversial subject in the finance literature. While taxing payments may be desirable for distributive reasons, it may also impose efficiency costs on the economy, potentially reducing savings and capital stock. On the other hand, in so far as distributions are determined residually after all profitable investments have been undertaken, taxes on distributions may be viewed as a lump-sum tax on shareholders’ equity. According to this line of reasoning, the relevant tax rate for investors is the (lower) capital gains rate, which implies some mitigation of the efficiency costs of the tax. This issue is also examined in the study.