Valuation of Income Trusts: An Exploration of Clienteles and Implicit Taxes

Abstract

Canadian income trusts are a publicly-traded flow through structure. Their use in Canada has expanded beyond the traditional real estate sector (REITs). We use this alternative business structure to explore the valuation of investor taxes in a broad equity market setting. Adapting a pricing model, we determine that the value of earnings generated by an income trust should be higher than a corporation only if the marginal shareholder has a low tax rate. Empirical evidence shows that the value of earnings is higher for income trusts than for a set of matched businesses operating as corporations, consistent with the marginal investor in income trusts being a low-tax rate individual. A second set of tests explores the implicit taxes borne by common shares. We find that the relation between pre-tax returns and earnings for common stock is significantly lower than for income trusts, consistent with the implications of implicit taxes. This research contributes to our understanding of clienteles and implicit taxes in the common equity market.