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2006-11-01 :: Energy Trust Changes

Below is an article from Change Wave Investing discussing the surprise move by the Canadian Government to propose changing the income trust rules that many Canadian companies have adopted as their corporate structure.  This has been a great income investment for clients looking for levels of income that they can’t get from bonds.  There has been a lot written about this situation today, since it impacts so many Americans (particularly retired ones living from the income of their investment portfolios), but I thought this analysis was the best.

CANADIAN TRUST UPDATE

Well, it was quite a day for us energy trust holders.

Overnight, the Canadian government panicked over the conversion of “too many” operating businesses into business trusts that distribute the bulk of their income to shareholders. And in their panic they have thrown energy trusts into the same boat as a garbage company or Yellow Pages supplier.

This notion that energy trusts are like operating service businesses is absurd, and ultimately, I think cooler heads will prevail. As I write this, just about every CEO from the major Canadian energy trusts is winging his or her way to Ottawa to start the negotiations.

But this is NOT the law of the land yet — it’s just a first salvo. And even if this proposal stands, we have a four-year phase-in exemption for existing trusts like the ones we recommend.

The best way to view this proposal is as an emergency “time out” for Canadian Bell (BCE) and another $100 billion of business assets that have filed to convert to trust status. Revenue Canada wants to stop what it perceives to be an unintended consequence of their business trust rule change that was made many years back. This is NOT a shot at the energy trusts.

So, take a deep breath — now is not the time to panic. As the market stands now, we have a 10%-15% correction in the trusts, and that is fair if this proposal lives as-is.

Levying the taxable part of an energy trust distribution at 41% (versus the 15% withholding on the taxable portion of dividend) at first blush seems to be a deal killer. Remember the last time a proposal like this was tossed out by the Canadians? It got whacked like an extra on “The Sopranos.”

The energy trust industry can make a solid case to be carved out of the “business trust” group that the government is really going after. All the negative rhetoric on business trusts concerns big corporations that have proposed converting $70 billion -$150 billion (Canadian) into business trusts SOLEY for the better tax treatment.

The big worries up north are that:

* the tax take from corporations will drop below 30% of all taxes paid (i.e., where it is now)
* there will be no money left for R&D in companies that pay out so much of their earnings in dividends

Real estate investment trusts (REITs) maintain a separate status in this proposal — why not energy trusts?

It doesn’t make sense for Canadians to tax corporate dividends of operating, non-energy enterprises differently than trusts, unless the goal is to improve the after-tax income of retired Canadians. And I don’t think that’s the intent.

IS THIS REALLY A GOOD IDEA?

Energy trusts are not in the game of costing Canadians much in the way of taxes, for the most part.

Yes, less corporate taxes are paid if you own long-lived energy assets in a trust rather than in a regular tax-paying corporation, but only slightly when you consider how many additional assets are under management and production by energy trusts.

So, fewer taxes are paid to the extent that a Canadian energy trust is owned by Americans and other foreigners, but this doesn’t happen in a vacuum. What about the higher rates of income tax and income generated by the industry in Canada, and the extra taxes paid by lawyers, accountants, energy services companies, etc. employed by these trusts?

We’re talking literally billions of extra income tax dollars CREATED by the energy trust business. Nowhere does this calculation come forth in the proposed new laws.

And what about the extra $5 BILLION – $8 BILLION in capex invested each year by energy trusts that goes mostly to the Canadian economy? For crying out loud, doesn’t anybody read their 10-Qs?

If these laws go into effect, much of that money used for capex spending goes back to goosing monthly dividends. Don’t these jokers understand the energy trust business model?

Energy trusts are a new business model for the capital-intensive energy business — NOT a corporate tax dodge.

They serve an important role in Canada and North America by creating a capital structure that makes it economical to drill non-exploration production wells in marginal but long-lived energy assets that would not be feasible for E&P companies.

Mixing energy trusts with operating business enterprise trusts does not make sense. Maybe this is the time to change THAT part of the Canadian tax code.

MITIGATING FACTORS — OUR TAX CODE TO THE RESCUE

Let’s take a look at the foreign tax credits.

The change, if approved, would negatively impact dividends to non-residents by 26.5%, according to BMO Capital Markets. But that does not take into account the tax CREDITS that no one is talking about. That’s because most of the people doing the talking are Canadian.

Our foreign dividend tax credit with an 85% exclusion for foreign taxable dividends still makes a big difference in owning energy trusts. A rise in the withholding would OFFSET the tax credit — every dollar withheld would be converted to a tax credit that could be applied against U.S. taxes. So U.S. shareholders would not be taking a 26.5% decrease in after-tax or after-tax-credit distributions.

(Note: The dollar-for-dollar foreign tax credit is awesome, but your foreign tax credit cannot exceed your U.S. tax liability multiplied by a percentage. The percentage is your total foreign-source income divided by your total worldwide income. You must figure the allowable amount by various categories of income. Examples of these income categories include investment income and wages.)

However, when we figure after-tax credit returns, energy trusts are still very attractive versus other income vehicles.

If this proposal becomes law, energy trusts will ramp up their payout percentage of income to partially offset the decline in post-tax cash flow. This will reduce their ability to invest in the conversion of probable reserves to proven, which will start to affect energy trusts AFTER 2011, not before.

When you figure in after-tax credit cash of cash returns, one thing stands out: It will be better to own these trusts as an American than a Canadian. Hmm … was that really their intent?

This quote from BMO analyst Gordon Tait in a MarketWatch report today sums it up nicely: “We would point out to the minister that a potential 10% correction in the capitalization of the trust market equates to an approximate $25 billion destruction of wealth. A $25 billion hammer to fix a $500 million to $800 million problem does not look like a very equitable solution.”

Another key issue is long-lived reserve asset prices.

Until today, energy trusts paid up to $18 a barrel for reserves versus $12 or so for the exploration and production companies. If energy trusts can’t raise more capital, it takes a buyer out of the market and lowers the value of long-lived reserves — just another factor that was overlooked in the initial discussion.

Bottom line: this is just the first volley in a showdown about these trusts in Canada. We’ll hold tight with our Canadian trusts until the picture becomes clearer.