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Canadian Income Trusts: 1,457 Days Later

By Roger Conrad and David Dittman on October 27, 2010

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It was evident as early as Jan. 8, 2007, that Canadian income trusts and the high-yield legacy they’ve established won’t be consigned to the ash heap. That day, Colabor Income Fund followed its business sense rather allow its future and that of its investors to be determined by tax policy, completing the acquisitions of Summit Food Service Distributors in a transaction found to violate the “undue growth” principles spelled out in the minority Conservative government’s Oct. 31, 2006, Tax Fairness Plan.

That we still have an impressive set of sound businesses spinning off generous dividends to investors is a victory of fundamental supply and demand. Investors want yield, and public companies have to compete for capital. Distributing a significant slice of cash flow attracts investors, and the practice has the added benefit of instilling discipline on management teams that might otherwise get a little too aggressive when it comes to looking beyond the confines of the business plan.

Canadian income trust Colabor Income Fund converted into Canadian corporation Colabor Group (TSX: GCL, OTC: COLFF) in 2009 without cutting the distribution it had maintained since the summer of 2005, and throughout the period it paid the so-called SIFT tax. During the four years of grace that will soon expire many more Canadian income trusts have executed cut-less conversions and become high-yielding corporations.

Unfortunately, along with the very encouraging course the process of conversion took, there is a persistent bureaucratic gnawing at investors’ portfolios. US investors who hold shares of corporations that converted from income trusts after Oct. 31, 2006 in IRA accounts are still being victimized by American brokerages, clearing houses such as the Depository Trust Corporation and the Canada Revenue Agency that conspire by inaction to allow 15 percent withholding from dividends paid in respect of these shares.

Despite “clarifying” language attached by both countries to an amendment to the US-Canada Income Tax Treaty and a letter interpreting the history of the legal issues from counsel to the Internal Revenue Service US and Canadian institutions continue to denying IRA investors what’s theirs.

But despite the best efforts of bureaucrats, public and private, in Canada and the US, the good news of these last four, long years is that Canadian income trusts will leave in their wake a new class of high-yielding securities.

The immediate purpose of the Tax Fairness Plan, introduced four years ago this Sunday, was to stop conversions of existing Canadian corporations into income trusts. Word on the Street was that a few heavyweights, including EnCana Corp (TSX: ECA, NYSE: ECA) and BCE (TSX: BCE, NYSE: BCE), were on the verge of making the switch, which, according to studies alluded to but never disclosed by the government, would add to the already significant “tax leakage” wrought by the sector. Encana and BCE each eventually underwent significant changes–the former split in two, while the latter became the object of a CAD30 billion going-private transaction that eventually fell apart during the global credit crunch.

The long-term goal of the Plan was to eliminate Canadian income trusts altogether. Minister Flaherty announced a four-year grace period before trusts that refrained from “undue growth” would continue to enjoy their tax-advantaged status. But 2011 was the meant to be the end. Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF) will do its part to prevent that becoming literally true, while countless other companies, led by Colabor Group, which charted the course, will continue to dish out market-beating yields backed by solid underlying operations.

Chemtrade will maintain its present structure because the costs of conversion at this point don’t justify the potential impact on other parts of the business. Chemtrade is relatively small, so the legal fees associated with conversion, even in the streamlined manner fashioned by the federal government, are relatively huge. Nevertheless, Chemtrade has committed to remaining an income trust and maintaining its current payout rate beyond Jan. 1, 2011. The company also derives nearly 80 percent of revenue outside Canada, shielding much of its income from taxation.

Colabor Income Fund was in advance negotiations to buy Summit at the time of the Halloween Massacre. Management had no idea at the time whether consummating the move would make it immediately taxable at the entity level, largely because the government failed to articulate with any sort of precision what constituted “undue growth.” “Notwithstanding this uncertainty,” the company explained

management of Colabor believes the acquisition of Summit constitutes a strategic acquisition for Colabor and is consistent with the Fund’s objectives of generating sustainable, predictable and growing distributable cash. Further, the Summit acquisition positions Colabor to take advantage of opportunities in the sector while strengthening the financial and operational base of Colabor.

Colabor made the deal because it made sense from a long-term business perspective. At the end of 2007 Canada’s Finance Dept ruled the Summit acquisition an “undue expansion.” Colabor Income Fund was therefore subject to SIFT taxation in 2007. The company still has yet to cut its payout; it yields 9.9 percent, though paid on a quarterly rather than a monthly basis.

It’s impossible to say that Colabor set a trend that others followed. As one analyst wrote at the time of the Halloween Massacre, there will eventually be more than 250 different responses to the Tax Fairness Plan, one for each company impacted by it. But the record is full of companies that have converted without cutting or will convert on or about Jan. 1, 2011, without cutting.

The list includes agriculture stalwart Ag Growth International (TSX: AFN, OTC: AGGZF), Atlantic Power Corp (TSX: ATP, OTC: ATLIF) and its ever-growing portfolio of clean-energy projects, Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF) and its CAD1 billion project backlog, Cineplex Galaxy Income Fund (TSX: CGX-U, OTC: CPXGF), the dominant movie theater operator in Canada, and recently converted Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF), which is just about the safest, most predictable way to play the Canadian oil sands.

Canadian income trusts are dead. Long live high-yielding Canadian corporations.

Editor’s Note: For additional information on this topic, check out Roger Conrad’s latest report on Canadian Income Trusts.

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