Investing Daily

President Obama submitted his proposed budget for fiscal year 2011 to Congress this week. Congress has the power of the purse and therefore the ultimate decision making power on what gets in and what doesn’t. But with Democrats in firm control of both chambers, odds are Mr. Obama will get at least most of what he wants.

The president won’t get everything, though. That didn’t even happen with his first budget, which was sent up for approval in the full flush of the Democrats’ sweep of the 2008 elections. A good example is the fate of the proposal to limit the tax deduction for charitable contributions from Americans making over $250,000 a year, which was shot down largely because of opposition from Democrats who are gearing up to oppose it again this time around.

Overall, however, the majority party is anxious to be seen as doing something to address the nation’s economic ailments, particularly high unemployment, in an election year. This budget is already heavy on carrots and light on sticks. The finished product is likely to lean even further that way. Moreover, all that’s required is a majority in both houses to approve. Republicans can’t filibuster the budget in the US Senate, despite their newfound 41st seat.

The headline number of the Obama budget is $1.3 trillion, the record deficit expected between expenditures and receipts. The biggest factor behind that shortfall is, of course, the accelerating cost of entitlement programs, which, as predicted for decades, are consuming an ever-growing portion of national expenditures. These are not tackled by this budget in any meaningful way.

Another contributor is soaring interest costs from the record amounts of US government debt issued to finance the record deficits of the last decade, when President Bush launched two wars, slashed taxes, passed a prescription drug benefit and also failed to do anything about entitlement programs, despite enjoying huge Republican Congressional majorities.

It’s hard to believe now that President Clinton and the Republican Congress of the 1990s actually succeeded in balancing the budget and cutting into the national debt. And it may get harder still as the country continues to spend unprecedented amounts more than it takes in, becoming ever-more dependent on Asian lenders in particular to keep the lights on.

The other item getting attention is taxes. The Obama administration is loath to consider rolling back the Bush-era tax cuts for the middle class, insisting it can balance the budget on the backs of those making over $250,000 a year. Unfortunately, the middle class cuts account for some $2.4 trillion in lost revenue, versus less than $700 billion for the Bush tax cuts for higher income investors. But in an election year that’s turning increasingly populist--a natural consequence of a weak economy--it’s a lot easier to tax the “wealthy.”

There’s one piece of very good news in the Obama budget. The Bush era investment tax cuts passed in 2003 are set to expire Jan. 1, 2011. At that point, unless extended, the tax rate on dividends and capital gains would go to the individual’s ordinary income rate.

That’s a top rate of 39.5 percent for the highest-income investors. But the higher tax would also take a bite out of many other investors’ returns as well. The result would be an additional tax on investment income, which many people have come to rely on, and which would make income investments in general less attractive, which could depress share values.

The Obama budget would not only extend preferential tax rates for dividends and capital gains. It would basically make them permanent, firmly establishing the principle that savings and investment be rewarded, not just for buying and selling stocks, but for holding on and collection income.

The catch is that the top rate would go from 15 to 20 percent. But that could easily be adjusted by future governments. In the meantime, it could well boost valuations for dividend-paying stocks, as the old 15 percent rate was almost surely never fully priced in by investors because it was passed as a temporary measure.

Because the advantaged rate would be permanent, the Internal Revenue Service (IRS) will be forced to set clear-cut rules for what is a qualified dividend. That will eliminate some of the hassle investors face now with 1099s filed by brokers who slavishly adhere to the outdated and incomplete report issued by accounting firm Ernst & Young years ago.

Coupled with conversions to corporations, that should clear up quite a bit of the confusion that’s surrounded Canadian income trusts every tax time. As Associate Editor David Dittman and I have written at our advisory Canadian Edge, trusts are equities and their distributions should be considered qualified for US tax purposes.

That’s clearly the advice of the trusts’ own counsel, reflected in statements issued by management every year and posted on their websites. And our advice has been to file the dividends as qualified, using the companies’ statements as backup, even if the broker has filed it as “ordinary income.” That’s what the IRS itself has advised; it stated that it’s sanctioned no list of companies paying qualified dividends, including Ernst & Young’s.

The bottom line is Obama’s support for making permanent the preferential tax rates on dividends and capital gains is pro-investor. Boosting the top rate to 20 percent is a political necessity to get it done, but it still leaves high-yielding investments attractive for even the highest earners. And that’s a big plus for income investors, the market, and for inducing companies’ to pay generous dividends as a way to attract capital.

One of the biggest mistakes investors will make this year is over-estimating the impact of the Obama budget on individual industries and companies. There are, however, some definite winners and losers in this budget.

Take contractors who rely on dollars from the US Dept of Defense (DoD). The generals’ decision to end the “don’t ask don’t tell” policy regarding gays and lesbians in the military may be grabbing all the headlines now. But the real shakeup in the DoD is the ongoing refocusing of priorities, which is basically shifting billions of dollars from some systems and technologies to others. My colleague Gregg Early at Portfolio 2020 has written extensively on the winners and losers from the shift.

Energy Shift 

Even more stark is the Obama administration’s dramatic shift in energy policy from the “drill, baby, drill” of the pro-oil Bush years. Obama’s first budget and the related $700 billion-plus of stimulus spending included billions of dollars for everything from promoting smart grid systems and wind and solar development to funds for clean coal technology. This one goes even further in that direction.

Overall, the Dept of Energy will take in nearly 8 percent more funding in its fiscal 2011 over 2010, one of the budget’s larger departmental increases. That’s basically in line with the president’s previous statement as well as the support in Congress, not only for greener energy but for more home-grown sources to reduce still-growing dependence on the Middle East.

The administration has kicked the can down the road somewhat by declaring Yucca Mountain as “not a workable option for a nuclear waste repository.” And details are yet to be fleshed out on the budget’s pledge for the DoE to “carry out its responsibilities under the Nuclear Waste Policy Act within the Office of Nuclear Energy” to “develop a new nuclear waste management strategy.”

On the other hand, the budget allots an additional $36 billion in new loan authority to finance the construction of nuclear power plants in the US. That brings the total to $54.5 billion, an amount that, if fully allocated, would dramatically reduce financing costs for new nukes.

That, of course, wouldn’t solve the problem of ensuring adequate rate relief for costs, particularly in states with a history of retroactive rate making, i.e. routinely disallowing capital expenditures already made by power companies and forcing steep writeoffs and even bankruptcies. This was the legacy of the last building boom for nukes and utility managements--though the personnel have changed--haven’t forgotten.

The loans, however, do reduce the costs and, in states with good regulatory relations, nuke building will be suddenly a great deal more economic. That’s a big plus for the likes of Entergy Corp (NYSE: ETR), SCANA Corp (NYSE: SCG) and Southern Company (NYSE: SO), all of which operate in areas with a history of utility-regulator cooperation.

Even the nuclear waste problem may not be such a challenge. As a nuclear physicist, Energy Secretary Stephen Chu has long been interested in financing research for technologies to process and store waste on site, i.e. at the plants themselves. And that’s also part of this budget.

As expected, the DoE budget also includes increased funding for renewable energy and energy efficiency measures, such as the construction of the smart grid. There’s also support for clean coal research, a topic very near and dear to the heart of US utilities, which still generate roughly half of the country’s electricity from the black mineral.

The raw dollars, however, are dwarfed by the commitment to nuclear energy. Energy efficiency programs, for example, picked up another $500 million in the budget. That, however, took the total up to only $3 billion to $5 billion in loan guarantees, less than a tenth the amount allocated to nuclear energy.

Carbon capture and technologies to capture greenhouse gas emissions, meanwhile, totaled only $545 million. Renewable energy overall got $2.4 billion, an increase of $113 million; $302 million of that was for solar, $320 million for biofuel and biomass research and development, $325 for advanced vehicle technology and $231 for energy efficient building technologies.

Those are all tidy sums and will benefit quite a few companies and their investors. On the other hand, however, even added up together, the total pales in comparison with the DoE’s nuclear commitment. And that’s not including $2.7 billion on various projects to prevent the spread of nuclear weapons.

The predominance of nuclear is in large part inevitable. Even after record spending over the past few years, all renewable energies together still contribute less than 10 percent of overall US power supplies--and that includes hydropower. Even the largest wind farms don’t generate much more than 100 megawatts (MW).

They’re extremely profitable, thanks in large part to the mandates of state governments to build them. But it’s simply impossible to construct enough of the kind of scale projects that are capable of displacing the 1,500 to 2,000 MW-sized coal-fired plants that still dominate US electricity production.

Only nuclear plants have that capability and therefore the ability to truly transition the US into a low carbon economy, the oft stated goal of the Obama administration. That’s a reality Secretary Chu clearly understands. And the fact that his ideas dominate this budget is a very good sign for nuclear energy, which nonetheless remains opposed by many, particularly on the left-hand side of the majority Democrats.

Since I started Utility Forecaster in 1989, I’ve been a consistent skeptic of the idea that there would be any kind of major building boom of nuclear power plants anytime soon. That remains my belief today. For one thing, opposition to greenfield nuclear plants is extremely emotional and fierce.

This means only sites where plants already exist are feasible for consideration of new construction, as the local overwhelming support the idea. And that’s exactly what SCANA and Southern Company are doing as the first companies to put construction plans into action. But Greenfield opposition does limit the number of reactors, at least as long as so many still remember fairly or unfairly the accidents at Chernobyl and Three Mile Island (TMI).

The other reason is simply distrust of regulators. Even the meltdown following the collapse of Enron in 2001 didn’t compare with the absolute disaster in the electric utility industry following the last building cycle for nuclear plants. Utilities in a handful of states such as Wisconsin were able to recover their investment, despite final costs that vastly exceeded estimates due to inflation and increased regulation following TMI in 1978. But in most states--particularly where utilities completed units and asked for rate hikes in the 1980s--regulators deemed billions of dollars of costs unreasonable, even if officials has previously approved them.

Recent action in Florida has, very reasonably, increased that distrust. FPL Group (NYSE: FPL), for example, immediately shelved some $10 billion in planned capital spending in the state, following a near total disallowance of a requested $1.2 billion.

Happily, as I’ve pointed out in UF, utility bashing hasn’t yet spread elsewhere. In fact, even states like Michigan are maintaining cooperative relations with their utilities.

Building a nuclear power plant can take up to a decade between siting and startup. As a result, it requires an extraordinary amount of trust between regulators, utilities, and investors who will provide the needed cash. The upshot is plants are only going to be built in states where utilities and regulators have especially constructive relations.

That means the Southeast and Midwest primarily. But for those companies that do build, nuclear power will be an extraordinary money maker in coming years. And these loans are a great start for the likes of Dominion Resources (NYSE: D), Duke Energy (NYSE: DUK), SCANA and Southern Company to make it happen, to the enrichment of customers and shareholders alike.

Question of the Week 

Last week I spoke at InterShow’s Orlando MoneyShow. Here’s a question I heard a lot from readers. Submit your question to utilityandincome@kci-com.com.

• You’ve written that a change in the US-Canada tax treaty has eliminated the 15 percent withholding of dividends by the Canadian government, for Canadian stocks held in IRAs. How can I stop my broker from withholding?

The Fifth Protocol of the US-Canada tax treaty basically restored an earlier agreement between the two countries to not withhold taxes from each others’ residents, provided those investments were held in tax-deferred retirement accounts. As of 2009, distributions paid by Canadian equities--as well as bonds and fixed income--held in US IRAs are not withheld the previous 15 percent.

Unfortunately, investors face two problems. First, there’s an enormous amount of confusion on this issue, on the part of brokers, transfer agents and the companies themselves. As a result, many investors are still being withheld the 15 percent, with doubtful prospects of clawing any of it back.

Second, there appears to be considerable confusion about whether distributions paid by Canadian income trusts actually qualify as equity dividends, and therefore avoid withholding. The view of several trusts’ managements, for example, is that dividends will not be withheld after they convert to corporations, but will continue to be withheld as long as they remain organized as trusts.

In our opinion, this point of view is inconsistent with the way trusts have declared their distributions as “qualified” for US tax purposes. Statements issues by trusts in past years have routinely stated that their dividends are qualified and are therefore entitled to the preferential tax rate. In fact, many taxpayers have used them as proof that trusts’ dividends should be considered qualified.

Our view, therefore, is IRA investors should NOT be withheld the 15 percent on dividends paid by either Canadian trusts or ordinary corporations. Getting that back or even halting the withholding is likely to be difficult, but it certainly makes sense to try. It was Vanguard’s customers, for example, that lit a fire under management and rolled back the transfer agent’s decision to withhold 25 percent erroneously. Only customer pressure will induce brokers to expend the effort to make this right.

The good news is that there’s an emerging consensus that dividends paid by Canadian corporations held in IRAs are exempt from the 15 percent withholding. That means as these trusts convert to corporations, IRA investors will see an immediate boost in their take-home dividends, as the 15 percent withholding tax goes away.

There have been 28 conversions so far in the universe of trusts that I cover in Canadian Edge. Half of the converters haven’t cut distributions one penny. In fact, trusts with strong underlying businesses are less and less likely to slash their payouts significantly, as they’ve clearly seen how the market has rewarded companies that hold most or all of their dividends.

As a result, US IRA investors in many trusts are going to actually see their take home dividends rise as conversions to corporations are completed. That’s bullish indeed, and a good reason to put some of these into your portfolio.

Race to the Summit

How best to ride this market? Join me and my colleagues GS Early, Elliott Gue, Yiannis Mostrous, and Benjamin Shepherd at the historic Hotel del Coronado for the 2010 Wealth Society Member Summit.

You’ll have the extraordinary opportunity to meet one-on-one with me, Elliott Gue, Yiannis Mostrous, Benjamin Shepherd and GS Early and ask anything you want about how to keep and grow your nest egg.

We’ll give it to you straight: the brightest trends and our best recommendations, and anything else you might want to know about how to profit in 2010 and beyond.

Space and time limit us to 100 participants, so mark the date on your calendar: April 23-24, 2010, in San Diego, where they say it’s 72 and sunny every day of the year. You may find all details at www.InvestingSummit.com. Better yet, call 1-800-832-2330 (between 9:00 a.m. and 5:00 p.m. EST Monday through Friday) or go online now to reserve your seat at the table.