Maple Leaf Memo

Let’s See The Cards

Prime Minister Stephen Harper’s income trust move is starting to look a lot like President Bush’s aborted proposal to overhaul Social Security.

In early 2005, Bush touched the proverbial third rail of American politics. He wanted to save it. The people heard “privatization.” The resulting shock knocked Bush off his stride; a series of events followed, including the strange case of Harriet Myers, and those in and concerning Iraq…well, you know the rest. In a parliamentary system, he’d be long gone. In reality, he sits in the oval office, still commander in chief of the armed forces (but not of the entire civilian population), a lame duck.

Last Halloween, Canadian Finance Minister Jim Flaherty stepped up in the name of simple fairness to propose a tax on the distributions of income trusts. Canadians lost a lot of money and have raised a steadily rising stink. The hit to the bottom line for pensioners, retirees and other investors only made the campaign lie–“We won’t tax income trusts”–more personal.

Now Harper is under pressure over Afghanistan; the provinces are disturbed over revenue sharing, and nobody’s happy about anybody’s environmental policy. There’s a “Donald and Daffy” joke here, but they don’t have political “ducks” in Canada. Unfortunately for Flaherty and Harper, they do govern in a parliamentary system, and they have no confidence votes and new elections.

You might say here that the North American variety of the ideology is engaged in a massive test of the “conservatives say government doesn’t work, get elected and prove it” bumper-sticker broadside. It’s a cheap shot, sure, and let the e-mails fly. But let’s acknowledge this: It’s not too much to ask that democratically elected officials be honest with and respect the sense of the people for whom they work.

Flaherty said he couldn’t let companies continue to dodge corporate income tax by restructuring themselves as trusts. “If corporations don’t pay their fair share of taxes, this tax burden would be shifted onto the shoulders of hard-working individuals and their families,” the finance minister declared in announcing the reversal of a Conservative campaign promise to leave trusts alone.

Flaherty will be the first witness Tuesday. Bureaucrats have so far refused to offer concrete evidence–actual numbers–supporting the tax proposal. Attempts to pry more out of them through Canada’s Access to Information Act have been unsuccessful.

The Canadian Association of Income Trust Investors has raised a number of questions, the answers to which could make Flaherty’s the “Tax Fairness? Plan”:

What are the policy reasons behind this year’s subtle and yet profound change that will permit Canada’s largest pension plans to own the economic equivalent of Income Trusts in their private equity portfolios and not be subject to the same double taxation that would be paid by average Canadians in their individual [Registered Retirement Savings Plan (RRSP), the equivalent of the US IRA] under your tax proposal?

How is something that is being denied the average Canadian saving for retirement, on the basis of its presumed negative effect on Ottawa’s tax base, be allowed to persist for the exclusive benefit of those in the public civil service and others so advantaged?

Do you agree with the 2005 Consultation Paper which revealed that businesses under the corporate model paid, on average, taxes at the rate of 6.3 percent in 2004?

Is it fair to say that if these same earnings were paid out from an income trust to Canadian individual investors, then taxes would be paid to Ottawa at the higher rate of personal taxation, which the study indicates is 38 percent on average?

On this intuitive level, how can income trusts cause tax leakage?

Has the Department of Finance come to a determination yet as to the cause behind the unexplained surge in personal taxes reported on October 27, 2006 (immediately prior to your Halloween announcement) in an article by Steve Chase of the Globe and Mail entitled “Tax cash floods in, leaving experts at a loss.” Which starts by saying: “There’s a mystery bedeviling the Finance Department: Canadians are sending far more personal income taxes to Ottawa than expected–and nobody knows exactly why. Personal income taxes collected–the single biggest source of Ottawa’s revenue–are up nearly 11 per cent in the first five months of this fiscal year compared with last year.”

“The puzzle also appears to play a role in the massive CD6.7 billion budget surplus Ottawa posted for the five months of this fiscal year–CD2 billion ahead of where finances stood at the same time last year.”

Given that the five assertions of the Ways and Means Motion, which is the enabling legislation, are based on readily quantifiable concepts, when do you intend to provide Parliament and in turn Canadians with any of the supporting studies and analyses that provide the justification for these far reaching measures? The methodologies and assumptions behind this body of work are as important, if not more important, than the numbers themselves. To date no such information has been provided.

What is the specific section of the Access to Information Act you are relying upon and the underlying reasons the government is invoking to justify the denial of access to information by Gordon Tait who was seeking full disclosure of your tax leakage analysis, to the extent such studies even exist?

Is the NDP [New Democratic Party], which to date has supported you in this policy to double tax income trusts in RRSPs, been provided with any more information on your assertion of tax leakage than you have made available to the public at large? Have they at any time requested any such additional information?

We understand that NDP MPs have, during the past few days, written to their concerned constituents, in what appears to be form-type correspondence, stating: “I am confident that government estimates of future tax leakage are solid.”

What is the basis for their confidence, since it could only have come from your office? Have other elected representatives either within your own party or from other parties sought or received such publicly undisclosed information?

Do you believe the comments of the Governor of the Bank of Canada on income trusts that were made in October 2006 that were prefaced by the words, “limited evidence suggests” are more or less authoritative than the work of a major accounting firm whose study of December 7, 2006, is based on an exhaustive study of all 250 income trusts and evaluates their contribution to the Canadian economy?

We note that the CEO of Manulife Financial has been called as a witness. Is this witness representing the interests of a multibillion Canadian “corporation” proper or as the marketer of products which it sells as principle and which have to compete directly with Income Trusts for market “shelf space”? Products such as life annuities and the heavily promoted and advertised proprietary product known as “Income Plus,” again sold by Manulife Financial as principle rather than as agent. Income trusts are issued by issuing Canadian businesses to fund their business activities and are purchased by Canadians through agents without promotional advertisement.

These are just some of the unanswered questions that Canadians who are affected by your policy have at this point in time on the “debate” on income trusts. We thank the committee members in advance for asking them on behalf of these negatively affected Canadians.

Canadians generally welcome a tax base that supports a robust social welfare system, including universal healthcare. Seduced by the thought of a majority government and maybe nudged by narrow corporate interests, Harper flip-flopped. The income trust tax proposal superficially reflected the sensibilities of the left-leaning opposition (the Liberals, Bloc Quebecois and NDP). Although it would nauseate low-tax, small-government conservatives, where could they turn?

Low-risk, high-reward: It’s the only description that fits a political bet worth breaking a “Read My Lips”-level promise over. Twenty billion dollars and a squandered chance at a majority later, the Conservatives have a chance to back up the rhetoric they’ve been forced to spout after this particular misread of the electorate.

Harper capitalized on Liberal corruption–first the sponsorship scandal in Quebec, then the Goodale Goof on trusts and the subsequent Royal Canadian Mounted Police investigation–to scratch out his minority government. Breaking a campaign promise isn’t a great way to go from 40 percent to 50 percent plus one, let alone a mandate-quality majority. And it’s a dumb move if you don’t have the cards.

Flaherty claims outrage that trust conversions shift the tax burden to the backs of ordinary Canadian mules. Corporations have to pay their fair share! (I hate exclamation points, but I think it works here to emphasize Flaherty’s shout-it-loud-and-vague public arguments. There are a million old-school references I could invoke, starting with William Faulkner’s sound and fury, of course.) He wants Canadians–the people for whom he works–to think he’s protecting them, their children, their future.

On the other hand, a lot of pensioners, retirees, working people planning for better-than-halfway-decent golden years and many just trying to make a buck from all over the demographic were happy.

The Roundup

The hearings in Ottawa are obviously of great interest, and we may have a clearer view on a post-Harper income trust policy afterward. But as we’ve tried to convey, this is still a long process; developments since Halloween have generally been in our favor, and the hearings are just one more bit of good news. There are many steps left to be taken.

In the meantime, proceed as though there will be no changes to the tax proposal and that taxation of trusts will begin in 2011. The only trusts we want to own now are those that will profit under this worst-case scenario.

The good news is that 2011 trust taxation is more than priced in already. If the proposal to tax Canadian trusts is changed, we can expect a mighty recovery for all trusts, including the weakest. But only the best of the bunch–those we’re focusing on–will provide strong returns if there are no changes. The strong will also hand us the biggest profits if things are changed.

One further caveat: Energy producing trusts and energy service trusts will continue to mirror the ups and downs of energy prices, regardless of what happens in Ottawa. That means we could see more dividend cuts before things turn up, particularly among the weaker trusts. Recovery will happen, but patience and prudent purchases are essential.

Oil & Gas

Advantage Energy Income Fund (AVN.UN, AVNUF) is issuing 7.8 million trust units at CD12.80 each for total gross proceeds of CD99.8 million to be used to reduce debt and fund capital programs. Advantage has also granted the underwriters, led by RBC Capital Markets and BMO Capital Markets, an over-allotment option to purchase up to an additional 1.17 million trust units at the same offering price. If the over-allotment is fully exercised, the total gross proceeds will be about CD114.8 million. The offering is set to close by Feb. 14, 2007. Advantage continues to issue shares at an alarming rate. Sell Advantage.

Canadian Oil Sands Trust’s (COS.UN, COSWF) profits fell to CD128 million in the fourth quarter from CD174 million in the year-earlier period on higher royalties, higher operating expenses and higher foreign exchange losses, while production fell short of expectations because of equipment problems. The trust, the largest partner in the Syncrude oil sands consortium, reported net income of 27 cents Canadian per unit in the fourth quarter of 2006, down from 38 cents Canadian per unit in the fourth quarter of 2005.

Syncrude production during the fourth quarter of 2006 totaled 27.8 million barrels (approximately 302,700 barrels per day) compared to 20.8 million barrels (approximately 226,000 barrels per day) in the fourth quarter of 2005. The net realized selling price fell to CD63.71 per barrel in the fourth quarter, down from CD72.07 in the year-earlier period. The trust‘s operating costs in the fourth quarter of 2006 declined to CD23.60 per barrel from CD25.54 on lower natural gas prices required for oil sands processing. That was offset by an increase in the value of Syncrude‘s employee compensation.

The higher production output was due to the completion of the Stage 3 expansion earlier in the year, offset primarily by an equipment outage in the fourth quarter of 2006. Cash from operating activities during the fourth quarter increased to CD412 million, or 88 cents Canadian per unit, in the fourth quarter of 2006 up from CD281 million or 61 cents Canadian per unit for the fourth quarter of 2005. For the full year ended December 31, the trust‘s net income was CD834 million, or CD1.78 per diluted unit. That compares with 2005 net income of CD831 million, or CD1.80 per unit diluted.

Cash from operating for 2006 was CD1.14 billion, up from CD949 million or CD2.07 per unit. Included in Canadian Oil Sands Trust‘s guidance for 2007 is a Syncrude production estimate in a range of 105 million to 120 million barrels this year, or 39 million to 44 million barrels net to the trust. Operating costs are estimated to be CD25.83 per barrel with purchased energy costs accounting for CD7.08 per barrel of this amount. Buy Canadian Oil Sands Trust up to USD27.

Pengrowth Energy Trust (PGF.UN, NYSE: PGH) is holding its capital development to USD275 million in 2007 as it waits to see the fallout from Ottawa’s decision to tax income trusts. Pengrowth spent USD300 million on capital expenditures in 2006, but commodity prices are expected to be lower in 2007. The strategy isn’t unlike the capital spending programs announced recently by junior exploration companies–many are holding back, waiting to see if natural gas and oil prices rise later in 2007. Pengrowth has maintained its distribution throughout the current energy-patch downturn.

Pengrowth also closed a USD1.04 billion acquisition of four subsidiaries of Burlington Resources Canada, a subsidiary of ConocoPhillips. That deal, announced in late November, was the largest property acquisition by a Canadian royalty trust and the first blockbuster since the Oct. 31, 2006, bombshell. Pengrowth plans to raise USD300 million to USD450 million by disposing of some noncore core assets gained through the acquisition of Espirit Energy Trust and the ConocoPhillips deal. The trust said it anticipates those asset sales will close in the first and second quarter of 2007. Hold Pengrowth Energy Trust.

Electric Power

Calpine Power Income Fund (CF.UN, CLWIF) accepted a sweetened CD802.6 million (USD678.6 million) takeover offer from Harbinger Capital Partners. Calpine accepted the CD13 per unit offer after adviser BMO Capital Markets found it to be “fair, from a financial point of view.” Harbinger’s offer of CD12.25 in December was rejected by the fund as inadequate. The improved bid followed a January 22 court order for the sale at auction of management rights for the fund and stakes in its 300-megawatt power plant in Alberta and a 240-megawatt plant in British Columbia from a unit of Calpine Corp. The agreement is contingent upon either the fund or Harbinger winning management control and the plant stakes in the auction. Calpine Canada Power, a unit of Calpine Corp, holds management rights for the fund and 30 percent stakes in each of the two plants. Relations between the fund and its manager soured a year ago after Calpine Canada Power reneged on an agreement to purchase the output of the Alberta plant. Harbinger has the right to match any better offer made by another bidder; it will get a breakup fee of CD23.3 million should the fund accept another offer. Calpine Power Income Fund is a hold.

Gas/Propane

Energy Savings Income Fund (SIF.UN, ESIUF) plans to convert away from the trust structure within the next two years in response to the federal government’s proposed legislation to tax the cash distributions of income trusts, the company’s executive chairman said yesterday. “We have looked at our options, and this company is looking at converting sooner rather than later,” Rebecca MacDonald said in a panel discussion at the RBC Capital Markets Income Trust Investor Symposium in Toronto. She added that whatever the structure, Energy Savings would remain a high income-yielding investment vehicle, but she declined to elaborate on the options the company is contemplating.

Energy Savings is a retail marketer of natural gas and electricity. Its sales force goes door to door selling fixed-price supply contracts to residential and small to midsized commercial customers. The company’s revenue stream from existing customers is guaranteed under the fixed-price contracts, while the costs for its gas and electricity supplies are also locked in by contracts with producers. Energy Savings reiterated guidance that its distributable cash will increase by 15 to 20 percent in 2007 and by 10 to 15 percent in subsequent years. Buy Energy Savings Income Fund up to USD15.

Business Trusts

Custom Direct Income Fund (CDI.UN, CUDFF) reported that sales and gross profits increased by 0.3 percent and 0.6 percent, respectively, and operating income increased 5.9 percent compared to the fourth quarter of 2005. Sales increased 3.2 percent, and gross profits were up 2.4 percent, while operating income decreased 0.4 percent for the full year ended Dec. 31, 2006, compared to 2005. Custom Direct Income Fund is a sell.

Real Estate Trusts

Cominar REIT (CUF.UN, CMLEF) increased its offer for Alexis Nihon REIT by 8.8 percent to CD18.50 from CD17; the extra CD1.50 in cash is now a three-way battle. Cominar received a unanimous endorsement for its earlier offer from the board of Alexis Nihon in December, but the deal has fallen apart as rivals look at making their own offers. Summit REIT, the third-largest real estate investment trust (REIT) until it was taken private by ING Group last year, announced this month that it had taken a 19.9 percent stake in the company. Two weeks ago, Homburg Invest announced that it had increased its stake to 8.6 percent; last week it announced that it had raised this stake to 19.5 percent with the private purchase of another 2.96 million shares.

The Halifax, Nova Scotia-based Homburg is listed on the Toronto Stock Exchange but has heavy European financial backing. Alexis Nihon chairman Robert Nihon has pledged his 16.3 percent stake to Cominar, but former chief executive officer, Sen. Paul Massicotte, has yet to be heard from. He wasn’t involved with the talks with Cominar, even though he could still hold a 12 percent stake in Alexis Nihon–roughly the same amount of shares Homburg said it acquired from an unknown party. With a vote scheduled for Monday, February 5, on the Cominar bid, Alexis Nihon was forced to extend a vote on the Cominar bid until February 22 when unitholders will get a chance to look at the increased offer. Buy Cominar REIT up to USD20.