Maple Leaf Memo
Executives of more than 40 energy trusts, whose combined market value was slashed after Jim Flaherty proposed taxing the investment vehicles, said on Monday they want Ottawa to consult with them before imposing changes they said will send investors fleeing and crush the sector’s competitiveness.
Flaherty said he was willing to listen to the group’s concerns, but said his mind “will not change.”
The federal Finance Minister admits that although he has received an earful of opposition to his decision to tax income trusts, the government will stick to its policy and put the matter to a vote in Parliament this week. The motion before Parliament will allow the government to collect a tax on income trusts formed after October 31 until formal legislation amends Canadian tax laws. The measure enjoys the support of two opposition parties, the Bloc Quebecois and the New Democrats. The plan imposes taxes on income trusts for the first time and effectively raises dividend tax rates for pension funds and foreign investors that own trusts.
Here’s the simplified optimistic story: The rules appear to be changing, but the game is still the same. The best-run trusts remain an attractive asset class. The tax change is already priced in, and you have a four-year tax holiday.
Meanwhile, good trusts will have plenty of time to adapt to the changes, and a fair number appear to be exempt from Flaherty’s moves altogether. Finally, the proposed changes are sparking a takeover wave for Canadian assets, with the likely consequence of sizeable gains for investors.
The S&P/Toronto Stock Exchange (TSX) Composite Index jumped 94.24 points Monday; the TSX’s main index has now recovered all its losses from last week after Ottawa announced that it would start taxing income trusts.
The TSX income trust sector was ahead 2 percent Monday but is still down 11 percent from last Tuesday when Ottawa made the announcement after the market close. The 70 trusts in the S&P/TSX Composite Index lost USD19.4 billion in market capitalization last week in the wake of Ottawa’s decision to start taxing income trusts.
Is the two-day bounce due to the so-called smart money chasing cheap, potential takeover targets? Canadian Oil Sands Trust advanced amid speculation that the government’s plan to tax the entities will spark takeovers. So did Enerplus Resources and several others in a wide range of sectors.
And Macquarie Infrastructure Partners agreed to buy Halterm Income Fund, the operator of a container terminal on Canada’s east coast, for about CD172.8 million, or CD19 a unit, in cash. That’s about 29 percent more than Halterm’s November 3 closing share price of CD14.70.
Bill Gates’ Cascade Investments LLC and Prince Alwaleed Bin Talal offered USD82 a share in cash to take Four Seasons Hotels, the manager of 74 luxury properties, private. The bid is 28 percent higher than Four Seasons’ November 3 US closing price of USD63.87.
Private capital managers anticipate more takeouts and privatization. If nothing else, the Four Seasons bid is a reminder that there’s still an enormous amount of capital looking for opportunities for privatization. This highlights the most unfair, unintended consequence of Flaherty’s action: It will affect a transfer of the fruits of productive assets from retail investors to financial elites.
Prime Minister Stephen Harper, whose power base is concentrated in the oil-producing West, has often touted Canada as an up-and-coming “energy superpower.” And the Canada story remains about energy, but Ottawa’s tax decision puts that in jeopardy.
Oil and gas trusts are unique to other trusts in many regards with the role in the energy sector. Part of the message the Coalition of Canadian Energy Trusts will try to convey is that it’s doing a lot of important things for the economy. The coalition will argue that the proposed changes have already hurt its ability to buy and drill oil fields that major oil firms have deemed too small. Trusts have had a positive economic impact because of their investments in drilling, construction, and research and development–during the last five years, trusts in the energy sector have invested CD10 billion in oil and gas development.
The coalition has called for the federal government to consider an exemption for oil and gas trusts, for which the current favorable tax status was first created.
The US experience with flow-through entities–which Flaherty was careful to point out in rationalizing his actions–reveals a much more accommodating framework.
In the US, the business trust structure appeared with publicly traded partnerships (PTPs) that were limited liability partnerships (LLPs) with units that trade on public securities exchanges, combining the tax advantages of partnerships with the liquidity of public companies.
In 1987, conversions numbered more than 100, and Congress estimated that the trend was costing Washington USD245 million a year in lost revenue.
The law that began the taxing of PTPs as corporations was enacted in 1987. However, a PTP that had shares traded before Dec. 12, 1987, was exempt from the law under a grandfather exclusion of 10 years’ duration that was set to expire for tax years beginning after Dec. 31, 1997. The Taxpayer Relief Act of 1997 extended the exclusion, allowing “electing 1987 partnerships” to continue partnership status. This exception is only available to partnerships that qualified under the 1987 grandfather exclusion.
To maintain status as an electing 1987 partnership, the partnership must pay an annual tax of 3.5 percent of its gross income from business activities. The 3.5 percent tax applies at the partnership level and is subject to corporate estimated tax rules.
All PTPs except those categorized as “slow-growth investments” (roughly a third of them) were given 10 years before they’d be taxed as corporations. Most of them converted back as unit prices fell, but the decade-long transition meant fewer sharp losses for investors. Others, such as Cedar Fair, received a special corporate tax rate on the condition that they wouldn’t be allowed to diversify outside of their core businesses. Additional rules require any partnership that’s publicly traded to receive 90 percent of its income from specified sources. A PTP not meeting this test would be treated as a corporation for tax purposes.
Qualifying income for PTPs includes interest, dividends, real estate rents, gain from the sale or disposition of real property, income and gain from commodities or commodity futures and income and gain from mineral or natural resources activities. Mineral or natural resources activities include exploration, development, production, mining, refining (including fertilizers), marketing and transportation (including pipelines) of oil and gas, minerals, geothermal energy or timber. This means that most PTPs today are in energy, timber or real estate-related (including mortgage securities) businesses.
The RoundupThe headline news in the sector is obviously the proposed change in the entity-level tax status of income and royalty trusts. But businesses continue to operate, and the third quarter reporting period continues. Ultimately, how they operate will determine what they’re worth as investments, whether they’re affected by the tax changes or not.
Here’s the roundup of news from the CE coverage universe, including comments by specific trusts on the Flaherty announcement.
Oil & Gas
ARC Energy Trust (TSX: AET.UN, OTC: AETUF) reported higher third quarter profits and cut its capital spending budget slightly because of expected price drops in the oil services and equipment industry. ARC reported its profits for the three months ended September 30 rose to CD116.9 million from CD114.6 million last year. The trust’s board has approved a 2007 budget, which includes a CD360 million capital spending program, about CD10 million less than what it will spend this year.
The company said it’s budgeted for a 5 percent decrease in the costs of supplies and services in 2007 on the expectation of lower industry utilization rates for drilling rigs and equipment. ARC will continue to focus on maintaining its production through internally generated development opportunities. ARC currently produces about 63,000 barrels of oil equivalent output per day from five core areas in Alberta, British Columbia and Saskatchewan. Buy ARC up to USD25.
Crescent Point Energy Trust (TSX: CPG.UN, OTC: CPGCF) will proceed with its CD732 million (USD646 million) takeover of Mission Oil & Gas despite Ottawa’s decision to start taxing income trusts, Crescent Point’s chief executive said on Thursday, November 2. Crescent Point units and Mission shares have fallen nearly 25 percent since the tax announcement. Shareholders of both firms are slated to vote on the deal on November 30. Crescent Point is offering 0.695 of one of its units for each Mission share to gain light crude oil output in southeastern Saskatchewan. Crescent Point’s CEO Scott Saxberg said changes in oil prices have a bigger impact on the value of the underlying assets than shifts in the tax regime for trusts. Crescent Point is a hold.
Vermilion Energy Trust (TSX: VET.UN, OTC: VETMF) recorded third quarter 2006 production of 28,411 barrels of oil equivalent per day (boe/d) compared to 25,452 boe/d in the second quarter of 2006. Vermilion completed the acquisition of approximately 3,900 boe/d of production during the second week of July and will benefit from the full impact of the acquisition in the fourth quarter. Production from the Netherlands continued to be affected by seasonal curtailments, which shouldn’t impact fourth quarter production. Vermilion maintained a stable distribution of 17 cents Canadian per month.
Cash distributions represented 35 percent of funds from operations during the quarter and 39 percent on a year-to-date basis. The value of Vermilion units fell 5 percent in the quarter compared to an 11 percent drop in the S&P/TSX Energy Trust Index. Vermilion’s drop was partially offset by a 1.5 percent return from distributions, resulting in a total 3.5 percent loss during the quarter. The year-to-date total return through Sept. 30, 2006, remained positive at 15.6 percent. Vermilion’s net debt increased to CD360 million in the quarter, reflecting an acquisition in France that was funded through existing credit facilities. The debt level at Sept. 30, 2006, represented less than one times annualized third quarter cash flow. Vermilion is a buy up to USD30.
Electric Power
Algonquin Power Income Fund (TSX: APF.UN, OTC: AGQNF) announced that, in light of the recent statements from the federal Minister of Finance respecting the taxation of income trusts and the ensuing impact to the capital markets, it’s at this time reconsidered completing the offerings announced Oct. 12, 2006, for 6.44 million trust units and CD50 million of convertible unsecured debentures and remains in discussions with the underwriters regarding same. The fund’s financing strategy involves periodic access of the capital markets to repay indebtedness incurred in respect of its continuing growth initiatives. The planned use of proceeds from the proposed offerings was to retire a portion of such growth-related indebtedness.
Algonquin believes any impact on its unitholders of the proposed taxation changes will be significantly mitigated due to the large proportion of distributions, which are a return of capital. Comprising more than 50 percent of the fund’s 2005 distributions, such return of capital isn’t subject to taxation under the proposed provisions. In addition, the fund receives a significant proportion of its income from US-based assets, which income may not be subject to the application of the proposed taxation rules. Algonquin is a buy up to USD9.25.
Boralex Power Income Fund (TSX: BPT.UN, OTC: BLXJF) announced that revenue from energy sales rose 14.6 percent to CD23.5 million, compared to CD20.5 million for the same period in 2005. Earnings before interest, taxes, depreciation and amortization (EBITDA) totaled CD13.6 million, compared to CD10.3 million in 2005. The fund generated earnings of CD6.3 million, versus CD3.7 billion before non-controlling interests in 2005, up 71.7 percent. Net earnings per trust unit rose to 11 cents Canadian, compared to 6 cents for the corresponding period in 2005. Boralex generated CD3.1 million more than its cash distributions.
The third quarter results stem largely from the 39 percent increase in power generation in the hydroelectric segment, compared to the same period in 2005. The excellent hydrologic conditions, particularly in the US, resulted in a CD2.9 million or 48 percent increase in EBITDA in the third quarter of 2006. The natural gas cogeneration plant is maintaining a steady level of performance. EBITDA in the third quarter was up CD0.5 million to CD2.5 million due to the positive impact of lower natural gas prices. Power generation by the wood-residue thermal power stations was in line with the fund’s expectations.
EBITDA for the quarter remained stable at CD3.9 million. Boralex’ management is currently analyzing the potential repercussions of the proposal by the Canadian Minister of Finance to impose a new tax on a portion of the fund’s cash distributions, effective Jan. 1, 2011. Because the proposal isn’t yet in effect, the fund is unable to assess its impact on operations. Boralex did say that the amount of the current cash distributions paid by the fund “isn’t likely to be affected by the proposal, at least during the anticipated period of transition, namely, fiscal years 2007 to 2011.” Buy Boralex up to USD9.
Great Lakes Hydro Income Fund (TSX: GLH.UN, OTC: GLHIF) total power generation was significantly higher in both the third quarter and the year to date compared with the same periods in 2005. In the quarter, total power generation increased to 923 gigawatt hours (GWh) from 712 GWh last year, due primarily to heavy rainfalls in Quebec. Revenues increased to CD37.7 million, and income before non-cash items was CD14.1 million. These results include a full quarter’s contribution from the Carmichael Falls facility in Ontario that was acquired in July 2006. For the comparable nine-month periods, total power generation increased to 3,183 GWh, revenue rose to CD135.1 million and income before non-cash items jumped to CD65.3 million, reflecting higher hydrology in all regions. Great Lakes Hydro is a buy up to USD15.
Business Trusts
Bell Aliant (TSX: BA.UN, OTC: BLIAF) announced that changes to the taxation of publicly traded income trusts and market reaction to those changes were prompting it to re-examine a proposal to privatize Bell Nordiq Income Fund (TSX: BNQ.UN, OTC: BNDQF). Bell Aliant already holds a 63.4 percent voting interest in Bell Nordiq. Glen LeBlanc, CFO for Bell Aliant, said none of the reasons for taking Bell Nordiq private have changed, but the decline in the value of both Bell Aliant and Bell Nordiq have changed and, considering that there was also a cash component in the deal, management wanted to look it over before moving ahead.
Back on October 11, Bell Aliant announced that it was offering Bell Nordiq unitholders CD4.75 in cash and 0.4113 of a Bell Aliant unit for each Bell Nordiq unit held. That represented CD19 per Bell Nordiq unit based on the closing price of Bell Aliant units on October 10, which was considered to be an 8 percent premium at that time. It’s expected that Bell Aliant will now change the terms it will offer for Bell Nordiq. The review of the offer should take only a couple weeks to complete, LeBlanc said. Bell Aliant is a buy to USD33; sell Bell Nordiq.
CI Financial Income Fund (TSX: CIX.UN, OTC: CIXUF) will revert to a corporation in four years when the government starts taxing income trusts for the first time, CEO William Holland said. “Today I look at CI as a corporation with a four-year tax holiday,” Holland said. Toronto-based CI, which has CD60.1 billion (USD53 billion) in assets under management, began trading as an income trust on June 30. Hold CI Financial.
Sun Gro Horticulture Income Fund (TSX:GRO.UN, OTC: SGHRF) reported a smaller third quarter profit compared with a year ago, as sales also fell in part due to wet weather during peak harvesting in New Brunswick. The fund said it earned a third quarter profit of CD3.4 million, or 15 cents Canadian per unit, for the three months ended September 30. That compared with a profit of CD5.3 million, or 24 cents Canadian per unit, in the same period last year.
Revenue in the quarter totaled CD41.2 million, down from CD44 million a year ago. The fund said that the wet weather during peat harvesting in New Brunswick reduced the overall yield and limited the volumes of peat moss sold under a significant supply agreement. Sun Gro is producer of sphagnum peat and a distributor of peat moss and peat and bark-based growing media to plant growers and retail customers in the US and Canada. Sun Gro is reserving comment on the tax changes proposed by Flaherty as it assesses the strategic and economic issues. Sell Sun Gro.
Real Estate Trusts
RioCan REIT (TSX: REI.UN, OTC: RIOCF) reported CD41.8 million in net earnings during the third quarter, up 4.2 percent from year-earlier levels. RioCan said its rental revenue for the three months ended September 30 rose to CD145.3 million, up 8.3 percent from CD134.2 million for the comparable period in 2005. Net earnings for the quarter amounted to 21 cents Canadian per unit and compared with CD40.1 million, or 21 cents Canadian per unit, for the third quarter of 2005. Funds from operations was CD72.5 million, or 36 cents Canadian per unit, up from CD69 million, or 36 cents Canadian per unit, a year earlier. RioCan is concerned that foreign content restrictions under the proposed new income trust tax rules will hamper its plans for growth and is asking that the federal government make some changes before they’re written into law. Buy RioCan up to USD23.