Beyond the 2011 Tax
Since the initial shock, however, the looming tax change has had surprisingly little impact on investor returns. Trusts have faced challenges, ranging from weak natural gas prices and a soaring Canadian dollar to severe restrictions on raising capital. But Canadian Edge Portfolio recommendations scored an average return in 2007 of 11.4 percent.
Meanwhile, some four-dozen individual trusts have raised distributions at least once since Halloween 2006. That’s a sure sign they intend to be big dividend-payers for a long time to come, no matter how they’re taxed. It’s also positive proof that their businesses are strong enough to weather very difficult conditions.
Here in early 2008, the key to successful trust investing remains the same as it ever was: buying trusts backed by healthy and growing businesses. Do that, and you’ll score fat returns well past 2011, no matter how the trust tax situation shakes out.
But dealing with prospective 2011 taxation will have an impact on trusts’ business success. This is still very much a work in progress. A handful of trusts have announced their intentions for the post-2011 environment. Most are still weighing their options, taking full advantage of their tax-advantaged status in the meantime.
This isn’t a one-size-fits-all situation. Like corporations, every trust has its own opportunities and limitations when it comes to controlling its taxes. Most will probably elect to convert to corporations just before 2011. But some may find it more advantageous to remain trusts for several years after, and some may switch well before 2011.
The upshot is we’re only going to discover exact future tax liability—and the impact on distributions—one trust at a time. And that’s going to happen slowly.
Fortunately, just as the stress tests of the past year have separated the best trust businesses from the rest, enough has happened on the tax front to give our holdings a once over. Here’s how they rate.
Pricing in the Worst
For investors, the most important fact about 2011 taxation is that it’s been priced in since mid-November 2006. Markets always look ahead, never behind. And immediately following the Flaherty announcement, Canadian income trusts sold off to reflect the absolute worst case for distributions: a roughly one-third, across-the-board reduction.
Check out the graph “The Aftermath.” The broad-based S&P Toronto Stock Exchange Trust Composite (SPRTCM)—which includes trusts of all varieties—began sliding along with natural gas prices in mid-2006. The real selling pressure hit in November 2006 in the wake of the post-taxation shock, as SPRTCM fell from roughly 170 to 140.
Trusts surprised many investors by rallying sharply in late June, following the official passage of trust taxation legislation. That was the first proof that 2011 taxation had already been priced in, as investors reacted with relief at the end of uncertainty. And although selling pressure resumed later in the year on concerns about US economic weakness, trusts have rallied recently as they’ve proven the resilience of their businesses in fourth quarter earnings.
Of course, the financial media has continued to focus on 2011 and, more recently, the prospect for trust tax repeal. But prices of trusts themselves have decidedly stopped following those developments and instead are moving in response to business strength and overall market/economic considerations.
Trinidad Energy Services Income Trust’s (TSX: TDG-U, OTC: TDGNF) planned conversion to a corporation is even more compelling proof that the worst case for 2011 taxation is well baked into trusts’ prices. Trinidad’s focus on deep drilling, long-term contracts and US locations had spared it the fate of other Canadian energy services providers, all of which have had to cut distributions at least once over the past 18 months. But as a trust, it was unable to take advantage of rivals’ weakness because of restrictions raising capital and the fact that it was paying out more than 60 percent of its monthly cash flow in dividends.
By converting, Trinidad frees itself of the restrictions placed on new share issuances from trusts. It will also be able to invest more of its operating cash flow toward investments to increase business growth because conversion includes more than halving its monthly distribution and converting it to a quarterly payout.
So how did the market treat Trinidad’s move? The day of the announcement (Jan. 10), shares bled a few percentage points. But since then, they’ve turned markedly higher and are now up 20 percent from preannouncement levels.
Rather than trigger some kind of doomsday for Trinidad as so many feared, the market’s verdict was that the conversion will unlock value. Clearly, preconversion Trinidad was already pricing in the worst effects of prospective 2011 taxation.
Trinidad’s situation is unique from that of other strong trusts in that its capital needs make conversion the most tax-efficient road to growth. Most other strong trusts probably won’t elect to cut dividends that deeply or soon. But the process of conversion will likely play out similarly between now and 2011.
Only time will tell if the market will treat other converting trusts as warmly. Trinidad’s surge this year has been aided by rising natural gas prices, which have revived hope of a turn in the services industry later this year. And with the tax issue out of the way, the share price began to reflect the trust’s considerable business prospects. That’s a good indication there won’t be a day of reckoning for other good trusts either when 2011 rolls around.
Moreover, trusts continue to trade at steep discounts to equivalent corporations. More than half the trusts in the How They Rate Table now sell for less than 1.5 times book value, with nearly a quarter selling for less than book. Even cutting a theoretical one-third off their distribution yields, trusts would still pay several times what equivalent corporations do.
In the widely watched oil and gas producer sector, the typical trust sells for nearly a 10 percent discount to its net asset value (NAV), which is the value of proven reserves at conservative projections for oil and gas. The discount is far greater when throwing in probable reserves (60 percent or better chance of development) or assuming a price closer to the current spot market. And the NAV figure also includes the prospective impact of 2011 taxation, which trusts are already accounting for in their books.
In other words, trusts are being valued at far lower levels than equivalent corporations. Once they convert, those discounts should disappear. Rather than a 2011 doomsday, that would mean a windfall for investors.
The bottom line: There’s no approaching doomsday or additional downside risk on the 2011 trust taxation situation. Further, any evidence that trusts would pay less than full rate—and, therefore, not have to cut dividends by at least a third—is decidedly not priced in. That also means considerable upside.
What’s Not Priced In
To date, just about all discussion of upside on trust taxation in the media—i.e., anything to reduce prospective tax burdens—has focused on Canadian politics. Specifically, that’s the possibility of the ruling Canadian Conservative Party reversing its 2007 trust taxation legislation or for it to be run out of power.
The lead opposition Liberal Party’s continuing proposal is to cut the top rate for trusts post-2011 to 10 percent. Meanwhile, the Bloc Quebecois is still on record supporting postponing full taxation of income trusts to 2017, and even the Green Party is now challenging the policy.
Any of these proposals would shift trusts’ 2011 tax situation radically in investors’ favor. None are expected and definitely aren’t priced in for trusts in any way, shape or form. So the result of such a change would almost certainly be a steep rise in share prices and windfall profits for trust investors.
But a lot has to happen to get us there. As the graph “Canadian Federal Election 2008: An Overview of the Polls” shows, despite a brief surge last year, the Conservative Party has largely failed to win the popular support needed to form a majority government, which under Canadian rules would require support of at least 40 percent of voters. The Liberal Party, however, hasn’t been able to benefit from its failure.
That’s the primary reason neither party has called for a new election. In fact, as we pointed out in the complementary weekly e-zine Maple Leaf Memo in late February, the Liberals turned down an opportunity to call a no-confidence motion on government policy in Afghanistan, which was supported by the Bloc and the fourth major faction in the Canadian parliament, the New Democrats. Rather, they elected to support the Conservatives’ approach with conditions. Liberal leader Dion turned down another opportunity to push an election some months before regarding the budget, after Conservative Prime Minister Stephen Harper practically dared him.
By statute, the parties will have to hold a general election by mid-2009. At that point, proponents of reversing the 2011 trust tax plan will have their best chance to elect a Liberal/Bloc or Liberal/Green alliance. That’s a real possibility; it’s just not one we can count on.
The good news: It’s all blue sky. No one’s counting on it, so there’s no downside if it doesn’t happen.
There are, however, several developments that will reduce trusts’ prospective tax burden, with or without a major change in the law. Item one is the action by the Conservative Party government in December 2007 to cut future corporate and trust tax rates.
As previously reported in Canadian Edge, the government has relaxed the more troublesome restrictions placed on REITs. The result is virtually all of them will remain tax advantaged well after 2011.
To date, the government has made no such concessions for other types of trusts. It has, however, reduced the maximum prospective tax rate for all specialized investment flow-through securities (SIFTS) to 28 percent starting in 2012, from the prior rate of 31.5 percent. That move was accompanied by a cut in the prevailing corporate tax rate from 20.5 percent this year to 15 percent in 2012.
That’s a relatively small downward shift in prospective trust tax rates, compared to the increase from zero that was enshrined in law in June 2007. It does, however, greatly enhance the dividend-paying ability of trusts that do convert. Moreover, it’s a decided move in the right direction for investors that may presage further cuts, such as a deal between the federal and provincial governments to reduce combined tax rates.
Item two is trusts’ ability to reduce tax burdens on their own. As pointed out here previously, Canadian corporations have numerous loopholes available to increase tax efficiency depending on the businesses they’re in, as do their US counterparts. As a result, according to government figures, the average Canadian outfit pays less than 7 percent of its real income in taxes.
Many of those same opportunities to minimize tax burdens will be there for converting trusts. Trinidad management, for example, cited its wealth of “tax pools” and heavy investment in the US as reasons it no longer needed the tax protection of a trust structure.
Tax pools are incentives meant to encourage investment in the energy industry. These have little value for trusts because income is already shielded from taxes. But they’re very important for corporations, and trusts are furiously building them in advance of 2011. These include “Canadian Exploration Expense,” “Canadian Development Expense,” “Canadian Oil and Gas Property Expense,” “Undepreciated Capital Costs,” “Non-Capital Losses” and “Share and Unit Issue Costs.”
All of these reduce taxable income. None of them involve hard cash. As a result, the more tax pools a trust has, the more of its income or cash flow it can shelter as a corporation. And although some tax pools do eventually expire—such as noncapital loss carry forwards—the bulk of them can be continually rolled forward to be used when it’s most advantageous for the trust/corporation.
The magnitude of these is considerable, with ARC Energy Trust (TSX: AET-U, OTC: AETUF) alone reporting CAD1.84 billion. The result: Few oil and gas trusts will pay anything close to full rate on what’s effectively their income, which means they’ll have a lot more to divvy out in distributions than for which their share prices now give them credit.
Other businesses with considerable tax pools include basically anything to do with infrastructure. Pipelines, power plants (particularly carbon-neutral ones), energy storage and processing facilities, communications wires and other backbone assets require huge amounts of capital to build. Once that’s done, however, they require relatively little additional cash to maintain. And they can be written down or depreciated, which also requires no cash but does shelter income from taxes. That’s in addition to whatever government incentives they enjoy for building.
It all adds up to a lot of sheltered cash flow and ability to pay big dividends even if they have to pay corporate income taxes. Rural phone companies in the US, for example, are able to pay huge distributions from the massive cash flow they generate, largely thanks to their ability to shelter income. That’s a good reason to expect Bell Aliant Regional Communications Fund (TSX: BA-U, OTC: BLIAF) will be able keep paying big dividends well beyond 2011 after it converts from trust to corporation.
Assessing 2011
As stated in Peyto Energy Trust’s (TSX: PEY-U, OTC: PEYUF) 2007 reserve report, “Peyto’s primary objective is to grow the resources which generate sustainable distributions for unitholders.” That pretty much sums up the chief goal of every trust inside the CE Portfolio. And it applies to many of those outside as well—at least those that survived the stress tests of the last 18 months or so.
Where there’s a will to pay generous distributions, good trusts will figure out a way. And as far as we investors are concerned, that’s the critical factor. Little by little, however, details are leaking out about the ways available to them, what they’ll actually pay and how that will affect dividends.
Starting with the Conservative Portfolio, all four REITs are assured to retain their favorable tax status in 2011: Artis REIT (TSX: AX-U, OTC: ARESF), Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF), Northern Property REIT (TSX: NPR-U, OTC: NPRUF) and RioCan REIT (TSX: REI-U, OTC: RIOCF). Under the revised rules, that will hold even if these trusts elect to buy property in the US market, as RioCan was once planning to do.
Atlantic Power Income Fund (TSX: ATP-U, OTC: ATPWF) shareholders will also see no impact from the tax. That’s because Atlantic is actually already a taxpaying corporation whose securities trade as “staple shares,” combining debt with equity. In addition, Atlantic’s operations are all in the US, from which income would be exempt from new taxation even if it were a trust.
US operations are also substantial portions of income for Algonquin Power Income Fund (TSX: APF-U, OTC: AGQNF) at 67 percent, Arctic Glacier Income Fund (TSX: AG-U, OTC: AGUNF) at 80 percent and Energy Savings Income Fund (TSX: SIF-U, OTC: ESIUF) at 20 percent. That alone reduces their effective tax rates from the statutory 28 percent to just about 10 for Algonquin, 5 percent for Arctic and 22 percent for Energy Savings. Moreover, all three are set to expand their operations south of the border in coming years, which would take those effective rates down further still.
As an infrastructure company, Algonquin has the additional advantage of huge, noncash expenses such as depreciation, which it can use to shelter cash flow from taxation. So do AltaGas Income Fund (TSX: ALA-U, OTC: ATGFF), Bell Aliant, Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF), Macquarie Power & Infrastructure Income Fund (TSX: MPT-U, OTC: MCQPF) and Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF).
As of yet, we haven’t heard much in the way of post-2011 plans from these infrastructure-based trusts. Most of them seem to have concluded that there’s no real advantage in converting from trusts to corporations until late 2010 at the earliest. Also, all have increased distributions at least once since Halloween 2006, demonstrating they intend to keep paying out at a high level.
Beyond that, the best indication of what may happen comes from another infrastructure trust blessed with large levels of depreciations and modest income from the US: Great Lakes Hydro (TSX: GLH-U, OTC: GLHIF), which is 51 percent owned by conglomerate Brookfield Asset Management. In a statement released soon after the taxation announcement, Great Lakes pronounced its cash flow would be reduced by 14.4 percent as a result of the tax.
Because the hydro plant operator has consistently maintained a low payout ratio—despite water conditions—that doesn’t necessarily translate into a 14.4 percent dividend cut. But it does provide a rough gauge of the worst case, as well as what we might expect with infrastructure trusts in general.
The two Conservative Portfolio trusts that appear to be most exposed to 2011 taxation are GMP Capital Trust (TSX: GMP-U, OTC: GMCPF) and Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF). Yellow does have a substantial amount of annual depreciation and amortization. But the primary strategy for both trusts as far as distributions go seems to be to outgrow their liability.
In its fourth quarter 2007 earnings release, Yellow’s management affirmed “its intention to convert to a traditional corporate structure in late 2010.” It also reiterated its previous contention that its “strong growth trajectory” makes it “able to generate increasing levels of free cash flow to fund expected future cash income taxes.” The only impact, therefore, is “the company has adopted a more prudent approach to cash distributions,” meaning lower increases than would otherwise have been the case.
As for GMP, converting to a corporation seems to be its course as well. But with a fast-growing business backed by conservative payout and debt policies, it also looks perfectly capable of paying out at its current rate after converting to a corporation and offering up a few distribution increases along the way.
Turning to the Aggressive Portfolio, Trinidad will soon officially convert to a high dividend-paying corporation, pending almost certain approval of unitholders. Future dividend action will depend on how effective management is in growing its business, but it will be wholly independent of any change in 2011.
AG Growth Fund (TSX: AFN-U, OTC: AGGRF) at 70 percent, Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF) at 20 percent, Provident Energy Trust (NYSE: PVX, TSX: PVE-U) at 25 percent and Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) are the Aggressive Portfolio trusts with the greatest portion of their income coming from outside of Canada. Vermilion has stated it doesn’t expect any impact on its distribution in 2011.
Provident’s recently floated plan to sell substantially all of its US operations could significantly increase its 2011 tax liability by eliminating foreign income. On the plus side, it would probably create a substantial near-term windfall for shareholders, and it would make the trust more digestible in a takeover as well. That’s at least the market’s verdict on the possibility: Provident shares have rallied sharply in the aftermath.
In the final analysis, Provident’s ultimate tax rate will depend mainly on how much it can shelter through the use of tax pools. That’s also true of each of the other energy producer trusts except Vermilion: Advantage Energy Income Fund (NYSE: AAV, TSX: AVN-U), ARC Energy Trust (TSX: AET-U, OTC: AETUF), Enerplus Resources (NYSE: ERF, TSX: ERF-U), Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF), Penn West Energy Trust (NYSE: PWE, TSX: PWT-U) and Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF).
As for the remaining Aggressive Portfolio trusts—Newalta Income Fund (TSX: NAL-U, OTC: NALUF) and TransForce Income Fund (TSX: TIF-U, OTC: TIFUF)—neither has stated its intentions, nor does either have obvious tax advantages as a corporation. TransForce has a hefty, noncash depreciation expense and has recorded only a small charge for future taxation, promising for its future liability. Newalta, meanwhile, also has substantial depreciation amortization, which should convey the same benefits over time.
At any rate, both trusts’ yields are high enough and share prices low enough to discount a substantial dividend haircut. And scorned by recession-fearing investors, they also stand to enjoy substantial upside if they prove their businesses are still strong in future earnings.
Last but not least are the three mutual funds: EnerVest Diversified Income Fund (TSX: EIT-U, OTC: EVDVF), Select 50 S-1 Income Trust (TSX: SON-U, OTC: SFYIF) and Series S-1 Income Fund (TSX: SRC-U, OTC: SRIUF). Their distributions’ exposure to 2011 dividend taxation basically lies in how their holdings are affected. Total returns, however, are likely to be far more affected by their skills at picking the best businesses. Given their strong track records, that’s a good bet for us as well.
The table “Asessing 2011” is far from the last word on CE Portfolio trusts’ future tax exposure. I fully expect to make major changes before 2011, and it has pretty much zero relevance until then because trusts will continue to pay distributions under the old tax-advantaged arrangement. It does, however, summarize what we know now about future tax liability.
As for the rest of the trust universe, the best rule of thumb is that trusts with similar businesses will likely pay similar tax rates. Other REITs, for example, will be exempt from higher levies with very few exceptions. Power and infrastructure trusts will likely find a range somewhere around Great Lakes’ 14.4 percent.
Oil and gas trusts face perhaps the most difficult dilemma about their future structure. Many of the tax advantages available to sector corporations only apply to funds reinvested in production. However, they do have one major advantage when it comes to future distributions: The mature wells they produce from don’t require a great deal of additional investment to keep pumping.
As long as energy prices remain strong, that means a lot of cash inflow and a lot of discretion on the outflow. In any case, energy prices are the key to our future returns. And for the next few years at least, that looks like a pretty good bet.