The Trust Tax: That’s Debatable

Diane Francis sends word that Brent Fullard of the Canadian Association of Income Trust Investors has formalized the anonymous-tough-guy-Tory talk quoted in Ottawa’s political daily The Hill Times in April: Fullard has challenged Finance Minister Jim Flaherty to a debate, offering him 90 minutes to defend the Tax Fairness Plan. Fullard will rebut; he’s also pledged to underwrite a CAD50,000 minimum donation to charity to provide a little motivation for Flaherty.

An anonymous Conservative corner man said back in the spring, “I don’t think Jim’s losing any sleep over it. As a matter of fact, I’m sure of it. I’m sure he’d love to go a couple of rounds with these guys in a debate situation.”

“It” refers generally to the tax leakage caused by the fact that many entities that purchased weakened income trusts following the Halloween 2006 nightmare either aren’t taxable (pensions) or will lever up debt and write off cash flow as well as the damage investors suffered when the trust market sold off.

This particular debate may or may not happen, but it looks more and more as though Prime Minister Stephen Harper wants an election, soon, and that Fullard’s going to make enough noise about the trust tax issue to attract the ear of at least one ambitious opposition party.

We’re still in the middle of what will be a long play-out phase of Flaherty’s Oct. 31, 2006 bombshell announcement that, contrary to Conservative campaign promises and post-election public statements, the minority government would propose legislation imposing corporate-style taxes on trusts. The nauseating selloff in the immediate aftermath became a sustained rally; unit prices for the strongest businesses rebounded and investors have enjoyed significant distribution increases.

Trusts have been taken private, some have merged or been acquired, some have converted to corporations. And some have said they’ll maintain their current status. We’ve seen several announcements in recent weeks detailing the many ways trusts will, or won’t, adjust to the minority Conservative government’s trust tax.  

Birch Hill Equity Partners Management and Westerkirk Capital are taking Sleep Country Canada (TSX: Z.UN, OTC: SLPCF) private for CAD299.2 million (CAD22 per unit). Sleep Country, which operates more than 200 stores in Canada and the US, reported net income of CAD9.8 million on CAD173 million in sales in the first six months of 2008.

Bonterra Energy Trust (TSX: BNE.UN, OTC: BNEUF) announced Aug. 15 it would convert via a plan of arrangement that includes the acquisition of an insolvent shell company, SRX Post Holdings. SRX is an inactive public company and has been operating under the protection of the Companies’ Creditors Arrangement Act since Nov. 19, 2007.  

Bonterra will invest CAD11.25 million in SRX, outstanding shares will be redeemed for nominal consideration, and the company name will become Bonterra Energy Ltd. The plan of arrangement is designed to avoid the risk of being taxed on capital gains arising from a conversion; Bonterra had largely completed the details of the transaction before Flaherty proposed draft rules designed to allow trusts to convert back to a corporate structure without taking a tax hit and chose to honor verbal commitments.

Here’s where it gets interesting for us: Bonterra CEO George Fink said “We’re going to try to distribute exactly the same” and pointed to the company’s existing tax pools that should make that possible post-2011.  

BFI Canada Income Fund (TSX: BFC.UN, OTC: BFICF) announced its own conversion plan Aug. 18. It includes a 73 percent reduction in cash distributions, and that explains why the unit price dropped 17 percent Aug. 19. BFI was widely expected to make the corporate move, but the market was surprised by the depth of the payout cut. 

BFI management is repositioning for a growth story and wants to maximize flexibility to make acquisitions. But it may have trouble attracting attention as a low-dividend-paying growth corporation. There are a lot of investors who value current income over growth potential. The distribution cut could lead to increased costs of capital that actually make it more difficult to make acquisitions.

Recent converts have cut distributions; Trinidad Drilling (TSX: TDG, NYSE: TDGCF) went from CAD1.38 per unit annually to CAD0.60 per share, TransForce (TSX: TFI, OTC: TFIFF) went from CAD1.59 a unit to CAD0.40 per share, and Aeroplan Group (TSX: AER, OTC: GAPFF) went from CAD0.84 a unit to CAD0.50 a share. None has been as steep as BFI, either its cut or its unit-price action.

One energy trust recently made clear its intention to steer clear of a fate similar to BFI’s. Pengrowth Energy Trust (TSX: PGF.UN, NYSE: PGH) CEO Jim Kinnear said Pengrowth would be able to employ CAD3 billion worth of tax pools to shelter distributable income to unitholders for at least the next four years.

“We believe there will remain strong demand for yield-based investments,” Kinnear said on Pengrowth’s second quarter earnings conference call. “These pools can be used either to shelter income from the tax and can also be used to mitigate impacts to our unitholders beyond 2011.”

Stephen Harper is arranging the pieces for a(nother) fall campaign.

Fall is the perfect time to enjoy Washington, DC’s outdoor treasures and catch a glimpse of nature’s splendor. And this year you can enjoy the immediate aftermath of the Presidential election in the seat if the federal government.

Join me and my colleagues Neil George and Elliott Gue for the DC Money Show, Nov. 6-8, 2008, at The Wardman Park Marriott.

Go to www.moneyshow.com or call 800-970-4355 and refer to priority code 011362 to register as our guest.

We also have a special invitation for our readers. KCI Communications, Inc., is organizing an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal. Participants will have the opportunity to meet and chat with my colleagues Gregg Early, Neil George and Elliott Gue.

This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.

It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.

For more information, please click here or call 877-238-1270.

Harvest Energy Trust (TSX: HTE.UN, NYSE: HTE) is looking for a partner to share the costs of expanding its Come-By-Chance refinery in Newfoundland; the project is estimated to cost CAD2 billion and would boost output from the facility by 65 percent. The work would involve installing a delayed coking unit, retooling existing gear and adding new equipment to allow the plant to process heavier and more sour grades of crude. A final decision on whether to move forward is still a year away and will be informed by further engineering studies, financing options and potential partners. Harvest Energy Trust is a buy up to USD20.

Pengrowth Energy Trust’s (TSX: PGF.UN, NYSE: PGH) administrator, Pengrowth Corp, announced the closing of a private placement consisting of USD265 million of 6.98 percent notes and CAD15 million of 6.61 percent notes due in 2018. The notes are unsecured and rank equally with Pengrowth’s bank facilities and existing term notes. Pengrowth will use the proceeds to reduce bank debt. Pengrowth Energy Trust is a hold.

Natural Resources Trusts

Chemtrade Logistics Income Fund (TSX: CHE.UN, OTC: CGIFF) reported an explosion early in the morning Aug. 21 at its Beaumont plant in Texas. Two employees were injured. Chemtrade said there were no releases into the environment as a result of the blast, which occurred in a furnace as the plant was being restarted after being shut down for maintenance.

The company is currently investigating the cause of the explosion; the plant is likely to be shut down for at least a month. Chemtrade carries property and business interruption insurance, but the amounts of any claims can’t be determined until the investigation is complete and repairs are made so the plant can be safely restarted. Chemtrade Logistics Income Fund is a buy up to USD15.

Precision Drilling (TSX: PD.UN, NYSE: PDS) finally sealed the deal with Grey Wolf (AMEX: GW), inking an agreement to buy the land drilling services firm for USD2 million. Grey Wolf shareholders will get USD5 and 0.1883 trust unit per share. That amounts to a 4.8 percent premium to Aug. 22 closing prices but is lower than a previously rejected bid. Precision has made three runs at Grey Wolf and had to sweat out a competing deal until Grey Wolf shareholders voted down management’s attempt to acquire Basic Energy Services (NYSE: BAS).

Precision’s unit price has fallen 12 percent since Grey Wolf’s Basic option was cut off, sliding alongside natural gas prices. Grey Wolf has dropped 11 percent from a high of USD9.50 a share on June 23. Precision will issue about 42 million new units to Grey Wolf shareholders; Grey Wolf shareholders will own 25 percent of the combined company and three of its directors will join the Precision board at closing. Grey Wolf shareholders will vote on the deal before the end of 2008. Buy Precision Drilling up to USD30.

AltaGas Income Trust (TSX: ALA.UN, OTC: ATGFF) has acquired the interest in GreenWing Energy Development LP it didn’t already own for CAD12.3 million in cash. AltaGas now owns interests in wind energy development projects with a combined generating capacity of over 1,400 megawatts. AltaGas Income Trust is a buy up to USD28.

Pembina Pipeline Income Fund (TSX: PIF.UN, OTC: PMBIF) subsidiary Pembina Pipeline Corp is building two pipeline systems for a combined CAD400 million. Pembina has 10-year initial agreements with Canadian Natural Resources and EnCana Corp on the systems. The Nipisi Pipeline will move 100,000 barrels per day (bpd) of blended heavy oil from Utikuma, Alberta, to Edmonton, Alberta.

The Mitsue Pipeline will deliver 22,000 bpd of condensate from Whitecourt, Alberta, to Utikuma for use as a diluent for heavy oil. The receipt point of the Mitsue Pipeline is connected to Pembina’s existing Peace pipeline system at Whitecourt. The pipelines and supporting facilities should be in service in mid-2011. Based on Pembina’s internal projections, the two pipelines are estimated to contribute approximately CAD45 million in initial net operating income (NOI) per year. Buy Pembina Pipeline Income Fund up to USD18.

Extendicare REIT (TSX: EXE.UN, OTC: EXMUF) is a target of a class action lawsuit filed Aug. 21, 2008, against Extendicare Homes and Fir Lane Terrace Convalescent Center, two wholly owned US-based subsidiaries, in Washington state court in Seattle. The suit alleges that 15 of Extendicare REIT’s Washington facilities violated the Washington Consumer Protection Act by fraudulently advertising their services when the corporation knew that the Washington facilities had deficiencies in its surveys. The class action alleges that private pay residents of these facilities were influenced in their choice by the fraudulent advertising practices during a four-year period of time. Sell Extendicare REIT.