Initially created for resource-oriented businesses, one of the big ideas was to make it easy for Canadian citizens to benefit from their land’s natural bounty. The first tax ruling enabling the income trust structure was awarded in December 1985 to Enerplus Resources.

Soon businesses outside the resource space interpreted the law as written and found a way to make themselves into double-tax-avoiding dividend payers. The first corporate conversion into a business trust, using the 1985 ruling, was Enermark Income Fund in 1995.

An explosion in trust issues reflected a hunger for yield in the wake of the crash of the dot-com-blown late-1990s stock market bubble. The first high-profile conversion was former Bell Canada Enterprises unit Yellow Pages Group, becoming Yellow Pages Income Fund.

By 2002, trusts accounted for 79 percent of all money raised through initial public offerings in Canada, with only 38 percent in the traditional sectors of petroleum and real estate. By 2005, the income trust sector was worth CD160 billion (USD135 billion).

All that changed Oct. 31, 2006.

Where Will You Be Tomorrow?

The Canadian government as currently constituted won’t change the tax law.

The Coalition of Canadian Energy Trusts (CCET) and the Canadian Association of Income Trust Investors (CAITI) continue to press for change to make the case for the income trust as an asset class.

Bill Andrews, co-chairman of the CCET and CEO of Penn West Energy Trust, told the Toronto Globe and Mail, “We’re trying to impress on the government the impact this decision has had on investors, and will have on Alberta and the national economy. There is a relationship between a healthy trust sector and a healthy energy industry.” The CCET’s new Web site, www.iexpectmore.ca, invites Albertans “to demand honesty and respect from their MPs.”

Marcel Coutu, CEO of Canadian Oil Sands Trust, was asked during the recently concluded Canadian Association of Petroleum Producers annual conference whether he would stop fighting. He replied, “Not as long as I live and breathe. Whether it’s this government, or the next, or the one after that, the decision will be changed and the trust structure will exist.

“Long term, this is a structure that has a profound benefit for Canada and Alberta that will prevail, at least in the energy sector,” Coutu said. “We will continue to fight.”

The Liberal Party of Canada continues to advocate a 10 percent tax on distributions and has promised to make that proposal a prominent part of its platform for the next election, whenever it happens

Liberal Party Finance Critic John McCallum, during a town hall meeting in Orillia, Ontario, denounced the trust tax. McCallum, a former senior vice president and chief economist with Royal Bank of Canada, focused his most recent criticism on the Conservatives’ broken campaign promise, but he and Liberal leader Stephane Dion both support lowering the distribution levy to 10 percent.

The next opportunity to change the government will come, at the latest, in October 2009 (based on a new law that passed Parliament during the last session).

The Questions of the Next Four Years

The one bone Flaherty has thrown is a four-year tax break for trusts in existence on or before Oct. 31, 2006. Not all trusts have the operational strength, organizational skill or intestinal fortitude to wait it out until 2011 or later.

Many, however, work in areas where the supply/demand profile is favorable, have managed to maximize alternatives or understand the market advantage the tax window affords. And a significant group combines all three. That’s where you want to be if your focus is sustainable yield with identifiable growth potential.

To sell or not to sell? That’s really the place to start, for you and the individual trusts.

The trust tax was basically priced into the market by Nov. 14, 2006, when the S&P/Toronto Stock Exchange Income Trust Composite Index established its post-Halloween low. Including dividends, trusts have outdone typical US-based stocks, returning 33.9 percent versus 10.4 percent for the S&P 500.

Private-capital takeovers, management-led buyouts, structural conversions and strategic acquisitions have obviously ramped up since the fall. But for the most, the market is now pricing businesses trading publicly as income trusts based on operational issues, not the looming distribution tax.

The Canadian income trust remains, all things considered, one of the best investment vehicles for yield-seeking investors.

The Roundup

Sell the acquirer, and buy the target: That’s pretty much the market’s reflexive reaction to any takeover announcement.

The only important thing for investors is whether the deal makes sense. If it does, the last thing you want to do is sell a company or trust that has just made a key strategic move, especially if it’s trading more cheaply because of it.

Last month, Conservative Portfolio holding Macquarie Power & Infrastructure Income Fund (MPT.UN, MCQPF) completed its takeover of Clean Power Income Fund, for a combination of cash and shares. The announcement of the deal initially triggered selling in Macquarie as nervous investors worried management might be overpaying.

Not too long after, however, it became crystal clear that Macquarie knew exactly what it was doing. First, Clean came in with its first decent quarterly results in at least a couple years, with first quarter cash flow actually covering the distribution by a comfortable margin. Then, Macquarie announced its buyout terms, essentially forcing Clean’s US investors to take cash proceeds from a sale of their shares in Toronto.

The rebound in the trust’s shares since the deal’s completion in late June is only the most recent sign that this was a good deal for Macquarie Power & Infrastructure and its shareholders. And with the trust still yielding nearly 10 percent, there’s a lot more to come. Macquarie Power & Infrastructure Income Fund is still a buy up to USD12.

This month, Aggressive Portfolio holding Advantage Energy Income Fund (AVN.UN, NYSE: AAV) has made the big move, snapping up troubled Sound Energy Trust (SND.UN, SNDFF).

Predictably, there’s been some selling of Advantage and buying of Sound. And as much as the aforementioned Macquarie deal, this one looks like a huge long-term winner for the buyer.

Sound’s motivation as a seller is obvious. As a small trust with limited access to capital, it was capable of surviving on its own only by restricting capital spending and distributions to cash taken in from operations. There was no hope for growth and precious little even for staying in business beyond the 5.5-year projected life of its proven reserves.

In contrast, this deal offers Sound shareholders either 0.3 Advantage units or 0.2557 units plus 66 cents Canadian in cash. Either way, they get a stake in a much bigger outfit that’s building staying power to both grow and pay competitive distributions well beyond 2011.

As is always the case for an acquirer, the benefits to Advantage are more subtle. In my view, however, they’re far more compelling. Mainly, the purchase price—or potential dilution—won’t impact the trust’s current distribution. Rather, it enhances its long-run viability in three ways.

First, because Sound has been struggling to survive, its share price has actually been at a discount to the value of its reserves in the ground. As a result, the transaction is immediately accretive (adds to) to Advantage’s per-share production, cash flow, reserves and net asset value, and reduces its payout ratio. Proved plus probable reserve life is now at 11.8 years or a little less than eight years based on proved reserves alone.

If natural gas prices continue to slide for the rest of 2007, this deal at a minimum makes it easier for Advantage to maintain its current distribution rate. And if gas prices rebound as is likely, it will increase the trust’s ability to actually increase the payout. As it stands now, management is projecting maintaining the current rate of 15 cents Canadian per month for the foreseeable future.

Second, the deal adds a huge amount of undeveloped land to Advantage’s base of properties. Sound’s 400,000 acres will more than double Advantage’s tally to some 760,000 acres. That’s one of the largest totals in the trust sector, and it means numerous opportunities to ramp up output if market conditions warrant.

Finally, this deal is extremely accretive to Advantage’s tax pool situation. As I pointed out in the June 2007 issue of Canadian Edge—when I first added the trust to the Aggressive Portfolio—Advantage is being managed to maximize tax pools for the years 2011 and beyond, when it will presumably be taxed as a corporation.

Tax pools are basically noncash expenses that can be carried forward to reduce taxable income dollar-for-dollar. Before this merger, Advantage had about CD1.2 billion in tax pools to write off against post-2010 income. That was roughly equivalent to 95 percent of the trust’s market capitalization and 18 quarters of cash flow (4.5 years). With Sound, that rises to CD1.6 billion, one of the highest totals in the industry.

Even with Sound, Advantage remains a midsized trust and will need to grow again, very likely with at least one or two additional mergers. Meanwhile, its tax pools, building reserve position, increasingly solid finances and low price of just 1.39 times book value mean it’s also a potential takeover target.

Natural gas prices are still the single most-important factor that will determine what Advantage shares will be worth going forward. That won’t change following the Sound deal, though Sound does have a slightly higher oil reliance than Advantage.

Gas has been weak now for several weeks. And though Advantage has been among the stronger gas trusts—in part because of a large hedge position—its shares could still be vulnerable in coming months if prices head much lower and stay there.

If that happens, the damage should be temporary. Meanwhile, the near-term risk is dwarfed by the long-run potential of this growing and aggressively managed trust. Advantage Energy Income Fund remains a buy up to USD14.

Oil & Gas

Vermilion Energy Trust (VET.UN, VETMF) subsidiary Vermilion Resources is buying 2.1 million shares in Verenex Energy for CD30 million as part of a CD100 million bought-deal financing announced by Verenex July 9, 2007.

Verenex announced an agreement to sell, on a bought-deal basis, 6.9 million common shares at CD14.50 per share for gross proceeds of CD100 million to a syndicate of underwriters. Vermilion’s ownership stake in Verenex will be between 41.8 percent and 42.8 percent after completion of the deal. Buy Vermilion Energy Trust up to USD35. 

Gas/Propane

Wellco Energy Services Trust (WLL.UN, WLLUF) has discontinued previously announced discussions on the potential sale or merger of the trust or other material transactions. The discussions began after Wellco received an unsolicited offer in May.

Said CEO Kenneth M. Bagan, “At this time, based upon the results of these discussions and other considerations, the board of directors has concluded that the best course of action is to move forward with the trust’s operating business plan. We continue to be open to all avenues to enhance value and will update unit holders, as appropriate, should opportunities present themselves.” Wellco Energy Services Trust remains a buy up to USD8.

Real Estate Trusts

Canadian Apartment Properties REIT (CAR.UN, CDPYF) is buying two luxury adult-lifestyle communities in Ontario. The two communities consist of 1,233 rental sites on 371 acres of land.

Occupancies at the two properties are 99.5 percent. The total purchase price is CD75 and includes the acquisition of all community services and amenities.

The purchase will be financed by a CD55 million first mortgage financing, the issuance to the vendor of CD8 million in new Canadian Apartment Property REIT limited partnership units (at a weighted average price of CD19.45 per unit, exchangeable into Canadian Apartment Property REIT trust units) and the balance from its acquisition facility. Canadian Apartment Properties REIT is a buy up to USD19.

RioCan REIT (REI.UN, RIOCF) will record a CD150 million noncash charge to earnings in the second quarter of 2007. The charge relates to RioCan’s future income tax liabilities to be recorded as a result of tax legislation included in Canada’s 2007 federal budget bill.

This is a noncash charge to earnings related to RioCan’s share of the temporary differences between the accounting and tax basis of RioCan’s assets and liabilities. The charge will have no impact on RioCan’s cash flows or distributions.

The tax won’t apply to an entity that qualifies for the real estate investment trust exemption; RioCan intends to qualify for the exemption but may be required to restructure its operation somewhat. Buy RioCan REIT up to USD25.