Maple Leaf Memo
To the surprise of absolutely no one, Finance Minister Jim Flaherty offered no new documentation supporting tax leakage in his testimony to a House of Commons Finance Committee special hearing last week. To the surprise of absolutely everyone, he was boxed into admitting that the effective Canadian corporate tax rate was 6.9 percent.
That blows the level-playing-field argument; 6.9 percent and 31.5 percent aren’t even the same sport.
Were he able, Flaherty would have produced silver-bullet numbers on leakage and lost productivity. What he offered was more of the same times two–in some cases times 10.
Day two of the hearings featured Bank of Canada Governor David Dodge. Dodge’s comments fit the “all income trust economy versus zero income trust economy” frame the Conservatives have essentially been forced to defend, and headline writers for the major media outlets played along. But take a look at his prepared statement, reminiscent as it is of the tightrope walking of a recently departed North American central banker.
Dodge provided a lot of cover for Harper, Flaherty and the Conservatives in his testimony before the special committee Thursday, plenty of headline-worthy snippets and all-ships-in-the-same-direction endorsements. Intentional or not, Dodge pulled off a great imitation of noted political sophisticate Alan Greenspan, spinning enough “gray area” on which to build a 10-year transition window and an energy-patch exemption.
Dodge narrowly defined the BoC’s interest in the matter:
I should start by making clear where the Bank of Canada’s main interest in the income trust sector lies. Our interest in income trusts relates to the efficient functioning and health of Canada’s financial system …[W]e are naturally interested in developments in financial markets, such as the evolution of the income trust market, that have the potential to affect financial system efficiency.
Last year, before Halloween, Dodge spoke positively of trusts’ impact on the financial system. Dodge then referred to that one study his shop produced directly addressing trusts, the June 2006 edition of the Bank of Canada’s Financial System Review:
…we noted that limited evidence suggests that income trusts can enhance market completeness in a couple of ways. First, income trusts can provide diversification benefits to investors, because trusts can have different risk-return characteristics than either equities or bonds. Second, the income trust structure appears to allow some firms improved access to market financing. So, insofar as income trusts allow investors to achieve risk-return benefits that they could not otherwise achieve, and serve as a source of financing to firms that might not otherwise have had access to markets, it can be said that income trusts enhance market completeness, and therefore support financial system efficiency.
The Financial System Review also noted that accounting and governance standards aren’t the same for trusts as for corporations. This is certainly a legitimate area of concern, one raised by an organization of pensioners. “The federal government should not be giving tax incentives for seniors to purchase an investment that is risky and does not have a proper investor protection regime in place,” the National Pensioners and Senior Citizens Federations said in its brief to the Finance Committee. Even this “support” for the government’s action highlights the government’s clumsiness. Trusts and investors would certainly welcome a discussion on reporting requirements as part of a package that doesn’t kill them.
Dodge spoke directly to issues the BoC had studied and on which he had sufficient knowledge to comment, pointing out that they hadn’t looked at the long-term impact on the Canadian economy.
These are the aspects of income trusts that we at the Bank have looked at and on which we are best able to comment. Of course, there are very important public policy questions related to income trusts that fall outside the Bank’s mandate. The Bank has done no specific research on how the income trust structure affects economic performance, or would affect the future productivity of the Canadian economy.
In closing, Dodge left a lot of room for an industrious policymaker to craft a proposal that preserves market efficiency and satisfies investor demand within a framework that properly exempts certain assets and businesses.
While we at the Bank have not done any research on how the rules of the tax system could be designed so that they do not give inappropriate incentives that would bias the choice of firms to operate either as an income trust or as a corporation, the changes proposed by the government last October would appear to substantially level the playing field. For the income trust sector to deliver efficiency benefits through the enhancement of market completeness, it’s important that the tax system provide a level playing field.
Dodge’s observation that Flaherty’s proposal levels the playing field is factually true, in the sense that no sane manager would kiss off 31.5 percent of income as opposed to 6.9 percent. Trusts will convert back, and everyone will play on the same field.
It’s not hard for anyone unconstrained by a bad debating position to see that an exception for energy producers could be appropriate, or a 10-year transition window may also serve the public interest.
Liberal finance critic John McCallum signaled his party’s intention to continue the debate, noting that the central bank boss admitted that income trusts enhance financial markets by allowing investors to diversify their portfolios and by easing access to capital markets for businesses that might not otherwise get financed. “I’ve never heard a less qualified endorsement of a government by a central bank governor,” McCallum said. “The central bank governor works for the government, he cannot possibly say the government is wrong.”
As for the politics, Harper can’t flip flop on the flip flop. He’s already lost some of his straight shooter sheen trying to win votes–morphing on the environment and climate change, failing to address healthcare wait times as promised. Trapped in Harper’s majority gambit, Flaherty is like John Iselin to the prime minister’s Mrs. Iselin, shouting different numbers in different directions, answering no question in particular.
On one important thing all relevant parties would agree, politics aside. There are certain assets, business plans and management teams suitable for the income trust structure. Most are not. (Funny enough, the market weeded out a good number of nonhackers. Go figure.)
There’s a great story in financial market efficiency, investor choice and useful exploitation of vital resources buried under the headlines and the political hide-covering.
And the trust tax issue may have exposed a subtle change in the investor class–it’s bigger and a lot more diverse than, obviously, the Conservatives in Canada realized. It’s ironic that a left-leaning party in a liberal country could lead the way in carving out an asset class that makes use of natural resources and at least partially addresses a pressing demographic problem.
The Liberals have already offered a broad hint that they’ll carry the ball as far as they consider it a political asset. It just so happens that the longer that’s the case, the more pressure will build for them to follow through with a legislative change, should they take power. National polling suggests a tight race, with neither the Conservatives nor the Liberals showing the makeup of a contender for majority control. But if they don’t have to toe a minority government party line, Conservative backbenchers should certainly have more leeway to vote their conscience.
The Liberals still have a lot of room and time to exploit Flaherty’s oversimplifications and Dodge’s accommodations. A new government has been and continues to be the best hope for a tax holiday extension and an exception for energy trusts.
The RoundupA combination of cold weather, inventory drawdowns, an announced production cut from Saudi Arabia and general uncertainty about global oil supplies have pushed black gold back up into the high USD50s range.
Oil and gas trusts have perked up, reflecting their tie to energy prices. Trust returns will continue to depend on energy prices going forward, no matter what happens with Ottawa’s ongoing debate on trust taxation.
The other two key issues affecting income stocks are interest rates and earnings.
The rise in the 10-year Treasury yield stalled last week, as the Federal Reserve reiterated its anti-inflation stance, and the employment report came in weaker than expected. The benchmark rate remains within a stone’s throw of 5 percent, and it wouldn’t take much to push the market over the top and start rates rising again.
We’ve endured such rate spikes each of the past four years; one this year is certainly within the realm of possibility. I’ve seen nothing, however, to indicate that a spike this year wouldn’t be just as short lived as its predecessors, creating a lot of sound and fury signifying nothing, except an opportunity to buy low or sell low depending on the individual.
In short, it still looks like we’re in a two-steps-forward-one-step-back economy where inflation is generally well behaved despite the highest energy prices in a generation. No one should discount the damage to portfolios that a rate spike in the next couple of months could do. But if and when it occurs, it will be time to think of buying quality, not selling it.
As for what constitutes quality, earnings season continues to provide the best window available. We’ll provide updates as reports begin to flow in earnest.
Electric Power
Countryside Power Income Fund’s (COU.UN, COUUF) USD99 million settlement of a claim against US Energy Biogas Corp has been approved by the US Bankruptcy Court for the Southern District of New York. US Energy Biogas said Monday that the agreement, announced January 16, enables it to pay all creditors in full, exit bankruptcy restructuring and support the growth of the business. Of the USD99 million secured claim, USD3 million has been paid so far, with USD30 million to be paid by March 31 and the rest by May 31. Its dividend still under pressure, Countryside Power Income Fund is a sell.
Northland Power Income Fund (NPI.UN, NPIFF) unitholders approved the internal reorganization of the fund’s ownership of its Kingston, Ontario, facility. The reorganization was carried out to consolidate the fund’s investment in its Kingston facility into a flow-through entity for tax purposes, lessening the potential for taxation within the fund that could reduce the cash available for distribution. The reorganization was underway prior to and isn’t a response to the recent proposal to tax income trusts. Buy Northland Power Income Fund up to USD13.25.
Business Trusts
Bell Aliant Regional Communications Income Fund (BA.UN, BLIAF) boosted its monthly distribution by 2.9 percent, as it reported operating revenues of CD852.2 million in the fourth quarter. For the three months ended December 31, Bell Aliant reported net earnings of CD163.1 million or CD1.31 per unit. Operating revenues were up CD16.4 million, or 2 percent, over the same period last year. The distribution increase to 23.5 cents Canadian from 22.83 cents Canadian per unit will begin with the February payout, on or about March 15. Bell Aliant is a buy up to USD30.
Consumers’ Waterheater (CWI.UN, CSUWF) is buying the waterheater rental business of city-owned Toronto Hydro Energy Services for CD40.9 million. The fund is acquiring 85,000 gas and electric water heaters and associated rental contracts. Consumers’ Waterheater, with a total rental portfolio of 1.4 million units, said the purchase will add to this year’s distributable income and will be funded from available cash and a secured credit line, which its bank is increasing to CD35 million from CD15 million. Consumers’ Waterheater is a buy up to USD13.
Pipeline Trusts
Enbridge Income Fund (ENF.UN, EBGUF) reported earnings of CD35.3 million, or CD1.02 per unit, for the year ended Dec. 31, 2006, compared with CD15.2 million, or CD0.44 per unit, in the prior year. The earnings increase was due primarily to future tax recoveries in Alliance Canada and the Saskatchewan System, resulting from a reduction in future tax rates substantively enacted during the year. Growth in the Saskatchewan System’s operations and fourth quarter wind power asset acquisitions also boosted earnings. Higher corporate costs took a small bite out of the increase.
Fourth quarter 2006 earnings of CD3.2 million are comparable with earnings of CD2.5 million in the prior year fourth quarter and include the addition of wind power assets acquired on Oct. 1, 2006. Financing costs associated with the acquisition partially offset the earnings contribution from these assets. Based on current operations, Enbridge estimates that approximately 80 percent of cash to be distributed in 2007 will be included in the income of unitholders for tax purposes. The remaining 20 percent will be nontaxable return of capital. During 2006, approximately 80 percent of cash distributed was included in the income of unitholders for tax purposes. Enbridge Income Fund is a buy up to USD12.
Real Estate Trusts
IPC US REIT (IUR.UN, IPCUF) is soliciting acquisition and merger proposals. The real estate investment trust (REIT), which invests exclusively in US commercial real estate, went public in 2001 and now has a portfolio of 10.1 million square feet. RBC Capital Markets and Banc of America Securities Canada are acting as the REIT’s financial advisors. The move is the result of a review initiated in August with the intention of taking advantage of favorable market conditions and disposing of some noncore holdings. Those factors include a series of profitable transactions for IPC, the repayment of the preferred equity investment in Prime Group Realty Trust, the increase in the US dollar relative to the Canadian dollar and analysts’ reports that have created an expectation in the marketplace during the past several months that IPC is a prime takeover target. Hold IPC US REIT.