By Roger Conrad
  December 12, 2006
  Maple Leaf Memo

By Roger Conrad & David Dittman

The income trust tax issue won’t bring down the Conservatives.

But Afghanistan might.

The opposition Bloc Quebecois party hinted yesterday at toppling the minority government over Canada’s mission in Central Asia. The Bloc, the third-largest party in Parliament, said it may try to get the House of Commons to declare no confidence in the government unless it puts more emphasis on reconstruction in Afghanistan and less on security.

This salvo follows Bloc Finance Critic Pierre Paquette’s December 4 announcement that he had asked Finance Minister Jim Flaherty to extend the transition period before existing income trusts would be taxed like corporations from four to 10 years.

The trust tax issue will be used to hammer Prime Minister Stephen Harper’s image as a straight shooter/truth teller. The Liberals’ bungled income trust review and subsequent Royal Canada Mounted Police insider trading investigation gave Harper and the Conservatives great material in fall and winter 2005; it provided an exciting climax to a campaign that got started because of the Sponsorship Scandal. “Liberal corruption!” rallied the Conservatives to a narrow win January 23.

Liberal leader Stephane Dion hasn’t publicly addressed the trust issue on the merits, but it’s tough to underestimate the political value of “Harper Lied.”

Dion does oppose the mission in Afghanistan. Support for the Liberals has surged under its new leader to the point where it would form the next government if an election were held soon, according to a poll published on Saturday.

The EKOS poll for the Toronto Star and Montreal’s La Presse indicated that 40.1 percent of voters would choose the Liberals, well ahead of the 33.5 percent support for the Conservatives. In the January 2006 election, the Conservatives unseated the Liberal minority government by garnering 36.3 percent of the vote versus 30.2 percent for the Liberals.

Liberal poll numbers bounced after the party chose Dion as its new leader on December 2, but this was the first time in three years it topped the pivotal 40 percent mark. To win a majority of seats in the House of Commons in Canada’s first-past-the-post electoral system, the winning party generally must win about 40 percent of the popular vote.

The EKOS poll had the Liberals leading in every province except for oil-producing Alberta, where the Conservatives dominate, and Quebec, where the separatist Bloc Quebecois leads.

The Bloc plans no action on the Afghanistan issue this week, after which Parliament adjourns until January 29.

With only 51 of the 308 seats in the House, the Bloc would have to have the support of the 104 Liberals to defeat Prime Minister Stephen Harper’s government. There’s some margin there, though, if a few members of the left-leaning New Democratic Party (NDP) and the two independent members of Parliament backed a no-confidence vote. The Conservatives have 124 seats, and the NDP has 29 seats. Opposition to the Afghan mission has been one of the NDP’s defining issues.

…Should You Choose To Accept It

BMO Nesbitt Burns issued a study, Trusts Provide Tax Gain for Government, by analyst Gordon Tait. Tait writes:

We looked at 126 businesses that converted from equities to trusts between 2001 and 2005 to prove that Ottawa reaped more, not less, tax revenue after firms converted to income trusts…We found that on average the government stood to collect 2.2 times more in taxes by taxing the distributions of the trust than had been paid by the corporations prior to their conversion.

A few days later, PricewaterhouseCoopers spoke on a related matter:

A review of Canada’s more than 250 income trusts indicates that trusts have been making an important contribution to the economy, investing their capital and growing their businesses at impressive rates. A study of the five-year performance of income trusts reveals that sales, net income and capital expenditure grew significantly during the period 2000-2005 even as the trusts were returning cash to their investors.

The study of more than 250 income trusts concluded that last year CD26.5 billion, or 230 percent of profit, went toward capital spending. In 2004, capital spending was CD21.8 billion–376 percent of profit. Canada’s income trusts reported a 62 percent increase in profit and a 54 percent rise in sales in 2005, the report said. The findings are more evidence that companies that converted to trusts continued to invest in productivity-enhancing projects and technologies and raise cash for capital spending and acquisitions.

Here’s the mission: Contact the Canadian equivalent of the US Government Accountability Office.

The Auditor General of Canada (AG) conducts independent audits of federal government operations and reports to the House of Commons, not to the government. These audits provide members of Parliament with objective information to help them examine the government’s activities and hold it to account.

A panel of Special Advisors reports periodically to the AG. Although a submission through the AG’s Web site will probably get lost, contacting the Special Advisors may not be so quixotic.

A few general points of advice when communicating with Canadian authorities:

• Be courteous. Never threaten. A cordial relationship keeps the door open.
• Be constructive. Rely on the facts, and avoid threats of political influence or demands.
• Be direct. State the subject of your letter clearly, keep it brief, and address the issue.
• Be accurate. Beware of false or misleading information. Always double-check if you aren’t sure.
• Be informative. State your own views, and support them with knowledge.

Here’s contact information for two members of the advisory panel:

Mr. David A. Brown, Q.C.
Davies Ward Philipps & Vineberg LLP
Toronto, Ontario M5X 1B1
dbrown@dwpv.com

Mr. Kevin Dancey, FCA
Canadian Institute of Chartered Accountants
Toronto, Ontario M5V 3H2
kevin.dancey@cica.ca

Simply ask if they can reconcile what BMO Nesbitt Burns and PricewaterhouseCoopers have to say with what’s come out of Flaherty’s shop.

Here’s a sample letter:

Dear [Mr. Brown/Mr. Dancey]:

I’m a [retiree, pensioner, individual investor, working person saving for the education of my children] and a US resident. I write to express concern over Finance Minister Jim Flaherty’s recently announced Tax Fairness Plan. The Plan, promulgated in a Notice of Ways and Means Motion to Amend the Income Tax Act, was recently approved by Parliament and is awaiting legislation.

Among the stated objectives of the Plan, I’m interested in two: helping corporations make choices that are consistent with economic growth and competitiveness, and bringing Canada’s approach to the taxation of trusts and partnerships back in line with other jurisdictions

Both of these objectives are based on the premise that income trusts cause a loss of tax revenue compared to corporations. This premise is widely referred to as “tax leakage,” or in the misleading language of the Notice as “unfair shifting of taxes.”

The notion of tax leakage has achieved the status of an urban legend in the press and public. The absence of any transparency by the Department of Finance on this issue contributes to the myth.

Can you please urge the Auditor General to provide Members of Parliament with the objective, fact-based information they need before enacting legislation that will harm the public?

Thank you for your time and attention to this matter.

Respectfully,

(signature)

The Roundup

Last week we provided summaries of third quarter earnings and a basic analysis of the impact of Flaherty’s announcement that trusts would be taxed as corporations in 2011 for Portfolio recommendations.

We’ve since made a few adjustments to the CE Portfolio. Below we look at three points for each trust currently included in the Conservative and Aggressive Portfolios, based on their most recent results: Good Business Points, Bad Business Points and 2011 Tax Position.

For more numbers and current trading advice, see the How They Rate Table.

Conservative Portfolio

Algonquin Energy (APF.UN, AGQNF)

1. Good Business Points: Acquisitions of wind power assets and strong hydroelectric assets lift third quarter sales 19.4 percent. Algonquin continues to find ways to increase cash flows.
2. Bad Business Points: Its payout ratio remains on the high side as the trust focuses on growth.
3. 2011 Tax Position: Return of capital was 60 percent of 2005 distributions, and non-cash expenses were 63.4 percent. These should be sustainable figures.

Atlantic Power (ATP.UN, ATPWF)

1. Good Business Points: Third quarter cash flows per share were up 23.3 percent as new investments pay off. The Path 15 power line should be a very valuable asset.
2. Bad Business Points: Management doesn’t control assets but depends on partners to run them well.
3. 2011 Tax Position: Technically an income deposit security, Atlantic should be exempt from the Canadian tax proposal. The interest portion of its dividend isn’t withheld by Canadian authorities.

Bell Aliant (BA.UN, BLIAF)

1. Good Business Points: The rural phone business faces little competition and steady growth. The trust has multiple opportunities to up-sell customers to advanced services.
2. Bad Business Points: Like all local phone businesses, there will be some loss of customers for local phone service.
3. 2011 Tax Position: Return of capital is estimated at 12 percent of 2006 distributions, based on Bell Nordiq’s 2005 return of capital.

Boralex Power (TSX: BPT.UN, OTC: BLXJF)

1. Good Business Points: Its hydro plants run well. Biomass and cogeneration output are steady and diversify against unpredictable water conditions.
2. Bad Business Points: The payout ratio is on the high side, which limits growth, though it’s sustainable.
3. 2011 Tax Position: Return of capital was 75 percent of 2005 distributions. That number may decline to 2011 unless the trust adds assets.

Keyera Facilities (KEY.UN, KEYUF)

1. Good Business Points: Keyera controls solid midstream assets that generate exceptionally steady cash flows. It’s also pursuing several opportunities for low-risk growth.
2. Bad Business Points: Third quarter earnings demonstrate that cash flow isn’t immune from slowdown in activity in gathering and processing, but the dividend should be solid.
3. 2011 Tax Position: Return of capital was 75 percent of 2005 distributions, which should fall slightly in 2011.

Northern Property REIT (NPR.UN, NPRUF)

1. Good Business Points: A 5.1 percent boost in the real estate investment trust’s (REIT) dividend was spurred by a 7 percent increase in funds from operations per share. Properties are located mostly in remote areas and are rented to creditworthy parties.
2. Bad Business Points: The challenge is finding new place to invest, but management has a conservative focus.
3. 2011 Tax Position: REITs focused on Canada are exempt from the tax changes.

Pembina Pipeline (PIF.UN, PMBIF)

1. Good Business Points: The trust enjoyed a 12.4 percent boost in distributable cash per share in the third quarter, fueling a 10 percent increase in its dividend. The midstream business thrived, as did the trust’s conventional gas and oil sands pipelines operations. The best news is that there’s a lot more on tap as the trust adds assets in coming years.
2. Bad Business Points: A crash in the oil sands business would rob Pembina of a key growth measure. Profitability will also depend on executing new asset construction and the operation of old ones.
3. 2011 Tax Position: Return of capital was 25 percent of 2005 distributions, which should be sustainable.

Primary Energy Recycling (PRI.UN, PYGYF)

1. Good Business Points: Primary Energy continues to find new plants and investments to boost output and cash flow.
2. Bad Business Points: The increase in cash flow in the third quarter was directly offset by shares issued to finance growth, but payoff should come later.
3. 2011 Tax Position: A staple share combining debt and equity, Primary Energy’s taxation shouldn’t be affected by the Canadian tax proposal.

RioCan REIT (REI.UN, RIOCF)

1. Good Business Points: Canada’s largest REIT continues to enjoy steady sales and cash flow growth, with strong occupancy. RioCan is now cashing in on the first of a series of investments with a major Canadian pension plan. The REIT is also a logical takeover target for US investors.
2. Bad Business Points: The trust’s strong position means growth is moderate.
3. 2011 Tax Position: REITs focused on Canada are exempt from the tax changes.

TimberWest Trust (TWF.UN, TWTUF)

1. Good Business Points: The third quarter was very rough because of extremely dry conditions that prevented harvesting, as well as rising production costs. It’s well reserved for cash shortfalls, and nine-month cash flows cover the dividend.
2. Bad Business Points: The timber market is vulnerable to continued weakness in the US housing market, as well as a slump in Asian sales.
3. 2011 Tax Position: Shares are technically stapled securities of debt and equity. They’re not affected by the proposed change in Canadian tax law.

TransForce Income (TIF.UN, TIFUF)

1. Good Business Points: Sales rose 18.2 percent in the second quarter, fueling 26.3 percent growth in operating income. Management continues to find solid opportunities to add business with expansion and acquisitions.
2. Bad Business Points: Expansion hasn’t done much lately for the bottom line, as cash flow per share dipped 2.2 percent. Much of the growth lately has come in the energy patch, which may be slowing down.
3. 2011 Tax Position: Return of capital was 3 percent of 2005 distributions.

Yellow Pages Income (YLO.UN, YLWPF)

1. Good Business Points: The trust’s basic print pages business is very steady, while its Internet business is growing rapidly, and it continues to add new advertising media to its mix. Cash flow per share rose 11 percent in the third quarter, continuing a string of solid growth.
2. Bad Business Points: The print pages business has been stagnant for a while, as business migrates to the Internet. Yellow Pages appears well prepared for that. It’s also one of the first to declare that it will remain a trust for 2011 and beyond.
3. 2011 Tax Position: Return of capital was 4 percent of 2005 distributions.

Aggressive Portfolio

Altagas Income (ALA.UN, ATGUF)

1. Good Business Points: The third quarter showed more evidence that asset expansion and acquisitions are paying off. Cash flow per share was up 35.1 percent.
2. Bad Business Points: Lots of moving parts mean management must keep a tight grip.
3. 2011 Tax Position: Return of capital was 35.7 percent of 2005 distributions, which should be sustainable.

ARC Energy Trust (AET.UN, AETUF)

1. Good Business Points: A solid balance of production from long-life, low-cost reserves, low payout ratio, low debt and strong management keeps the trust at the top of the heap for oil and gas producers. It had 12 percent production growth with only 7.2 percent share growth during the past 12 months.
2. Bad Business Points: Production costs have risen during the past year. Like all oil and gas producers, cash flow is vulnerable to energy price volatility.
3. 2011 Tax Position: Return of capital was just 2 percent of 2005 dividends, but non-cash, non-taxable expenses were 43.8 percent.

Avenir Diversified Income (AVF.UN, AVNNF)

1. Good Business Points: Oil and gas production continues to increase. The EnerVest management contract and other financial investments are solid and offset energy price volatility. Avenir is within a targeted payout ratio.
2. Bad Business Points: EnerVest profit depends on the size of the fund’s assets and took a major hit when the trust market declined. Funds from operations per share fell nearly in half in the third quarter of 2007 and will take a further hit from a decline in EnerVest in the fourth quarter. Oil and gas operations remain small.
3. 2011 Tax Position: Return of capital was zero in 2005, though non-cash expenses were 14 percent. Management could move to alternative structure after 2011.

Enerplus Resources (ERF.UN, NYSE: ERF)

1. Good Business Points: A solid balance of production from long-life, low-cost reserves, low payout ratio, low debt and strong management keep Enerplus at the top of the heap for oil and gas producers. Enerplus also has investments in oil sands and other prolific oil developments.
2. Bad Business Points: Like all oil and gas trusts, this one isn’t immune from a drop in energy prices.
3. 2011 Tax Position: Only 5 percent of Enerplus’ 2005 dividend was ROC, but more than half was noncash, nontaxable expenses. Enerpluse will do well whether it’s a trust or a corporation.

Essential Energy Services (ESN.UN, EEYUF)

1. Good Business Points: Acquisitions continue to drive rapid growth at the energy services trust. Third quarter earnings lagged, but fourth quarter activity is off to a rapid start.
2. Bad Business Points: Energy services trusts are extremely vulnerable to a drop-off in energy patch activity, as appears to be happening in Canada’s shallow natural gas.
3. 2011 Tax Position: Return of capital for the new trust isn’t available for 2005, but non-cash, non-taxable expenses were equal to distribution. The trust’s management says it may have to make a strategic move due to small size.

Fording Canadian Coal (FDG.UN, FDG)

1. Good Business Points: Fording’s metallurgical coal reserves are first rate, as is its partner Teck-Cominco.
2. Bad Business Points: Demand for metallurgical coal has fallen, particularly in Asia, which is pushing down both demand and prices from last year’s robust levels.
3. 2011 Tax Position: Return of capital was 25.7 percent of 2005 distributions, which should be sustainable.

Harvest Energy (HTE.UN, HTE)

1. Good Business Points: It’s increased output and diversification of tax flows over the past year with a series of mergers and acquisitions, including of a refinery in the summer. Third quarter earnings were generally solid, as strength in oil sales offset natural gas price weakness.
2. Bad Business Points: The jury is still out on last summer’s generally expensive acquisitions. The financing of the refinery deal was completed on worse terms than expected because of the government’s tax proposal timing. It’s payout ratio, debt and operating costs are high.
3. 2011 Tax Position: None of the distribution was return of capital in 2005, but non-cash, non-taxable expenses were 80 percent-plus of third quarter cash flows.

Newalta Income Fund (NAL.UN, NALUF)

1. Good Business Points: Sales rose 83 percent in the third quarter of 2006, fueling an 11 percent increase in cash flow per share. Return on investments rose to 27 percent, up from 24 percent a year ago. Expenses were cut, and both industrial and energy services enjoyed growth.
2. Bad Business Points: Exposure to the energy services business means sales could slow if that industry does, though they’re shielded by the environmental focus.
3. 2011 Tax Position: Return of capital was just 1.7 percent of 2005 distributions.

Paramount Energy (PMT.UN, PMGYF)

1. Good Business Points: Paramount has a large reserve of undeveloped land that’s enabled it to maintain production year after year. It also derives a steady stream of cash flow from the Alberta government as part of a settlement for shutting in a portion of its capacity.
2. Bad Business Points: Falling natural gas prices have taken a bite out of cash flows this year. The third quarter payout ratio is still 83.2 percent because of extensive hedging, and rising gas prices are helping. But this remains an extremely aggressive play on gas and a small trust.
3. 2011 Tax Position: Only 4.6 percent of the 2005 dividend was return of capital, though 80 percent of third quarter cash flow was non-cash, non-taxable expense.

Peak Energy (PES.UN, PKGFF)

1. Good Business Points: Peak’s payout ratio is low and preserves the dividend in the third quarter, despite a drop in energy patch activity. The trust has a solid fleet of energy services assets and rigs.
2. Bad Business Points: All energy services trusts are very vulnerable to a drop-off in energy patch activity. Third quarter funds from operations per share were off 30 percent.
3. 2011 Tax Position: Return of capital was just 6.7 percent of 2005 distributions, which should be sustainable.

Penn West Energy (PWT.UN, PWE)

1. Good Business Points: A solid balance of production from long-life, low-cost reserves, low payout ratio, low debt and strong management keeps Penn West at the top of the heap for oil and gas producers. The trust also has investment in oil sands and prolific oil developments.
2. Bad Business Points: Penn West is still absorbing the Petrofund merger. Its third quarter payout ratio came down, but there’s potential dilution from share issues.
3. 2011 Tax Position: None of the 2005 dividend was return of capital, but nearly 60 percent was non-cash, non-taxable expense.

Peyto Energy (PEY.UN, PEYUF)

1. Good Business Points: Low-cost production and reserves ensure Peyto can survive and thrive in a negative price environment. Management has entered “sustainability mode” and is financing capital spending plus dividends with cash flow.
2. Bad Business Points: Peyto is still on the small side, and production will be flat until natural gas prices tick up. It’s dependent on gas output.
3. 2011 Tax Position: Twenty-five percent of Peyto’s 2005 dividend was ROC and 22 percent was noncash, nontaxable expense, indicating that’s about the exemption shareholders can expect in 2011.

Precision Drilling (PD.UN, PDS)

1. Good Business Points: The rust’s assets and business growth continue to fuel superior performance.
2. Bad Business Points: Like all energy services trusts, Precision is affected by a slowdown in energy patch activity. Seventy percent of its business is in the natural gas sector, and its payout ratio in the third quarter rose to 83.8 percent.
3. 2011 Tax Position: Return of capital was just 0.2 percent of 2005 distributions.

Trinidad Energy (TDG.UN, TDGNF)

1. Good Business Points: Third quarter earnings surged 54.1 percent as Trinidad added rigs and focused on the deeper drilling market, which remains robust. The payout ratio is now just 59.6 percent.
2. Bad Business Points: Like all energy services trusts, Trinidad isn’t immune from a slowdown in activity, but it doesn’t appear to be hurt yet.
3. 2011 Tax Position: ROC was 13 percent of 2005 distributions, which should be sustainable.

Vermilion Energy (VET.UN, VETMF)

1. Good Business Points: A solid balance of production from long-life, low-cost reserves, low payout ratio, low debt and strong management keeps Vermilion at the top of the heap for oil and gas producers. The trust’s global diversification is a major plus, as is its ability to fund dividend and capital costs internally.
2. Bad Business Points: Like all trusts, this one is vulnerable to a drop in energy prices. International exposure means management must keep on top of more.
3. 2011 Tax Position: The 2005 dividend was 13.7 percent return of capital, and non-cash, non-taxable expenses were 48.7 percent. Foreign income may also be exempt from new Canadian tax proposal.