Maple Leaf Memo
Those of you who came of age during the 1970s might remember Rita Moreno’s impassioned plea that kicked off the Public Broadcasting Service’s seminal children’s educational program “The Electric Company,” referenced in today’s title.
It’s time again to think electric.
Canadian Finance Minister Jim Flaherty’s newly announced tax will apply to a trust or partnership that’s a “specified investment flow-through,” or SIFT. SIFTs will be subject to a special tax at a rate equal to the general federal corporate tax rate plus 13 percent on account of provincial tax in respect to income from business carried on in Canada and certain income and capital gains respecting “non-portfolio properties.”
A Canadian resident trust or a partnership will normally constitute a SIFT for the purpose of the new tax if it holds one or more non-portfolio properties and its units are listed on a stock exchange or other public market. In addition to various types of real property situated in Canada, a non-portfolio property is broadly defined to include an investment in a Canadian resident corporation, trust or partnership (Canadian Issuer) if the investor holds more than 10 percent of the fair market value of the Canadian Issuer’s “equity value” or the investor holds securities of the Canadian Issuer (including securities held in its affiliates) with a fair market value that’s greater than 50 percent of the equity value of the investor itself.
Basically, all publicly traded income trusts will be SIFTs, as will publicly traded partnerships that hold significant investments in Canadian properties. Notably, the government excluded real estate investment trusts (REITs), provided the REIT continually satisfies certain conditions.
But, according to the Finance Ministry’s proposal, “[a] ‘return of capital’ isn’t deductible by the trust, and is therefore not included directly in the income of the unitholder.”
There’s the legal mechanism.
The question now is where to find value in the income trust space–value, as in a sustainable distribution and a business the market will soon come to appreciate.
One group that may survive and prosper long after 2011 is the electric power trusts. The health of the power funds’ distributions lies in the way the group characterizes them: Part is a dividend, and part is a return of capital.
Pretty much all the dry, nuts-and-bolts literature–authored by CPAs, financial analysts, tax lawyers and economists–defines the suitable business for the income trust structure as one with long-lived assets generating predictable cash flows. That basically describes electric power trusts.
Algonquin Power Income Fund (TSX: APF.UN; OTC: AGQNF), for example, said it believes any impact from the proposed taxation changes on its unitholders will be significantly mitigated due to the large proportion of distributions that are a return of capital (ROC). ROC comprises more than 50 percent of Algonquin’s distribution. Return of capital isn’t subject to taxation under the proposed provisions.
Management at the respective electric power funds perceives an opportunity in the changed landscape: that the capital markets appreciate the impact resulting from the high percentage of distributions that constitute an ROC.
Algonquin Power has also said that the long-lived nature of its assets should allow it to “continue to provide its unitholders with this benefit (distributions with a high return-of-capital component) following the proposed application of the tax rule changes in four years.”
Algonquin and the other power trusts have perhaps already realized some important facts about our reality: It’s still a yield-hungry world, and they can better compete for capital by maintaining a market-beating distribution, until 2011 and beyond.
Is it optimistic to assume their simple responses reveal a straightforward commitment to the trust form? Sure, but it’s the best thing we’ve heard since October 31.
In the post-Halloween ruckus, the group was calm. Unit prices across the sector slid with everyone else the day after “All Flaherty’s Evil” but have rebounded. Haircuts were limited to about 10 to 15 percent.
From the beginning, Canadian Edge stressed sustainability–focusing on companies with a track record of generating significant cash streams from easily understood assets. In a strange (macabre?) way, Flaherty has brought us back to the beginning.
The signs were all around on the way up; the big ones earned spots in S&P indexes, and large institutions jumped in. The signs are still there, if you know where to look.
Great Lakes Hydro (TSX: GLH.UN; OTC: GLHIF) included a breakdown of the impact of the proposed tax on investors in its third quarter 2006 Supplemental Information filing. The downward adjustment basically reflects the 26.5 percent hit to distributions, but the net effect for taxable accounts is nil. Great Lakes took an important step, though, in simply providing a detailed comment on the real-world impact on its unitholders; several electric power trusts have similarly guided their investors.
This willingness to speak directly to the problem–meanwhile addressing the most-pressing question of what will become of the distribution–indicates that the electric power trusts understand the unique benefits to their business model a trust format brings. They’re not afraid of a little discipline when it comes to capital expenditures, and they recognize the advantages a high yield conveys when competing for capital in the marketplace.
Flaherty Speaks To Rumors…
…and nobody believes him.
The Canadian government will issue guidelines “in weeks” on how income
trusts can operate during a four-year tax moratorium that ends in 2011,
Flaherty said late last week. But reports that the government will put
caps on how much capital trusts are able to raise during the period, as
a November 16 story in The Globe and Mail noted, are speculation, the Finance Minister said in an interview with Bloomberg News in Melbourne, Australia.
“Right now we’re working on how the system will work over the next
several years, and there will have to be some guidance there, of
course,” Flaherty said. “The department is doing some work on that.
What has been said so far is speculative.”
The government won’t waive any other taxes for trusts that decide to convert back to corporations before 2011 and won’t extend the four-year grace period, he said.
Flaherty is in Melbourne for a meeting of finance ministers and central bankers from the Group of 20 industrialized and developing economies. Canada is leading discussions on energy at the summit.
Flaherty said in the interview that some of the state-owned oil companies are beginning to recognize the need for more investment in new fields to help meet growing demand. “There is some inclination and some indications from some of the national oil companies that they, too, recognize the need for investment,” he said.
The Finance Minister also said falling global prices for natural gas and oil weren’t unanticipated and won’t threaten Canada’s fiscal outlook. The Canadian government will publish updates to its current budget projections on November 23 and lay out an economic plan that will include discussion of monetary policy in the country.
Canada has posted nine straight budget surpluses, including a CD13.2 billion surplus last fiscal year. Flaherty has budgeted a surplus of CD3.6 billion for the year ending in March 2007 and CD3.4 billion for the year ending in March 2008.
The Roundup
All news, for better and worse, coming from the Canadian royalty and income trust sector revolves around the still-reverberating decision to tax such businesses at the entity level.
The viability of a particular investment is–and has always been–a company-specific, operations-oriented evaluation. News continues to come in about how particular trust sectors or specific companies will cope going forward, but strong, investor-oriented businesses will continue to attract the attention of the financial markets.
Oil & Gas
Crescent Point (TSX: CPG.UN, OTC: CPGCF) and Mission Oil & Gas are rethinking their proposed CD730 million merger in light of the income-trust tax decision. The companies “have been evaluating the tax consequences of the proposed changes to the Income Tax Act.” The boards of both companies will report to stockholders by November 27 “and each will make a recommendation at that time whether to proceed with the arrangement, amend the arrangement agreement, extend the meeting date or terminate the arrangement.” Crescent Point announced in September its plan to buy junior oil and gas producer Mission. Crescent Point offered 0.695 of a unit for each Mission share as well as about CD28 million of net debt. The transaction would give the trust 5,500 barrels of oil equivalent per day of light oil and natural gas, as well as about 550 square kilometers of undeveloped land in southeast Saskatchewan and northwest Alberta. Crescent Point was already a major Mission stakeholder, owning nearly 9 percent, or 3.8 million, of the junior producer’s shares. Most of Mission‘s current production is in the Bakken light sweet oil pool in southeast Saskatchewan, located “adjacent to and contiguous with” Crescent Point‘s core properties. Crescent Point is a hold.
Business Trusts
Bell Aliant (TSX: BA.UN, OTC: BLIAF) is cutting CD24.5 million from the value of its proposal to buy out minority investors in the Bell Nordiq Income Fund (TSX: BNQ.UN, OTC: BNDQF), citing changes in federal income trust tax policy. This is on top of CD94.3 million scalped from the deal by the fall in income trust values in the three weeks since the changes were announced. Bell Aliant, which owns 63.3 percent of Bell Nordiq, said it will pay other unitholders CD4 in cash and 0.4113 of a Bell Aliant unit for each Bell Nordiq unit. That represents CD15.37 a unit based on Monday’s closing price of CD27.65 for Bell Aliant units, or a total of CD503.2 million. Originally, Bell Nordiq unitholders were to receive CD4.75 in cash and 0.4113 of a Bell Aliant unit, representing CD19 per unit or a total of CD622 million at Bell Aliant’s unit price of CD34.65 just before the deal was announced October 11. Financial terms of the proposal have been revised to reflect the impact of the federal government’s announcement on October 31 concerning changes to the taxation of publicly traded income trusts and market reaction to that announcement. Buy Bell Aliant up to USD33.
ACS Media Income Fund (TSX: AYP.UN, OTC: AMOMF) agreed to terminate the fund and sell its assets, including subsidiary ACS Media Canada, to Pendo Acquisition ULC</i>.
ACS units will be redeemed for CD9.40 apiece. The termination comes
nearly three weeks after the federal government shocked the income
trust sector by announcing it would tax trusts the way it taxes
corporations. ACS units plunged after that announcement on November 1,
though they recouped much of their losses the same day. Pendo is an
indirect wholly owned subsidiary of Local Insight Media, LLC. Sell ACS Media Income Fund.