From the CEO of Enerplus Resources (ERF.UN, NYSE: ERF): “We intend to continue our yield-oriented distribution model given our belief that investor demographics, the demand for yield product and our asset base will continue to support such a model with a premium valuation.”

Management went on to state it “sees significant value in the four-year tax exemption period,” slamming the door on going corporate in the near future. And it affirmed it will keep building long life assets and maximizing its tax pools, currently around CD1.9 billion.

Enerplus’ position appears to be the consensus of the oil and gas trust sector in the wake of the final passage of the Conservative Party budget, which includes the provision to tax trusts as corporations beginning in 2011. In fact, the only attempt by a trust to convert to date—then-floundering True Energy Trust (TUI.UN, TUIJF)—was soundly rejected by unitholders earlier this year.

Not every trust will have Enerplus’ options. But the weaker ones’ hands are tied by the imperative of paying a high yield. That lays to rest fears of a value-destroying mass conversion to corporations.

Rather, we’re going to see a gradual adjustment as individual trusts boost their tax efficiency by a variety of means between now and 2011. With the average Canadian corporation paying less than 7 percent tax now, the opportunities are myriad. And because the market is still pricing in the increasingly unlikely worst case—a 31.5 percent across the board dividend cut in 2011—trusts that demonstrate a lower prospective burden will get a solid boost in share prices.

Trust takeovers by private capital will continue to hand investors near-term gains, though at the price of superior long-term returns. We saw more action on this front last month. Troubled Countryside Power Income Fund (COU.UN, COUFF) accepted an all-cash, CD9.60-per-share offer, a premium of about 6 percent to its pre-deal price, from Fort Chicago Energy Partners. Meanwhile, Dundee REIT (D.UN, DUNTF) acceded to a CD47.50-per-share, all-cash offer, a 19 percent premium adding up to a total return of more than 71 percent in the past year, from a unit of General Electric.

And there’s still the possibility the tax proposal will be altered dramatically before 2011. The chief opposition Liberal Party, for example, has made cutting the maximum tax rate to 10 percent in 2011 a major part of its campaign platform. Should its members win elections likely to be held in the next year—and by October 2009 at the latest—trusts across the board should reap a windfall. In fact, most would likely keep their current business model to maximize ability to pay dividends long term.

Both takeovers and tax changes, however, are beyond investors’ control. Rather, the key now is to focus on trusts that can do it on their own. That’s running good businesses and boosting tax efficiency against the impact of corporate taxation in 2011. If they’re taken over for a high enough premium or if the Liberals have their way, the trusts reap a windfall. Otherwise, they’ll keep pumping out solid returns well past 2011.

There’s A Way

With wholesale conversions off the table—at least until 2011—trusts’ managements’ chief challenge now is positioning to shelter income when taxation kicks in. The good news is most have the means to keep their future taxes well below the top 31.5 percent rate.

In fact, most will probably pay an effective rate closer to that of the typical Canadian corporation, which is less than 7 percent. And the closer they come to that low rate, the less their distributions will be affected post-2011 and, by extension, the better their shares should perform.

Last issue, I highlighted two ways trusts will cut their tax rates in 2011 and beyond: tax pools and a foreign operations focus.

Tax pools are basically noncash expenses that can be carried forward and written off against future income. The three primary pools Canadian energy companies alone enjoy are related to exploration, drilling and property expenses. They and other trusts also enjoy the benefit of depreciation, amortization and goodwill expense writeoffs.

Trusts now typically use tax pools to shelter whatever income kicked up from operations isn’t paid out to unitholders. Trusts with high payout ratios tend to use less and accumulate more tax pools, while those with low payout ratios use more and accumulate less.

After taxation, pools will take on a whole new meaning. They can be written off dollar-for-dollar against taxable income, with the result that taxes can be literally zeroed out or at least dramatically reduced.

Most trusts will probably find a formula that allows them to shelter enough income to sustain competitive distributions. This will be easier for trusts backed by strong businesses and next to impossible for the weakest trusts.

Ultimate success will be determined by business success. But trusts are also certain to work to improve their tax efficiency, i.e., increase their tax pools, as Enerplus has stated it will do.

Oil and gas trusts appear to have the greatest ability to use tax pools. But other industries—particularly in infrastructure—are also advantaged. As I pointed out last issue, for example, Keyera Facilities Income Fund (KEY.UN, KEYUF) has considerable tax pools related to its gas processing infrastructure and plans to work to maximize them over time.

The larger the entity, the better it can afford the expense to ensure tax efficiency. Moreover, mergers, depending on the terms, can actually increase tax pools. Consequently, we’re also likely to see more consolidation, particularly among the smaller and weaker trusts, along the lines of the ongoing deal between Shiningbank Energy Income (SHN.UN, SBKEF) and PrimeWest Energy Trust (PWI.UN, NYSE: PWI).

Foreign-based income is taxed at the source and, therefore, will also escape 2011 taxation. The June Feature Article also highlighted a number of trusts with particularly large foreign exposure. One of these—Aggressive Portfolio holding Trinidad Energy Services Income Trust (TDG.UN, TDGNF)—moved further down that road last month by acquiring another US-based drilling company. Enerplus and Provident Energy Trust (PVE.UN, NYSE: PVX) also have plans to expand their foreign exposure and move more of their income beyond the reach of Canadian tax authorities.

Last month, a third way for trusts to dodge 2011 taxation—shifting control of some or all of their assets from Canadian-based trusts to US-based master limited partnerships (MLPs)—was posited by major brokerage house UBS. Under this scenario, trusts would be shifting income from Canada’s jurisdiction to the US, utilizing the ability of the US limited partnership (LP) structure to avoid taxes on both sides of the border and maximizing their ability to pay big distributions.

If successful, this strategy would not only dodge Canadian taxes, but under favorable US rules for LPs, it would also avoid corporate taxes in this country. Trust unitholders would receive distributions from pre-tax cash flows as before, though with the additional burden of filing a form K-1 in the US. It would also enable fast-growing trusts to avoid restrictions on their growth, which limit share issues to 100 percent of capital between now and 2011.

Canadian oil and gas producer income trusts are deeply undervalued relative to US LPs that produce energy. Consequently, if one succeeds in making the leap, its shares should get a sizeable boost. And the same would likely go for trusts with similar strengths and characteristics.

It’s also possible a successful LP conversion would put further pressure on the Canadian government to reduce the prospective 2011 tax on trust income, if for no other reason than to prevent this practice. That, too, would give trusts a boost across the board.

Below, I look at the partnership option for trusts–the advantages, disadvantages and hurdles to getting it done. I highlight some good potential candidates for the move.

Escape From Ottawa

The biggest potential hurdle to trusts shifting assets to US-based partnerships is Canada’s General Anti-Avoidance Rule (GAAR). GAAR is designed to ensure taxes owed in Canada are paid in Canada.

GAAR would clearly prohibit a Canadian company with Canadian-based assets from locating offshore or in the US and claiming it owed no taxes in Canada. Less clear, however, is whether it would prohibit a US LP from acquiring a Canadian trust and its assets or if the Canadian government would be able to block such a deal.

One possibility is a trust would issue an LP in the US, with a listing on the New York Stock Exchange. That LP, in turn, would then borrow from the parent to purchase its equity control, effectively converting the entire trust to a US-based LP. The use of debt to acquire Canadian assets could effectively zero out tax liability in that country, maximizing income and allowing the converted trust to continue paying out huge distributions well after 2011.

If all that sounds deeply complex, it’s because it is. Moreover, even if GAAR can be hurdled in this way, it’s not the only challenge for would-be converters.

One big one is what will happen to a trust’s Canadian taxable unitholders should management decide to make such a radical move. Because there would be no perceivable tax advantage for them—only complications—many, if not most, would likely vote against such a move. Opposition could be further inflamed if prospective conversion is found to trigger a significant taxable or legal event.

That would seem to restrict the field of potential converters to trusts with strong majorities of US ownership. Some of the largest are shown in the table “Foreign Owned,” including Enerplus (70 percent), PrimeWest (65 percent) and Pengrowth Energy Trust (PGF.UN, NYSE: PGH; 63 percent).

Even these trusts may be deterred by other factors. For one, these are Canadian outfits run by Canadians who may be reluctant to swap nationalities for a tax dodge unless it’s the only possible way to proceed.

Another is there’s no certainty the US government won’t enact a similar crackdown on the burgeoning LP industry. A bill to tax hedge funds employing LP status to minimize taxes already enjoys considerable support in the US Congress. More restrictions could be on the way as Washington attempts to deal with a fix of the Alternative Minimum Tax in coming years.

Even existing complexity will likely give trusts considerable pause before contemplating a conversion. In fact, Enterra Energy Trust (ENT.UN, NYSE: ENT)—one of the handful of Canadian trusts that currently files needed paperwork to be considered an LP in the US—has elected to change its classification to a corporation for US tax purposes. Management stated the reason to be “simplify[ing] the tax analysis and reporting by the Trust for U.S. purposes.”

The fact that Enterra has made this move is noteworthy, particularly because it’s among the better-positioned trusts to become an LP. The trust has majority US ownership, trades on the New York Stock Exchange (NYSE) and produces nearly half its oil and gas in the US.

Given the hurdles and the seeming caution of trust managements, it seems highly unlikely we’ll see a mass-scale conversion of Canadian trusts to US-based MLPs. Rather, most will likely wait to see how the water is and whether the Canadian government responds with a swift crackdown on the first movers in the name of GAAR.

Three oil and gas producer trusts that may try to make a such move are Harvest Energy Trust (HTE.UN, NYSE: HTE), Pengrowth and Provident Energy Trust (PVE.UN, NYSE: PVX). Harvest has long been among the most aggressive trusts, going outside the box last year with the CD1.6 billion purchase of an Atlantic Canada refinery. It’s also 58 percent owned by foreigners and has had no problems successfully issuing securities in the US. Management to date has given no indication it would be willing to move in that direction.

Harvest’s refinery has been a big winner because that industry has enjoyed robust spreads and pricing. Last year’s acquisitions of properties at relatively high prices could prove a problem, and the shares have gained considerable ground in recent months. But Harvest Energy Trust still rates a hold.

Pengrowth is already listed as an LP in the US and has hefty US ownership as well. Its key problem listing entirely as a US LP is a lack of US-based assets, but management has proven aggressive and skillful in navigating financial matters. As long as the trust’s payout ratio is around 100 percent, however, investors should tread with caution. I rate Pengrowth Energy Trust a hold for aggressive investors only until we see some better numbers.

The other trust that seems best positioned to convert is Provident Energy Trust. Provident already has substantial operations in the US, which are organized under the partly spunoff BreitBurn Energy Partnership. It, too, has an NYSE listing and is heavily owned by US investors.

Provident, however, remains strongly committed to the Canadian market and Canadian assets. The trust this month completed the purchase of Capitol Energy for CD373.5 million, adding long-life assets in the country.

BreitBurn has also been expanding, in large part thanks to funds raised at a favorable cost of capital in the US. But it’s clearly only a part of Provident’s overall strategy, which includes running one the largest gas midstream asset businesses in Canada.

A Better Way

The possibility of full conversions of Canadian oil and gas trusts to LPs does offer considerable potential upside to the sector. Even if just one trust makes the leap, all should benefit with higher share prices.

More likely, however, is the possibility more trusts will follow Provident’s model, i.e., build a base of assets in the US by organizing them into LPs. This way, trusts can avoid Canadian taxes with greater reliance on foreign income. And they’ll be able to kick up more cash to shareholders by avoiding taxes under the US partnership label as well.

Investors should approach potential conversions the same we do takeover candidates: Never buy anything you wouldn’t want to own if no such deal occurs. No trust is worth holding unless there’s a good business behind it.

Sticking with a good business philosophy enables you to avoid the garbage that gets overhyped when takeovers are in the press. And odds are you’ll get a much bigger pop when something occurs as well because the underlying business is already valuable.

In the oil and gas sector, Provident’s BreitBurn looks set to continue its solid growth. The LP has already made two major acquisitions in California and Florida since its initial public offering, and more are apparently in the works.

Those additions, plus the Capitol purchase, induced the trust to boost 2007 targets for both capital spending and production. It also now projects operating costs in Canada to drop 5 percent from year-earlier levels.

Like all oil and gas trusts, energy prices will always play the largest role in determining profitability and growth at Provident. But the tax advantages of producing income outside Canada—and the possibility of a bigger move down the road—are a major plus for this trust, which is still largely panned on Bay Street and Wall Street and is, therefore, cheap. Buy Provident Energy Trust up to USD14.

Enerplus’ US operations aren’t nearly as extensive as Provident’s. But the trust is making a major move to expand operations in the Baaken region straddling the two countries, which could provide substantial assets and income to convert into an LP by the time 2011 taxation kicks in.

As noted above, the trust’s management has repeatedly proven its savvy and flexibility over the years; it’s carefully and patiently considering its options under a full taxation regime. And it’s well positioned to make a move to an LP should that prove to be the best path. Enerplus Resources is a strong buy anytime it trades under USD50.

Precision Drilling (PD.UN, NYSE: PDS) and Trinidad Energy Services Income Trust (TDG.UN, TDGNF) are also good candidates for spinning off at least a portion of their US assets as LPs. Trinidad, for example, completed another acquisition in the US last month for the express purpose of reducing its dependence on the Canadian market.

The company picked up four land-based drilling rigs and one barge drilling rig with the purchase, and it agreed to fund the construction of a second barge drilling rig for CD26 million. That will further diversify the asset base outside of Canada, which is already almost two-thirds focused on the US.

As of now, there’s no indication Trinidad’s management is considering such a course. For one thing, its US-based income will be sheltered anyway from Canadian taxes. But with other equipment-based firms in the US seeking the LP shelter, it remains an option for a company with many.

The Canadian drilling business remains on the weak side and—given drilling projections by major producers—is likely to remain in the doldrums for the rest of the year. Both Trinidad and Precision, however, have the size and financial stamina to weather these difficult times. Precision’s current distribution was less than half its first quarter cash flow after two recent reductions.

Barring a takeover of either or both, I don’t expect to see a major rebound for these shares until energy prices turn up. But they’re relatively inexpensive and still buys for aggressive investors who don’t own them and want a leveraged bet on energy. Buy Precision Drilling up to USD30 and Trinidad Energy Services Income Trust to USD18.