It’s been a solid month since Canadian Finance Minister Jim Flaherty dropped a bomb on his country’s thriving royalty and income trust sector. And there’s a still a lot we don’t know about how the plan to bring corporate taxation to trusts will work or how it will impact the individual trusts themselves.

Fortunately, we can make at least a few observations with confidence. First, while November was a very bad month for trusts, only five of the 130-plus trusts tracked in Canadian Edge are currently off more than 10 percent for the year on a total return basis. In fact, as of the close Nov. 30, 46 were actually showing positive returns for 2006.

The bulk of the damage to trusts last month was done in a single day, Nov. 1. As we’ve written in Flash Alerts and the weekly Maple Leaf Memo (www.mapleleafmemo.com), that day the market priced in the full impact of an additional 26.5 percent levy on distributions to foreign and Canadian tax-free investors.

The market continued sharply downward on Nov. 2, before recovering later in the day. It then surged for a couple days before crashing again, reaching a low mid-month as panic reached a fever pitch. Finally, the buyers began to come back with a vengeance, and most trusts proceeded to rally to the end of the month.

That, of course, wasn’t the case for every trust. And some trusts and trust sectors had a more volatile ride than others. Energy service trusts, for example, have been hit by the tax proposal as well as weakness in Canadian oil and gas drilling, so the blow to them has been doubly felt. As expected, oil and gas producer trusts have followed energy prices around by the nose.

Other trusts, meanwhile, have followed dramatic developments at their underlying businesses. For example, Calpine Power Income Fund (TSX: CF-U, OTC: CLWIF) is up more than 38 percent for the 12 months ended Nov. 30, as management announced it would be able to maintain its distribution, despite receiving a lower price for power resold after the bankruptcy of parent Calpine Corp.

On the other hand, Countryside Power Income Fund (TSX: COU-U, OTC: COUUF) was underwater 24.9 percent for the same period, due to questions about a key source of its cash flow. It’s made up a fair chunk of that ground today, as I noted in an earlier Flash Alert today.

Overall, however, it’s fair to say that the psychological blow from the proposal to tax trusts has been, at least to date, significantly greater than actual losses in the trusts’ share prices. And with the tax changes now priced in, it’s the individual prospects of the trusts themselves that are setting the tone for share price performance.

My second observation is the lack of reaction among the trusts themselves to the tax proposals. This week, I analyzed the statements of the management teams of each trust I cover, from letters to shareholders, documents filed with Canadian regulatory authorities and personal statements.

Except for the REITs and split-share companies—e.g., Atlantic Power (TSX: ATP-U, OTC: ATPWF) and TimberWest (TWF.UN, TWTUF), which are apparently exempt from the proposal—virtually every trust has expressed a combination of outrage and dismay as well as hope that the government can be persuaded to tweak the proposal. Many have urged shareholders to contact the government, and some have presented sample letters, as we’ve done on the Canadian Edge Web site.

Contrary to predictions of a massive retrenchment, however, most trusts appear to be taking a wait-and-see approach on the proposal. In fact, the majority continues to operate as though nothing has changed. This week, for example, Pengrowth (NYSE: PGH, TSX: PGF-U) announced a CAD1 billion deal to buy ConocoPhillips properties that will boost its output of oil and gas by 27 percent. Other trusts have been using their cash to buy back their own shares.

A handful—including Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF)— stated unequivocally that they intend to remain trusts until 2011 and beyond. And a dozen or so underscored their statements with sizeable dividend increases. This week, for example, Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) raised its dividend by 11 percent, even as it affirmed plans for a dramatic buildout of its oil sands pipeline and processing infrastructure.

I suspect we’ll see more adjustments and restructurings once the government has introduced and passed final legislation and when questions such as “what is taxable distributable cash flow?” are finally answered. But to date, trusts appear to be following my forecast of moving incrementally and trying to protect their shareholder bases, rather than moving dramatically in a way that may cause further damage to trust prices.

The third point of interest during the past month has been the actual makeup of trust buyers versus trust sellers. In the first few days after Flaherty’s announcement, foreign investors were relentless sellers: That’s the clear implication from the hit the Canadian dollar took during that time. As prices sank, however, Canadian institutions and research houses, which had been generally cautious to bearish on many trusts in the summer and early fall, began to get increasingly bullish.

As a result, the big boys, not Canadian individuals or American investors, have fueled the buying that led the late month recovery. Their increased participation and ownership of the trust sector continues the trend that began a couple years ago when the provincial governments abolished the unlimited liability for trust shareholders in the event of a bankruptcy.

Canadian institutions have patiently taken advantage of drops in trust prices to increase their ownership of good ones. That trend is certain to continue going forward. It will ultimately make the trust market less volatile and more accountable in terms of presenting key financial information and treating shareholders fairly.

One development I’ve noticed in my analysis of third quarter financial statements is the overall more-consistent presentation of distributable cash flow (DCF). Several trusts this quarter brought their numbers for DCF into alignment with operating cash flow, abandoning the practice of adding in one-time items and even cash reserves to present a more-palatable payout ratio.

My fourth observation is admittedly the most speculative: a potential mellowing of the government’s hard line position toward the existing income trust universe. I have no claims on clairvoyance, and I was dead wrong on my read of this government’s intentions before the tax proposal. But there are a few hopeful signs that there might be some tweaking ahead.

The biggest so far is the Finance Ministry’s apparent pre-approval of Pengrowth’s plan to buy the ConocoPhillips assets. As noted in a Flash Alert last month, there was speculation that the government wouldn’t allow trusts to make acquisitions that it deemed “undue expansion.” That stemmed from alleged comments from Flaherty himself. What then followed was a discussion of just what would constitute undue expansion and a consensus rumor that anything that involved a 15 percent increase in outstanding shares would be rejected.

By allowing Pengrowth’s deal to go through—which would involve increasing the trust’s share base by 10 percent—the Ministry is well within the 15 percent rumored guideline. But the sheer magnitude of the deal is without doubt audacious. If we see more of the same, as would seem likely, the percentage of Canadian oil and gas produced by trusts in 2011 will be a lot more than the current 20 percent.

When I first read the announcement, my view was that the government would reject the Pengrowth deal or else would be tacitly abandoning any plans to halt the expansion of trusts. The fact that trusts across the board are following its lead in announcing expansion plans as well as myriad actual deals may be a “damn the torpedoes” strategy. And the government could blow it up at any time. According to its previous statements, the Finance Ministry is still putting together its plans to control trusts’ expansion and could still release something onerous at any time.

On the other hand, the word is that Pengrowth did receive a comfort letter for its deal from the government, to the effect that it wouldn’t interfere. And it’s certainly possible that others have received the same.

At any rate, there appears to be an awful lot of talking going on in Ottawa about how to handle these issues. The Finance Ministry didn’t consult with the industry on its proposal to tax trusts. But it at least appears to be doing so with regard to the details, and anything can happen. There’s even been talk from Prime Minister Tim Harper about doing away with the 15 percent withholding tax on US citizens.

The best thing about this is that we already know what the worst case is with trust taxation. If nothing happens with these discussions and the government doesn’t budge or tweak, then nothing is lost. On the other hand, if something does happen, it will almost surely be for the good.

Make no mistake, however. As I said in my Nov. 1 Flash Alert—the day of the hit—we should assume the proposal will go through as is, with no improvement. And we should assume that trusts that depend on issuing a lot of shares aren’t going to fare well. Many of these were blowing up before the tax proposal. And if there are share issue limitations, they won’t be long for this world.

By keeping our expectations low, the only trusts we own will be those that can prosper if they’re taxed as corporations after 2011. And if there’s tweaking, so much the better.

That remains my view today. I’m currently working hard on the most important Canadian Edge issue yet. My goal is to present the outlook for trusts overall, by sector and finally trust-by-trust on their business prospects and how they should fare under the tax proposal. We’ll e-mail it to you on Dec. 8 at noon EST. In the meantime, if you have questions about individual trusts, feel free to e-mail me at canadianedge@kci-com.com.

Nov. 22, 2006: Beyond 2011

There are now more than 250 publicly traded Canadian royalty and income trusts. And there are likely to be just that many tax strategies for the years leading up to 2011 and beyond.

Again, here’s the math: The 41.5 percent rate represents absolute worst-case math for dividend trust taxation. It assumes that all distributable cash will first be taxed at the corporate rate, which is 31.5 percent. That would reduce the total pool of cash that can be distributed by 31.5 percent.

It doesn’t, for example, take into account the impact of return of capital, which would not be taxed and is a large piece of many trusts’ distributable cash. In the case of Great Lakes Hydro (TSX: GLH-U, OTC: GLHIF), for example, around 50 percent of the distribution over the past decade has been return of capital. Were they taxed as a corporation today, only half their distributable cash would be taxed at 31.5 percent, for an effective rate of just 15.75 percent.

In the coming weeks, the staff of Canadian Edge will be analyzing the tax picture of every trust we track to get an idea of what we can expect for their distributions. We’ll also be keeping a close eye on what trusts actually do as the tax legislation progresses in parliament and they’re forced to confront basic questions about where they want to go after 2011.

To date, we’ve heard a lot of speculation about mass conversions back to corporations, and huge accompanying dividend cuts. The theory is that management will have no incentive to pay a big dividend under the next tax scheme, and will move as quickly as possible to squirrel away capital.

As I said above, literally every trust will have to decide on its own strategy and one size definitely will not fit all. But at least one has already thrown in its lot with those of its income investing shareholders: Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF).

With the highest stability rating from the Dominion Bond Rating Service of any trust and routinely posting robust earnings, Yellow Pages has been a favorite of mine for some time. The shares had been weak over the summer, as a research report disparaged their print pages business as being in decline. They recovered sharply as earnings proved otherwise, with print advertising steady and internet sales robust. They slid again sharply in the wake of Finance Minister Jim Flaherty’s Oct. 31 announcement of trust tax changes, and have since been rising back slowly.

This week, Yellow Pages announced it would raise its annual cash distribution by 6 percent. Further, management said it would retain its income trust business model despite the government’s plan to tax the sector after 2011, stating “its business model and operating plans were unchanged as the Canadian government’s proposal to begin taxing most publicly traded income trusts in 2011 is not expected to affect the operations of Yellow Pages Group and Trade Corp.”

Going further, management stated “we are confident that our ability to generate free cash flow from operations in excess of cash distributions will provide the necessary flexibility to fund cash income taxes following the four-year transition period.” And it affirmed it would still look to expand its business with national and local advertisers and by integrating prior acquisitions.

The bottom line: Yellow Pages expects to be able to grow its way through its post-2011 tax liabilities. In fact, it’s so confident in its ability to do so that it’s increased its monthly dividend by a sizeable amount now.

Yellow Pages’ announcement comes on the heels of similar statements by other trust managements, who have increased distributions following the government’s tax announcement. And it’s the best sign yet that trusts backed by fast-growing, healthy businesses will remain solid investments well past 2011.

That’s certainly not to say that every trust out there will fare well. Since last Friday’s Flash Alert, the Canadian government has tried to assure investors that it would not impose tough limits on trusts’ ability to mint new shares. But the possibility of action on that front remains a grave threat to trusts that depend on share issues to maintain cash flows. That’s one reason there are still so many sell-rated trusts in the How They Rate table.

Oil and gas remains especially vulnerable, which is why investors should stick mainly to the core group of ARC Energy Trust (TSX: AET-U, OTC: AETUF), Enerplus Resources (NYSE: ERF, TSX: ERF-U), Penn West Energy Trust (NYSE: PWE, TSX: PWT-U), Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF), Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) and Zargon Energy Trust (TSX: ZAR-U, OTC: ZARUF). And even this group may be forced to tack some, and Penn West has seemed to indicate in its recent earnings report.

The bottom line, though, is that as details emerge, more and more trusts are distinguishing themselves as still being great long-term investments. There are still some adjustments to make and we haven’t heard from all the Canadian Edge Holdings yet.

The point, however, is that a portfolio of well-managed business trusts, power trusts–which, as Maple Leaf Memo states, remain very solid–Canadian REITs, stapled shares like Atlantic Power Corp (TSX: ATP-U, OTC: ATPWF) and the strongest oil and gas producers is still a winner. I still expect to have to replace at least one or two current CE Portfolio holdings to get the optimum mix. And until all the trusts report in, I want to wait for all the information to come in before doing so.

We’ve suffered a lot this month, and there’s still a lot of uncertainty left. But when prices are this low and yields this high, it’s time to think positive again.

Nov. 17, 2006: Less Is More

Not every trust that issues a lot of shares is doomed to fail. But if the money raised doesn’t earn a high enough return, the inevitable result is dilution and dividend cuts. That’s why I’ve often warned against investing in trusts that issue a lot of shares.

Now there’s another reason for caution on big issuers: recent statements by the Canadian Finance Ministry that it may prohibit trusts’ acquisitions that involve increasing the outstanding share count by 15 percent or more.

There’s some evidence the trust sector carnage of the past few weeks–and the resulting mass protest on both sides of the border–have caught the eye of at least some Canadian politicians. And there are definite rumors the government’s proposal could be altered. Before that happens, however, it’s also quite possible that we will see a cap on the size of acquisitions, which will be quite a blow to more than a few trusts.

The good news is we’ve been cautious about trusts that depend on issuing a lot of shares. Consequently, there’s not much in the Canadian Edge Portfolio that’s really vulnerable to such a move.

First off, most holdings haven’t been prolific issuers. And those which have issued a lot of shares to make acquisitions don’t depend on future deals to maintain current cash flow (and dividends). For example, Newalta Income Fund (TSX: NAL-U, OTC: NALUF), TransForce Income Fund (TSX: TIF-U, OTC: TIFUF) and Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF) have been able to grow both cash flow and dividends rapidly, largely by making acquisitions.

Limiting their future buying power as trusts would slow their torrid rates of growth. On the other hand, all have achieved a certain scale that should allow them to do pretty well with “tuck in” deals of existing assets. And more important, current levels of cash flow and dividends are not dependent on making further acquisitions.

That’s also true of energy infrastructure trusts like AltaGas Income Trust (TSX: ALA-U, OTC: ATGUF), Keyera Facilities (TSX: KEY-U, OTC: KEYUF) and Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF). It’s true of our four power trusts and rural telecom Bell Aliant (TSX: BA-U, OTC: BLIAF). TimberWest Forest Corp (TSX: TWF-U, OTC: TWTUF) and our REITs are of course unaffected as well.

Our energy services trusts–Essential Energy Services Trust (TSX: ESN-U, OTC: EEYUF), Peak Energy Services Trust (TSX: PES-U, OTC: PKGYF) and Precision Drilling (NYSE: PDS, TSX: PD-U)–converted largely because the move has helped them make more acquisitions. Restricting their moves would indeed hurt future growth. But all have good assets, and current cash flow levels aren’t dependent on making future acquisitions. Rather, it’s the level of energy patch activity, which I’m still convinced will surprise to the upside going forward. Precision, meanwhile, has enough scale to continue to grow, whether it chooses to convert back to a corporation right away or not.

The group that’s most vulnerable to an acquisition cap is the oil and gas producers. Specifically, many of these must make acquisitions regularly in order to replace declining reserve bases. If they can’t do so, they’ll simply wither away.

Happily, most of my recommended oil and gas have not been ardent issuers of shares. ARC Energy Trust (TSX: AET-U, OTC: AETUF) and Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) have issued virtually no shares over the past year. Enerplus Resources (NYSE: ERF, TSX: ERF-U) has issued shares, but mainly to finance growth from its existing assets such as the oil sands. Penn West Energy Trust’s (NYSE: PWE, TSX: PWT-U) share count zoomed this year, but only because it merged with Petrofund. In reality, its huge raw land reserves mean it only needs to make minor acquisitions. All four of these trusts also have very long-lived reserves.

As I pointed out recently, Avenir Diversified Income (TSX: AVF-U, OTC: AVNDF) is actually more REIT (60 percent of income) than oil and gas play. Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF), meanwhile, has issued very few shares as it has developed its own reserves.

That leaves Harvest Energy (NYSE: HTE, TSX: HTE-U) as my most vulnerable pick. The trust, however, has completed its financing for the purchase of a refinery and has built an impressive base of assets. Its challenge isn’t to buy more, but to integrate what it has. As a result, it shouldn’t be overly impacted either.

What’s vulnerable is most of the rest of the oil and gas producer trust universe. This group is already reeling from the impact of falling energy prices. This week, Advantage Energy (NYSE: AAV, TSX: AVN-U) slashed its dividend yet again, blaming “uncertain taxation” but really merely bowing to the inevitable due to overpriced acquisitions, too many shares being issued and slumping energy prices. I would sell virtually any oil and gas trust that’s increased its share base by more than 20 percent.

Of course, a cap on trust acquisitions, if enacted, would likely trigger some more selling in the sector in general, including of trusts that really have little exposure. The bottom line is still that if you like a trust and would still hold it if the dividend were cut 26.5 percent–the maximum impact of the tax changes–you should hold on.

In addition, the best oil and gas trusts are going to follow energy prices over the next year or so, regardless of what happens to the tax proposals. If you’re bullish on energy, as I am, it still makes sense to hold onto ARC, Vermilion and the rest, though not to their weaker peers.

Finally, there are signs that smart money is already buying up the better trusts. Some are investment funds that surely have the goal of flipping them for big profits in the near future. Some are Bay Street houses who see huge values. In any case, it’s becoming apparent that there are real bargains here, even if you factor in the impact of higher taxes.

My strategy over the next few months will continue to be focusing heavily on trusts that will escape the impact of the government’s proposals. But the rest of the CE Portfolio is also attractive. And Canadian government shenanigans or no, the best move is to stick with them.

Nov. 14, 2006: The 25 Percent Rule

It was another choppy day for Canadian royalty and income trusts. Trusts that are largely unaffected by the proposed tax changes appear to be getting some traction. Meanwhile, affected trusts continued to head lower.

In Flash Alerts yesterday and Friday, I outlined a tacking move in my trust investing strategy. First, I want to build a conservative core of high-yielding trusts backed by solid businesses that are unaffected by the proposed tax changes.

On Friday, I began to transition the formerly named Top 10 into a broader Conservative Portfolio by moving exempt Algonquin Power (TSX: APF-U, OTC: AGQNF), Atlantic Power Corp (TSX: ATP-U, OTC: ATPWF) and Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF) in and swapping out volatile and nonexempt Precision Drilling (NYSE: PDS, TSX: PD-U) to the Aggressive Portfolio.

I followed that up in yesterday’s Flash Alert by adding two exempt trusts: Frequent Canadian REIT recommendation Northern Properties (NPR.UN, NPRUF) and “straddle share” Primary Energy Recycling Trust (TSX: PRI-U, OTC: PYGYF) to the Conservative Portfolio. And I plan to add more exempt trusts to the Conservative Portfolio going forward.

The other part of my strategy is to decide which to hold of the battered trusts affected by the tax changes. Thus far, I’ve held onto pretty much everything and have been punished for it. Damage today was particularly severe among energy producers, as investors worry about what will happen to oil and gas prices this winter.

As we pointed out in this week’s Maple Leaf Memo, the simple litmus test for a battered trust is simply this: Would it still be an attractive holding if the dividend you now receive net of Canadian withholding were cut 26.5 percent? That’s essentially the additional amount of tax on trusts’ distributable income beginning in January 2011.

If you can honestly answer “yes” to that question, then you have no business selling. That’s because the trust’s price already factors in the absolute worst case scenario on taxes and then some. In other words, even if the taxes were raised today and the trust cut its distribution to reflect it, your trust would still pay a yield you’d be satisfied with.

When I look down the list of Canadian Edge Portfolio picks affected by the ruling, I see the following:

• AltaGas (TSX: ALA-U, OTC: ATGUF)—8.5 percent
• Bell Aliant (TSX: BA-U, OTC: BLIAF)—9.7 percent
• Keyera Facilities (TSX: KEY-U, OTC: KEYUF)—8.3 percent
• Newalta Income (TSX: NAL-U, OTC: NALUF)—8.9 percent
• Pembina Pipeline (TSX: PIF-U, OTC: PMBIF)—8.5 percent
• TransForce Income (TSX: TIF-U, OTC: TIFUF)—11.8 percent
• Yellow Pages (TSX: YLO-U, OTC: YLWPF)—8.5 percent
• ARC Energy (TSX: AET-U, OTC: AETUF)—11.9 percent
• Avenir (TSX: AVF-U, OTC: AVNDF)—14 percent
• Essential Energy (TSX: ENS-U, OTC: EEYUF)—19 percent
• Fording (NYSE: FDG, TSX: FDG-U)—22.1 percent
• Harvest Energy (NYSE: HTE, TSX: HTE-U)—17.7 percent
• Paramount Energy (TSX: PMT-U, OTC: PMGYF)—19.1 percent
• Peak Energy (TSX: PES-U, OTC: PKGYF)—18.8 percent
• Penn West Energy (NYSE: PWE, TSX: PWT-U)—12.4 percent
• Precision Energy (NYSE: PDS, TSX: PD-U)—14.6 percent
• Vermilion Energy (TSX: VET-U, OTC: VETMF)—6.6 percent

With the exception of Vermilion–whose low payout ratio and low debt make it virtually adjusted to a corporate format already–the rest of these are all yielding well above what they should were the tax change to tax place immediately. Moreover, all continue to grow their earnings rapidly, as we’ve pointed out in the trust updates in Maple Leaf Memo. The only exception is Fording, which is hostage to slumping metallurgical coal prices.

As I’ve pointed out, the oil and gas trusts will continue to be affected by oil and gas prices. For example NAL Oil and Gas (TSX: NAE-U, OTC: NOIGF)–a medium-grade trust I’ve recommended–this week announced a dividend cut in response to falling oil and gas prices.

No trust to date, however, has taken any kind of precipitous action with its dividend in response to the proposed taxation changes. As NAL’s representative assured me today, no one he knows of has that intention either. Rather, they’re going to wait to see how things play out before they take action on that basis.

As investors, that’s exactly what we should do as well. The daily trading remains very tough to take and I confess I don’t have a crystal ball. I can’t say prices won’t go lower still. But if the worst case still looks good–a 26.5 percent lower dividend–there’s no reason not to stick with good trusts.

Nov. 13, 2006: Exempt Trusts

Trusts across the board appear to be taking another haircut today. There’s no new development behind the selling, other than some weakness in energy prices. It just looks like more investors are throwing in the towel after the recent steep price decline.

The primary reason for selling remains consternation about the Canadian government’s plan to tax trusts as corporations, beginning in 2011. Here’s an excerpt from Essential Energy Services Trust’s (TSX: ESN-U, OTC: EEYUF) third quarter earnings announcement that offers the clearest and simplest explanation of the proposed change I’ve seen to date:

“On October 31, 2006, the Minister of Finance announced its proposal to amend the Income Tax Act (Canada) to apply a Distribution Tax on distributions from publicly traded income trusts. Under the proposal, existing income trusts will be subject to the new measures commencing in their 2011 taxation year, following a four-year grace period. The Minister of Finance issued a Notice of Ways and Means Motion to Amend the Income Tax Act and on November 7, 2006, obtained approval from Parliament to enact the proposal.

“In simplified terms, under the proposed tax plan, income distributions will first be taxed at the trust level at a special rate estimated to be 31.5%. Income distributions to individual unitholders will then be treated as dividends from a Canadian corporation and eligible for the dividend tax credit. Income distributions to corporations resident in Canada will be eligible for full deduction as tax free inter-corporate dividends. Tax-deferred accounts (RRSPs, RRIFs and Pension Plans) will continue to pay no tax on distributions. Non-resident unitholders will be taxed on distributions at the non-resident withholding tax rate for dividends. The net impact on Canadian taxable investors is expected to be minimal because they can take advantage of the dividend tax credit. However, as a result of the 31.5% Distribution Tax at the trust level, distributions to tax-deferred accounts will be reduced by approximately 31.5%, and distributions to non-residents will be reduced by approximately 26.5%.”

Essential went on to clearly state management’s view on the change and how it would affect the trust:

“Given the four-year grace period before existing trusts will be taxed, Essential has an opportunity to examine its strategy and, if warranted, modify it to provide the best possible return for its unitholders. At the same time, Essential’s investors have an opportunity to arrange their investments before 2011 to minimize the impact of the proposed tax changes on their portfolios. The long-term effect of the proposed tax changes announced is yet to be determined.”

Essential, then, will take its time to adapt to the changes in the way that makes sense for its future. Its management is also joining with other trusts to lobby the government for changes to the policy.

That’s what we’re looking at here: After 2011, trusts’ cash flow will be taxed just as corporations’ earnings are. That means they’ll have less cash to pay shareholders. Withholding tax on US investors will be the same as it is for ordinary Canadian equities. And most, if not all, trusts will use the full four years to make the transition.

That’s it. There will be no 41.5 percent withholding tax levied against US investors, as some US advisors have written. Neither are trusts likely to pay full corporate tax rates, as all will have an opportunity to become more tax efficient in the next four years.

What We’re Doing Now

For some investors, the selling we’re seeing today—and could see off and on during the next few weeks—will be too much to bear. Holding on is the only sure way to catch what should be a major rebound.

Even if you factor in a 26.5 percent dividend cut for US investors across the board (see above), you’re still looking at some outrageous yields on a large number of high-quality trusts. Just take a gander at the Portfolio trusts. As a result, I’m not doing any selling of Portfolio recommendations now.

On the other hand, I wouldn’t blame anyone for throwing up his/her hands in this market, especially because there may well be a few more gut-wrenching days ahead. On Friday, I sent you a Flash Alert announcing some changes in the Portfolios to better reflect what’s going on now in the trust sector. The first was changing the Top 10 Portfolio to a Conservative Portfolio, with a major focus on stronger trusts that are also exempt from the Canadian government’s tax changes. The Super Yielding Portfolio will be called the Aggressive Portfolio.

Friday, I moved my three electric power trusts—a group virtually unaffected by the tax changes—to the Conservative Portfolio. They are Algonquin Power (TSX: APF-U, OTC: AGQNF), Atlantic Power (TSX: ATP-U, OTC: ATPWF) and Boralex Power (TSX: BPT-U, OTC: BLXJF). Two other exempt securities in the Conservative Portfolio are RioCan REIT (TSX: REI-U, OTC: RIOCF) and TimberWest Trust (TSX: TWF-U, OTC: TWTUF). I also moved Precision Drilling (NYSE: PDS, TSX: PD-U) to the Aggressive Portfolio.

Today, I’m adding two additional exempt securities to the Conservative Portfolio. Northern Property REIT (TSX: NPR-U, OTC: NPRUF) specializes in properties in Canada’s resource patch and other largely remote areas, where it has little competition. In addition, its major customer in many markets is the Canadian government, minimizing the risk of vacancies or bad debt. The REIT has consistently maintained a low payout ratio—allowing consistent dividend growth—and a strong balance sheet, and has been a frequent buy recommendation in Canadian Edge. More information is available in the Archive on the Web site (www.canadianedge.com).

Yielding more than 5 percent—nearly 2 percentage points more than US REITS of similar quality—Northern Property REIT rates a buy up to USD23. I plan to add at least one more REIT to the Conservative Portfolio later this month.

The other addition is Primary Energy Recycling Corp (TSX: PRI-U, OTC: PYGUF), which specializes in recapturing waste energy from steel making and coking plants. Its portfolio consists of five projects capable of delivering 283 megawatts of electricity, along with commensurate amounts of steam, hot water and pulverized coal.

Canadian utility giant EPCOR is the major owner and manager of its projects, after acquiring the assets of the previous manager this summer. Output is sold under long-term contracts to primarily two major steel producers, with expiration dates ranging from 2011 to 2018. The plants in question are ranked among the most efficient in the US, which should ensure they’ll remain in operation even if the steel market slows. And there’s no fuel cost risk.

The payout ratio is expected to average about 96 percent during the first five years of the trust, with surplus cash going to a reserve for future dividends. The Dominion Bond Ratings Service has ranked the trust at STA-3 (low), though all stability ratings are currently under review following the proposed tax changes. The third quarter rate of 111 percent was due to disappointing results at one of the plants but is expected to return to normal levels in the fourth quarter. The distribution was most recently lifted in June, by 4.6 percent.

Primary Energy is exempt from the change in Canadian tax law because it’s technically an enhanced income security (EIS), rather than a classic trust. Each EIS consists of one common stock and an 11.75 percent subordinated note. The current monthly distribution of 9.59 cents Canadian breaks down to 7.14 cents Canadian in cash dividends and 2.45 cents Canadian of interest.

As is the case with Atlantic Power, the equity portion is withheld at the Canadian border in the amount of 15 percent, while the interest portion is not. The equity portion is considered qualified for tax purposes in the US, while the interest part is not. I’m initiating coverage of Primary Energy Recycling Corp in the How They Rate Table under Power Trusts, and it’s a buy up to USD9.

Nov. 10, 2006: Tacking, Slightly

Following the script from 2005, Canadian royalty and income trusts had a choppy few days after their massive plunge last week. Some gained on the week; some lost. On Monday, we saw a coalition of oil and gas trusts formally launch a campaign to convince Ottawa to rescind or at least alter its plans to begin taxing them as corporations in 2011.

“No exceptions” was the immediate response from Finance Minister Jim Flaherty, though later statements indicated he’d be willing to at least listen to suggestions down the road. The ruling Conservatives then rammed through parliament the first half of the proposal—to begin taxing any trusts that converted after October 31 to a full corporate rate. Their only opponents were the Liberals, who ironically owe their defeat in January to trying to alter trust taxation last year.

New trust conversions are dead. That appears to have been the government’s chief goal all along, with giants like BCE, Telus and Encana threatening to go trust. But for the existing trusts, the bottom line is that we don’t know how this is going to play out. And odds are we’re not going to know for some time.

What we do know is that a good many trusts and trust-like securities are exempt from this proposal. These include Canadian REITs, which remain much cheaper than US REITs and are a play on a hotter market. Note the exemption may not apply to hotel REITs or REITs invested primarily in the US. I’ve made the distinction in the How They Rate Table.

Electric power trusts already pay taxes and also look set to escape the knife. Timber was noted in the proposal as an exception. Finally, stapled shares—which pay big yields by combining debt with ordinary equity—are a different animal that doesn’t fall under the government’s definition. Their ranks include Atlantic Power (TSX: ATP-U, OTC: ATPWF) and TimberWest (TSX: TWF-U, OTC: TWTUF).

These exempt securities are still an exceptionally solid foundation for portfolios. There are also other trusts that are backed by extremely solid assets, are growing rapidly and already appear prepared to keep paying big dividends after converting back to corporations, particularly if the government follows through on plans to eliminate tax consequences on these reverse conversions.

As I stated in prior alerts, we have to assume that the tax changes will be the law of the land in 2011, when they’re scheduled to take effect. The altered taxation is now priced into the market. In fact, it’s more than priced in for many, now that the government has passed the first half and begun taxing new conversions.

Effective sailors always maintain their course, but they also tack when the wind shifts to keep up their speed. That’s what I’ll be doing in the Canadian Edge Portfolio in coming weeks.

We can still make a lot of money with Canadian trusts, particularly those exempt from the changes, but also with some that are being hit by them. The key is to put our efforts where they have the best chance of being rewarded.

In coming weeks, I’ll be changing the titles of the portfolios from the Top 10 Portfolio and Super Yielding Portfolio to better reflect my objectives in the post-taxation announcement world. The Top 10 will transition into the Conservative Portfolio, which will include securities exempt from the tax changes along with those best suited for an easy and profitable transition in 2011 and beyond.

The Super Yielding Portfolio will become the Aggressive Portfolio, with myriad opportunities for value and high income that have appeared in the wake of the selloff. These will include the best takeover opportunities, as foreign investors sift the trust universe for good assets selling at fire-sale prices.

Trusts’ organizations give them plenty of ways to block hostile deals at take-under prices, so the best of these have the potential for huge returns. The Aggressive Portfolio will also have the best opportunities in oil and gas, which is still more than anything else a bet on an inexorable trend of rising energy prices.

In reality, there probably won’t be that many changes regarding individual securities. I’ll be adding some exempt securities. But as I said in the first hours following Flaherty’s flip-flop, I’m comfortable with the businesses of all the trusts that are currently in the Portfolios.

Even Harvest Energy (NYSE: HTE, TSX: HTE-U) posted relatively solid third quarter earnings. And perhaps more important, the trust was able to complete its financing package for the recently acquired refinery, albeit on slightly less favorable terms. That’s a clear sign that Bay Street is comfortable with the Harvest’ business model and prospects.
  
What these changes will do is better take into account what’s happened to trusts and what you can expect by owning each individual trust. I’ll have the full lineup for you with the December issue.

In the meantime, the best idea is to hold onto what you own. With the exception of exempt securities, it’s best for conservative investors to go easy on new purchases, at least until we really know what the future rules will be.

Also, continue to adhere to the 20 percent rule: No more than 20 percent (25 percent at the extreme outside) of an income portfolio should be in any one particular type of security. There are some incredible bargains among Canadian trusts now, even if you assume the worst on the tax changes. But there are also many other income investments that are working now.

Don’t ignore, for example, US utilities, preferred stocks and bonds to try to make back what you’ve lost in the last two weeks all at once. You’ll get it back and a lot more if you’re patient and prudent.

Nov. 1, 2006: The Worst-Case Scenario

Canadian Finance Minister Jim Flaherty played a nasty Halloween trick on the market last night with his proposal to phase out Canadian trusts’ tax advantages. The move is a 180-degree reversal from the Conservative Party’s position prior to the January parliamentary election, as well as from a statement Flaherty himself made just two weeks ago.

Like most investors in Canadian trusts, I’m steamed. On the other hand, the damage has been done with today’s massive erasure of wealth. More important, the worst-case scenario is now crystal clear and largely in the trusts’ share prices.

Admittedly, this isn’t what I expected. I remain convinced that Flaherty’s proposal wasn’t a logical move and that it will wind up hurting Canadians more than anyone else.

The country’s pension system, for example, owed its better funding to the fact that income trusts had proven so successful. Also, it’s hard to imagine Canadian oil and gas production not shrinking even more, particularly after the recent drop in prices.

There will be opposition to the government’s proposal in coming weeks, as the trusts themselves organize their efforts to block it. And I advise investors to contact the following persons with their views: Dan Miles, Director of Communications Office of the Minister of Finance at 613-996-7861 and David Gamble at 613-996-8080. In addition, if you’d like to receive automatic e-mail notification of all news releases, please visit the Dept of Finance Web site at www.fin.gc.ca/scripts/register_e.asp.

We should not count on a reversal or even a partial softening of the ruling. If there’s one, it will no doubt catapult all trusts to big gains from here, as happened last year. But we, as investors, need to be sure we’re OK even if the proposal goes through as written.

Dividends on ordinary Canadian equities are not withheld by the authorities at the 15 percent rate trusts are. Presumably, when trusts are taxed as corporations in four years, this 15 percent withholding will vanish as well. We’ll have more as details appear. But remember, no changes are occurring in trust taxation for four years under this proposal.

The Roundup

Here’s an initial analysis of the various trust sectors, based on what we do know about the worst-case scenario:

All Trusts

Every trust now publicly traded will be grandfathered from corporate taxation until 2011. At that time, under the plan, they’ll be taxed at the same rate as corporations. Until then, they’ll continue to enjoy the same favorable taxation they do now, though most are likely to begin transitioning toward paying more taxes (and, by extension, less dividends) once the Finance Ministry’s proposals become law.

New Trusts

The government didn’t propose formally ending new conversions. But it would end their favorable taxation effective immediately, so the result of no new trusts is almost certain to be the same.

Oil and Gas Producers

This was the group for which trust taxation was first created, to encourage development of marginal and depleted wells. As I’ve pointed out, one size hasn’t fit all in this sector, as trusts vary greatly in terms of scale, costs, size, payout ratio policies, debt financing, reserve quality and other factors.

Doing away with producer trusts’ favorable taxation can’t help but curtail energy production in Canada, including quite possibly the oil sands, as companies are forced to shepherd more cash flow to pay taxes. And smaller trusts will be forced to either seek combinations to get bigger or else go out of business.

Because energy production is so important to Canada, oil and gas trusts stand the best chance of winning an extension of trust status. But whether they succeed or fail, the best trusts to own will remain ARC Energy (TSX: AET-U, OTC: AETUF), Enerplus (NYSE: ERF, TSX: ERF-U), PennWest (NYSE: PWE, TSX: PWT-U), Vermilion Energy (TSX: VET-U, OTC: VETMF) and Zargon Energy (TSX: ZAR-U, OTC: ZARFF). Also, Peyto Energy (TSX: PEY-U, OTC: PEYUF), though gas focused, is similarly a low-payout, low-cost trust that should be able to shepherd the necessary cash flow to keep growing.

Energy Service Trusts

These could be hurt if Canadian oil and gas drilling slows down in the wake of small trust failures. They’re not sheltered from the proposal, but most have been covering distributions with ordinary earnings per share. The key for them is still how much energy activity slows in the coming months, which will likely depend more on the level of energy prices than the government’s actions.

Electric Power Trusts

The situation here is a little murkier, given the use of debt interest, which will still be tax deductible. At least one Canadian Edge recommendation—Atlantic Power (TSX: ATP-U, OTC: ATPWF)—is exempt from the new tax rules, since it’s organized as an income deposit security rather than a trust. Power could prove to be a safe haven.

REITs

The only trust sector that was spelled out to be immune from the change in taxation is REITs. These dropped marginally today but should recover their losses and more. Interestingly, Avenir Diversified Income Fund (TSX: AVF-U, OTC: AVNDF) now derives 60 percent of its distributable cash flow from real estate, making it a good candidate for conversion to a REIT during the next four years.

Business Trusts

This is where the worst damage was done today in the market. Not all business trusts, however, will be equally impacted by switching to corporations. The likes of AltaGas (TSX: ALA-U, OTC: ATGUF), Newalta (TSX: NAL-U, OTC: NALUF), TransForce (TSX: TIF-U, OTC: TIFUF) and Yellow Pages (TSX: YLO-U, OTC: YLWPF) have been using their trust status to grow rapidly during the past few years. Now with sufficient scale and very steady assets that generate a ton of cash, all are still likely to pay sizeable dividends even if they’re forced to convert to corporations in 2011. In the meantime, it shouldn’t be too much trouble for them to gradually shift more cash to cover payouts.

Pipeline and Infrastructure

These businesses are generally organized as limited partnerships (LPs) in the US. One of the more dubious provisions of Flaherty’s proposal is to begin taxing LPs as corporations, so that may be out as an option, though some could win permanent flow-through status as they have in the US.

In any case, Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF) and Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) have been generating a lot of cash, and most capital expenditures have been for growth, rather than maintenance. Converting to a corporation means cash for taxes will have to come at the expense of either growth or dividends. But with other Canadian pipelines paying big dividends they’ll likely continue paying on the high side.

Natural Resources

Timberwest Trust (TSX: TWF-U, OTC: TWTUF) is a stapled share, rather than a conventional trust. As such, it appears to be exempt from the ruling. Fording Canadian Coal (NYSE: FDG, TSX: FDG-U) on the other hand isn’t exempt, but its royalty interest in one of the world’s richest sources of metallurgical coal give it major takeover possibilities.

Trust Mutual Funds

These entities are basically closed-end mutual funds holding trusts. As such, their value fluctuates with the values of the trusts that they own. Most of these took a big hit today. But there are no additional tax questions for investors to ponder, as they’re not trusts themselves.

Summing Up

Since Canadian Edge’s inception in summer 2004, my approach has been to buy trusts that represent the best mix of growing businesses I can find. That’s still my approach, and it’s also the strategy of Neil George, editor of CE’s sister letter Personal Finance (www.pfnewsletter.com).

Looking over the trusts in both newsletters’ Portfolios, we remain confident on the merits of their respective businesses. We’re still comfortable with what those businesses are doing on an operational level. And they’re free to operate within the pre-announcement rules for the next four years.

The problems going forward: how the market reacts to the news of a change in trust taxation as more investors become aware of it over coming weeks and how the trusts themselves will behave given the four year limit on their lifespan before they have to convert to corporations.

I’m not advising wholesale selling at this time. But I do advise focusing only on the trusts that operate good businesses. I’ll do my best to point those out to you in coming issues. The November issue—which will be e-mailed to you on Friday at noon EST—looks at earnings news for the recommended trusts that have announced profits so far, as well as the issue of dividend safety based on business strength. I’ll be recapping profits for the other picks as they appear throughout the month.

Even in this worst-case scenario, there are still trusts worth buying and holding for the long haul, as their businesses grow. And once the proposed new rules are in place, equalizing the taxation between all business entities, I intend to begin covering selected dividend-paying Canadian corporations as well as trusts within the pages of Canadian Edge. We’re also likely to see more use of convertible debt by trusts, as the interest remains tax deductible.

I agree with Neil that there’s a good chance that trust shares could drift still lower in the coming weeks, as news of the tax changes spread. Markets always overshoot on the downside to bad news.

Here’s my plan: I’m keeping the same buy targets on most of the recommended trusts and rating most other trusts as holds or sells for now. Again, while the market’s not making much of a distinction between the good, bad and ugly, I recommend trusts for their business strength, not just the yields. As a result, I’m comfortable holding them until we do get some clarification.

As for that, we’re in the process of contacting the industry lobbying groups and representatives of the trust industry as well as many of our trust management teams. We’re watching the market closely and will keep you appraised as the tax issue and the potential impact on our current and prospective holdings unfolds.

What He Said

Finally, here’s the actual news bit from the Canadian Dept of Finance on the proposed changes. As always, feel free to call or e-mail me if you have specific questions about any trusts you own.

“The Honorable Jim Flaherty, Minister of Finance today announced a Tax Fairness Plan for Canadians. The plan will restore balance and fairness to the federal tax system by creating a level playing field between income trusts and corporations.

“‘The measures I am bringing forward today are necessary to restore balance and fairness to Canada’s tax system, to ensure our economy continues to grow and prosper and to bring Canada in line with other jurisdictions,’ said Minister Flaherty. ‘Our plan is the result of months of careful consideration and evaluation. Our actions are clear, decisive and in the best interest of all Canadians.’

“For months there has been a growing trend toward corporate tax avoidance. Top Canadian companies, operating within the current rules, have announced their intention to convert to income trusts. They feel compelled to seek more favourable tax treatment by capitalizing on an available tax rule.

“While these decisions offer corporations short-term tax benefits, they are creating an economic distortion that is threatening Canada’s long-term economic growth and shifting any future tax burden onto hardworking individuals and families. If left unchecked, these corporate decisions would result in billions of dollars in less revenue for the federal government to invest in the priorities of Canadians, including more personal income tax relief. These decisions would also mean less revenue for the provinces and territories.

“Canada stands alone in its treatment of income trusts. The structure being used in this country was shut down in the United States and Australia.

“‘The landscape has changed dramatically in the short time I have been Minister of Finance, and in fact, this year we have seen nearly $70 billion in new trust announcements,’ said Minister Flaherty. ‘The current situation is not right and is not fair. It is the responsibility of the Government of Canada to set our nation’s tax policy, not corporate tax planners.’

“The measures in the Tax Fairness Plan include:

1) A Distribution Tax on distributions from publicly traded income trusts and limited partnerships.
2) A reduction in the general corporate income tax rate of one-half percentage point as of January 1, 2011.
3) An increase in the Age Credit Amount by $1000 from $4,066 to $5,066 effective January 1, 2006. This will benefit low and middle-income seniors.
4) A major positive change in tax policy for pensioners. The government will permit income splitting for pensioners beginning in 2007.

“These measures represent a major tax reduction. Our Tax Fairness Plan will deliver over one billion dollars of new tax relief annually for Canadians.

“For income trusts that begin trading after today, these measures will apply beginning with their 2007 taxation year. For existing income trusts and limited partnerships the government is proposing a four-year transition period. They will not be subject to the new measures until their 2011 taxation year.

“‘The time has come for Canada’s New Government to act,’ said Minister Flaherty. ‘By introducing our Tax Fairness Plan today we are acting in the national interest, doing what’s right for all Canadians, and significantly enhancing the incentives to save and invest for family retirement security.’

“The Tax Fairness Plan will build on the steps taken in Budget 2006. In that document Canada’s New Government delivered significant tax relief for Canadians with 29 tax cuts amounting to $20 billion in tax relief over the next two years.

Nov. 1, 2006: Tax on Trusts

Conservative Finance Minister Jim Flaherty has blindsided the income trust sector with his announcement after the close of trading Tuesday that Ottawa will start taxing trusts as corporations, effective immediately for new trusts and beginning in the 2011 tax year for existing trusts.

The effective tax rate to be paid by trusts on distributable cash will start at 34 percent, to mirror federal and provincial taxes on companies, and will drop to 31.5 percent by 2011.

The income trust sector has lost about CAD18 billion of its value as of 10:30 am Wednesday morning. The Toronto Stock Exchange’s capped income trust sub-index is down 11.5 percent. The value of the sector yesterday was worth about CAD157 billion, according to Bloomberg.

In the fall of 2005, the government’s consultation on trusts caused enough market uncertainty to shave CAD23.3 billion in market cap from Sept. 19 to Oct. 21, according to a note from Canaccord. Canaccord expects a CAD25 billion decline in trusts as a result of Tuesday’s announcement.

The announcement will immediately impact Telus and BCE, which recently announced plans to convert to the income trust structure. Those plans almost certainly won’t go forward.

Canadian Edge has consistently evaluated the income trusts recommended within the Top 10 Portfolio and the Super Yielding Portfolio on the merits of their respective businesses. We’re still comfortable with what those businesses are doing on an operational level. And they’re essentially free to operate within the pre-announcement rules for the next four years.

Regarding the viability of those businesses as investment opportunities, the Flaherty announcement would seem to open a four-year window of opportunity to benefit from what will remain attractive distributions. Our task now is to gauge the reaction of the individual trusts and how they adjust to the new imposition on distributable cash.

Today and the following several days will be extremely volatile–panic selling overtook the Canadian market in the early hours Wednesday, but some stability returned after the initial reaction.

We’ll provide a more in-depth analysis after the market closes this afternoon.