Worthy of Trust

There’s no accounting for investor expectations. When Newalta Income Fund (NAL.UN:TSX) announced in November the details of its conversion to a corporation from a trust, cutting its annual distribution by more than 50%, you’d think the units would get punished in the market. Instead, they actually rose.

The same thing happened to Canadian Oil Sands Trust (COS.UN:TSX), the largest partner in the Syncrude consortium. In January, the trust cut its quarterly payments to unitholders from 75 cents to 15 cents, after the market closed. Investors had clearly expected reduced distributions, but that was a huge cut. And yet, when the units started trading the next day, they went up (even though oil prices fell that day and even though they were left yielding a paltry 3%).

In contrast to both of these, when Toronto-based garbage hauler BFI Canada Income Fund (BFC:TSX) announced last summer that it was converting to a corporation and reducing distributions, its units were hammered by almost 20%.

So what can you expect from your income trusts as the “end of the era” draws near on Jan. 1, 2011 when, as decreed by federal Finance Minister Jim Flaherty back on Halloween 2006, trust distributions become taxable? The answer depends on a number of factors. (Don’t the answers to important questions always?) It’s worth thinking about as you contemplate how your portfolio will respond.

The first thing you should understand is that the decision to close the tax advantages enjoyed by trusts does indeed affect their values. When corporations were announcing trust conversions a few years ago, their stocks would almost always rise, usually sharply. Where did that extra market value come from? It came from the fact that cash that used to go to governments was now going to equity owners.

But you have to assume that this is priced into the units of trusts today. It’s what isn’t that’s of interest. Let’s start with taxes, which is central to this issue. A trust avoids taxation by using debt. The creation of an income fund starts with piling large amounts of debt onto a company such that most of the operating profit is eaten up by interest payments. Remember that interest is tax-deductible, meaning that there’s little operating income left to tax (most trusts pay a little tax; they’re not totally tax-free). What’s not consumed by interest or taxes can be paid as a dividend.

Now imagine that you owned both the debt and the stock in this company. You’d get the interest payments and the dividend. And that’s exactly what trusts do: they own both the debt and the shares of a company. A unit in a trust is actually more of a debt position than equity. As long as trusts distribute their income to owners, they are not taxable.

So, by definition, a company that’s growing will effectively lose its tax advantage, because its operating profits will grow but its debt stays the same, meaning there’s more and more profit left over after interest. And what happens to that income after it gets taxed? Right: it can be distributed to unitholders as a dividend. So any income trusts you own that are already paying some tax will be less affected by the change to the law. You can easily find out how much tax a trust (or, more accurately, the underlying corporation whose debt and shares the trust owns) is paying by reading its financial statements. You can also ask yourself how well the business will do in the intervening time.

In oil and gas, the situation is a little different. These businesses generate tax pools as a result of generous tax policies aimed at encouraging exploration. These pools are used to offset taxes, and are usually described in the company’s financial literature. The greater the pools relative to the company’s cash flow, the longer it can have a tax holiday. Some trusts have already announced how long they can go on without paying tax post-2011.

Penn West Energy Trust (PWT.UN:TSX, NY) is a good example of a trust expecting to extend its tax-avoiding status beyond the deadline. Whatever conversion shock the company experiences after 2011 is already priced in. (That’s not to say it’s a buy – that depends on the unit price at the time you read this – just that it’s not set up to take a fall.)

That said, be careful of certain trusts that are planning on converting to dividend-paying exploration and production companies after 2011. That’s a very, very tough game and demands top-notch talent. Many trusts don’t have it. They may have great people as far as running an income trust goes, but by definition, they don’t have top-tier E&P people, since that’s essentially a different business model. A financial engineer is no substitute for a petroleum engineer, you might say.

One last word of caution: some companies will use the new law as an excuse to satisfy their growth ambitions. That’s what happened to BFI; management decided to convert, but also to slash the payout ratio to keep more earnings internally and try to grow with it. That’s not what investors signed up for, hence the fire sale on the stock the next day.

This is a tough warning to heed, but set your browser to send news alerts about your trusts and be wary of too much talk of growth. It might work out, but it’s probably riskier than what you want, and it certainly won’t offer you stable monthly cheques, whether you call them distributions or dividends.

Fabrice Taylor is the Prairie Trader. He is an award-winning journalist and equity analyst.

Prairie Trader is an independent overview and assessment of investments available to Albertans. Alberta Venture assumes no responsibility for the accuracy of any stock recommendations. You can send letters about this column to feedback.

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