Stock brokers, money managers and wealthy coupon-clippers cried foul, but cooler heads predicted natural gas industry activity and supplies will emerge as winners from a surprise move to tax income trusts by the Canadian government.
"They're just E&P and service companies again," investors were told in a research circular by Peters & Co., a Calgary energy investment boutique, which is not as heavily reliant on securities marketing and transactions in the trust sector as many of its peers on Canada's financial street.
The sudden action, announced by Finance Minister Jim Flaherty with enthusiastic backing from Prime Minister Stephen Harper, closed a corporate tax loophole estimated to cost the federal government in Ottawa up to C$1 billion (US$900 million) a year. Revenue leakage was also forecast to accelerate as use of the tactic became increasingly fashionable after two of Canada's largest telecommunications chains (Telus and Bell) recently declared intentions to convert themselves into trusts.
In Alberta alone, annual losses of the provincial share in corporate income taxes due to trust conversions were estimated at up to C$400 million (US$360 million). The chief energy province was home to pioneers of the trust conversion wave, which started in the late 1990s: gas producers. As of year-end 2005, a survey of Canadian energy companies by PricewaterhouseCoopers counted 36 trusts. The group had a total market value (as measured by prices of "units," the sector's word for its counterpart to shares) of C$75 billion (US$68 billion) -- up 66% from C$45 billion (US$40 billion) 12 months earlier.
With notable exceptions led by Canadian Oil Sands Trust, a partner in the Syncrude bitumen complex, the energy trusts focused on gas. Average production was 82 MMcf/d and nudged 300 MMcf/d for the largest trusts. The trusts' total share of Canadian production approached 3 Bcf/d or about 18% of all output by the entire industry. Trust unit prices fell as much as 20% and conversion plans were put on hold immediately after Flaherty announced Ottawa was closing the loophole that sired the sector.
Prior to Oct. 31, companies largely ceased to be taxable if they converted to a trust and their shares became investment units. The critical ingredient of such conversions was commitments to pay unit owners, as "distributions," most of company's cash flow.
In practice, distributions were mostly in the range of 80% of cash flow but sometimes ran as low as 60% in cases known as "hybrids" where significant spending on exploration and development continued.
Effective immediately under Flaherty's changes, standard federal and provincial corporate taxes (the two government levels share collections in Canada) will be levied on distributions by new trusts created after the Oct. 31 date of the change. As of 2011 the new rules will also apply to currently established trusts. Levies on distributions to currently nontaxable investors will rise to 31.5% from zero. American owners of Canadian income trust units will see taxes jump to 41.5% from the current 15% withholding levy on foreign investors.
Apart from prompting a sell-off by current investors and discouragement of new unit sales, the Peters firm saw a potential long-run silver lining in the clouds -- described as nothing less than "carnage" -- cast on the trust sector for the short run.
One major side-effect of closing the tax loophole will be a sudden end to trusts' advantages in buying up other producers or gas-field assets. A hallmark of trust corporate culture has been reliance on purchasing "legacy" assets from large orthodox producers at premiums made possible by the advantages of being nontaxable. That is, trusts often tended to rely heavily on acquisitions rather than supply development to maintain or grow production.
Early in the conversion wave, field contractors tried to resist and calculated supply investments lost to investor distributions in billions of dollars per year. The resistance died out as trust conversions spread and contractors saw nothing to gain by fighting potential customers.
"The trusts, whether they stay in the trust structure or convert back into corporations, will have to look beyond mature asset purchases and start to spend more like growth E&P entities," the Peters firm predicted. "While this may be difficult to change in the short term with stretched balance sheets, capital spending levels should increase over the next five years."
Securities firms also lost no time in spotting investment bargains and potential new leaders in the trust pack by looking for the operations that operated most like conventional companies with long-life assets and properties with sound prospects of yielding up added supplies to drilling.
"There will definitely be winners and losers," predicted FirstEnergy Capital Corp., a Calgary investment firm with a long history of playing a large role in trust conversions and units marketing. (The difference in emphasis from the Peters firm was palpable, and it expressed the depth of feeling aroused by the government's move. The headline on FirstEnergy's research circular about the tax changes was "Liar, liar, trusts on fire, hanging from a telephone wire." The wording alluded to accusations that the Conservative government broke a promise and was driven to it by trust conversions of telecommunications giants.)
The winners will be "those who have both the proven technical acumen and an inventory of opportunities, including development projects and longer reserve-life-index resource plays," FirstEnergy predicted.
The Peters analysts likewise predicted a return to operational fundamentals. "The elimination of the trusts' tax advantage, and therefore cost of capital advantage, by 2011 will force the market to evaluate all these... entities in the same way over the long term, highlighting a return to a focus on management quality control and inventory depth."
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