Last week’s announcement by Canadian Finance Minister Jim Flaherty of a proposal to tax income trusts shocked many in his country’s oil patch, but soon a degree of calm had returned as it sunk in that existing trusts wouldn’t be affected until 2011. Some even predicted a silver lining of greater fiscal discipline among energy trusts, should the measure pass, while many still found much not to like.

The sudden action, announced by Flaherty as part of a “Tax Fairness Plan” with enthusiastic backing from Prime Minister Stephen Harper, would close a corporate tax loophole estimated to cost the federal government in Ottawa up to C$1 billion (US$900 million) a year. Revenue leakage had also been forecast to accelerate as use of the tactic became increasingly fashionable after two of Canada’s largest telecommunications chains (Telus Corp. and BCE) recently declared intentions convert to trusts.

Canadian oil and gas royalty trusts took it on the chin in stock market trading following the Tuesday night announcement. 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. For instance, Harvest Energy Trust fell nearly 14% to $25.29. Enerplus Resources lost nearly 15% to close at US$46.25, and Pengrowth Energy Trust lost 12.01% to close at C$19.27. Canadian companies dominated the list of biggest losers on the New York Stock Exchange in trading Wednesday. Harvest ended the week at US$24.30; Enerplus at US$44.26; and Pengrowth at C$17.66.

While it’s not a done deal, the tax changes are seen as likely to proceed. Companies have been largely nontaxable if they convert to trusts and their shares become investment units. The critical ingredient of such conversions is commitments to pay unit owners, as “distributions,” most of a company’s cash flow. In practice, distributions are mostly in the range of 80% of cash flow but sometimes run as low as 60% in cases known as “hybrids” where significant spending on exploration and development continued.

Under Flaherty’s changes, standard federal and provincial corporate taxes (the two government levels share collections in Canada) would be levied on distributions by newly created trusts. 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.

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.

“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 Jim Flaherty, Canada’s minster of finance. “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.”

PrimeWest Energy Trust was one of the trusts that was quick to reassure its unitholders. “The relevant measures announced include a proposed tax on distributions paid by publicly traded income trusts and limited partnerships, and will result in less after-tax cash being available for payment to all unitholders,” PrimeWest explained in a press release. “As an existing income trust it is important to note that these measures will not apply to PrimeWest until January 2011. Under the government’s proposal the existing tax treatment on distributions will remain in effect during the four-year grace period to 2011.”

Some cried foul at the news, claiming the conservative government was going back on a previous promise to not tax trusts.

“In Wall Street terms, bad news like this proposal turns perception into reality,” John Olson, co-manager of Houston Energy Partners, told NGI. “In other words, the proposal here is to kill any new income trusts or royalty trusts up there basically now going forward with a tax holiday until the end of 2010, and at 2011 they start paying a 31.5% effective tax rate. What you will very likely see is many of these unit trusts sell down 20 to 30% depending on their tax positions.

“This may turn into a death by bureaucracy or by legislation up there, a slow death, though,” said Olson. Others were more sanguine.

“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. With notable exceptions led by Canadian Oil Sands Trust, a partner in the Syncrude bitumen complex, the energy trusts focus 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.

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.”

Unlike Peters, the capital markets unit of investment firm Canaccord Capital predicted dire consequences of the move to tax trusts. “If the tax proposal is enacted as presented, we believe that Canada will lose control of its energy sector and investment activity will decline in conventional oil and gas production,” the firm wrote in a note. “Investors should be concerned that this proposed tax policy will reshape the energy industry and slow the growth of conventional oil and gas development.”

Standard & Poor’s Ratings Services said in a note that strategic responses from existing trusts could include conversions to corporations, acquisitions of corporations with large tax losses, leveraging to obtain a tax shield, or acquisition of the fund by other entities. “In any event, the future for the Canadian income trust market is once again in a state of uncertainty,” said S&P stability analyst Ronald Charbon.

He said certain funds face immediate consequences that could result in a stability ratings impact given unique circumstances affecting short-term potential risks to distributable cash flows and distributions to unitholders. On an immediate basis, all funds will have reduced financial flexibility due to prohibitive access to the equity caused by lower unit prices.”

Citigroup analyst Richard Roy was a little more optimistic than Olson but equally alarmed in his Wednesday research note on the proposed tax change.

“In our view the recent decision will cause an extended period of turmoil for the income trust sector as investors decide which trusts will still be worth owning in 2011,” Roy wrote. “While our expectation is that trusts in the energy sector will lobby for a change, given the uncertainty involved we expect considerable volatility over the next few days (For U.S. investors, the change in tax law implies an increase in taxes withheld from the Canadian government from 15% to 41.5% starting in 2011).”

The note said Citigroup expects the oil and gas trusts in its universe to be around after 2011. “However, in the near term we believe absolute performance will be challenging and will be greatly affected by headlines related to this issue.” According to Roy, look for the following:

But investors in this space shouldn’t bother looking for a place to hide. “This is a very complex issue and we believe the entire sector will be down; no exceptions,” Roy wrote. “Potentially, trusts with large foreign ownership could be impacted more significantly because nonresident taxation changes dramatically (i.e. a 26.5% increase).”

The next step toward any taxation change in Canada is the drafting of the legislation. Following that will be three readings in the House of Commons and then a vote. With approval, the legislation would go to the Senate for final approval. “Given that the liberal government made a similar proposal last year, we believe at this point it is likely that the proposed changes are passed,” Roy wrote.

“The tax announcement raises questions on the strategic response from existing funds. Responses could include fund conversions to corporations, acquisitions of corporations with large tax losses, leveraging the funds to obtain a tax shield, or the acquisition of a fund by other entities,” said Standard & Poor’s stability analyst Ronald Charbon. “In any event, the future for the Canadian income trust market is once again in a state of uncertainty.”

What brought the trusts under scrutiny was their growing popularity, in energy and elsewhere. Master limited partnerships (MLPs) the income/royalty trusts’ south of the border cousin have seen similar growth in their popularity among energy companies, particularly the midstream. NGI asked Olson if a similar tax change might be proposed for MLPs in the United States.

“If Exxon or Chevron or Marathon decided to do a master limited partnership, then that would certainly raise a lot of hackles in Congress,” Olson said. “The [impact on] tax revenues would be huge.”

But a greater threat to MLPs is a changing of the guard in the House and Senate come Nov. 7. Olson said it’s “very plausible” that Democrats could win control of both houses on election day and the resulting committee chairmanships. Liberals “who have had a history of badgering the oil industry” could be in charge, Olson said. “Where this goes from there, Lord only knows.”

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