A Taxing Affair (ERF, PWI, HTE, PGH, PVX, BTE)

If you're a holder of American-listed Canadian energy trust units, you'll know that it wasn't only the Republican Party that got a "whupping" recently.

At the beginning of the month, investors in these very-high yield (10%-18% pre-tax) units received a most unpleasant bit of news when the Canadian finance minister announced that he was unexpectedly changing the tax rules on these and other "income trust" securities, slapping them with a major tax hit. The next day, the sector lost roughly 20% of its value.

Up until that point, Canadian income trusts had been enjoying the mother of all tax breaks.

All had earlier taken advantage of a Titanic-sized loop-hole in the Canadian tax code which allowed them to avoid paying any corporate taxes if they re-organized as trusts and adopted the policy of paying out all their free cash-flow to unit holders.

Now that loophole has been suddenly slammed shut with the re-instatement of the full corporate tax levy of 31.5% on all these entities.

So, why the sudden about-face by the Canadian government?

Simply put, the government was losing billions in tax revenue, while the bulk of those missing taxes were winding up in the hands of foreign investors. With the extremely attractive yields resulting from the generous payout policies of these trusts, tax exempt and low-tax bracket foreign investors were natural buyers.

U.S. investors, who had seen their dividend tax rate drop to 15% as a result of the 2003 tax changes, comprised the bulk of the foreign demand. That would explain why there is now a good selection of Canadian income trusts of the energy variety now listed on the NYSE. The more notable issues include Enerplus Resources Fund (ERF), PrimeWest Energy Trust (PWI), Harvest Energy Trust (HTE), Pengrowth Energy Trust (PGH), Provident Energy Trust (PVX) and Baytex Energy Trust (BTE).

Cash-flows generated by these trusts are derived from the sale of oil and gas from reserves that have an average ten year life-span. However, unlike their American counterparts, which can't add new reserves once they convert to a trust, Canadian energy trusts can add reserves via acquisitions in addition to on-going development efforts designed to coax more oil out of existing reserves. This introduces a growth element to the value equation of a security which would otherwise be regarded as a commodity-type bond, paying out until all the fixed reserves are depleted.

Taxable U.S. investors in these trusts collect a monthly payment in U.S. dollars net of a Canadian 15% withholding tax that in most cases can be used as a foreign tax credit to offset the domestic 15% dividend tax. With a 12% pre-tax yield being the norm for this group, the current after-tax yield comes to about 10.2% for most U.S. investors.

However, now that a new corporate tax of 31.5% is set to kick-in starting in 2011, less after tax free cash flow at the corporate level implies lower payments to unit holders from that date forward. Based on those previous figures, the current 12% pre-tax yield would drop to 8.2%, with the net after-tax yield to a U.S. investor coming in at only 6.9%. Another downside aspect of the tax is the adverse impact it has on the ability of these trusts to fund future reserve acquisitions, thus adversely impacting the growth element of the value equation.


So the big question is, has the recent 20% price plunge discounted all the bad new? My sense is that we should expect further selling in this sector.

An 8.2% pre-tax yield simply fails to make the grade when one considers the commodity risk, exchange rate risk and depletion risk inherent in these securities. This seems especially true when you consider that American-based REITs are still expected to deliver total pre-tax returns in the 9%-12% range next year and they carry a lot less risk. Energy trusts still have their appeal, especially if you're bullish on oil prices, but prices at this juncture still appear too high for my liking.