Energy Trust

What Is an Energy Trust?

An energy trust is a type of investment vehicle that holds mineral rights for oil and gas wells, mines, and other natural resource properties. Energy trusts do not operate these properties themselves, instead, they rely on third-party companies to generate income from their assets.

Energy trusts are notable in that they are not required to pay corporate income taxes, provided that they payout at least 90% of their income to their shareholders. This income is then taxed at the level of the individual shareholders, bypassing the issue of double taxation.

Understanding Energy Trusts

Energy trusts are popular investment vehicles in the United States and Canada. However, there are some notable differences in how these vehicles are regulated in each country.

In the United States, energy trusts are only allowed to generate income from the mineral rights of existing properties; they are not allowed to acquire new properties, such as by buying additional wells. This means that U.S. energy trusts are required to draw down their existing income streams and eventually liquidate the trust once their mineral rights are fully depleted.

This makes it especially important for investors in U.S. energy trusts to understand the remaining reserves of the trust, as this will be critical in accurately estimating how long the trust will be able to continue making distributions to shareholders.

By contrast, Canadian energy trusts are permitted to raise ongoing capital in order to purchase new properties. This means that, in principle, a Canadian energy trust could continue paying distributions to shareholders indefinitely, provided it plans ahead to ensure an ongoing portfolio of mineral rights.

Example of an Energy Trust

A significant change in the energy trust market occurred in 2006 when the Canadian government announced plans to modify the tax treatment of Canadian energy trusts.

Previously, Canadian energy trusts were able to avoid corporate taxation altogether by passing through their distributions to shareholders, who were then taxed at the individual level. However, this resulted in a significant decline in government tax revenues, prompting the government to eliminate this favorable tax treatment by requiring energy trusts to pay taxes on their distributions as well.

This change effectively eliminated the relative tax efficiency of Canadian energy trusts as compared to corporations, prompting many trusts to convert themselves into corporations. In the midst of this transition, shares in many Canadian energy trusts declined significantly, driven by fears that the more onerous tax burden would necessitate a decline in the energy trusts' dividend yields.