2011, A Canadian Tax Odyssey: Canadian Income Trust Investors' Guide

Part 8 of The High Dividend Investor’s Collapsing Dollar Survival Guide

1. MARKET STATUS

Before ever considering investing in stocks, we must always first look at the overall market, since almost all stocks follow the major indices.

A. The Short Version

Unchanged from Part 7B. Still trending down, invest only funds not needed for the near term expenses. Lots of fear means the market is news driven and even more unpredictable than usual. The latest news is the increasing likelihood of a GM (GM) bankruptcy, maybe other big 3 too. The auto industry is one of the U.S.’s largest employers, just like (gulp) the housing and financial services industries.

With the market already retreating from firm resistance, this latest bad news emphatically begins the next test down.

B. Ramifications for High Dividend Stock Investors

Unchanged from Part 7B. Consider a combination of partial short term hedges with ultrashorts, sell stops, buying partial positions at strong support with available investing capital.

2. THE CASE FOR AND AGAINST THE US DOLLAR

See Part 1, Part 2, and Part 7A of this series for the full story and updates.

Recently China has openly called for replacing the dollar with a special newly created basket of currencies. Obviously just pre G-20 bluster, given the practical difficulties involved, and the amount of dollars the Chinese hold. However, it must be noted by those with major USD holdings as a sign of things to come. There are lots of big players and governments now unhappy about holding mountains of dollar assets. Could it be that “We Won’t Get Fooled Again” becomes more than just a lyric from The Who?

It’s an ominous sign for the U.S. dollar. Unless the Obama administration does an extraordinary job in restoring stability and confidence in its currency, one of the long term ramifications of this U.S.-ignited world crisis will likely be a long term decline in demand for the USD as the large investors justifiably seek to diversify out of the USD and limit their currency risk. Can you blame them?

3. WHAT MAKES A HIGH YIELD STOCK USD INFLATION RESISTANT?

See Part 3 for the full details, but here’s the summary.

We’re seeking stocks of strong companies that mostly earn and distribute a high dividend in a non-USD currency and have a dominant position in a market for an essential product or service.

In the coming installments in this series, we’ll begin exploring opportunities in the best single country in the world for stocks that combine high reliable dividends and USD hedge, Canada.

4. WHY THE CANADIAN DOLLAR IS ONE OF THE BEST U.S. DOLLAR HEDGES

In sum, one of the healthier banking systems and real estate industries (yes, this is a very relative term), and a hard asset based currency that will rise with the inevitable recovery of energy prices. Yes, Canada is also expanding spending and money supply, but no more than other economic blocks, and less than Washington, since Ottawa has not needed to print trillions for bailouts. Meanwhile the depressed CAD further discounts these shares.

A note of caution: they key point here is that we are recommending the CAD is a diversification move for those in USD. I make no predictions about near term currency movements at this time.

See Part 7B for the details.

5. A BRIEF HISTORY OF CANADIAN INCOME TRUSTS

In the late 90s, Canadian economic reforms spawned an ideal business structure to encourage economic development of barely profitable energy assets, the Energy Income Trust (aka Canadian Royalty Trust, or Canroy). It was a smashing success for creating wealth and prosperity because:

1. It created a new way for income investors to play energy. Like Master Limited Partnerships and S-Corporations in the U.S., there was no tax at the entity level, with income and expense passed straight through to the unit holders. Distributed income was a deductible expense.

Thus the trusts could get a much higher proportion of their income to investors than corporations. Income not needed for ongoing operation and development went to the investors, usually 60%-70% of distributable income. While these distributions were less steady than those of large energy producers because they varied directly with energy prices, the far higher yields (typically 3-4 times higher) justified the risks. Individuals, pension funds, and other income oriented investors piled seeking exceptionally high returns poured in.

2. It spurred growth in energy development. It allowed capital-hungry exploration companies holding mature oil and gas properties to monetize those assets by selling them for cash to these trusts. The explorers could now afford the billions in capex needed to rapidly expand production via:

a. Investing in equipment to extend the useful lives of more inaccessible sources

b. Drill and upgrade “probable” reserves to “proven” ones and thus extend the reserve lives of these energy trusts

3. It helped grow the Canadian economy. It attracted billions from income investors for expansion of energy production industry, one of the mainstays of the Canadian economy. Rising energy prices made these investments more profitable, compounding the growth of the Canadian energy industry and its contribution to the economy.

Soon, other mature corporations that could not attract growth investors realized that they too could attract income investor funds by converting to income trusts. As regular corporations, any dividends they paid were subject to an onerous 41% withholding tax. The size of income trust industry grew from a few billion to $80 billion.

Fearing a reduction in tax revenue (for “necessary” government programs) if this movement continued, the ruling Conservative party broke its promise to leave the trusts alone and on Halloween night 2006 truly kept with the scary tone of the date and announced changes that will force trusts to convert to corporations and be taxed at much higher rates discussed below. Overnight, $20 billion was frightened away from the trusts, as was an undetermined amount of future energy development. Prices recovered due to rising energy prices, but have since receded to decade lows, due to both energy price declines and the impending higher tax and uncertainty it creates about ultimate yields on each individual trust.

Why they didn’t simply reduce the high taxation on corporate dividends and continue to encourage investment and growth is beyond the scope of this article. They did it.

6. WHAT THE NEW TAX MEANS FOR INVESTORS IN CANADIAN INCOME TRUSTS

So, now what?

Since I’m writing for investors not accountants, I’ll minimize the technical aspects and focus on the ramifications for investors. Consult your tax advisor for details regarding your specific situation.

Assuming the legislation remains in its current form (?), here are the key points.

A. The Worst Case Scenario

The total federal and provincial tax on distributions will be 29.5% in 2011, and 28% in 2012.The tax will apply only to distributions of income, not to returns of capital. Most trust distributions are considered qualified dividends for U.S. investors and thus are taxed at 15%.

It’s unclear as of this writing how much, if any, of the Canadian tax could be treated as a tax credit for U.S. investors. The IRS does give a tax credit via filing form 1116 for the current 15% Canadian withholding tax for foreign investors. If that’s any guide, U.S. investors can expect at least some relief to get them closer to the 15% qualified dividends level.

I haven’t gotten clarification as of this writing. Has anyone heard anything definitive about U.S. tax credits for Canadian taxes withheld on dividends of U.S investors when that tax rises above 15% in 2011?

Thus the worst case scenario for U.S. investors is a total tax increase on distributions close to about 30%. Does 70% of the current yield seem acceptable to you? If so, read no further. In fact, for many trusts bought at current prices and distributions, the yield is still relatively high for the risk involved.

B. The Likely Case

The good news is that none of the trusts I’ve mentioned expect to be paying anything close to the worst case rate, due to one or more of the above factors. At a 2007 Money Show in Washington, one trust claimed it would pay only around 6.5% tax.

The actual tax paid will vary with each individual trust. For full details, consult the Management’s Discussion and Analysis of recent financial statements available on each trust’s web site.

C. The Key Variables

The main factors that will ultimately determine the tax on each trust include:

• Tax Pools: Many trusts have tax pools that will keep the tax low for a number of years, depending on the type and amount of tax pools.
• Depreciation and other non-cash deductible expenses: To the extent that cash distributions exceed taxable income, these distributions become tax exempt “returns of capital” (though these returns of capital reduce your cost basis and thus possibly increase tax on capital gains if any exist when you sell the shares). Some trusts have higher depreciation and other non cash expenses than others, so more of their distribution will be exempt from tax. For example, the below mentioned Great Lakes Hydro Income Fund (GLHIF.PK) has a distribution that is about half return of capital due to its huge depreciation expenses, thus cutting its tax bill in half without even considering tax pools or foreign energy production.
• Foreign production: Others like Vermillion Energy Trust (VETMF.PK) have production assets outside of Canada. Revenues from these are exempt from tax. Expect all others to at least consider this option, which bodes well for development in the nearby and familiar U.S., at the expense of Canada.
• Certain high yielders are exempt from the new tax, such as previously covered Atlantic Power Corporation (ATPWF.PK). It’s a Canadian company, but it’s organized as a corporation issuing income deposit securities, not as a trust. REIT income trusts are specifically exempt from the new tax, like soon to be discussed Canadian Apartment Properties REIT (CDPYF.PK), Northern Property REIT (NPRUF.PK), RIOCAN REIT (RIOCF.PK).
• All will be seeking to exploit the above and any other means to reduce their tax bill.

D. Yield and Price Appreciation Matter More than Tax

Remember that for those buying at current decade-plus low prices and distributions, when energy prices recover to 2008 highs and beyond, the yields and prices on these will also recover, meaning between two to three times increase from current levels, making even the worst case tax far more palatable.

For example, if current distribution share price were $100 and the annual distribution is $10, worst case it becomes $5.50 (combined 30% Canadian and 15% U.S with no U.S. tax credit). With all other factors (production levels, expenses, etc) remaining the same, a recovery to 2008 levels brings that $5.50 to anywhere from $11 to $16.50 (i.e. 11%-16.5%) and the share prices also rising 200-300%. Some of these energy trusts, like Provident Energy Trust (PVX) have fallen 4 to 5 times, and thus could see an increase of that same magnitude.

E. Possible Future Scenarios

Hey, 2 years is a long time in politics. It’s possible there will be future tax changes on at least some trusts due to:

• Pressure to increase investment in energy production. Preferential tax treatment worked before. Yes, $200/barrel oil prices would also do the trick, but no one wants the economic damage that the implied supply shortages entail, at least not if they can avoid it with intelligent energy policy.
• Pressure from Retirees and their pension funds: A growing population of retirees hungry for yields causes further tax reduction on trusts. Indeed, the trusts were a factor in the greater health Canada’s pension funding.
• Takeovers from foreign companies: Continued share price weakness could lead to foreign takeovers of some of these trusts, as happened with PWI. It’s unclear how foreign ownership would affect their tax status, and even if it did lower the tax burden, how the Canadian government would respond to a wave of foreign takeovers.

Disclosure: I have positions in most of the above mentioned investments.

Comments

[Uncle Pie:]

As far as I can see, the 15% withholding tax charged foreigners by Canada has nothing to do with the plan to tax income trusts after 2011. It's a different animal. After all the 15% withholding tax applies to taxpaying corporations' dividends like BCE or Encana or Petro Canada, etc as well as to the distributions from income trusts. I have not seen anything in the press about the possibility of any change to the 15% withholding tax charged US investors by Canada, but your article made me wonder if I had missed something. Anyway most of us can claim the 15% withholding tax charged by Canada as a tax credit against our US tax liability, as long as we own the security in a taxable account (and not in an IRA). As to distribution cuts post 2011, I suspect that the price of oil and gas is a far bigger factor in the equation than the imposition of a corporate tax on the income trusts.


On Apr 02 10:59 AM Cliff Wachtel wrote:

> Exactly my question, to which I've yet to get a clear answer. As
> of now, there is no tax at entity level, and Canada w/hs 15% for
> foreign unit holders. Now there's already going to be tax at entity
> level, so will Canada continue to w/h another 15% on top of the the
> entity level tax? Or is the w/h no longer needed? I wasn't able to
> get a clear answer as of the time of writing.
>
> Until I hear otherwise, I assume that Canada will be happy with the
> nearly 30% tax at entity level that all unit holders now bear and
> will not, in additon, w/h another 15% unless they truly don't want
> foreign unit holders. It would be butt stupid to do so, but then
> again, so is the entire "reform" so nothing would shock me, sorry
> to say.
>
> In sum, I don't know. Hope to find out, or hear from my esteemed
> readers, one of whom I hope has gotten clarification.

Apr 02 04:24 PM

[January Thaw:]

Income Trusts, as far as I'm concerned are about as safe as anything out there except for 30 yr. US Treasury's, it's an insane time to be in the markets so the best thing to do is to find the insanity that suits you best. Since I've been through this for so long with Canada, guess I'm getting used to being battered about. Temporary shelter....good book by the way..

Apr 02 10:00 PM

[mac.barron:]

Great article and great follow-up on the comments.

I'm almost certain that there must be a BNA International Tax Portfolio with the final answer to the 15% withholding tax question but I don't have a subscription at the moment, Cliff?

Apr 03 02:04 AM

[User 385213:]

Cliff,

Apr 04 02:00 PM

[User 385213:]

My tax adviser assures me that the 15% Canadian w/h tak is fully offsetable against U.S. federal income tax (but only to the extent that one has tax liability in excess of the total withheld.

My understanding from reading the material from various Canroys is that the new 25% tax at the entity level will be just that. Distributions will be made only after payment of that tax, and the 15% witholding to U.S. taxpayers will still apply (Canada has just rediscovered double taxation of dividends!). However, many of the Canroys have sufficient tax shields to offset the new corporate tax for a number of years, and even after that, with depreciation, depeletion allowances, etc., it seems unlikely that the full 25% will apply. But if the entity is still commited to making distributions to shareholders, it would still represent an attractive holding.

Cliff, you might add to your list the U.S. based MLP's that are oil and gas producers. A number of these offer attractive yields that are to some extent tax sheltered. Some, like LINE and EVEP, have hedged their prices for the near term, so the unit owner's returns are protected for long enough for prices (and returns) to go back up.

Also, take a look at PAA-- it is an equally high quality player in the infrastructure MLP group.

Apr 04 02:20 PM

[casey00001:]

Cliff:
I had heard some rumblings that the Canroy's if forced to Incorporate, might just go ahead and do that in mass in the US. Basically a company should be able to incorporate anywhere? Also the dollar is weaker than the looney making this cheaper. This action or the threat of this action may lead to the repeal of the 2011 legislation. So Canada would then get squat if the firms left. What are your thoughts?

Apr 05 09:04 AM

[Delojozafado:]

"Also the way the withholding tax was applied to retirement accounts was clarified." ?????? It has been my understanding that Canada would no longer assess/withhold any taxes to US holders of these investments or the structures they might morph into if held in an IRA. If you own (RY) in your IRA do you pay Canadian tax on your dividends? If this issue/question has in fact been clarified could some one share with us what this clarification's guide lines are proposed to be? As I understand it the (ATBUF), is for instance already proceeding into a restructuring into a REIT.


On Apr 02 03:10 PM dvlatas wrote:

> This is a very informative article. I made a bundle of money investing
> in canroys, and lost a bundle when the Canadian Government decided
> to stop the rush to trust form. As I recall, Bell Canada was about
> to switch from corporate to trust form. In any event, I decided
> that Canada was going to act like a banana republic, so that it was
> time to search for that other bull market somewhere else.
>
> If anyone considers investing in Canadian Royalty trusts they might
> want to investigate the following.
>
> The treaty governing taxes between the Canada and the USA has been
> renegotiated/modified, but not yet approved by the US Senate. I
> had heard, and this should be checked out, that Canada will be allowed
> to withhold 25% rather than 15% at present. Also, the way the withholding
> tax was applied to retirement accounts was clarified.
>
> Additionally, there was a Congressman from Massachusetts that put
> a bill in the hopper last year to eliminate the favorable treatment
> of canroy distributions by the IRS.

Apr 06 12:26 PM

[DuffBeer:]

I would like to give a big thanks to Cliff for his sharing such knowledge
with us all. He has come a long way in a short time in his postings. We all have learned and profited from this . I must also tip my hat to all of you who also have shared and commented. Gosh were would we be if not for this great SA site . We have come togather to find ways to be better investors and crave a better life for our selves . Thanks to each and every one of you . I toast with an IPA form Flossmoor Station. great little micro pub
Cheers DuffBeer

Apr 06 02:28 PM

[Cliff Wachtel:]

They're already "on the list" check the executive summary, you'll see they're part of the series (though they lack the currency hedge, their solid fundamentals, high yield, and pricing power give them the ability to keep up with inflation better than most US stocks. See also my past articles on the Energy infrastructure MLPs. Cliff


On Apr 04 02:20 PM User 385213 wrote:

> My tax adviser assures me that the 15% Canadian w/h tak is fully
> offsetable against U.S. federal income tax (but only to the extent
> that one has tax liability in excess of the total withheld.
>
> My understanding from reading the material from various Canroys is
> that the new 25% tax at the entity level will be just that. Distributions
> will be made only after payment of that tax, and the 15% witholding
> to U.S. taxpayers will still apply (Canada has just rediscovered
> double taxation of dividends!). However, many of the Canroys have
> sufficient tax shields to offset the new corporate tax for a number
> of years, and even after that, with depreciation, depeletion allowances,
> etc., it seems unlikely that the full 25% will apply. But if the
> entity is still commited to making distributions to shareholders,
> it would still represent an attractive holding.
>
> Cliff, you might add to your list the U.S. based MLP's that are oil
> and gas producers. A number of these offer attractive yields that
> are to some extent tax sheltered. Some, like LINE and EVEP, have
> hedged their prices for the near term, so the unit owner's returns
> are protected for long enough for prices (and returns) to go back
> up.
>
> Also, take a look at PAA-- it is an equally high quality player in
> the infrastructure MLP group.

Apr 06 04:49 PM

[Cliff Wachtel:]

Thanks for you always kind words. Whatever climbing I've done is due to appreciative souls like you who put me there. Hope to continue to be of assistance. Cliff


On Apr 06 02:28 PM DuffBeer wrote:

> I would like to give a big thanks to Cliff for his sharing such knowledge
>
> with us all. He has come a long way in a short time in his postings.
> We all have learned and profited from this . I must also tip my hat
> to all of you who also have shared and commented. Gosh were would
> we be if not for this great SA site . We have come togather to find
> ways to be better investors and crave a better life for our selves
> . Thanks to each and every one of you . I toast with an IPA form
> Flossmoor Station. great little micro pub
> Cheers DuffBeer

Apr 06 04:51 PM

[E Nuff Sed:]

US withholds 15% of dividends for Canadian investors - Canada does the same for US investors.. If and when the dividend tax rate rises in the US this will likely to be revised.

To a Canadian, US dividend is like ordinary income ie taxed at the marginal rate (46% in Ontario). Canadian dividend is taxed at 50% of the marginal rate (23%).

Apr 06 10:35 PM

[Delojozafado:]

As no one as yet has offered an explanation of the "clarification" question I have posed. I will add my understanding of this as currently applies.

If you GOOGLE: "US Canadian tax treaty IRA with holding", one of the very first sites that appears is the "Canadian Tax Resource" web site. A blog there of 1/12/09 by one "Tax Guy" explained how this tax issue inside an IRA currently is treated.

"Unfortunately you will not be able to recover the withholding taxes related to Fording Coal because Fording Coal was structured as a trust. However dividends you receive from Teck should not be subject to Canadian withholding taxes at all, since Teck is a corporation. Under the Canadian - US income tax treaty, interest and dividends received from investments inside an IRA or 401-K are EXEMPT from Canadian taxes. "

Teck of course acquired Fording near the peak of the "met" coal hysteria in late 2007 or early 2008. Their bonds are now virtually traded as "junk". The unit holders received a near triple of the 52 week bottom in the unit price at the time the deal closed.

So those under water in their Can-Roy investments MAY be OK in a longer term scenario based on what occurred with Fording.
The person (Tax Guy) blogging on this site pretty much supports my contention that US taxpayers who hold NON-trust structured shares, NOT "UNITS" in Canadian CORPORATIONS will not have a 15% withholding applied to their tax sheltered investment distributions. If Cliff or there is any blogger here that can explain how this is to be "clarified", or changed I would certainly want to gain that insight.

As long as this situation applies to Can-Roys that are eventually morphed into Corporations, REITs (?) or even perhaps MLP*s, that means no with holding will be taken against the tax sheltered US investor with these newly structured Canadian holdings, then we are left to a possible conclusion. The tax reserve pools that many Can-Roys have been creating against maintaining or increasing the current distributions are in some sense creating a closed end fund at a discount, type investment. If a frog had a glass ... he wouldn't jump around so much. If we look at the IRA investor who is under distributions. Increasingly that would be the Boomers going forward we might surmise. They might be inclined to buy commodities and energy centric themes with yield. A trader who bought CHK-PRD in the shadow (after) of the last ex dividend date would now be sitting on a profit of $1000 + a full year of distributions, in terms of what they have now against their cost basis. Any way you can see how some of these Can-Roys when morphed might gain some following among the asset managers looking for these kind of investments for IRA clients that will provide some kind of protection against the coming great inflation. Unintended consequences... This beaten down asset class could emerge as the next excellent diversification segment to a broad group of US tax sheltered investors. They will effectively be getting the benefit of the tax pools now being created against the distributions of current unit holders. It is like that portion of the property tax bill a 78 year old pays that represents "Capital Reserve funds", to build new libraries, police stations, sewers, and buy fire trucks and such. They pay but never enjoy the benefits that accrue from these taxes as they find themselves not outliving the reserve funds.
*In the case of a morphing into an MLP there would be other complications,

This morning on Bloomberg we find a snippet postulating that the "Q" easing that is expected to be announced on or around 4/24 , by Mr. Carney "barker" and the BOC , will be a watered down less pernicious version against what the US has already been doing. US investors of all things Canadian should brace for the Loonie to briefly breach .78/1.28 in the wake of that statement near the end of the month. This may then be a great buying opportunity? EH?

Apr 07 08:22 AM

[JCCIII:]

Cliff. You provide pink sheets symbols for all of the Canadian income and REIT trusts mentioned. I assume this means you purchase these equities via the pink sheets. These equities are listed on the Toronto Stock Exchange (TSX). Accordingly, I assume they could be purchased through one's broker via the TSX as a foreign ordinary purchase transaction, or via an internet global account such as those available through E-Trade and Interactive Brokers. Is my assumption about your using pink sheets for the trades correct? If you use the pink sheets, why is this preferable to making a foreign ordinary transaction through either your broker or an internet global account? Thank you, JCarroll

Apr 07 03:52 PM

[oscar13:]

What about the tax treatment of Acadian Timber income fund?

Apr 09 08:25 PM

[Envir:]

A Question:
Re: Canadian income trusts
An income trust I'm looking at (AltaGas) says they'll convert to a corporation "before 2011"- What does this imply for their unit price?
What happens to units held when a trust becomes a corporation? Do they become preferred shares paying dividends?
Their 2008 annual report says as a corporation they will pay dividends competitive with their industry? What might this mean?

Apr 22 04:48 PM

[Envir:]

A Question:
Re: Canadian income trusts
An income trust I'm looking at (AltaGas) says they'll convert to a corporation "before 2011"- What does this imply for their unit price?
What happens to units held when a trust becomes a corporation? Do they become preferred shares paying dividends?
Their 2008 annual report says as a corporation they will pay dividends competitive with their industry? What might this mean?

Apr 22 04:50 PM

[max12345:]

Cliff Wachtel's postings regarding Canadian Income Trusts and various related info. are the only postings on Seeking Alpha that I have ever found of immediate and practical value. (super-thanks!)

I have bought a lot of them (oil and gas but also other regular business trusts) (and luckily for me also right around mid March) and I am up over 100% already on several and already seeing those fat dividends come in monthly)

And in particular after reading about "dividend aristocrats" (a total waste of time just as Cliff explains) it's great to see those dividends (distributions) actually come in monthly.

At first I thought it might be some kind of a hoax...but it's all for real.
And of course it's true that there may be some marginal risk in 2011 but as Cliff explains above, the upside is much greater.

Long live CANADA! (even if the conservative government was stupid enough to try to mess up a good thing) (including for themselves)

May 09 09:02 AM

[Cliff Wachtel:]

I've used pink sheets out of sheer laziness-better to buy on the tsx, better execution. Can you recommend good online brokers that trade directly on the tsx? Thanks, Cliff


On Apr 07 03:52 PM JCCIII wrote:

> Cliff. You provide pink sheets symbols for all of the Canadian income
> and REIT trusts mentioned. I assume this means you purchase these
> equities via the pink sheets. These equities are listed on the Toronto
> Stock Exchange (seekingalpha.com/symbo...). Accordingly,
> I assume they could be purchased through one's broker via the TSX
> as a foreign ordinary purchase transaction, or via an internet global
> account such as those available through E-Trade and Interactive Brokers.
> Is my assumption about your using pink sheets for the trades correct?
> If you use the pink sheets, why is this preferable to making a foreign
> ordinary transaction through either your broker or an internet global
> account? Thank you, JCarroll

May 12 07:57 AM

[anarchist:]

Cliff, I know one can buy tsx stocks at interactive brokers and I would guess it is through direct trades. I think you can buy on other exchanges besides the US and Canada also. Nice thing is that their commissions are low low low.


On May 12 07:57 AM Cliff Wachtel wrote:

> I've used pink sheets out of sheer laziness-better to buy on the
> tsx, better execution. Can you recommend good online brokers that
> trade directly on the tsx? Thanks, Cliff

May 12 08:58 AM

[Claud9:]

Regarding ATPWF.PK, isn't ATP the symbol to look at on the TSX and if so why is there no data concerning the stock such as 52 wk hi/lo, yield, etc?

Dec 02 08:04 PM