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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 (OTC:GLHIF) 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 (OTC:ATPWF). 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 (OTC:CDPYF), Northern Property REIT (OTC:NPRUF), RIOCAN REIT (OTCPK:RIOCF).
  • 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.

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