PDS: Tax-Free Ride Ends for Canadian Trusts

Nov. 1.06 | About: Precision Drilling (PDS)

Well, it turns out that my purchase of Precision Drilling Trust (NYSE:PDS) a couple weeks back was very poorly timed. Today, in a hugely surprising move from the conservative Canadian government, Canadian Income Trusts lost their tax advantages over regular corporations.

Previously, trusts operated roughly like US REITs -- they didn't pay corporate income taxes, and instead distributed most of their earnings to investors in the form of dividends.

Now, however, in the face of a massive wave of trust conversions that shows no signs of a letup, the government that issued campaign promises to leave trusts alone is going back on its word. They will begin taxing distributions from new trusts next year at a rate analogous to the corporate income tax rate, and existing trusts (including PDS) will begin to pay that tax in 2011 (though they plan to cut the rate slightly by then).

Less Value Due to Taxes and Distribution
So what does this mean? Well, apparently it means that trusts are now worth about 10-12% less than they were yesterday -- that's been the drop across the board. And with pretty good reason, since these trusts might be significantly hobbled by the fact that they have to pay taxes on their distributions AND still pay out most of their free cash flow in distributions, in addition to investors paying income taxes on those distributions. Trusts are certainly losing their advantages over corporations, which is exactly the point (it appears that the government really panicked when Telus (NYSE:TU) and BCE (NYSE:BCE), two of the largest corporations in Canada, announced planned trust conversions).

And it looks like this tax will be paid at the corporate level, so it won't be any different for US investors than for Canadians -- we'll still pay tax on the actual dividends received, but the dividends would be expected to be roughly 30% smaller to account for provincial and federal tax.

If this was in effect for Precision Drilling today, and we estimated the maximum corporate tax rate of about 34% on trust distributions, that would theoretically reduce the existing yield to about 8.5% (from close to 13% on today's price drop).

It's possible that by the time we get to 2011 that impact could be either drastically reduced by much higher distributions if the business performs well, or the company could react to the tax by minimizing their distributions to avoid tax, further cutting into dividends. It's certainly possible that the trusts will spend the next few years coming up with financial work-arounds that help to minimize the tax impact. It's way to early to know what will happen.

Worse Worst Case Scenario

So what should I do? 8.5% was the low end of what I thought we might see as a dividend if business hit a downtrend with lower oil prices and higher rig counts in Western Canada -- so now I guess my worst case scenario is going to have to fall significantly further.

But while this had an immediate stock market bite, it's also true that the tax implications are four years out. The distributions will remain untaxed until the 2011 tax year, and there's also plenty of time for Ottowa to change its mind before then (this move is opposed by at least 2/3 of Canadians in the polls I've seen this morning) -- or, perhaps, for trusts to convert back into corporations.

The fact that the tax change is several years out makes me want to take a few days to think about this, read the new rules carefully, and see how the market feels about the shares once the shock wears off. But this is certainly going to make income trusts dramatically less popular in Canada, and that means I need to seriously reconsider holding these shares.

PDS 1-yr chart:

PDS chart