PDS: Tax-Free Ride Ends for Canadian Trusts

Well, it turns out that my purchase of Precision Drilling Trust (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 (TU) and BCE (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:

Comments

[David Jackson:]

Travis, this is the party line (read that to be the broker-dealers and promoters) that the government "is going back on its word". That is not a fact.

In fact, the prior Liberal government, which allowed these trusts to happen, always stated that they were closely reviewing the impact on taxation, and that last Liberal govt finally fell over loss of confidence when they announced the govt was going to tax these instruments.

Now the Conservative govt has studied the matter, and despite having a bare minority govt, they have bitten the bullet on the need to tax thee companies.

If the Liberals come back around to defeating the present govt on this issue, that will show the utter hypocrisy of politics.

The fact is that no govt ever specifically approved these income trusts; they permitted them until further study could detail the implications. Now they know how bad the fiscal situation is and they have given five years for the market to resolve the impact of their taxation decision. During that time, the govt of the day will study and determine the best way they believe these trusts ought to be taxed, and that will be legislated.

Note also that Canada's former (Liberal govt) Finance Minister Goodale stopped granting advanced tax rulings related to income trusts on Sept 19
2005. The conservatives never said they would support them.

Canada, like many countries, is in dire need of a complete overhaul of its income tax system. There have been, over the years, too many vested interests that have created too many loopholes, etc. It needs to be cleaned up.

2006 Nov 02 09:26 AM

[Travis Johnson:]

Bill -- thanks for your informed comment. In the big picture, I absolutely agree that these Trusts were a mess that the government clearly had to clean up in some way before all corporations opted to convert ... but I understood that the campaign promise by the current government was that they would leave the trusts alone, especially after the liberal dithering over trust taxation last year really brought the conservatives to power. I know it's silly to rely on campaign promises, and I suppose the Telus and BCE news really put the fear into them that a change had to come immediately.

I think it's probably the right thing to do (for Canada, if not for me) to change the trust rules significantly, especially because of the tremendous advantage they give (gave) to foreign investors. But as one who is much more accustomed to following US politicians, I'm really shocked that they were willing to take the heat for this and make such a dramatic change that seems to be unpopular. I would have guessed that they would have done something much less dramatic, and that they would have waited for a few years -- until the oil-driven budget surplus disappeared, to give them political cover -- to do anything about it.

I think it's probably the right thing to do, but I'm quite surprised that they did it -- and that the change is as severe as they're proposing. It's really unfortunate that they didn't do something about trust taxation three years ago, before they became so widespread and popular.

In regards to PDS, I'm still of two minds -- that four years really is throwing me off and I'm not sure how to value the impact, though with roughly a 30% cut to the dividend expected (just from taxation, regardless of any corporate decisions) it appears that the market is discounting half of that decline immediately and may slowly account for the rest over the remaining time. The potential business strength of PDS is the wild card, of course, and that really depends on the price of natural gas price over the next several years -- which might as well be the rosetta stone for all the ability I have to decode it.

Thanks,
Travis

2006 Nov 02 01:14 PM

[Greg Pinelli:]

It's time to add a dose of reality to the commentary...Income Trusts provided several things the Canadian market will be sadly lacking in the future...One is credibility. The Conservatives were VERY CLEAR that the Trusts were safe. They made a calculatred political move...and believe me...investors will make them pay for it.
Second..Trusts wewre very good business for all concerned. They provided significant income for Canadians and non Canadians and they encouraged structures and risks that would not otherwise exist.
Do the math over the next 2 or 3 years..this was, most certainly, not something that needed doing. f Travis is confused about "impact" and "decoding" look at what investors have voted with...thier feet and money. A loss of credibility and trust is VERY hard to overcome in the investment world.

2006 Nov 05 08:44 PM

[L Mills:]

I suggest reading this article

theglobeandmail.com/bn...

2006 Nov 09 06:52 PM

[Billtur719:]

I am wrestling with the PDS Canadian Trust issue, but at a different time and about a different part of the issue. With PDS buying Grey Wolf for cash and stock, I want to know what are the US tax ramifications. Will I have to use the Tax Form K as with Limited Partnerships or is it treated like normal US stock dividends and sales? Can you shed any light on this issue?
[e-mail]

2008 Aug 28 02:13 PM