INCOME TRUST TRUTH VOLUME 1, ISSUE 12
ENERGY TRUSTS: MORE IMPORTANT THAN REITS
-- So Why Is The Government Destroying Them With Punitive Measures?
Guest Editorial
By Brent Fullard
President and CEO
Canadian Association of Income Trust Investors (CAITI)
Introduction:
The following is a look at the impact of income trusts (royalty trusts) on Canada’s energy sector from the vantage point of the past, the present and the future. The purpose of this review is not to argue that the energy sector receive special exemption per se like REITs, to the exception of business trusts, since our association’s position following the Public Hearings on Income Trusts is, to quote from our press release:
“Therefore as a result of these hearings, our association is calling for a full repudiation of the Tax Fairness Plan in the name of fairness and good governance. As such, all the existing income trusts should be fully grandfathered and be free of growth constraints. Measures should be taken for a transition period to protect these companies from the takeover frenzy that this policy has induced. Future conversions should be the subject of further study and policy evaluation involving stakeholder input through public consultation.”
Tax Leakage:
No discussion about income trusts can begin without first discussing the claim that income trusts result in a loss of tax revenue, or so called tax leakage. The notion that income trusts cause tax leakage has taken on urban-legend status. The inconvenient truth is that income trusts do not cause tax leakage, in fact the reverse is true. The highly guarded and secretive analysis that the Finance Department performed, to arrive at its assertion of tax leakage, fails to acknowledge ANY of the taxes paid by the 38% of income trusts that are held in RRSPs and retirement accounts.
Proper inclusion of these “deferred” retirement taxes in Finance “tax leakage” analyses would result in a conclusion of tax neutrality regarding income trusts (in other words, they are not a drain on the Canadian treasury). Clearly Finance uses the wrong methodology.
A more definitive and unassailable analysis can be had by looking at what happens to income trust taxation in the real world. BMO Capital Markets performed such a real world exercise by looking at all the businesses that converted to income trusts in the period since 2001. There were 126 such businesses as detailed in the attached file. Here are the summary results:
Average Taxes Paid Before Conversion to Income Trust: $3.3 million x 126 = $415.8 million
Average Taxes Paid After Conversion to Income Trust: $6.1 million x 126 = $768.6 million (excluding deferred taxes)
Average Taxes Paid After Conversion to Income Trust: $9.8 million x 126 = $1,234 million (including deferred taxes)
Therefore this comprehensive real world analysis demonstrates the vastly more effective tax generation associated with businesses formed as income trusts versus businesses formed as corporations. The tax raising effectiveness, for the government, is improved by a factor of 3 times for all taxes when a corporation converts to an income trust (and 1.8 times if, like the Finance Department), one totally ignores the present value of deferred retirement taxes.
Cost of Capital Advantage of Income Trusts:
As graphically demonstrated above, income trusts do not cause tax leakage. As well, in today’s protracted low interest rate environment, Canadian retail investors prefer a business that is organized as an income trust relative to the same business structured as a corporation.
There are many reasons for this, the primary one being that these investors are seeking monthly income at returns higher than those generated through investments in GICs, bonds or high yielding sticks. Further, these very investors are more comfortable with the management discipline associated with trust managements having to meet monthly distribution payments to unitholders.
This investor preference manifests itself in higher market valuations for income trusts (certainly before the government’s onerous income trust tax announcement, anyway). This is the market’s decision. As a result of this valuation enhancement, income trusts have a competitive advantage in the form of a lower cost of capital. This is an important strategic advantage that allows income trusts to compete on a global basis, where cost of capital advantages can be a significant cost advantage.
Most important, this cost of capital advantage has been conferred on these companies by the capital marketplace and not through any “tax loophole” as the Finance Minister is so fond of saying, which implies it is being subsidized by Ottawa. Saying so amounts to a patent falsehood, as the absence of tax leakage can hardly support the existence of a tax loophole.
Income Trusts and Canada's Energy Sector: Past:
Before the emergence of the trust sector, many of Canada's intermediate oil and gas companies were being acquired by international corporations, predominantly from the U.S. The expansion of the Canadian energy trust business halted this tide of foreign takeovers and has actually reversed the trend. In the five years ended 2005, trusts purchased over $8.9 billion of oil and gas properties from foreign-owned corporations. Pengrowth's recent acquisition of assets from ConocoPhillips will push this total close to $10 billion. This is made possible by income trusts’ competitive cost of capital and income trusts’ ready access to capital markets (before Mr. Flaherty’s actions).
Income Trusts and Canada's Energy Sector: Present:
At present 20% of Canada’s oil and gas production is produced by Canada’s 31 oil and gas royalty trusts, representing more than 1 million barrels of oil equivalent per day. The combined market capitalization (pre Flaherty ) was almost $100 billion.
In 2005, the oil and gas trust sector generated over 30 percent of the tax revenue collected from publicly traded Canadian entities in the oil and gas sector while representing 16 percent of the revenue. In 2006 the energy trust sector will generate payments of an estimated $5.7 billion to governments in Canada including royalties, property and capital taxes, and the estimated $2.4 billion in personal taxes to be paid on distributions to trust investors.
In 2006, energy trusts reinvested approximately $7 billion of capital into Canada’s Western Sedimentary Basin, and operating and administrative expenditures were expected to total almost $6 billion annually.
Mr. Flaherty’s new income trust tax regime is designed to shut down income trusts. In that regard, it is certain to succeed. In doing so, however, the Finance Minister’s actions have left all 250 income trusts highly vulnerable to hostile takeover.
Most of this takeover activity will be foreign based and largely driven by foreign private equity investors. This takeover frenzy has already begun and will multiply in intensity once the Minister’s TFP proposal is passed into law.
Flaherty’s misguided policy announcement has created what is known in the business as an “event driven” buying opportunity for foreign private equity interests. This is where an event artificially depresses the value of a publicly traded security to a level below its true worth.
Mr. Flaherty has inflicted this possible fate on all 250 income trusts. True value in this context usually means the value that a private equity fund or other investor would be willing to pay for the business. And in the normal course, income trusts traded at their true value until recently.
However, the Finance Minister’s actions have created an artificial discount, one that foreign private equity funds are keen to exploit as they scour the world looking for just such opportunities. Private equity is flush with capital, and ready deployment of capital is their only major constraint. And Mr. Flaherty has handed them a $200 billion capital deployment bonanza. Canada’s incredibly lax takeover rules, and the 8% decline in the Canadian dollar since Halloween, just makes this task even easier and more lucrative for them.
Upon purchasing these vulnerable income trusts, these foreign buyers will return them to corporate form and in doing so achieve two advantages. First as corporations they will now be free of the arbitrary growth restrictions that Mr. Flaherty has imposed on income trusts as the second leg of his trust crackdown. Second, these foreign investors will structure their investments in the form of debt in order to take full advantage of the corporate deductibility of interest. As such, these debt interest payments will be made from pre-tax cash flows and will flow to foreign tax jurisdictions free of any Canadian taxation.
That is, these newly acquired business entities (as corporations) will be structured in such a way, so as to not pay a cent of tax to the Canadian government.
This is a strategy known as “income stripping”. The consequence of this inevitable outcome is that it will create tax leakage for the Canadian government.
This is the ultimate irony of Mr. Flaherty’s policy to combat alleged but non-existent tax leakage from Canada’s income trusts. The very policy that was designed to stem the non-existent tax leakage will itself induce tax leakage -- through a hollowing out of a growing and vibrant sector of the Canadian economy via foreign takeovers.
Income Trusts and Canada's Energy Sector: Future:
As noted above, the emergence of income trusts in Canada resulted in a repatriation in ownership of Canada’s energy sector while at the same time creating a “triple bottom line” result. However, the Finance Minister’s new policy will make Canada’s existing energy trusts vulnerable to foreign takeover and eliminate this triple bottom line result in the process.
Furthermore much of these strategic energy infrastructure assets are likely to fall into US hands. Beyond that, we are leaving other sectors of Canada’s energy sector more vulnerable to foreign takeover as well. For example it was just recently announced that Western Oil Sands is putting itself “in play” and looking to maximize shareholder value.
Western Oil Sands is the 20% owner and operator of the Athabasca oil sands project that produces 155,000 barrels of oil equivalent a day and is currently expanding its scope. Western Oil Sands is a corporation, not a trust and has a market value of $5.5 billion.
Thanks to Jim Flaherty’s destruction of the energy trust market, Western Oil Sands is no longer able to convert itself into a trust as a value maximization/disposition strategy -- even though this conversion alternative would have led to a high level of ongoing Canadian ownership.
Secondly, because of the restrictive growth constraints on existing trusts imposed by Mr. Flaherty, Canadian Oil Sands -- which is an existing energy trust, and which has been an aggressive consolidator of interests in oil sands -- will not be in a position to acquire Western Oil Sands’ 20% Athabasca interest -- even though Canadian Oil Sands is a majority Canadian owned income trust.
As a result, Western Oil Sands is now easy prey for foreign takeover and at prices lower than would otherwise have had to be paid. The plight of Western Oil Sands provides a real time example of how the elimination of income trusts will ultimately cause ongoing dilution to the Canadian ownership and control of Canada’s strategically important tar sands reserves.
As acknowledged in a February Barrons report on Canada’s vast Western energy reserves: “Asset prices in Canada are expected to soften now as the trusts’ access to lower-cost capital dissolves. This means U.S. producers can compete for assets in the region again. Now in play, the trusts are up for grabs by traditional US producers.”
One has to wonder how premeditated such an outcome is in light of the fact that the The Security and Prosperity Partnership of North America agreed to between Stephen Harper, George Bush and Vincente Fox in June 2006 had identified as its top priority the North American Energy Security Initiative. Its mission statement states that “a secure and sustainable energy supply is essential for our economic prosperity in North America”.
Whose prosperity? Whose security? That of the good old U.S.A.?
Other Unintended Consequences:
Whenever major changes are made to government policies without consultation of affected parties, unintended consequences result. In this case, these include:
Massive capital losses to millions of individual investors, on the order of $35 billion, and the associated lost tax revenue;
Reduced or lost income for millions of investors, many of whom depend on this income to live and maintain a decent standard of living in retirement;
Flight of Canadian investment capital to other markets, which offer sought after income-trust-like investment attributes, such as US High Yield Market, US Tax Free Minicipal Bond Market and US MLP market
Loss of confidence in the integrity of the Canadian Capital markets on the part of Canadian and foreign investors, resulting in a dramatically weakened Canadian dollar and a loss of foreign and domestic investment capital
A ripple effect of reduced income for economic spending and lost investment value for millions of Canadians, including charitable organizations;
Exposing Canadian corporations to leveraged buy-out groups seeking to acquire intermediate-sized corporations;
Loss of head office jobs as management control leaves the country;
A shifting of focus from implementing improved, energy-efficient optimization methods on existing developed pools to less energy-efficient, grassroots mega projects. This in turn imposes tremendous strain on infrastructure, available labour and project costs; and
Ultimately reduced production and lower recovery of Canada's oil and gas reserves.
Only in Canada, you say? Tis a pity!
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