Northern Beauties:
Four Canadian Trusts for Yield and Gains

In 1979, the founder and chief executive of America's largest independent oil company faced a serious problem. Although he had built his company, Mesa Petroleum, from a small Texas operator into one of the world's largest global oil producers, it was becoming increasingly difficult to expand the company's oil reserves.

Mesa's once-prolific Texas oilfields were now mature. These fields produced safe, reliable cash flows with little need for investment, but it was nearly impossible to grow production or boost reserves. And without growth, Wall Street just wasn't interested in the stock. Mesa desperately needed to unlock the value of those mature fields and raise cash for exploration and expansion to appease investors.

Meanwhile, America was in the early stages of a demographic sea change. The nation's population was already graying and older Americans were desperately in need of regular income. Ultra-high inflation in the late 1970s had ravaged returns from most traditional income investments. Meanwhile, corporate tax rates were sky-high, greatly reducing corporations' ability to pay dividends. As a result, millions of investors were in need of other investment opportunities that could throw off high yields, as well as a steady, predictable income.

Enter the income trust. In the late 1970s, trusts were a relatively new type of business organization. A trust is a unique kind of company that's designed to pay out large distributions to its unitholders (in trust lingo, shares are known as "units" and dividends are dubbed "distributions"). Trusts allow income and cash flow to be passed directly to investors as distributions, without corporate taxes. In the beginning years of trusts, individual investors pay taxes on any distributions received, as if those distributions were regular dividends.

Energy Trusts Flood the Corporate Landscape
Although a variety of companies in different industries, including utilities and real estate, have set up their corporate structure as trusts, energy trusts have been the most popular type. The typical energy royalty trust holds production rights to a group of oil and gas fields.

Generally, the oil and gas fields held in a trust are mature and will gradually be depleted over a number of years. Until the fields stop producing, they continue to produce solid cash flows with minimal need for investment; infrastructure to pump, store, and transport oil are already in place. It is this safe, stable cash flow that back up the trust's large distributions. In essence, owning a trust is owning a piece of a continued stream of oil and gas production.

The royalty trust structure solved Mesa's growth problems and quenched investors' thirst for income. In 1979, Mesa's founder, oil billionaire T. Boone Pickens, formed the nation's first royalty trust, which he called Mesa Trust. Pickens spun off nearly half of Mesa's reserves into Mesa Trust, which ended up holding 8 million barrels of oil and 800 billion cubic feet of natural gas reserves. A vast majority of these reserves were part of Mesa's mature fields and had years of profitable operating history.

Pickens raised billions to fund an aggressive exploration program by selling Mesa Trust to the public. Moreover, Mesa was able to concentrate further investment on developing younger, faster-growing fields. As a result, Wall Street got the growth that it so desperately sought from Mesa's regular common shares.

Meanwhile, Mesa Trust unitholders received a healthy stream of income in the form of distributions. This was far superior income than was available from most comparable investments at the time. Capital raised by Mesa Trust allowed further investment in the company's mature oil fields that might have otherwise been abandoned. The result: Mesa and Mesa Trust soared. By 1981, less than two years after Pickens formed the first energy royalty trust, the value of his two companies had tripled.

(1.)  Royalty Trusts Migrate North

While royalty trusts still exist today, the trust structure that Pickens put together didn't last long in the U.S. By the middle of the 1980s, Congress reformed trust legislation, thereby severely limiting the types of assets trusts could hold. Furthermore, U.S. trusts were no longer allowed to fund new acquisitions by either issuing new units or raising debt capital. When their reserves run dry, U.S. energy trusts have no value and are dissolved.
In addition, thanks in part to this legislation, U.S. trusts' distributions do not qualify for the reduced 15% tax rate on dividends.

But trusts aren't just a U.S. phenomenon. In particular, a handful of savvy income investors soon followed Pickens' lead, even after U.S. trust law changed. Specifically, a cadre of Canadian income trusts has been paying generous, tax-advantaged cash flow to investors for nearly two decades.

But while Canadian trusts continue to offer advantages over their U.S. counterparts, the structure is no longer as attractive as it once was. Specifically, in a move reminiscent of the U.S. tax law changes of the '80s, on October 31, 2006, the Canadian government laid out a proposal to tax Canadian trusts as corporations. The changes are intended to stop the loss of tax revenue from the income trust structure, which formerly allowed trusts to avoid paying corporate income tax.

Under the legislation, trusts will be taxed at regular corporate tax rates before distributions, and unitholders will be taxed on distributions as though they were normal dividends. (As of yet, no changes have been made to the individual tax treatment of Canadian income trust distributions for U.S. investors.)

These changes take effect in 2011 for all existing trusts and start immediately for new trusts rolled out after October 31, 2006. And despite lobbying efforts by a 40-member Coalition of Canadian Energy Trusts, Canada's Finance Minister Jim Flaherty remains adamant his government will not reverse its decision.
Given that the legislation has a three-year grace period before existing income trusts are taxed, the proposed changes shouldn't affect near-term cash flows or distributions.

Meanwhile, existing trusts will continue to pay out distributions, otherwise they will face punitive tax rates. You can think of these trusts as essentially having a tax holiday during which investors should continue raking in an above-average income stream. In addition, many trusts have accumulated tax credits known as "tax pools." These credits can be used to offset taxable income and will allow some trusts to avoid Canadian corporate tax rates for a few years after 2011.

Longer term, however, existing income trusts will likely be forced to markedly reduce their dividend payouts. Some are likely to pre-empt the tax regime by converting back to corporations, at which point they may or may not pay dividends.

A Silver Lining
While trusts aren't the income superstars they once were, investors can't afford to totally ignore the group. Select trusts with strong fundamentals and reasonable valuation levels should continue to prosper and reward investors who scoop them up at bargain prices. And some may continue to offer above-average yields even under the new tax system.

A majority of trusts haven't laid out their plans for handling the imminent tax change. Most have announced they want to fully explore their options. Here are some of the key issues to watch in the next few years that could affect unit prices and distributions positively:

Tax Pools -- Tax pools are nothing more than tax credits that allow a trust to avoid paying tax or severely reduce their tax exposure. Pools may allow some trusts to postpone the effects of the tax law change for as long as three to five years. Look for trusts to step up disclosure of their tax pools and how they plan to use these credits. 

Growth Limitations -- The limits on how many new units Canadian trusts can issue is based on the current market capitalization of the trust. This is a disadvantage for smaller trusts, as it makes it difficult to raise capital to expand. Larger trusts could be in a better position.

Acquisitions -- By taking the trusts private, it's possible to avoid the new trust taxes. Since the changes were announced, a number of trusts have been bought by private-equity buyers, and a handful of others have announced strategic reviews of their operations -- that's equivalent to putting up a "For Sale" sign. In addition, foreign oil or gas exploration companies may see buying the trusts as a cheap way of adding to their reserves.

The U.S. LP Structure -- Some Canadian trusts have already re-packaged their U.S. assets into a master limited partnership (MLP) or limited liability company (LLC) structure. The MLP is a pass-through setup similar to Canadian trusts, which means MLPs don't pay tax at the corporate level. While there are some legal issues, it may also be possible for U.S.-based MLPs to acquire Canadian trusts directly, further reducing the tax liability under the Canadian law.

(4.)  Picking the Right Trusts