The future of Canada’s energy income trusts is in disarray amid a bloodletting on the Toronto Stock Exchange after the federal government broke a key January election campaign promise and imposed a tax on cash distributions from the highly popular investment vehicles.
Talk of sweeping consolidation, foreign takeovers and the loss of small exploration and production companies is rampant after the change trusts had feared most took place with a bombshell from the Canadian government.
Finance Minister Jim Flaherty turned what has been a treat for investors into an unwelcome trick on Halloween by announcing that Ottawa will start taxing trusts as corporations, effective immediately for new trusts and in 2011 for existing trusts.
The effective tax rate to be paid on distributions will start at 34 per cent, to reflect federal and provincial taxes on corporations, and drop to 31.5 percent by 2011.
The Conservative party, which now forms the minority government of Prime Minister Stephen Harper, said in the final days of last winter’s election campaign that it would “preserve income trusts by not imposing any next taxes on them.”
Emboldened by that pledge, a new wave of companies with a market value of C$70 billion converted to trusts to avoid paying corporate tax by distributing the bulk of their earnings to investors, who are then taxed on the payouts.
Current estimates put the loss of federal and provincial tax revenues at C$800 million to C$1 billion.
Crunch came in October
The crunch came in October when BCE and Telus, Canada’s two largest telephone companies with a combined market value of C$45 billion, announced their intention to join the trust sector — plans that many analysts think will now be derailed.
Government sources said the fear spread in the Harper administration that banks were preparing to move all or most of their assets to trusts, while EnCana and Suncor Energy were said to be modeling trust conversions that could have set off a tidal wave in the petroleum industry.
Flaherty conceded the government was troubled by the prospect of moves from financial institutions and energy companies.
He said the pace of change this year left the government with no choice.
“We’re faced with a situation where Canada was moving to an income trust economy,” he said.
“Left unchecked, such corporate decisions would result in billions of dollars in less revenue for the federal government to invest in the priorities of Canadians.”
Flaherty said the conversions were seen as a way to avoid paying corporate taxes and “that’s a clear and present danger to fairness in the Canadian tax system. I felt we needed to act.”
Immediate carnage
There was immediate carnage from what has been described as betrayal by many Harper loyalists, many of them in Western Canada’s oil and natural gas base. Nov. 1 produced among the largest one-day losses in the history of the Toronto Stock Exchange.
Sheer panic gripped investors, with the S&P/TSX composite index, home to 76 trusts with a 10 percent weighting, tumbled 2.4 percent (BCE fell 11.4 percent and Telus 13.9 percent), with the index of income trusts shedding about C$19 billion or 12.4 percent of shareholder wealth.
The expectation was that U.S. investors, who own about 60 percent of the energy trusts, had scrambled for the lifeboats.
They currently pay a 15 percent withholding tax on trust distributions. Under the changes that would soar to 41.5 percent.
Flaherty said he was concerned about what has been described as a “hollowing out” of the Canadian corporate world, as foreigners — “usually Americans,” in his words — snapped up prime assets.
He said a new economic strategy, due to be unveiled this month, would protect Canadian firms from takeover by strengthening their ability to raise capital.
Energy trust left reeling
But energy trusts were left reeling.
Some of the heaviest initial losses were absorbed by Focus, Progress, Baytex, Newalta, ARC, Penn West and Enerplus, along with Canadian Oil Sands Trust (or COST), the largest owner at 35 percent of the Syncrude Canada consortium, covering a broad spectrum from well-established to new trusts.
COST Chief Executive Officer Marcel Coutu said he expects some “pretty nasty re-evaluations of all trusts,” leaving the sector to assess how it can now evolve.
Analysts believe trusts may be forced to unload assets as their values shrink, leaving them vulnerable to foreign takeover — the kind of outcome Flaherty said he was trying to avoid.
Some suggest the clock will be turned back to the late 1990s when trusts were seen as a way to level the playing field with conventional E&P companies at a time when major U.S. companies such as Apache, Anadarko Petroleum, ConocoPhillips, Murphy Oil, Devon Energy and Burlington Resources saw Western Canada as a cheap entry to natural gas assets.
The emergence of trusts made it difficult for U.S.- and Canadian-based companies to compete for properties, human resources and services, prompting many of the U.S. companies to pull out.
Gosbee expects return of U.S., foreign companies
George Gosbee, chairman of Calgary-based investment bank Tristone Capital, told the Financial Post he expects the next two or three years will see a return of U.S. and foreign companies and a restoration of the traditional industry structure built around junior, intermediate, senior and integrated (those that explore, produce, refine and market oil and gas) players.
Gosbee said a “proliferation” of acquisition activity could occur early in 2007 if the trust changes accelerate the lower valuations that were already under way because of weakened gas prices.
George Kesteven, president of the Canadian Association of Income Funds, told the Calgary Herald that end result could be a tax loss greater than what the government was hoping to prevent.
He also warned the fallout could result in a “very rough” period because U.S. investors tend to be slower to react to Canadian developments.
The Small Explorers and Producers Association of Canada said a downsizing of the trust ranks would be a blow to its member companies, who have worked hard to build up producing assets which have either been converted to, or bought out by trusts.
Reactions: end of trust conversions; opportunity for cherry picking
The level of anger in the industry was mirrored by David Carey, senior vice president at ARC, who accused the government of lying to investors by showing it could not be trusted to keep its hands off the equity markets.
He predicted that the days of trust conversions in the oil patch are over.
Producer trusts, which account for almost 1 million barrels of oil equivalent per day, distributed C$5.37 billion to unit holders last year from cash flow of C$10.29 billion, while payouts over 2003-2005 totaled about C$11.7 billion.
Not everyone is depressed by the move.
Gilbert Palter, chief investment officer at Edgestone Capital Partners, said it creates a “terrific investment opportunity to take private a lot of business trusts” by giving buyout firms a chance to cherry-pick for cheap deals, especially at the lower end of the market.
The scope of that opportunity is reflected in the fact that only C$5 billion will be raised and invested in Canada this year in private equity deals, compared with US$200 billion (C$220 billion) in the U.S.
Craig Thorburn, a partner at the law firm of Blake, Cassells & Graydon, told U.S. investment firms that the trusts that are now on the S&P/TSX will be “going through a life-changing event within the next four years.”
On the merger and acquisition front he anticipates “enhanced opportunities for purchasers of all stripes including private equity firms” as well as hedge funds and pension funds.
