Saturday, March 17, 2007

Monday Mar 19: Judgment Day for CanRoys?

Ok, I may be exaggerating, but Monday is crucially important as it is when the Canadian parliament reconvenes and the budget is to be tabled. First a little background: last October, Finance Minister Jim Flaherty surprised investors (and contrary to campaign promises made by his party) by proposing a new 31.5% tax for Canadian Royalty Income Trusts (CanRoys). The ensuing loss of 20-30% in many CanRoys as well as Cdn $35 billion in total market capitalization has been dubbed the “Halloween Massacre”. Early this year, I wrote about political developments in Canada that may induce change in the tax proposal as it now stands. On Feb 28, The Finance Minister promised to include this legislation in the upcoming budget.

Canadian Association of Income Trust Investors (CAITI) is an organization formed in the wake of the “Halloween Massacre” to “to preserve the ongoing viability and sustainability of the Canadian income trust market”. It has organized letter-writing and billboard campaigns aimed at influencing the legislative outcome.

The Standing Committee on Finance in the Canadian House of Commons has made several recommendations, including, 1) to release the detailed calculation with which the government claim the income trusts result in a tax leakage; 2) to table the proposal as a separate piece of legislation rather than part of the budget; and 3a) to reduce the proposed tax rate from 31.5% to 10%; or 3b) to extend the proposed transition period from 4 years to 10 years.

I admit that I was trying to be dramatic in the title (got you to read, didn’t it?) In fact what the Canadian government does matters little to my view on this sector. We live in a world increasingly hungry for energy while world oil supply may be peaking or already peaked. The oil/gas CanRoys own assets in a politically stable part of the world and will be valued accordingly. It has been argued that if there is advantage to convert these trusts into regular companies then it will happen. They can easily be acquired by private equity firms which will structure the deal with high levels of debt. Since interest payments are deductible, the government of Canada will see some real “tax leakage” then.

Disclosure: I own several names in this space.

Update, Mar 19, 4:30 pm
CTV reports:

Flaherty had signalled [sic] the budget would include legislation to include a tax on income trusts, vehicles that have been used to avoid paying most corporate taxes, but in an unexpected turn of events, the agenda did not include this measure.

I think this is positive.

Update, Mar 19, 5:40 pm

I spoke too soon. According to this Reuters report the tax was included.