Friday, June 27, 2008

The price of higher current yield -Canadian Royalty Trusts

There are several Canadian royalty trusts which trade on the NYSE.

Advantage Energy Income Fund (AAV), based in Calgary, currently yields 11%. Its monthly dividend payments have declined from $0.23/unit in 2004 to $0.12/unit in 2008.

Baytex Energy Trust (BTE), also based in Calgary, currently yields 7.50%. Its monthly dividend payments have increased from $0.16/unit in 2006 to $0.20/unit in 2008.

Enerplus Resources fund (ERF) currently yields 10.70%. Its monthly dividend payments have greatly fluctuated between $0.20/unit and $0.52/unit since 2000.

Harvest Energy Trust (HTE) currently yields 14.40%. Its monthly dividend payments have fluctuated significantly less than other trusts – between $0.29/unit and $0.36/unit since 2005.

Pengrowth Energy Trust (PGH) currently yields 13.50%. Its monthly dividend payments have also fluctuated significantly less than other trusts – between $0.19/unit and $0.23/unit since 2004.

Penn West Energy Trust (PWE) currently yields 12.20%. Its monthly trust distributions have fluctuated between $0.29/unit and $0.35/unit since 2006.

They do look appealing to investors because of their high dividend yields of 10%-15% annually. Not only are the dividends paid monthly, which allows for a better dividend income compounding, but some of them also allow investors to purchase shares through DRIPs at discounted prices. Unlike most other “normal” stocks, dividend payments from the Canadian income trusts tend to fluctuate a lot.

Most trusts are engaged in oil and gas production and have average reserve lives of about 10 years. Unlike similar US trusts however, Canadian Royalty trusts can purchase new assets and make acquisitions, which could extend their lives forever.

The Canadian government applies a 15% non-resident withholding tax on distributions to U.S. investors. U.S. investors can apply for a refund for at least a portion of the amount withheld. Many Canadian trusts provide information for income tax filing instructions for U.S. unitholders on their Websites. Nevertheless, it can be a complicated process at tax time, thus U.S. investors should consult with a qualified tax advisor before investing.

Like any other investment that offers above-average dividend yields however there’s a catch: the reason why CanRoy’s are able to pay huge dividends is because they are not taxed at the corporate level and pass all of their income to shareholders. This is going to change in January 2011. Since many trusts pay all of their income in distributions to unit holders, they expand their operations through sales of additional units. The uncertainty related to the 2011 tax law changes make it difficult for trusts to expand. For example trusts that were formed before October 31 2006 cannot sell more than a certain amount of new units (stock), otherwise they will lose their preferential tax status even earlier than 2011.

Under the existing provisions of the Tax Act, income trusts can generally deduct in computing their income for a taxation year any amount of income that they distribute to unitholders for the year. According to the new bill, introduced in 2006, Income trusts will not be able to deduct certain portions of their distributed income (referred to as specified income).
Pursuant to the draft legislation, the distribution tax will only apply in respect of distributions of income and will not apply to returns of capital. Some trusts have substantial tax pools that could be applied to reduce the impact of the new tax for several years post-2011.

Under the new legislation the proposed tax will be 29.5 percent in 2011 and 28.0 percent in 2012 based upon a 13 percent provincial tax rate and a federal tax of 16.5 percent reducing to 15 percent in 2012. Add this to the 15% tax that US investors already pay on income trust distributions, and the higher yields might not look so good. Under the budget released by the Minister of Finance on February 26, 2008, the 13 percent provincial tax will be replaced under an allocation formula with the applicable provincial income tax rates for each province in which the income trust has a permanent establishment. Trust are likely to continue to take advantage of growth opportunities with an increased focus on assessing international acquisition opportunities given that revenue from outside Canada will likely not be subject to the new tax. In addition, trusts will likely continue to carefully manage their substantial tax pools to mitigate the impact of the new tax on our unitholders.

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