At this point, most trusts are waiting until trust taxation is set before setting their plans in motion. But it’s already clear that initial fears of an automatic 31.5 percent cut in trust distributions were way overblown. In fact, many trusts should be able to avoid any reduction at all.

Just as in the US, few–if any–Canadian corporations pay full rate. During recent hearings on trust taxation, the government admitted the country’s companies paid an average effective rate of less than 7 percent. The clear upshot is there are plenty of loopholes available that trusts will be able to use to reduce their effective tax rate and preserve cash for distributions and growth.

Not all the avenues to tax avoidance will be open to every trust. Some will find themselves with little choice but to pay close to full rate and reduce distributions accordingly. For these, the best way to maximize shareholder value will likely be to put themselves up for sale. And as I pointed out in last month’s Feature Article, there’s no shortage of willing buyers, particularly private capital anxious to own solid, cash-generating businesses.

It’s likely most trusts will draw a far different conclusion: They have enough potential tax efficiency to shelter huge chunks of cash flow to perpetuity and, therefore, continue to pay outsized yields for years to come.

In mid-May, I hosted a panel of top executives from Advantage Energy Income Fund (AVN.UN, NYSE: AAV), Enerplus Resources (ERF.UN, NYSE: ERF) and Pengrowth Energy Trust (PGF.UN, NYSE: PGH) at InterShow’s Las Vegas investment conference. One of the biggest surprises for me was how all three trusts had accepted taxation as certain and—though they were fighting it politically—had already drawn up a Plan B for dealing with it.

Obviously, trust executives would prefer the government drop its plans to tax trusts altogether or, at a minimum, adopt the Liberal Party’s proposal for a much-lower maximum rate of 10 percent. And that certainly remains a very real possibility, with Canadian politics in flux. Failing that, however, they’re anxious the rules be set so they can get on with the task that every taxable corporation faces every year: maximizing tax efficiency to minimize taxes paid.

Below, I look at some of the potential strategies trusts will use to reduce their tax burden, so they can continue to pay outsized distributions. I’ve also identified trusts that are well positioned to take advantage of them, including new Aggressive Portfolio addition Advantage Energy.

As we approach 2011, these techniques are likely to be modified to fit the unfolding particulars of the tax code. There will also be new strategies developed that will only become clear after rules for trust taxation become final.

That’s to be expected in the complex world of taxes and tax avoidance. It’s why the legal and accountancy professions are so prolific, and we’ll be staying on top of it for you.

Trusts will have to pay for advice and restructuring measures to improve their tax efficiency. It will be an ongoing process, both to 2011 and well beyond. Accounting and legal costs may even induce more industry consolidation, along the lines of last month’s PrimeWest Energy Trust (PWI.UN, NYSE: PWI)/Shiningbank Energy Income Fund (SHN.UN, SBKEF) merger, so the burden can be spread out over larger enterprises.

The bottom line is trusts backed by solid, growing businesses will be able to make the adjustments they need to shelter income and keep paying distributions. Just as important, trust executives—including the trio on my Las Vegas panel—are as committed as ever to paying big dividends. And where there’s a will, there will be a way.

Into The Pool

One way to shelter income that’s likely to be increasingly popular in coming years is the use of tax pools. Most corporations routinely book noncash expenses such as depreciation of assets. These don’t cost the company a penny of cash. But they’re written off dollar for dollar against income, reducing the company’s tax burden. The result is the corporation gets to keep more cash for growth and distributions.

Tax pools are basically noncash expenses that can be carried forward to whatever time the company or trust needs to use them. Some examples are depreciation of capital costs, amortization, goodwill from acquisitions, noncapital losses, tax credits from certain governments, the cost of issuing new shares and certain deductions, such as exploration and development expenses, for use by oil and gas producers.

Up until the Halloween trust taxation announcement, most trust managements focused very little on tax pools. They were chiefly used to reduce the tax burden on cash flow trusts reinvested, rather than paid out to shareholders. High-payout-ratio trusts had less to shelter, so they used tax pools less, while high-plough-back trusts used them more extensively.

Assuming trusts are taxed as corporations beginning in 2011, tax pools will take on much more importance. That’s because they can be used to reduce taxable cash flow dollar for dollar, thereby shielding the cash from Canadian corporate taxes and freeing it up to be paid out in distributions.

For example, suppose a trust has CD300 million in tax pools in 2011 and, on average, makes CD30 million in cash flow per quarter. Theoretically, it will be capable of sheltering all its income for 10 quarters, avoiding all Canadian corporate taxes.

In addition, tax pools aren’t static but are constantly being added to by a trust’s activities. Trusts’ tax pools are decreased when they’re used to shelter income. But they’re increased by expenditures on exploration, development and acquisitions of properties, as well as virtually every other noncash expense. These include acquisition and development of oil and gas properties, mergers, construction of infrastructure assets like pipelines and power plants or even issuing more shares.

According to Penn West Energy Trust’s (PWT.UN, NYSE: PWE) CEO William Andrew, Canadian income trusts collectively have some CD23 billion in tax pools. That figure is likely to rise sharply before 2011, as trusts position for maximum tax efficiency.

Up to now, the market has made little differentiation between the various trusts in terms of future tax liability in 2011, treating all as equally vulnerable to a flat 31.5 percent dividend haircut. In addition, few Bay Street analysts to date have bothered to study and understand tax pools, let alone research who has them.

The upshot is that trust share prices don’t currently reflect the post-2010 tax efficiency of their business—i.e., the value of their tax pools—let alone the fact that tax pools are likely to grow considerably by 2011. That spells considerable upside for the trusts that are rich in tax pools, both for their ability to sustain distributions long term and as takeover targets because acquirers will inherit tax pools if a deal is constructed properly.

Many trusts have tax pools. But oil and gas trusts tend to have more because of the tax incentives inherent in exploration and production activities. The sector’s undisputed tax pool king is Advantage Energy, whose CD1.2 billion is roughly equal to 95 percent of its market capitalization and more than 18 quarters of its cash flow.

The trust’s wealth of pools is due to two reasons. First, Advantage has long had a policy of paying out a high percentage of cash flow in distributions. Coupled with a heavy reliance on natural gas, this has made the distribution extremely vulnerable to dips in energy prices such as we saw in 2006. However, it’s also had the salutary effect of allowing the trust to hang on to its tax pools, rather than using them to plough back cash flow into growing the business.

Second, Advantage’s management has long had a policy of factoring in tax pools to any acquisition it’s made. Pools have been cheaply valued for many years, so it’s been able to do this at little cost. And it continues to seek out deals that make sense for tax pools, as well as reserves and production.

Looking ahead, CEO Andy Mah says the trust is looking at a range of new potential acquisitions, with quality and quantity of tax pools as major objectives. Sooner or later, however, it’s likely a major will take interest in the trust’s ability to shelter cash for 2011 and beyond, as well as its solid asset base. That’s a good reason to buy Advantage Energy Income Fund up to USD14.

Another trust with a high takeover value in tax pools is Daylight Resources Trust (DAY.UN, DAYYF). As of the end of the first quarter, the trust’s tax pools of CD768 million actually exceeded its market capitalization of CD759 million. That’s also equivalent to roughly 18 quarters of cash flow. The company is smaller and considerably more speculative than Advantage. But yielding nearly 16 percent, Daylight Resources Trust a buy up to CD12.

PrimeWest and Shiningbank will have a combined CD2.65 billion in tax pools once they complete their proposed merger. More important, the deal will create a much-stronger overall trust that’s more capable of handling the ups and downs of the market. But tax pools equivalent to more than 90 percent of market capitalization—and more than 17 quarters of cash flow—will ease the way considerably into 2011 and beyond.

Both PrimeWest Energy Trust and Shiningbank Energy Income Fund are holds while they complete their merger. Shiningbank holders should tender their shares for 0.62 PrimeWest units when asked. Note that Shiningbank holders will receive a small distribution increase when the share exchange is made.

Portfolio Pools

As for the rest of our Portfolio oil and gas trusts, they’ve been largely managed for stability in all markets and, therefore, have had low payout ratios during the past several years. As a result, they’ve had to use their tax pools to shelter income ploughed back into the operation and have less left over as a percentage of either cash flow or market capitalization.

Nonetheless, there’s still considerable value and management has a lot of latitude beefing up positions in tax pools between now and 2011. That includes acquiring pool-rich trusts like Advantage.

ARC Energy Trust (AET.UN, AETUF) has a total of around CD1.22 billion in tax pools from all of its subsidiaries, according to the most-recent data available. That’s roughly equivalent to 27 percent of its market capitalization and about seven quarters of cash flow.

According to its 2007 Form 6-K, Enerplus Resources has some CD1.8 billion in tax pools. That’s about 29 percent of market capitalization or a little more than nine quarters of cash flow, based on the first quarter tally. 

Penn West’s tax pools came in at CD2.4 billion and change, with much of the increase in prior years coming as a result of the 2006 merger with Petrofund. That total, however, is still only about 28 percent of market capitalization, or about 7.7 quarters of cash flow.

Somewhat smaller Peyto Energy Trust (PEY.UN, PEYUF) had nearly CD700 million in tax pools at the end of 2006. Its extensive development program generates a lot of tax pools, but management’s low-payout-ratio strategy burns them up quickly as well. That means total tax pool exposure is still relatively low at 37 percent of market capitalization and equal to 8.7 quarters of cash flow at first quarter 2007 levels.

As of this writing, up-to-date tax pool information at Paramount Energy Trust (PMT.UN, PMGYF) and Vermilion Energy Trust (VET.UN, VETMF) wasn’t possible to track down. In Paramount’s case, that’s owing to a recent major acquisition made by the trust of properties formerly owned by Dominion Resources.

The deal roughly doubled reserves and increased reserve life index by 58 percent, thereby dramatically changing the asset mix of this all-gas producer. But because mergers are a primary source of increasing tax pools, the purchase is bound have improved Paramount’s position.

Baytex Energy Trust (BTE.UN, NYSE: BTE), for example, purchased Dominion’s Canadian oil production properties as part of the same deal. Its purchase should improve its tax-pool position as well from its current level of roughly a third of market capitalization. But until we see hard figures, we can only conjecture.

As for Vermilion, management has stated that its tax-pool position plus foreign income will roughly zero out its potential 2011 tax liability. Exact figures on tax pools won’t be known until after recent acquisitions are factored in. That also goes for Provident Energy Trust (PVE.UN, NYSE: PVX), which in the middle of acquiring Capitol Energy, though it, too, should be in good shape.

Outside the oil and gas sector, trusts are only starting to report their tax-pool positions. One that has is Keyera Facilities (KEY.UN, KEYUF), which counts CD375 million in tax pools as of the beginning of 2007. That’s roughly equivalent to 37 percent of market capitalization and about 11 quarters of cash flow at first quarter levels. Tax pools consist mainly of undepreciated capital costs at the trust’s subsidiaries.

Interesting, Keyera’s management is currently studying a reorganization of its internal legal structure to reduce its use of available tax deductions from 2007-10. This will maximize the level of tax pools available to reduce its tax burden in 2011, when corporate taxation of trusts kicks in.

Keyera’s tax pool wealth is a pretty good indication that other energy infrastructure trusts should also be able to dodge a sizeable portion of their prospective taxes. That includes the electric power, pipeline and midstream energy trusts in listed in the  Conservative Portfolio and How They Rate tables, as well as trusts involved in developing natural resources.

No trust, of course, is a worthy buy on the basis of tax pools alone. For example, I’m still concerned that the impact of high-cost acquisitions isn’t fully reflected in distributions at Canetic Resources (CNE.UN, NYSE: CNE). As a result, Canetic Resources rates a hold. This is despite listing some CD1.8 billion in tax pools, a level that’s a little less than half its market cap.

Tax pools are a major bonus to owning trusts that are already backed by strong, growing businesses. That’s particularly true now, with the market only beginning to wake up to their potential value. That’s another good reason to buy all the oil and gas trusts in the Aggressive Portfolio, as well as Conservative trusts like Keyera, at prices listed in the Portfolio and How They Rate tables.

Going Abroad

The other major tax loophole available to trusts after 2010 is to expand operations abroad. Basically, foreign income is already taxed in the country where it’s earned and, therefore, isn’t subject to prospective trust taxation. The more a trust earns abroad, the less the impact on its overall cash flow and ability to pay big distributions.

The biggest drawback to income earned outside of Canada is it’s not in Canadian dollars. The rise in the Canadian dollar/US dollar exchange rate, for example, has decreased the value of US dollar receipts by more than 10 percent during the past few months. That’s hurt some exposed trusts’ bottom lines, putting their distributions at risk.

Trusts that have diversified beyond North America have built-in protection from the drop of a single currency like the US dollar. So do trusts that produce oil and gas and other natural resources. Their product is priced in US dollars, but the price tends to rise in US dollar terms when the greenback drops.

With more than two-thirds of its oil and gas output coming from Europe and Australia, Vermilion Energy is a good example of a trust that’s gone international and become immune to Canadian trust taxation, without putting itself at risk to a further drop in the US dollar. So is Versacold Income Trust (ICE.UN, VCLDF), though its pending takeover means it won’t be independent much longer.

Arctic Glacier Income Fund (AG.UN, AGUNF) has a bigger challenge, with some 80 percent of its income coming from the US in the first quarter. The Canadian dollar value of those receipts dropped sharply in recent months as the US dollar sank. But the company has thus far been able to hedge the currency losses that it can’t pass along in prices. Meanwhile, coupled with tax pools, its distribution is virtually immune from prospective trust taxation starting in 2011. Buy Arctic Glacier Income Fund up to USD14.

Last month, major US brokerage UBS issued a very bullish view on New York Stock Exchange-listed Canadian oil and gas producer trusts, in large part on the expectation that many would convert to master limited partnerships (MLPs). The brokerage also forecasted a series of mergers involving many of the biggest trusts, with the result that the industry will eventually contract to a handful of very strong majors.

We’ve already seen one of the larger trusts convert some of its operations to an MLP: Provident Energy, which has spun out most of its US producing properties in the BreitBurn partnership. The advantage gained is the trust can flow through virtually all of its US income tax free. Meanwhile, BreitBurn’s high yield also makes it a valuable financing vehicle for making further acquisitions. Last month, the partnership completed its first major purchase; more are expected.

Enerplus has also ramped up its expansion in the US, particularly in the Baaken region. And management is apparently looking at more acquisitions here as well that will further increase its presence.

Ultimately, that could lead to Enerplus spinning off a new MLP that would further its expansion here. It’s even possible the entire trust will convert to a partnership. UBS, for one, expects “legal and tax issues to be overcome, allowing trusts to convert to MLPs, which should be a positive catalyst for valuations in the sector—regardless of the government’s reaction.”

In my view, if one trust successfully converts to an MLP, all should benefit with higher share prices. No one, however, should count on this happening any more than we should bank on a high-premium takeover of a trust or a change of heart by the Canadian government on trust taxation.

All of these things are certainly possible. As Tips On Trusts points out, the situation in Ottawa is still very much in flux. Private capital continues to snap up trusts, taking out real estate investment trust Dundee REIT (D.UN, DUNTF), at lofty levels this week. And trusts are certainly going to look at all their options as far as 2011 taxation, including possibly converting to MLPs.

The key to successful investing in Canadian royalty and income trusts remains buying those backed by good businesses. If you do that, you’ll prosper even if nothing else happens. And if something does, you won’t have to wait long for a windfall.