Maple Leaf Memo
Time to Take a Swim
By Roger S. Conrad and David Dittman
Shiningbank Income Fund is now part of PrimeWest Income Trust, as the merger received final ratification by unitholders July 10. News stories emphasized the importance of tax pools for post-2011 dividend viability. The combined entity, now the seventh-largest Canadian energy trust, will benefit from CD2.6 billion in tax pools.
Reports on Advantage Income Fund’s acquisition of Sound Energy Trust also played tax pools in the first couple paragraphs. The deal will boost Advantage’s tax pool by 35 percent to approximately CD1.6 billion.
The ability to provide a tax-deferred return of capital distribution is driven by the accumulation and drawdown of tax pools; it’s not an actual return of capital to investors. Tax pools provide a shelter, enabling a trust to return distributions to unitholders in two ways: as a return of capital and as a return on capital, or investment income.
The tax-pool-sheltered portion is deemed a return of capital and is taxed as a capital gain when a unitholder sells his or her units. Capital distributions have two advantages: The tax payment is deferred until the units are sold, and a capital gains tax applies.
Non-sheltered distributions are deemed a return of investment income. The capital/income ratio of cash distributions is determined by the size and availability of the given trust’s tax pools.
Tax pools are of value because they reside primarily at the corporate level where income is generated. Significant balances are available for high rates of annual claim, such as Canadian Exploration Expense (100 percent), non-capital losses (100 percent), Canadian Development Expense (30 percent) and undepreciated capital cost (25 percent).
A Canadian Development Expense (CDE) consists of expenses incurred in drilling, converting and completing an oil well in Canada or sinking or excavating a mineshaft, main haulage way or similar underground work for a mine in a mineral resource in Canada built or excavated after the mine came into production. The cost of any Canadian mineral property or of any right to or interest in any such property also qualifies as a CDE.
CDEs are accumulated in a pool called Cumulative Canadian Development Expenses (CCDE). The taxpayer/business can deduct up to 30 percent of the unclaimed balance in that pool at the end of each year. Unclaimed balances may be carried forward indefinitely.
In the case where an entity doesn’t have taxable income against which to claim CDE, the CDE can be used to create a noncapital loss. This noncapital loss can then be carried backward or forward to taxation years where the entity can use the deduction to reduce its taxable income.
A Canadian Oil and Gas Property Expense (COGPE) is the cost of acquiring an oil or gas well; an interest or right to explore, drill or extract petroleum or natural gas; or a qualifying interest or right in oil or gas production (excluding Crown royalties).
The Canadian tax system allows an optional deduction of this cost up to 10 percent per year on a declining balance basis. The COGPE account is credited when any disposition takes place, but an entity’s negative COGPE account may be offset by the CDE account. Any negative COGPE account still remaining is treated as resource income.
Tax pools are basically built on the exploration, development and production of oil and natural gas; the advantage from the perspective of a Canadian trust is that they can help reduce future federal income taxes.
The need to build shelter against the 2011 tax was a factor in Advantage’s recent acquisition. But Sound’s assets also add to the combined entity’s sustainable value.
“This was driven more by the fact that we see some very good synergies here, in the land and the strategies of the both companies,” said Advantage President and CEO Andy Mah. “We think it’s going to be a great fit in many aspects.”
But the biggest thing it does is continue to push out when Advantage will have to pay taxes.
Tax pools do make dividends safer beyond the imposition of Minister Flaherty’s levy. Trusts with a lot can shelter cash flow based on fiscal incentives accumulated through their development efforts. They represent a significant advantage for those trusts that have significant pools for the foreseeable future.
Though a comfortable and cozy refuge under the heat of the now-passed tax fairness plan, a tax pool is basically just another asset a particular trust controls. True, the more you have, the better you are–at least on the basis of supporting a high payout to investors.
The Canadian government has recognized that certain development activities deserved special treatment, exploitation of natural resources among them. Authorities also saw the merits of facilitating the sharing of the fruits of those assets–the cash flow–with the people underneath whom they rested. It was Canadians’ land, but someone needs to take on the risk and make stuff move to get it out of the ground and bring it to market.
Canadian energy trusts were (and still are) a great proposition. Businesses were structured in a manner that encouraged exploitation of assets that didn’t present upside potential for exploration and production companies; trusts, due to lower costs of capital, were encouraged to exploit such resources and then shared much of the cash flow with investors.
Behind those generous cash flows are–most important–solid assets. Mah recognized the proper role of tax pools as essentially a complement to other assets of the underlying business. “Fundamentally, we always look at asset quality and the opportunities in that before we consider doing something just because the market has changed.”
Politics and Canadian-Finance-Minister-English
In Minister Flaherty’s mind, “fairness” means a lower effective tax rate on the cash a business entity generates. It’s an Orwellian nuance: Royalty and income trusts were essentially incentivized to pay out a large portion of cash flow, taxed at 46 percent in Canada with distributions to US investors levied at 15 percent. The effective Canadian corporate tax rate–broadcast during winter finance committee hearings on the matter and unchallenged by anyone–is 6.6 percent.
Flaherty caved to Canadian corporate interests; they didn’t want to be forced to operate under the discipline the trust structure demands. Like the recently ballyhooed private-equity buyout game, what’s left after a trust conversion or initial public offering is a business operating under the discipline of tight, substantial demands on cash flow, limiting opportunities for management to make stupid capital decisions.
As a recent piece in the Financial Times opines, highly leveraged privatizations are good for the underlying businesses because management is forced to strip it down, get to basics, limit waste, etc.
Can’t a high dividend do what debt so wonderfully does?
Speaking Gigs
Head out to the East Coast, and join me and my colleagues Neil George and Elliott Gue at the Washington DC, Money Show, Sept. 6-8, 2007. The conference will take place at the Wardman Park Marriott, located in downtown Washington DC. To register for free, go to https://inet.intershow.com/regnew/info.asp?sid=DCMS07&newReg=t&scode=007394. Be sure to tell them I sent you.
The Roundup
News from the Canadian Edge coverage universe is rather light in advance of second quarter earnings season, but we’ll have much to catch up on as trusts begin announcing results in the weeks ahead.
As always, we’ll have full coverage of Portfolio recommendations as results are made public.
Gas/Propane
Keyera Facilities Income Fund (KEY.UN, KEYUF) has initiated a project to extract ethane from the raw natural gas processed at its Rimbey gas plant in west central Alberta. The CD26 million project will involve plant modifications and the construction of a 32-kilometer pipeline to deliver the product to existing ethane gathering infrastructure in Alberta.
Project completion is expected in the third quarter of 2008. When operational, Keyera will extract about 5,000 barrels per day of ethane. The project involves the modification of the existing natural gas liquids extraction process at the Rimbey gas plant and the installation of new compression equipment.
Keyera has entered into a commercial arrangement outlining the terms for the sale of the ethane from the project to Dow Chemical Canada. Keyera operates the Rimbey plant and holds an 86.4 percent ownership interest. With a raw gas processing capacity of 422 million cubic feet per day and 2,500 kilometers of gathering pipelines, the plant’s capture area allows it to provide energy processing services to a large number of producers. Keyera Facilities Income Fund is a buy up to USD19.
Real Estate Trusts
Legacy Hotels REIT (LGY.UN, LEGYF) has agreed to a CD12.60-per-unit offer from a buyout group that includes InnVest REIT (INN.UN, IVRVF) and Cadbridge Investors LP, a limited partnership formed by Cadim and Westmont Hospitality Group. The total value of the deal is CD2.5 billion, including debt.
InnVest kicked in CD652 million for 11 Legacy hotels, bringing the number of properties it owns to 146. Legacy’s board has approved the deal.
InnVest will finance its portion of the acquisition through a CD200 million bought-deal financing round with RBC Capital Markets and Scotia Capital, as well as CD194 million in mortgage debt and CD215 million of bridge financing from RBC. Hold Legacy Hotels REIT; InnVest REIT is also a hold.
By Roger S. Conrad and David Dittman
Shiningbank Income Fund is now part of PrimeWest Income Trust, as the merger received final ratification by unitholders July 10. News stories emphasized the importance of tax pools for post-2011 dividend viability. The combined entity, now the seventh-largest Canadian energy trust, will benefit from CD2.6 billion in tax pools.
Reports on Advantage Income Fund’s acquisition of Sound Energy Trust also played tax pools in the first couple paragraphs. The deal will boost Advantage’s tax pool by 35 percent to approximately CD1.6 billion.
The ability to provide a tax-deferred return of capital distribution is driven by the accumulation and drawdown of tax pools; it’s not an actual return of capital to investors. Tax pools provide a shelter, enabling a trust to return distributions to unitholders in two ways: as a return of capital and as a return on capital, or investment income.
The tax-pool-sheltered portion is deemed a return of capital and is taxed as a capital gain when a unitholder sells his or her units. Capital distributions have two advantages: The tax payment is deferred until the units are sold, and a capital gains tax applies.
Non-sheltered distributions are deemed a return of investment income. The capital/income ratio of cash distributions is determined by the size and availability of the given trust’s tax pools.
Tax pools are of value because they reside primarily at the corporate level where income is generated. Significant balances are available for high rates of annual claim, such as Canadian Exploration Expense (100 percent), non-capital losses (100 percent), Canadian Development Expense (30 percent) and undepreciated capital cost (25 percent).
A Canadian Development Expense (CDE) consists of expenses incurred in drilling, converting and completing an oil well in Canada or sinking or excavating a mineshaft, main haulage way or similar underground work for a mine in a mineral resource in Canada built or excavated after the mine came into production. The cost of any Canadian mineral property or of any right to or interest in any such property also qualifies as a CDE.
CDEs are accumulated in a pool called Cumulative Canadian Development Expenses (CCDE). The taxpayer/business can deduct up to 30 percent of the unclaimed balance in that pool at the end of each year. Unclaimed balances may be carried forward indefinitely.
In the case where an entity doesn’t have taxable income against which to claim CDE, the CDE can be used to create a noncapital loss. This noncapital loss can then be carried backward or forward to taxation years where the entity can use the deduction to reduce its taxable income.
A Canadian Oil and Gas Property Expense (COGPE) is the cost of acquiring an oil or gas well; an interest or right to explore, drill or extract petroleum or natural gas; or a qualifying interest or right in oil or gas production (excluding Crown royalties).
The Canadian tax system allows an optional deduction of this cost up to 10 percent per year on a declining balance basis. The COGPE account is credited when any disposition takes place, but an entity’s negative COGPE account may be offset by the CDE account. Any negative COGPE account still remaining is treated as resource income.
Tax pools are basically built on the exploration, development and production of oil and natural gas; the advantage from the perspective of a Canadian trust is that they can help reduce future federal income taxes.
The need to build shelter against the 2011 tax was a factor in Advantage’s recent acquisition. But Sound’s assets also add to the combined entity’s sustainable value.
“This was driven more by the fact that we see some very good synergies here, in the land and the strategies of the both companies,” said Advantage President and CEO Andy Mah. “We think it’s going to be a great fit in many aspects.”
But the biggest thing it does is continue to push out when Advantage will have to pay taxes.
Tax pools do make dividends safer beyond the imposition of Minister Flaherty’s levy. Trusts with a lot can shelter cash flow based on fiscal incentives accumulated through their development efforts. They represent a significant advantage for those trusts that have significant pools for the foreseeable future.
Though a comfortable and cozy refuge under the heat of the now-passed tax fairness plan, a tax pool is basically just another asset a particular trust controls. True, the more you have, the better you are–at least on the basis of supporting a high payout to investors.
The Canadian government has recognized that certain development activities deserved special treatment, exploitation of natural resources among them. Authorities also saw the merits of facilitating the sharing of the fruits of those assets–the cash flow–with the people underneath whom they rested. It was Canadians’ land, but someone needs to take on the risk and make stuff move to get it out of the ground and bring it to market.
Canadian energy trusts were (and still are) a great proposition. Businesses were structured in a manner that encouraged exploitation of assets that didn’t present upside potential for exploration and production companies; trusts, due to lower costs of capital, were encouraged to exploit such resources and then shared much of the cash flow with investors.
Behind those generous cash flows are–most important–solid assets. Mah recognized the proper role of tax pools as essentially a complement to other assets of the underlying business. “Fundamentally, we always look at asset quality and the opportunities in that before we consider doing something just because the market has changed.”
Politics and Canadian-Finance-Minister-English
In Minister Flaherty’s mind, “fairness” means a lower effective tax rate on the cash a business entity generates. It’s an Orwellian nuance: Royalty and income trusts were essentially incentivized to pay out a large portion of cash flow, taxed at 46 percent in Canada with distributions to US investors levied at 15 percent. The effective Canadian corporate tax rate–broadcast during winter finance committee hearings on the matter and unchallenged by anyone–is 6.6 percent.
Flaherty caved to Canadian corporate interests; they didn’t want to be forced to operate under the discipline the trust structure demands. Like the recently ballyhooed private-equity buyout game, what’s left after a trust conversion or initial public offering is a business operating under the discipline of tight, substantial demands on cash flow, limiting opportunities for management to make stupid capital decisions.
As a recent piece in the Financial Times opines, highly leveraged privatizations are good for the underlying businesses because management is forced to strip it down, get to basics, limit waste, etc.
Can’t a high dividend do what debt so wonderfully does?
Speaking Gigs
Head out to the East Coast, and join me and my colleagues Neil George and Elliott Gue at the Washington DC, Money Show, Sept. 6-8, 2007. The conference will take place at the Wardman Park Marriott, located in downtown Washington DC. To register for free, go to https://inet.intershow.com/regnew/info.asp?sid=DCMS07&newReg=t&scode=007394. Be sure to tell them I sent you.
The Roundup
News from the Canadian Edge coverage universe is rather light in advance of second quarter earnings season, but we’ll have much to catch up on as trusts begin announcing results in the weeks ahead.
As always, we’ll have full coverage of Portfolio recommendations as results are made public.
Gas/Propane
Keyera Facilities Income Fund (KEY.UN, KEYUF) has initiated a project to extract ethane from the raw natural gas processed at its Rimbey gas plant in west central Alberta. The CD26 million project will involve plant modifications and the construction of a 32-kilometer pipeline to deliver the product to existing ethane gathering infrastructure in Alberta.
Project completion is expected in the third quarter of 2008. When operational, Keyera will extract about 5,000 barrels per day of ethane. The project involves the modification of the existing natural gas liquids extraction process at the Rimbey gas plant and the installation of new compression equipment.
Keyera has entered into a commercial arrangement outlining the terms for the sale of the ethane from the project to Dow Chemical Canada. Keyera operates the Rimbey plant and holds an 86.4 percent ownership interest. With a raw gas processing capacity of 422 million cubic feet per day and 2,500 kilometers of gathering pipelines, the plant’s capture area allows it to provide energy processing services to a large number of producers. Keyera Facilities Income Fund is a buy up to USD19.
Real Estate Trusts
Legacy Hotels REIT (LGY.UN, LEGYF) has agreed to a CD12.60-per-unit offer from a buyout group that includes InnVest REIT (INN.UN, IVRVF) and Cadbridge Investors LP, a limited partnership formed by Cadim and Westmont Hospitality Group. The total value of the deal is CD2.5 billion, including debt.
InnVest kicked in CD652 million for 11 Legacy hotels, bringing the number of properties it owns to 146. Legacy’s board has approved the deal.
InnVest will finance its portion of the acquisition through a CD200 million bought-deal financing round with RBC Capital Markets and Scotia Capital, as well as CD194 million in mortgage debt and CD215 million of bridge financing from RBC. Hold Legacy Hotels REIT; InnVest REIT is also a hold.
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