Dividend Watch List

For the second consecutive month, the only real dividend cut in the Canadian Edge universe was part of an income trust’s conversion to a corporation. Better, the reduction was less than the market expected and won’t be felt by investors until after Jan. 1, 2011, when the planned conversion will occur.

After that Avenir Diversified Income Trust (TSX: AVF-U, OTC: AVNDF) will pay a monthly distribution of CAD0.045 per share. That’s roughly 25 percent below the current level of CAD0.06, but still a yield of around 10 percent based on Avenir’s current unit price. More important, it’s well in line with my expectation when I upgraded the stock to “buy” last month.

Along with the move Avenir also announced it will attempt to sell its real estate operations and focus purely on energy production and marketing. The new distribution rate appears to be based on a conservative projection of energy prices and the company’s ability to produce oil and gas from what’s still a quite small base of assets. The Elbow River marketing group earned about 43 percent of the company’s first-quarter funds from operations, thanks in large part to an opportunity to market ethanol.

Oil and gas production contributed 51 percent at a rate of 3,450 barrels of oil equivalent per day. That’s the lowest production rate in the Canadian Edge universe of energy producers. And it’s been further diminished this year by strategic asset sales to cut debt. Current planned capital spending has been set to maintain that level of output.

In the past, the uniquely diversified nature of Avenir’s operations has prevented it from being taken over by larger players. The unloading of real estate operations simplifies matters somewhat. But a would-be acquirer would also be buying an energy marketing division with niche expertise that would have to mesh with business plans or else be sold at an uncertain price.

The upshot is Avenir is still likely to elude absorption, despite its very small size and rock-bottom valuations of just 1.02 times book value and 31 percent of sales. Rather, it’s best suited for those who want a conservative income bet on energy with virtually no debt after recent asset sales–and which hasn’t put 2011 risk behind it.

There’s still exposure to energy prices. But Avenir Diversified Income Trust is a buy up to USD6 only for those who want a more conservative and slower-moving play.

The only other distribution reduction last month was at Westshore Terminals Income Fund (TSX: WTE-U, OTC: WTSHF), which announced it will pay out CAD0.41 a share on July 15 versus the CAD0.42 paid on April 15. More important, however, the owner of port storage terminals paid out 46.4 percent more than it did in the year-earlier quarter, reflecting its vastly improved fortunes and strong outlook over that time.

The company earns the majority of its income from fees that don’t fluctuate with energy prices. The balance (roughly 30 percent) varies with energy prices, principally the price of metallurgical coal on global and particularly Asian markets. The company’s largest customer by far is Teck Resources (TSX: TCK/B, NYSE: TCK), due to the latter’s now full ownership of Fording Canadian Coal. Fording’s metallurgical coal is increasingly sought after in China, evidenced by the ownership stake taken by that country’s largest sovereign wealth fund China Investment Corp (CIC).

The interest by CIC and China is sound assurance that cash will continue to flow at Westshore in coming years, as met coal export volumes steadily rise. Throughput rose 23.5 percent in the first quarter from year-earlier levels to 6.3 million tons. And the company expects first half 2010 volumes to hit 12.4 million tons, an even more impressive 30.5 percent above the prior year’s level. Full-year 2010 projections call for volumes to take out the previous record of 23.5 million tons set in 1997.

That’s bullish for Westshore’s cash flow, distributions and, eventually, its share price, which has now climbed within 10 percent of its mid-2008 high set at the peak of that year’s energy price spike. Currently yielding well over 9 percent, Westshore’s not as secure as the typical CE Conservative Holding. And investors need to be ready for dividends to fluctuate to the downside when the economy weakens.

But for those who can handle the ups and downs, the shares are a solid bet on continued rising demand for metallurgical coal–an essential element for forging steel–around the world. Upside is particularly strong in China, which now produces seven times more steel than the US. Westshore Terminals Income Fund is a buy up to USD16 for income seekers who can handle the risk.

Here’s the rest of the Watch List along with my current advice for each. Note that with the Canadian economy strengthening, I fully expect to see more of these come off the List than other How They Rate companies come on. But I’ll always take my lead from the numbers, with the next batch appearing in quantity later this month.

Also note that this list excludes any trusts that have yet to declare their post-conversion distribution policies. The companies below all have endangered dividends because of weak operations. That sets them apart from companies with strong operations but whose managements elect to cut payouts to make converting to corporations easier.

The former is a business decision mandated by sub-par company performance. And when cuts are made, share prices typically fall hard and often never get back up.

The latter are entirely at management’s discretion. As I’ve said before, I’m not enough of a long-distance mind reader to make predictions on what executives may or may not do. But as we’ve continued to see, even the companies that have announced cuts with their completed or future conversions are beating what the market has been pricing in for them.

The cuts do reduce investors’ income, or will when conversions are completed as many plan to wait to do until Jan. 1, 2011. But the cuts are beating expectations and that eventually means higher share prices–particularly as nearly four years of uncertainty regarding trust taxation melt away.

• Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF)–SELL
• Consumers Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF)–SELL
• FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF)–Hold
• InterRent REIT (TSX: IIP-U, OTC: IIPZF)–SELL
• Phoenix Technology Income Fund (TSX: PHX-U, OTC: PHXHF)–Buy @ 8
• Primaris Retail REIT (TSX: PMZ-U, OTC: PMZFF)–Hold
• Royal Host REIT (TSX: RYL-U, OTC: ROYHF)–Hold
• Swiss Water Decaf Coffee Fund (TSX: SWS-U, OTC: SWSSF)–Hold
• The Keg Royalties Income Fund (TSX: KEG-U, OTC: KRIUF)–Hold

A Word from the IRS

A letter from the Internal Revenue Service (IRS) Office of Chief Counsel responding to an inquiry from Rep. Phil Gingrey (R-GA) on behalf of a constituent who holds interests in Canadian trusts through his US Individual Retirement Account (IRA) provides the best summation of this sorry mess we’ve seen to date.

The IRS’s lawyers establish the following:

• Generally, an individual is not liable for US taxes on amounts earned through an IRA until distributed. However, US tax law only defers US tax and doesn’t affect the ability of a foreign country to impose tax on income that the IRA derives from that country. Distributions from Canadian income and royalty trusts may be subject to tax in Canada depending on Canadian tax law and the terms of the US-Canada Income Tax Treaty.
• Certain US entities that are generally exempt from taxation in a taxable year in the United States–such as IRAs–are exempt from taxation on dividend income arising in Canada in that same taxable year according to Article XXI (Exempt Organizations) of the Treaty.
• Based on a 2005 change in Canadian tax law, Canada began imposing a 15 percent withholding tax on distributions from income and royalty trusts to US residents. Canadian tax law did not initially treat these distributions as dividends, however, and so they weren’t exempt from Canadian tax under Article XXI of the Treaty.
• In 2007, Canada amended its domestic law again and began taxing certain of these trusts as corporations and treating distributions from these trusts as dividends for purposes of both their domestic law and their tax treaties.
• Canada and the US signed an exchange of diplomatic notes in 2007, on the same day the two parties signed the Fifth Protocol to the Treaty, that include what we’ve often referred to as “Annex B.” These notes confirmed, among other things, “that distributions from Canadian income trusts and royalty trusts that are treated as dividends under the taxation laws of Canada shall be considered dividends for the purposes of [the Treaty].”
• However, Canadian law–the Tax Fairness Act–provides that Canada won’t tax income and royalty trusts already in existence as of Oct. 31, 2006, as corporations until Jan. 1, 2011. Until then, Canadian tax law won’t treat distributions from such trusts as dividends. Distributions from these pre-existing trusts won’t be exempt from Canadian tax under Article XXI of the treaty until 2011.
• The IRS acknowledges that investors who hold Canadian trust units in IRAs may not claim a foreign tax credit for the Canadian taxes withheld on the income paid in respect of those units. This is consistent with a general rule that foreign tax credits may not be credited against an individual’s tax liability unless the individual is liable for the tax. Nor can the IRA make use of a foreign tax credit because it’s exempt from tax in the US. This may ultimately result in double taxation when the IRA distributes this income to the unitholder.
• The 2007 Tax Fairness Act, when it and the Fifth Protocol have full effect, will generally eliminate the 15 percent Canadian withholding tax on dividends paid by income and royalty trusts in respect of units held in US IRAs.

The IRS position has been brought to the attention of at least one major brokerage, which places blame for continued incompetence on this issue at the foot of the Depository Trust & Clearing Corporation (DTCC), an old friend from the days of the qualified versus not qualified debate. Then as now DTCC was a stumbling block.

Citing the points made above, including references to the IRS chief counsel and Rep. Gingrey, contact the investor relations team at the trusts of which you hold units in your IRA. Let them know that DTCC is getting in the way of you and your proper payment.   

Bay Street Beat

Disaster in the Gulf of Mexico for BP (NYSE: BP) could spell opportunity for Vancouver, British Columbia-based Methanex Corp (TSX: MX, NSDQ: MEOH).

Rising costs associated with what’s already a massive clean-up effort–with no end in sight–will be a major drag on BP’s cash flow, probably for years. That raises the specter of potential asset sales. RBC Captital Markets suggests Methanex could be in position to make an accretive acquisition at the weakened Super Oil’s expense.

Methanex is the global leader in methanol production and sales. Its products are used in formaldehyde, acetic acid and other chemical intermediaries. Methanol is also used as an additive in gasoline and in fuel cell applications. BP owns a 36.9 percent stake in a joint venture (JV) with Methanex, under which they own and operate the 1.8 million tonne Atlas methanol facility in Trinidad.

According to RBC, the addition of BP’s stake could add CAD0.14 per share to earnings. Methanex already runs operations and product marketing for the JV; although it’s not a strategic imperative, the opportunity to pick it up from a distressed seller may be too attractive to pass up, particularly as costs to clean up the Gulf continue to mount.

Tied tightly to the health of the global economy, Methanex fell hard along with everything else during the depths of the 2008-09 panic. It’s now well up off its low around CAD7 and still yields nearly 3 percent. More volatile than the steady players discussed in Canadian Currents, Methanex Corp is play for aggressive investors with a little cash on the side they can afford to risk.