Make it three months and counting. Once again, the only company in the Canadian Edge universe to cut its dividend last month was a trust announcing its conversion to a corporation. And again, the cut was both less than the market expected and won’t take place until Jan. 1, 2011.

At that point, Rogers Sugar Income Fund (TSX: RSI-U, OTC: RSGUF) will pay a quarterly distribution of CAD0.085 per share. That’s roughly 26 percent below the current level of CAD0.03833 paid monthly. And it leaves a current yield of around 7 percent, based on Rogers Sugar Income Fund’s current price, which underscores my advice to buy up to USD5.

Rogers’ business is distributing and manufacturing sugar, mainly from Canada’s beet crop, which is primarily grown in Alberta. The company has major refineries in Montreal and Vancouver, output of which is used for a wide range of processes and products, including soft drinks.

Rogers’ profits depend heavily on the price of sugar, particularly in North America, as well as the company’s ability to compete with producers elsewhere in the world. This has been made more difficult in recent years by US import quotas and the rise in the Canadian dollar. The former has walled off a segment of the market from Rogers and other non-US producers. The former has raised Rogers’ cost structure versus those of rival companies.

In that light, recent results are impressive indeed. Second-quarter revenue rose 21.7 percent over year-earlier levels. That was due in part to higher selling prices but also to a 7.7 percent increase in volumes sold. The volume boost was achieved without the benefit of additional market concessions from US authorities. The company hedges selling and input prices to limit commodity price exposure.

The bad news is margins were lower by 19 percent per metric tonne. as the company relied on a less profitable sales mix. Higher exports to the US incurred a higher US duty, which came directly out of profits. That was partly offset by management’s diligence in cutting controllable costs, such as administration and marketing, though the company also took a hit from the rise in the Canadian dollar-US dollar exchange rate.

Nonetheless, the company continued to cover its distribution by a secure margin, with a payout ratio of 79.1 percent for the first nine months of fiscal 2010 (end Sept. 30). And management has kept the balance sheet strong as well, with no significant maturities until 2013, when CAD84.3 million of a convertible security will come due.

The package here is a conservatively run company that’s been able to generate steady returns consistently in what’s otherwise a volatile, commodity industry. The new distribution rate should leave plenty of cash flow to reinvest in the business and smooth out the ups and downs that come with the territory.

Investor returns are going to depend heavily on how well the North American economy performs, which will determine demand for Rogers’ sugar products. The stock is roughly double its late March 2009 lows and within 10 percent of its all-time high set in March 2008. I’d be surprised to see it advance much beyond USD6, barring a takeover bid. But Roger Sugar Income Fund remains a solid income play with some growth potential up to USD5.

Below is 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.

I’ve divided this month’s List in two. The first comprises companies that have endangered dividends because of weak operations. The second includes companies that have yet to set a dividend after they convert from trust to corporation.

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 strong 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. As a result, the companies on List 1 typically rate sells.

Meanwhile, in stark contrast, those on List 2 are often buys, despite the remaining uncertainty about their future plans for paying dividends.

List 1: Weak Businesses

• 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 Properties REIT (TSX: IIP-U, OTC: IIPZF)–Sell
• 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

List 2: Conversion Cut Candidates

• ARC Energy Trust (TSX: AET-U, OTC: AETUF)–Buy @ 22
• Big Rock Brewery Income Trust (TSX: BR-U, OTC: BRBMF)–Hold
• Bonavista Energy Trust (TSX: BNP-U, OTC: BNPUF)–Buy @ 22
• Brookfield Real Estate (TSX: BRE-U, OTC: BREUF)–Buy @ 12
• Canfor Pulp Income Fund(TSX: CFX-U, OTC: CFPUF)–Buy @ 15
• Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF)–Hold
• CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF)–Buy @ 12
• Freehold Royalty Trust (TSX: FRH-U, OTC: FRHLF)–Hold
• IBI Income Fund (TSX: IBG-U, OTC: IBIBF)–Buy @ 15
• Liquor Stores Income Fund (TSX: LIQ-U, OTC: LQSIF)–Buy @ 16
• NAL Oil and Gas (TSX: NAE-U, OTC: NOIGF)–Buy @ 15
• Penn West Energy Trust (TSX: PWT-U, NYSE: PWE)–Buy @ 22
• Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF)–Buy @ 15
• Phoenix Technology Income Fund (TSX: PHX-U, OTC: PHXHF)–Buy @ 8
• Provident Energy Trust (TSX: PVE-U, NYSE: PVX)–Buy @ 8
• Westshore Terminals Income Fund (TSX: WTE-U, OTC: WTSHF)–Buy @ 16

Taxing Questions

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.

Broker-Dealers’ Dodge

Each individual state has its own securities laws and rules, commonly known as “Blue Sky” laws, designed to regulate offers and sales of securities.

Blue sky laws are state or jurisdictional laws in the US that regulate the offering and sale of securities in order to protect the public investors from fraud. These laws vary among states. States may require securities to be registered at the state level or to have an available exemption from registration. Without compliance with, or exemption from, Blue Sky laws, statutes can prevent brokers from soliciting interest in a company from their clients.

Companies listed on a US exchange such as the New York Stock Exchange or Nasdaq are granted automatic Blue Sky exemption in all 50 states. But issuers don’t apply for over-the-counter (OTC) listing; OTC listings–either on the Pink Sheets or the Bulletin Board–are the result of broker-dealers who are market makers applying to publish quotations through the particular OTC tier. For Pink Sheets listings there are no Securities and Exchange Commission (SEC) filing requirements, while the Bulletin Board requires some compliance with SEC requirements. Once a company commences trading in the OTC market its Blue Sky status must be determined on a state-by-state basis before offers be made in a given state.

The majority of the US states/jurisdictions have written into their statutes a provision for a “manual exemption” that may exempt a company from state registration if it’s covered in a “Recognized Securities Manual” such as Standard & Poor’s Corporation Records.

More often than not assertions by your broker that it’s illegal to own a particular OTC-listed company are driven more by a desire to get you to invest in equities for which his or her broker-dealer house is making a market.

The Blue Sky laws, in other words, restrict the ability of brokers to solicit you to purchase a non-Blue Skied equity. There’s no restriction on you asking your broker to execute a trade of such an equity. If it’s quoted on the Pink Sheets or the Bulletin Board, a broker worth his or her salt will put your interest ahead of his or hers and get the trade executed.

Bay Street Beat

Bank of America Merrill Lynch quantitative analyst Savita Subramanian dug up an intriguing nugget this week: “Dividend yield and dividend growth were only two strategies amongst our quantitative factors that outperformed the market in the second quarter and in July,” she said in a research note. “In fact, of the stocks that beat the benchmark in both the second quarter and in July, the majority offer above-market dividend yield.”

The S&P 500 fell 11.9 percent in the second quarter, dragged down by fear of a European sovereign debt crisis and anxiety about the strength of the US economy. All 10 sub-indexes fell, but sectors with greater exposure to the global economy underperformed; materials, financials, energy stocks and industrials led the selloff. Utilities, telecom services and consumer staples stocks outperformed. But in July riskier stocks led the rally, while defensive stocks lagged.

But two sub-indexes generated positive gains during both the second quarter and the month of July: utilities and telecom services, sectors known more for their dividends than their explosive growth potential.

The April-through-June period was a tough one for the market, as represented by the S&P 500. July, on the other hand, was good to stocks. One group outperformed during both timeframes; during selloffs, during rallies, income pays.

As for Bay Street’s estimation of the Canadian Edge Portfolio’s second-quarter earnings season thus far, the reaction thus far, with 15 reports in as of press time, is best described as a collective yawn. The analyst community has issued 94 updates to coverage in the wake of earnings releases by Aggressive Holdings ARC Energy Trust (TSX: AET-U, OTC: AETUF), Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF), Daylight Energy Ltd (TSX: DAY, OTC: DAYYF), Enerplus Resources (TSX: ERF-U, NYSE: ERF) and Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) and Conservative Holdings AltaGas Income Trust (TSX: ALA-U, OTC: ATGFF), Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF), Colabor Group (TSX: GCL, OTC: COLAF), IBI Income Fund (TSX: IBG-U, OTC: IBIBF), Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF), Northern Property REIT (TSX: NPR, OTC: NPRUF), Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF), RioCan REIT (TSX: REI-U, OTC: RIOCF), TransForce (TSX: TFI, OTC: TFIFF) and Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF).

Results for all but Colabor, which was discussed last month, are detailed in Portfolio Update.

Bay Street has maintained its stance with 92 of these updates. Not even a distribution increase by Northern Property REIT was enough to move the needle, while Keyera Facilities suffered a downgrade (from “buy” to “accumulate,” and we’d love to know the difference in this distinction) but enjoyed a price-target boost…by the same analyst. On the positive side, UBS (NYSE: UBS) picked up coverage of ARC Energy, calling the oil and gas producer a buy with its initial report.

Daylight Energy remains the light of Bay Street’s life right now, as 14 analysts call it a buy, while three rate it a hold. Nobody’s telling you to sell Daylight at the moment. The converted trust closed at CAD9.41 Thursday (about USD9.10), but Bay Street’s consensus 12-month target is CAD13.11.