Dividend Watch List

Six companies in the Canadian Edge How They Rate universe announced distribution cuts last month: Bonavista Energy Trust (TSX: BNP-U, OTC: BNPUF), Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF), Brookfield Real Estate Services Fund (TSX: BRE-U, OTC: BREUF), IBI Income Fund (TSX: IBG-U, OTC: IBIBF), Parkland Income Fund (TSX: PKI-U, OTC: PKIUF) and Perpetual Energy (TSX: PMT, OTC: PMGYF).

Only Perpetual Energy’s reduction wasn’t related to a plan to convert from trust to corporation. Rather, as I pointed out in a Nov. 9 Flash Alert, the highly leveraged producer made its move in response to a depressed forward price curve for natural gas, with limited prospects for improvement.

Perpetual’s conversion to a corporation was completed June 30, 2010. Management was able to make the shift without cutting the CAD0.05 per share monthly dividend, largely thanks to previous aggressive hedging of future output and generally conservative financial policies. The company was able to book some of these gains from its hedging program in cash, enabling debt reduction as well as capital spending and continued distributions.

As I’ve pointed out, however, Perpetual’s business is highly aggressive. There’s only so much management can do to financially hedge in such a low-price environment with virtually all of its production made up of natural gas. The company has done an excellent job keeping investors and analysts updated on its hedging program, dubbed “gas price management.” As gas prices have sunk over the past year, however, it’s had little choice but to lock in lower prices.

According to its Oct. 12 report, the company was locking in prices for 2011 of less than USD4 per gigajoule (GJ), a measurement roughly equal to the standard British thermal unit. That was barely half the USD7.54 per GJ price it was able to previously lock in for 49 percent of output to the end of the year.

As its Nov. 4 report on “Game Changers” demonstrates, Perpetual hasn’t been sitting idle while gas future prices have fallen. Like its competitors, management has now wholeheartedly adopted horizontal drilling techniques and has begun targeting light oil and liquids-rich gas from its lands in the Cardium, Wilrich and Montney formations. And results have been promising, opening the door to significant new production over the next couple years.

Third-quarter earnings, however, clearly demonstrate the pressures the company is under now from what management calls “extremely weak natural gas prices related to high gas storage levels and concerns about new supply.” Third-quarter funds from operations (FFO) slid 35 percent, as “netback” (essentially selling prices minus expenses) fell 22 percent.

Were it not for aggressive hedging producing an average selling price of USD6.18 per GJ for the quarter, results would have been far worse. And based on October results, they will be in subsequent quarters. As a result, Perpetual was left with a stark choice: Maintain the current dividend rate and slow capital spending plans to develop light oil and natural gas liquids (NGL), or ramp up spending by trimming the distribution yet again. The decision was made even more urgent by the fact that the company must do much of its development work in the winter months, before spring/summer thawing makes transporting heavy equipment to remote regions of Canada much more difficult.

Management’s choice to ramp up its 2010-11 capital budget and trim the distribution to CAD0.03 per month is in some ways a middle road. It will keep the company on track to cutting operating costs (down 11 percent from 2009) and pushing up output (up 3 percent), while improving the pricing of its output by pushing it more towards liquids. It also allows the company to continue making progress reducing its debt load.

After the cut, Perpetual still has a generous payout of a little more than 9 percent, based on its current share price. That rate should be sustainable even if natural gas prices remain stuck under USD4 per GJ in Alberta indefinitely. And as long as the current dividend holds, so should the current share price.

The bad news is as long as the company is nearly 100 percent dependent on natural gas production it will be hugely leveraged to natural gas prices. What happened last month clearly can happen again if conditions deteriorate, further for whatever reason.

High leverage to natural gas is, of course, why I’ve kept Perpetual in the Aggressive Holdings throughout its ups and downs. That’s hurt particularly since mid-2008, as the stock has dropped by more than two-thirds. On the other hand, it wouldn’t take much of a recovery in gas to erase that loss and then some, particularly with Bay Street analysts leaning so bearish–one buy, seven holds and four sells. Notably, company insiders have been heavily bullish all year, with more than a million shares purchased since mid-summer.

Perpetual is certainly not for everyone. In fact, anyone who’s interested in regular, reliable dividends is better off with any of the other oil and gas producers in the Aggressive Holdings. (See November’s Feature Article.) But if you want an aggressive bet on gas, are patient and have handled the mostly downside action thus far, Perpetual Energy remains a hold.

As for the rest of last month’s dividend cut announcements, all were part of plans to convert to corporations. Bonavista Energy Trust is natural gas-weighted and therefore has suffered from lower pricing. Unlike Perpetual, however, it’s been able to offset some of that impact by boosting output aggressively. Overall energy production surged 21 percent in the third quarter, triggering a 23 percent boost in revenue and an18 percent jump in FFO. Higher production, in turn, has increased scale, cutting operating costs per barrel of oil equivalent produced by 19 percent over the past year.

Instead, Bonavista’s decision to cut the monthly dividend by 25 percent at conversion Jan. 1 looks driven more by a desire to ramp up capital spending as the company absorbs corporate taxes. Opportunities include light oil and liquids-rich gas development in a range of shale areas in Canada, including the Cardium trend. The result should be a further slanting of the production portfolio towards liquids (39 percent of third-quarter output) as we move into 2011.

Looking ahead, Bonavista’s financial policies look set to remain conservative, with debt at just one times annualized cash flow. The new dividend level should be considered a baseline for future increases, which could result from higher production of liquids even if the outlook for gas prices fails to improve. There’s also the possibility of a takeover after conversion.

The only problem is Bonavista’s unit price has ratcheted dramatically higher since the conversion/dividend announcement last month. As a result, it trades 30 percent above my previous buy target of USD22. That makes Bonavista Energy Trust a hold pending further developments.

I’ve upgraded Boston Pizza Royalties to a hold for two reasons. First, the franchiser’s third-quarter earnings are a sharp improvement over previous quarters, the most important number being a 0.8 percent increase in same-store sales. “Same stores” are restaurants that have been in the royalty pool for more than a year; rising sales are a strong indication business has stabilized after consistent declines. Same-store sales a year ago, for example, plunged 8.5 percent in the third quarter.

Same-store sales for the past nine months are still off 3.9 percent from 2009 levels. And the increase in British Columbia restaurant taxes from 5 to 12 percent, beginning July 1, 2010, is likely to have at least some negative impact going forward. I’ll want to see at least one or two more quarters of rising same-store sales before I’ll upgrade Boston Pizza to a buy. But for one quarter, a key reason for my long-standing sell recommendation is no longer a factor.

The second reason I’m upgrading Boston Pizza is the company has declared a 2011 dividend policy that looks sustainable and remains generous as well. Management hasn’t set an exact amount, nor has it committed to converting to a corporation. But it has stated that dividends will continue to follow cash flow aggressively, and that the latter will be impacted by tax rates of approximately 26.5 percent in 2011 and 25 percent in 2012 and beyond.

That implies a likely dividend reduction of about 25 percent from the current rate of 11.5 cents Canadian per month. The payout ratio will be safely below 100 percent of distributable cash flow (DCF) and will still deliver a yield of around 7.4 percent, based on Boston Pizza’s Dec. 2 closing price.

Again, that’s not enough to convince me to raise the trust to a buy, particularly with the units making a new post-2008 crash high this week and an exact dividend level still not set. But these are steps in the right direction and enough reason to take off the sell advice. Boston Pizza Royalties Income Fund is a hold.

Brookfield Real Estate Services Fund announced its corporate conversion plans and third-quarter earnings on Nov. 8. And like Boston Pizza and Bonavista, its shares have been off to the races since, as what investors have seen has beaten prior expectations.

As reported here, parent Brookfield Asset Management (TSX: BAM/A, NYSE: BAM) had previously warned the company’s monthly distribution of 11.7 cents Canadian would almost surely be cut when it converted to a corporation Jan. 1. What it hadn’t done is clarify what the new payout level would be, which it did Nov. 8 at a monthly rate of 9.2 cents Canadian per share.

According to management, the reduction of roughly 21.5 percent “reflects the approximate level of taxes which will be payable by the business commencing in 2011.” It also confirms a continuing commitment to paying a high yield that will rise as Brookfield Real Estate Services continues to add to its network in the residential real estate industry.

Happily, the company’s third-quarter earnings confirmed its business strategy is still on track for solid growth. A slowing of Canadian property market activity in recent months caused third-quarter numbers to dip slightly from the highly robust levels of a year ago. The fund’s 2.5 percent decline in royalties, however, vastly outperformed the 23.3 percent decline in sales activity industry wide. Fixed fees, meanwhile, actually rose 5.4 percent in the quarter.

According to CEO Phil Soper, Brookfield Real Estate Services’ performance “is insulated from market fluctuations” because “approximately 69 percent of the Fund’s fees are fixed in nature, based on the number of agents and sales representatives in the network.” Adding to that network via organic growth and acquisitions remains management’s primary objective, even as it “maintains a positive outlook for (Canada’s) real estate market.”

The new dividend level–which is actually roughly equivalent to what was paid in January 2006–will be well covered by post-tax DCF, with a likely payout ratio below 70 percent. That argues for a return to growth, pushing up a yield that will already be generous in the neighborhood of 8 percent. Brookfield Real Estate Services Fund is now a buy on dips to my higher target of USD13.

As reported in a Nov. 12 Flash Alert, IBI Income Fund has set a monthly post-corporate conversion dividend of approximately 9.2 cents Canadian a share, or at an annual rate of CAD1.10 per unit. That’s a 31 percent reduction from the current rate and closely reflects the hit to corporation’s bottom line from its expected tax rate.

The good news is it still leaves a yield of nearly 8 percent that will almost certainly be ratcheted up in coming years, as management continues to grow its business globally. That’s basically an infrastructure design operation that now operates on virtually every continent.

IBI’s core business has been affected by the recession as contracts in the private sector have become much more difficult to come by. Third-quarter earnings, however, demonstrate just how much of that lost business management has been able to make up with a growing backlog of public sector and global projects, aided by expertise-based acquisitions.

Public sector work topped 67 percent in the third quarter, following the pattern of prior reporting periods. Moreover, backlog growth is accelerating, with the next 12 months’ business again higher than prior quarters. That could speed up again in 2011, thanks to the second-quarter acquisition of Nightingale Architects, which added architectural expertise in facilities for health care, education and science, as well as geographic reach in the UK, Eastern Europe, Australia, the Persian Gulf and South Africa. The company is also looking at acquisitions in China and India, where it already has a solid presence. And it’s pushing ahead with expansion in the US, despite a weakened market.

Overall third-quarter numbers were strong, as revenue rose 11.6 percent. Cash flow from operating activities surged 148 percent. And the payout ratio came back to well under 100 percent for the first time in several quarters. The January 2011 dividend will be back to roughly 2006 levels but looks set to grow in coming years along with the business. IBI Income Fund is still a buy up to USD15.

Lastly, Parkland Income Fund had for some months declared its post-conversion dividend would be between 75 and 110 percent of its current trust dividend of 10.5 cents Canadian. On Nov. 26 the company announced a new payout level of 8.5 cents Canadian per share that will kick in at corporate conversion Jan. 1.

The post-conversion dividend is roughly 81 percent of the trust distribution, putting it on the low end of the guidance. Parkland units, however, rallied sharply on the news, mainly because the company’s less-than-stellar third-quarter earnings reported on Nov. 12 had sharply reduced expectations.

The upshot has been a roller-coaster ride for Parkland units over the past few weeks, with a surge toward post-crash highs in early November followed by a steep, three-day plunge of more than 20 percent mid-month. That, in turn, has been followed by a recovery of roughly half the losses, with the result that Parkland now trades with a yield of nearly 9 percent–based on the post-conversion dividend amount and the current unit price.

Maintaining and increasing that over time will depend on Parkland’s ability to grow its business, while absorbing earnings volatility created by commodity price swings and economic uncertainty. Low refiners’ margins were a drag on third-quarter results, depressed by the combination of still soft market conditions’ downward impact on finished products and higher raw energy prices.

On the other hand, the company has been able to absorb the assets of acquisition Bluewave Energy more effectively than expected. Fuel sales volumes were up 25 percent from last year, while gross profit in the fuel marketing segment rose 24 percent. And the outlook for commercial fuel sales volumes is looking up, as activity in the forestry, trucking and oil and gas drilling industries improves. Meanwhile, the company’s conversion from a convenience store-based model is cutting costs.

Overall, Parkland’s gross profit rose 29 percent in the third quarter and 23 percent for the last nine months. Rising expenses from expansion, however, knocked down cash flow 15 percent, while DCF dropped 41 percent and the payout ratio surged to 150 percent for the quarter, and 104 percent year to date.

At least some of that is due to a changed seasonality of earnings to other quarters. Where the company should really see improvement, however, is in absorbing its new asset base and the gradual improvement in margins, as industrial Canada comes back to life. In the meantime, the new dividend level looks solid and will provide support to the stock. I continue to rate Aggressive Holding Parkland Income Fund a buy up to USD13.

As for the rest of the Dividend Watch List, only five How They Rate companies have yet to announce their post-conversion distribution policies, and most of these also face challenges at their core business. As a result, I’m recombining the two Dividend Watch Lists into one that includes companies that have endangered dividends because of weak businesses as well as those yet to set post-conversion dividends. Here are the names:

• Canfor Pulp Income (TSX: CFX-U, OTC: CFPUF)–Hold
• Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF)–Hold
• FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF)–Hold
• InterRent REIT (TSX: IIP-U, OTC: IIPZF)–SELL
• Royal Host REIT (TSX: RYL-U, OTC: ROYHF)–Hold
• Superior Plus Corp (TSX: SPB, OTC: SUUIF)–Hold
• The Keg Royalties Income Fund (TSX: KEG-U, OTC: KRIUF)–Hold

Of this list, only Canfor Pulp Income Fund (TSX: CFX-U, OTC: CFPUF) is a CE Portfolio member. I’m cutting it to hold this month pending the impact of the company’s absurd contention that it must cash out all US investors with less than $5 million in liquid assets at conversion.

Canadians and “qualified US investors” should hang on. US investors who don’t meet the definition of “qualified” should sell, with the idea of buying back after conversion. Note my forecast remains for a dividend cut of 25 to 30 percent to reflect the new tax burden after converting, which will still leave one of the highest payouts on the planet. Canfor Pulp Income Fund is a hold.

Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF) won’t qualify as a Canadian real estate investment trust after Jan. 1. Management, however, has said nothing about whether or not it will convert to a corporation and what will happen to its dividend, other than a statement by CFO Vlad Volodarski during the company’s third-quarter earnings conference call that the company “should have much better information within the next three to six months.”

The market seems to be assuming a relatively benign outcome. But that’s from assured. Chartwell Seniors Housing REIT is a hold.

FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF) faces a weakened market for advertising and subscriptions. But based on third-quarter results and a payout ratio of 77 percent, management seems to have prepared it for the worst. Unfortunately, while setting a general structure some months ago for 2011, management still hasn’t set a post-conversion payout level. The dividend could take quite a cut from its current level of around 12 percent before it would hurt the stock.

But until there’s more clarity and with the stock up sharply in late 2010, FP Newspapers Income Fund is a hold.

As a qualified real estate investment trust, Interrent REIT (TSX: IIP-U, OTC: IIPZF) won’t have to do anything in 2011. But the apartment owner’s high payout ratio remains a worry, especially given that even rising third-quarter rents and a seven percentage point gain in the occupancy rate couldn’t boost net operating income or create positive distributable cash flow. Management looks committed to the dividend, but there’s too much risk here for anyone seeking a safe, stable yield. Sell Interrent REIT.

Royal Host REIT (TSX: RYL-U, OTC: ROYHF), as an owner and operator of hotels and resorts, won’t qualify as a real estate investment trust in Canada in 2011. As a result, management committed to convert to a corporation in late September, with the understanding that the new entity would continue to pay dividends. As of now, however, it’s yet to set any clear level of payout.

Two factors lead me to believe a sizeable cut is in store. One is Royal Host’s hefty dividend of 13 percent-plus. The other is earnings that remain plagued by weak conditions in the tourism industry, which produced a 188 percent payout ratio in the third quarter. The high yield does offer some protection for the stock in the even of a cut. But Royal Host REIT is a hold for the aggressive only.

Superior Plus Corp (TSX: SPB, OTC: SUUIF) management is committed to maintaining the current monthly dividend rate of 13.5 cents Canadian. And the company faces no 2011 challenges, as it converted to a corporation more than two years ago. Earnings, however, have lagged the dividend in recent quarters, and the current payout ratio of 213 percent is clearly unsustainable.

Management seemed to lay it on the line during its third-quarter conference call that businesses would have to improve according to its expectations for the payout to hold into 2011. If it’s successful, investors will get nearly 15 percent in annual income as well as a sizeable capital gain. And the high yield offers downside protection in the event of a cut, as it reflects rock-bottom investor expectations. But in view of its challenges, income seekers are better off elsewhere. Superior Plus Corp is a hold.

The Keg Royalties Income Fund (TSX: KEG-U, OTC: KRIUF) has two major problems. One is core franchise weakness in the both Canada and the US, demonstrated by third-quarter declines in same store sales on both sides of the border.

Encouragingly, Canadian sales appear to have stabilized, the US returns should do so barring a big drop in the US dollar and management is finding room to grow by adding new franchise restaurants. But the payout ratio was again over 100 percent in the third quarter.

Second, the company has yet to set a 2011 dividend level, or even to really lay out what it’s going to do when the new taxes kick in. Again as is the case with other Watch List members this month, the company’s double-digit yield signals a very low bar of expectations. But until there’s clarity, The Keg Royalties Income Fund is a hold.

Bay Street Beat

Response to third-quarter earnings reports from Canadian Edge Portfolio Holdings was positive for the first 12 to issue numbers, and the good feelings continued throughout November as the balance of our recommendations revealed their performances for the most recent period.

Ag Growth International (TSX: AFN, OTC: AGGZF) is rated a buy by two Bay Streeters and a “hold” by six more. Three analysts downgraded the stock following third-quarter earnings, basically because it got too expensive. Ag Growth is trading nearly CAD2 north of the average target price for the eight analysts currently covering it, and it’s above the CE-recommended target of USD45, too. Ag Growth International remains a solid play on North American and global agriculture.

Nine analysts say “buy” ARC Energy Trust (TSX: AET-U, OTC: AETUF), while seven say “hold.” ARC, too, is scraping its average target price so has become a little expensive to the boys on Bay Street with the recent rally to post March 2009 highs. All 16 who cover it maintained their ratings post-earnings.

All four Bay Street analysts who cover Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF), which will remain a trust rather than pay the restructuring fees that might otherwise inhibit a company of its size, maintained their stances on the stock in November; two call it a buy, two a hold.

Prodigal Consumers’ Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF), once a Conservative Holding, now returned to the CE Portfolio as an Aggressive Holding, is only covered by two analysts. But one of them upgraded the stock to “sector outperform” following management’s third-quarter report. Consumers’ has done a decent job rescuing its sub-metering business and has put its core waterheater business back on solid footing as well. The company will also convert without cutting its distribution.

Enerplus Resources Fund (TSX: ERF, NYSE: ERF) is more than 10 percent above its average analyst target price; one analyst downgraded the stock to “hold” in November following third-quarter earnings. Only one has it as a buy right now, while 10 advise hanging. Four analysts say it’s time to sell.

Parkland Income Fund (TSX: PKI-U, OTC: PKIUF) is also trading above its average analyst target price north of CAD11. The advice from Bay Street is rather neutral, with one “buy,” three “holds,” and one “sell.” We like Parkland Income Fund up to USD13, particularly after management removed the uncertainty by announcing it will pay 82 percent of trust-level distribution upon conversion.

It’s a pair of eights for Penn West Energy Trust (TSX: PWE-U, NYSE: PWT), as the Bay Street community is roughly split on the major independent oil and gas producer, though nobody is saying “sell.” The third quarter satisfied all of Penn West’s followers, who maintained their ratings across the board.

Perpetual Energy (TSX: PMT, OTC: PMGYF) actually earned an upgrade to “sector perform” following its less than spectacular third quarter. One of the few Portfolio holdings trading well below its average analyst target price, Perpetual is a buy for one Bay Street, a hold for seven, and a sell for four more.

All seven of the Bay Street analysts who cover Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF) maintained their ratings; six call it a buy, while one says it’s a hold. Peyto, too, is trading well below its average analyst target price. Bay Street likes it up to a consensus price around USD19; we like Peyto Energy Trust, too, but only up to USD16.

Provident Energy Trust (TSX: PVE-U, NYSE: PVX) satisfied its analysts with its third-quarter numbers, its progress as it streamlines its business and with its conversion plan. All seven maintained their ratings, leaving Provident with three “buys” and four “holds.

Vermilion Energy (TSX: VET, OTC: VEMTF) earned an upgrade to “outperform” from FirstEnergy Capital; otherwise its standing on Bay Street remains firmly positive. Six say “buy,” while seven say “hold,” though it should be noted that Vermilion is trading above target for most of the analysts who cover it. The CE target is USD40.

Yellow Media (TSX: YLO, OTC: YLWPF), trading above its average target, is a clear hold for Bay Street, as nine of the 10 analysts covering the stock have a stand-pat rating. One says sell. We rate it a buy all the way up to USD8.

On the Conservative Holdings side of the Portfolio, Artis REIT (TSX: AX-U, OTC: ARESF, three buys, four holds, zero sells), Atlantic Power Corp (TSX: ATP, NYSE: AT, zero buys, three holds, three sells) and Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF, three buys, four holds, zero sells) experienced no ratings changes as a result of third-quarter earnings.

Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF), on the other hand, was upgraded by Scotia Capital to “sector outperform,” by Clarus Securities to “buy” and by National Bank Financial to “outperform.” Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF) earned two upgrades, to “sector perform” by CIBC World Markets and to “buy” by Dundee Securities. Three say “buy,” while three Bay Streeters say “hold.”

The 10 analysts covering Cineplex Galaxy Income Fund (TSX: CGX-U, OTC: CPXGF) maintained their ratings; six say “buy,” four “hold.” Canaccord Genuity downgraded CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF) to “hold,” giving the stock a perfect record of six hold recommendations on Bay Street. The stock is hovering near its average analyst target price.

IBI Income Fund’s (TSX: IBG-U, OTC: IBIBG) third-quarter performance earned it two upgrades, to “sector outperform” by NCP Northland Securities and to “outperform” by Raymond James Securities. Innergex Renewable Energy (TSX: INE, OTC: INGXF) was downgraded to “sector perform” by Scotia Capital, as was High Yield of the Month Just Energy Income Fund (TSX: JE-U, OTC: JUSTF) by National Bank Financial.

Northern Property REIT (TSX: NPR-U, OTC: NPRUF) and RioCan REIT (TSX: REI-U, OTC: RIOCF) also earned an upgrade apiece.

Fire Your Broker, Hire Schwab

Editor’s Note: The information below isn’t exhaustive of all possible US income tax considerations nor is it intended to provide legal or tax advice to any particular holder or potential holder of Canadian income or royalty trust units or common stock of Canadian corporations. Holders or potential holders of Canadian income or royalty trust units or common stock of Canada-based corporations should consult their own competent legal and tax advisers as to their particular tax consequences of holding Canadian income or royalty trust units or common stock issued by Canada-based corporations and the most beneficial way of reporting the distributions or dividends received and Canadian withholding tax paid to the appropriate taxation authorities located in the various jurisdictions.

We have it on solid authority that discount-brokerage kingpin Charles Schwab is treating distributions paid by tax-paying SIFTs and dividends paid by former trusts that have converted into tax-paying corporations in respect of SIFT units or corporate shares held in a US IRA account properly. That is to say, Schwab makes sure you get all the distribution and dividend you’re entitled too, not Revenue Canada.

The aggrieved on this issue may not number enough to get the attention of bean-counters and decision-makers at other large houses, but you can vote with your feet. Transfer your account to Charles Schwab.

To recover any amounts improperly withheld in the past, you’ll have to venture into the bellies of several public and private beasts, on both sides of the border.

Reputable brokerages, including Vanguard Brokerage Services, have informed investors that because of the costs and resources associated with furnishing up-to-date and accurate tax information to their transfer agent that it will not undertake such services. Scottrade has told clients that there is nothing that they can do about this withholding until the transfer agent, Depository Trust Company, stops the process. Others claim to be similarly impotent.

This effectively means the costs of stopping the 15 percent withholding tax on converted Canadian corporations and tax-paying SIFTs held within IRAs outweigh any potential benefit–that being fulfilling what should be a fiduciary obligation to ensure its clients and the accounts for which they act as custodian are made whole according to the law.

The essential problem of continuing improper withholding from dividends paid in respect of Canadian SIFTs and corporations that have converted from income trusts is that you–investors with units of tax-paying Canadian SIFTs or shares of former income trusts that have converted and are now paying corporate-level tax–are a subset of a subset.

There aren’t many of you concentrated in any one or two brokerages houses. There is little incentive for the brokerage house, the clearing corporations, the government agencies to absorb the time and expense it will take to make you whole.

Thanks, however, to work many of you have already done, we have a path that will get us if not to a satisfactory conclusion, to the point where the big boys will have to listen. It’s imperfect, time-consuming and acutely frustrating. As both private and public institutions on both sides of the border have acknowledged the letter of the law is on our side; this should be totally unnecessary.

Whether what follows be a long and winding road to nowhere, it’s your money. And every little bit counts.

The first step is to write a letter to the Canada Revenue Agency (CRA), the Great White Northern equivalent of our Internal Revenue Service (IRS), to request a Letter of Exemption under Article XXI of the US-Canada Income Tax Treaty. Your brokerage, as the custodian of the relevant account–the IRA of which you are the beneficiary–should write this letter, but this is one of the onerous service it’s refusing to engage in on your behalf.

Include your name, the name of your brokerage, the account number of the IRA, and an explanation of why there should be no withholding from dividends paid by Canadian SIFTs and Canadian corporations that converted from income trusts in respect of units or shares held in a US IRA account.

The argument, articulated here before and based on the contents of a letter to US Representative Phil Gingrey (R-GA) signed by Elizabeth U. Karzon, Branch Chief, Branch 1, Office of Associate Chief Counsel (International), US Dept of the Treasury, Internal Revenue Service, dated June 17, 2010, is as follows.

It’s a general rule of US federal taxation that an individual isn’t liable for US taxes on amounts earned through an IRA until those amounts are distributed. But US tax law can only defer US tax. US tax authorities have no power to influence a foreign country’s imposition of tax on income that the IRA derives from that country.

Distributions from Canadian income and royalty trusts therefore may be subject to tax in Canada depending on Canadian tax law and the terms of the US-Canada Income Tax Treaty (the Treaty).

Certain US entities that are generally exempt from taxation in a taxable year in the US–such as IRAs–are exempt from taxation on dividend income arising in Canada in that same taxable year, according to Article XXI of the Treaty, “Exempt Organizations.”

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 didn’t 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–when these income and royalty trusts will become “Specified Investment Flow-Throughs,” or SIFTs, taxed at the entity level.

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.

It may be helpful to attach to your letter a copy of Karzon’s letter to Rep. Gingrey; I’m happy to provide a pdf copy to anyone who requests it via e-mail to ddittman@kci-com.com.

Once the Letter of Exemption is issued you–or your broker–on behalf of your IRA must inform the transfer agent of the Canadian SIFT or former income trust that’s now a corporation from withholding for Canadian tax purposes.

The address for the Canada Revenue Agency is:

Non-Resident Withholding Accounts Division
International Tax Services Office
Canada Revenue Agency
2204 Walkley Road
Ottawa, ON
K1A 1A8
Canada

You can also call the CRA at 1-800-267-3395 or 1-613-952-2344. The fax number is 1-613-941-6905.

Contact information for transfer agents should be available on company websites, accessible via How They Rate. In addition to attaching a copy of the Karzon letter to your correspondence with the CRA and transfer agents, carbon copy your US congressman.
There’s no question this is an uphill battle. You’re likely to be told by the CRA that the brokerage, as the custodian of the IRA, must submit the request. That’s why we’re copying the folks on Capitol Hill. Let’s see, first, how accountable brokerages, transfer agents and government agencies are to self-directed investors and, second, whether the new wave of responsiveness washing over DC results in Congress correcting what should be an easily fixed problem.