Dividend Watch List

New taxes will trigger dividend cuts at 24 How They Rate companies in early 2011, beginning with the first disbursement declared after New Year’s. For companies paying monthly the cut will be first felt in February. For those switching to quarterly the cuts will likely begin in April.

The good news is all of these cuts were announced in advance, some as far back as March 2010. As a result the market has long since priced them in. There may be some selling by less informed investors when the actual cuts take place. But prices should quickly adjust back upward as the savvier take advantage.

Last month’s Feature Article included the table “Dividends to Change,” listing all the companies set to cut dividends in early 2011, most after converting to corporations. Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF) and The Keg Royalties Income Fund (TSX: KEG-U, OTC: KRIUF) chose to remain trusts and are cutting payouts after absorbing SIFT (specialized income flow-through) taxes, though The Keg has yet to confirm a target.

“Dividends to Change” shows the new rate as stated by the company, as well as changes in frequency. I updated the table again in a Dec. 20 Flash Alert, Bell Aliant, Canfor Pulp and Other Conversion Complexities.

The two major developments at that point were the announcements of post-conversion dividends by Canadian Oil Sands Ltd (TSX: COS, COSWF) and FP Newspapers Inc (TSX: FPI, OTC: TBD). Canadian Oil Sands’ quarterly dividend will be reduced to CAD0.20 from last year’s CAD0.50 beginning with the February payment. FP Newspapers will cut its monthly payout of CAD0.06 to CAD0.05, starting with the disbursement due out in mid to late February. We’ll have dividend dates in How They Rate once the companies officially announce them.

As I wrote in the Dec. 20 Flash Alert, Canadian Oil Sands’ 60 percent reduction was a bit higher than most expected, while FP’s 16.7 percent cut was less than anticipated. Canadian Oil Sands’ units, for example, fell sharply on Dec. 3, the day its new dividend and 2011 budget were announced. FP Newspapers, in contrast, has generally been up-trending since its mid-December announcement.

Based on the new rate and its current unit price, FP will be paying a generous 9 percent-plus yield as a corporation. Canadian Oil Sands, meanwhile, will be paying a considerably less generous 3 percent. My advice hasn’t changed for either company, however.

Canadian Oil Sands remains the premier play on the inexorable growth of production from north central Alberta’s oil sands, as essentially the trading stock for the Syncrude venture between ExxonMobil (NYSE: XOM) and other Super Oils. The dividend cut was telegraphed well in advance. In fact, management stated clearly the May boost to CAD0.50 from CAD0.35 was a move to minimize future tax burdens and would be reversed with conversion.

The reduction of the payout reflects the reality of new taxes, but also the capital costs Syncrude looks set to absorb as it pursues its aggressive production targets. Ultimately, these will pay off with higher cash flow and dividends, possibly later this year if oil prices continue to rise. Canadian Oil Sands Ltd is a buy up to USD28.

As for FP Newspapers, fourth-quarter and full-year 2010 numbers are due out on or about Mar. 10 and will reflect the company’s last quarter as a trust dealing with a tough market for print advertising. First-quarter 2011 numbers are likely to be released somewhere around May 5 and will give us our first read on its life as a taxable entity.

My advice is still to hold FP Newspapers, at least until we get a better idea of what its earnings will look like as a corporation.

Canfor Pulp Products Inc (TSX: CFX, OTC: CFPUF) has also set a post-conversion payout and completed its conversion to a corporation. As I also noted in the Dec. 20 Flash Alert, the company’s bizarre conversion procedures regarding US investors are a good reason for all investors to avoid it, including those meeting its definition of “qualified investor.”

The company’s conversion is complete, and it now trades on the Toronto Stock Exchange (TSX) under its new symbol, CFX. Less clear is whether the shares trading under the CFPUF symbol on the US over-the-counter (OTC) market are now restricted to US investors with more than USD5 million in investment assets, or if the threatened cash out of non-qualified investors has taken place.

Until these questions are truly answered, it doesn’t make any sense for anyone to buy it back. My recommendation remains the same as it’s been since Dec. 20: Sell Canfor Pulp Products Inc.

One other troubling development concerning Canfor Pulp is the apparent decision by management to reduce the current monthly rate of CAD0.25 to a new quarterly rate of just CAD0.35 per share. That’s a 53 percent reduction, with the first payment not until Apr. 30, 2011. The last dividend payment as a trust will be CAD0.25 plus a CAD0.30 supplemental cash distribution, all paid on Jan. 14 to unitholders of record as of the close of business Dec. 31, 2010.

As CE readers know, I recommended Canfor Pulp primarily because of its aggressive payout policy, which ensured an enormous yield when it was organized as an income trust and seemed to indicate a big payout after conversion. In fact, management had stated over the past year that as a corporation it would generally maintain its approach to dividends, which was to pay out 90 percent of distributable cash flow.

As a corporation, Canfor Pulp faces a combined federal/provincial corporate tax rate of roughly 25 percent. Taking the company at its word about continuing the payout policy, I assumed the post-conversion dividend reduction would be in that neighborhood, and that we would be looking at a monthly rate of approximately CAD0.18 to CAD0.19 going forward.

The more than halving of the dividend and going quarterly with it indicates one of two things. First, Canfor Pulp could be changing its payout policy to a considerably more conservative stance. In other words, it may now be resolved to pay out 60 to 70 percent of distributable cash flow, reinvesting the rest in the business.

Second, it could be telegraphing that business is slowing down after the rapid recovery of the past two years, as competitors come back on stream and demand growth slows, particularly in Asia. Canfor Pulp has made great strides cutting costs. But rising pulp products supplies could depress selling prices, which, in turn, would hit cash flow hard.

Of these two scenarios, No. 1 is by far the more benign for shareholders. Even at a quarterly dividend rate of CAD0.35 per share Canfor Pulp still yields nearly 10 percent. And if business is still robust the money could be used for expansion or to increase profitability of existing assets.

Unfortunately, the new yield isn’t enough to compensate for the risk that what we’re really seeing here is business weakness.

Simply put, even in this environment, with so many favorites bid up to all-time highs, there are still far better places to put your money–i.e., where the potential returns are at least as good and the risks are considerably less. If you’re out of Canfor Pulp Products Inc, continue to avoid it.

There was one other dividend cut in the Canadian Edge coverage universe last month. Closed-end fund ACTIVEnergy Income Fund (TSX: AEU-U, OTC: ATVVF) cut its monthly payout from CAD0.07 to CAD0.05, citing falling revenue from its holdings as part of their conversion to corporation and absorption of new taxes.

In the December In Brief I reported the fund’s 200 percent payout ratio–based entirely on distributions from its holdings–was on the high side and could portend a dividend cut. As of the last reporting period, five of its top 10 holdings, accounting for roughly 33 percent of assets, had either converted to corporations already or had announced cut-less conversions. The other five, accounting for roughly the same percentage, had announced dividend cuts ranging from 15 to 50 percent with their conversions.

The upshot is the energy-focused fund is experiencing a drop in investment income, even as it’s already paying out more than it’s earning this way–relying instead on capital gains and leverage. The good news is the post-cut payout ratio of 143 percent is considerably more manageable. And the fund’s units are actually up more than 11 percent since the dividend cut announcement.

ACTIVEnergy Income Fund remains a buy up to USD8 for those who want to own a basket of income-producing energy companies that still yields more than 7 percent. Just remember that these closed-end funds are really black boxes to us investors. What’s in them, what’s paid out in dividends and the reaction to market events is entirely up to management.

Diversification ensures their values will remain steadier than those of individual companies. But if you’re not comfortable with the concept of a volatile dividend, you’re much better off buying individual equities.

Note that a number of funds tracked in How They Rate have payout ratios of well over 100 percent. They can still be attractive for their holdings, management’s prowess navigating markets and generous dividend policies. But the exact payout amount is not set in stone.

One very encouraging development is that not one trust has cut its dividend more than it initially projected when it announced its corporate conversion. In fact several, like Baytex Energy Corp (TSX: BTE, NYSE: BTE), have actually raised dividends.

That’s extraordinary, particularly for those with long lead times such as Davis + Henderson Corp (TSX: DH, OTC: DHIFF), which announced in early March. High Yield of the Month Macquarie Power & Infrastructure Corp (TSX: MPT, OTC: TBD) actually announced its post-conversion dividend plans back in September 2009.

Management’s ability to anticipate what companies can pay after absorbing the new taxes demonstrates extraordinary skill, as well as the reliability of these businesses. And that’s a strong vote of confidence going forward for all converting companies, those that cut dividends as part of the process and those that did not.

With conversion-related dividend cuts now well known, my focus with the Dividend Watch List is back where it was prior to Oct. 31, 2006, when the tax on trusts was announced. My goal is to unmask companies that continue to face potentially dividend-threatening challenges at their core business.

My primary hunting ground for information is quarterly earnings numbers. One of the positive things about trust conversions to corporations is simplified accounting. Nonetheless, many companies will continue to pay their dividends from free cash flow or distributable cash flow rather than textbook earnings per share.

Making that distinction as investors–and knowing how to measure the proper metric–is the key to an accurate evaluation of dividend safety. Here’s the Watch List as it stands now. It’ll likely remain much the same until we start getting fourth-quarter and full-year 2010 numbers, starting in early February.

Note that Canfor Pulp Products remains on the List despite the recently announced 53 percent dividend haircut. That’s to reflect the possibility that the magnitude of the reduction was due to business weakness rather than a change in payout strategy.

Also, Futuremed Healthcare Products Corp (TSX: FMD, OTC: FMDHF) is on the List now. The seller of disposable nursing supplies and other equipment will still yield nearly 11 percent after a 27 percent cut in its distribution, first announced last spring. But until we see numbers–projected for Mar. 29–caution is in order. Hold Futuremed Healthcare Products Corp.

• Canfor Pulp Products Inc (TSX: CFX-U, OTC: CFPUF)–Hold
• Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF)–Hold
• Futuremed Healthcare Products Corp (TSX: FMD, OTC: FMDHF)–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

Bay Street Beat

Cineplex Inc (TSX: CGX, OTC: CGXPF), the successor corporation to Cineplex Galaxy Income Fund, was downgraded to “market perform” from “outperform” by Raymond James this week, a move that follows TD Newcrest’s downgrade of the stock to “hold” last month. Canaccord Genuity initiated coverage in mid-December with a “buy” rating.

Canada’s largest movie-theater chain and a lynchpin of the CE Portfolio Conservative Holdings now carries five “buy” recommendations and six “hold” advisories on Bay Street.

The issue with Cineplex, something the Bay Streeters are struggling to get a handle on, is price. The stock is making new 52-week highs on a consistent basis during this rally. The trouble is the Hollywood movie machine seems to be laboring a bit following an explosive era of superheroes-vampires-and-frat-pack-humor-driven box office numbers. Comparables have been tough for awhile, but the sting wasn’t easy when fourth-quarter 2010 North American box office totals, not buoyed by a solid performance by another Harry Potter entry, failed to meet expectations.

It’s important to note that Cineplex survived the Great Recession because the variables specific to its business continued to hold up in its favor. Box office receipts inevitably reflect the quality of the product coming out of Hollywood, a lot like, in the words of US professional football immortal Bill Parcells, “You are what your record says you are.” In other words, people can always scrape together the cash to buy a ticket to a good movie.

Cineplex will be tested during what appears to be a bridge period for Hollywood. Good, then, that the theater-chain operator has consistently found new ways to monetize its screen space, selling advertising, like many chains do, but also hosting special events such as rock concerts and broadcasts from the Metropolitan Opera. Management is also turning www.Cineplex.com into a cash center, offering downloadable content and building a vibrant community.

It will be a little bouncy for Cineplex until its diversification efforts are tried and tested and Hollywood stirs up fruitful creative juices once more. It’s important to note, first, that the recent era of blockbuster-franchise-driven boffo box office will be difficult, if not impossible, to replicate. It’s time for something different, and chances are, if history’s any guide, people will eventually respond.

It’s pretty clear that “3D” isn’t going to be the mechanism that puts fannies in theater seats, any more than it was during the 1950s, or things like “Sensurround” ever had a chance to be. The mix in the latter stages of this high point for Hollywood has tended too hard toward technology rather than story.

At any rate, we like Cineplex for its ability to support a solid payout over the long term. Management did not go complacent when it was easy to keep seats filled during the early days of the Harry Potter era. It maintained a payout ratio in a conservative range. It kept a clean balance sheet. It consolidated its already unassailable position as Canada’s dominant movie theater chain during the downturn.

Cineplex, which converted from Cineplex Galaxy Income Fund without cutting its dividend, is a buy anytime it trades below USD22.

IRA Issues

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.