Broken Trust Eric J. Fry Rude Awakening Newsletter
:... A wacky tax proposal from the Canadian Finance Minister, Jim Flaherty, triggered a massive rout of the country�s investment trust sector. We are inclined to view the rout as a buying opportunity � perhaps a phenomenal buying opportunity... � Under current Canadian tax laws, investment trusts pay no corporate taxes, although distributions to shareholders are taxable. Under the Finance Minister�s new proposal, dubbed the �Tax Fairness Plan,� this tax exemption would disappear... newly formed investment trusts would pay standard corporation taxes of 34%, dropping to 31.5% by 2011. Existing investment trusts would receive a 4-year holiday from taxation, but would begin paying standard corporate taxes in 2011. Flaherty also plans to raise dividend tax rates for pension funds and foreign investors that own trusts.
Why did Flaherty propose the shocking tax change? ... �This year alone,� he gripes, �there�s been almost $70 billion in new trust conversion announcements. We have seen a growing trend toward corporate tax avoidance.�... If he had merely ended the investment trust mechanism, he could have halted the erosion of the Canadian tax base, without also destroying $25 billion of shareholder wealth in a single day, shutting down the existing investment trust apparatus, violating the trust of every investor in Canadian assets, imperiling future investment in the country, eroding the Canadian government�s credibility, undermining the Canadian dollar...
If enacted, this proposal will not merely bite the hands that feed the Canadian economy, it will amputate them. Flaherty�s proposed retroactive tax reneges on longstanding agreements between investors and the Canadian tax authorities... The policy seems so ludicrous and counter-productive that we wonder if it might be retracted. The sheer stupidity of the proposal, therefore, is reason number one for buying an investment trust.
Reason number two for buying the battered investment trusts is that a fully-taxed investment trust is still an investment trust. In other words, it still offers a very high dividend yield, especially after yesterday�s shellacking. Hundreds of trusts now offer yields over 10%, and many offer yields of 13% and higher. Therefore, even after accounting for a tax hit as high as 34%, most trusts offer pro-forma yields between 7% and 10%, if our back-of-the-envelope calculations may be trusted.
What�s more, the current yields are still the ACTUAL yields until 2011, when existing trusts must begin to pay the tax man. So the owners of a trust like Trinidad Energy Services (TSE: TDG-U CN) would still receive this stock�s indicated yield of 11.8% for the next four years. And even after 2011 arrives, investment trusts will not suffer equally under the new tax regime. Some will fare much better than others. Using Trinidad as an illustration, Canaccord/Adams, a Canadian brokerage house, calculates that the company�s effective tax rate would only increase slightly, producing no worse than �a 12% reduction in distributable cash flow.� In which case, Trinidad�s yield would drop from 11.8% to about 9.8%, all else being equal.
Trinidad�s attractive yield, however, offers no guarantee that its share price will not tumble again today or tomorrow. Investors might sell just because the investment trusts are falling. They might swear off of Canadian investments like an AA newbie swears off Jagermeister shots. The Canadian dollar might also suffer more abuse, like it did today. The �loonie,� as it is sometimes called, fell about 1% yesterday.
No prudent investor can afford to ignore these risks. In fact, most prudent investors will probably toss their hands in the air, shrug their shoulders and ask themselves, �Why bother?� We have no ready answer. But we suspect the selling has been overdone and that rewards awaits those who take the plunge.