How the Income Tax Trusts helps rich get richer:
Canadian Income Trusts: An Analysis of the Current Situation
Peter Schiff, President and Chief Global Strategist
Many of you have probably noticed significant declines in the prices of the Canadian Income Trusts lately, the majority of which are energy related. As this is likely causing some concern I wanted to explain what has happened and offer my recommendations for the future.
The decline began in late summer as oil and gas prices fell significantly from their highs. Oil dropped from nearly $80 per barrel to just under $60 while natural gas prices plunged from $14 per mmbtu to under $5. As a result the trusts corrected, creating what I believed at the time to be excellent buying opportunities in an ongoing energy bull market.
As of late October share prices rallied significantly, recovering more than half of their post-summer losses. Then on November 1, the Canadian Government surprisingly announced that it would end favorable tax treatment for trusts, thereby subjecting 100% of their earnings to Canadian taxes. (Up until that point only retained earnings were taxed, with distributions to unit holders counted as deductible expenses against taxable income.) As proposed, the new tax rules will go into effect immediately for new trusts, and will begin on January 1, 2011 for existing trusts.
Given that the recently elected conservative party had promised not to tax trusts, the move blind-sided investors and caused prices to gap down significantly when the news first hit. They have trended lower ever since. Most trusts are now down between 20% and 30% since the announcement, and many are now 50% or more below their 52 week highs!
While this is certainly a negative development, it is not the total disaster that many assume it to be. In the first place, we have four more years of tax free distributions. At current prices, yields are now close to 20%. At that rate, over the next four years the trusts will pay back close to 80% of their current share prices in dividends alone. Plus, if my forecast on oil and gas prices proves correct, we will likely receive dividend distributions in excess of the current share price during those four years. Furthermore, for the next four years the trusts will have a powerful extra incentive to increase both the distributions and the pay-out ratios, to take full advance of the current tax break.
When the higher taxes finally do kick in (if the proposal is not modified prior to the end of the four year grace period,) yields for taxable American investors will decline by 26.5% However, the reduced dividends will likely still be relatively attractive, especially if they had already increased to reflect higher oil and gas prices.
The most interesting aspect of this change is that after-tax distributions for tax- paying Canadian investors will not be reduced at all. This means that for such investors these trust are incredible bargains, and as a result are far better investments now than before the proposal was announced!
The reason for this is that under current Canadian tax law, trusts' distributions are taxed at ordinary tax rates of 46%. When the new proposal takes effect, those distributions will be taxed at the lower 20.5% rate imposed on corporate dividends. The net effect is a push. Therefore, the recent price drop represents a bonanza for taxable Canadian investors, who can snap up these trusts at fire-sale prices and enjoy after tax yields higher than they ever could have imagined under the current system.
The big losers of course are those average Canadians who own these trusts in their retirement accounts. They will have their dividends reduced by 31.5% and still be subject to ordinary income tax rates once those distributions are withdrawn from their retirement accounts.. Since most lack the additional private savings necessary to buy these trusts in their taxable accounts, they can not take advantage of the higher after-tax yields that today's low prices have produced.
As a result of the news, and wide-spread panic, Canadians and other foreign investors, are dumping their shares at prices well below what the actual present value of their diminished cash flows would dictate. However, once this panic selling ends, I expect that wealthy Canadians and institutions (as well as off-shore investors from low tax jurisdictions,) will accumulate all the cheap shares they can get their hands on. These moves will bid prices significantly higher as they top off their positions in a market where all the sellers have been washed out.
Ironically, the new tax treatment will result in a significant transfer of wealth and income from middle class Canadians to rich Canadians. I suppose viewed from that perspective, the politics of the move makes more sense. A lot of very rich Canadians are going to owe the Conservative government big time.
The best strategy for current owners is to wait out the initial panic, and perhaps look for a more opportune time to sell. I am confident that such an opportunity will present it self prior to the end of the four year grace period. In the mean time we will continue to collect the full distributions. Do not worry if the value of your account is down as a result of lower current prices. Remember, it is only a number, and as long as we do not sell, and prices recover, it means nothing. Once the small investors are completely flushed out, I expect that number to be far more reflective of the actual value of the underlying units. In addition, once the institutions are loaded up with these trusts, I anticipate lots of buy recommendations and other efforts designed to improve prices and goose performance.
A lot of Canadian institutional investors missed out on the big rally in oil and gas, as most of the trust units were purchased by mom and pop investors in their retirement accounts. When oil was $20 per barrel the consensus among the big players was that it was going to stay that way indefinitely. Even as it rallied to $50, most main stream analysts were suspect. Average Canadians did have the foresight, and it paid off. However, by changing the rules, the big guys can re-write history. With oil likely to remain in the $60 dollars per barrel range, they can now buy shares as if oil prices were still below $30 per barrel. Ironically it will be the Canadian fat cats that end up owning all the oil and gas reserves, even though they totally missed the initial move. The small retail investors who called it right end up losing. It just shows you that political connections can be far more important than accurate forecasting when it comes to achieving superior investment returns.
Again the reason I am so confident of a price rise, apart from what might happen anyway as a result of rising oil and gas prices, is that for Canadian taxpaying investors the after-tax appeal of these trusts has not been diminished. Therefore demand should be stronger than ever from those Canadians with the deepest pockets. The temptation to line them with these now significantly enhanced after tax yields should be too great to resist. In addition, these reduced prices make the trust excellent targets for foreign acquisition, particularly by the Chinese, who are anxious to diversify their stash of U.S. dollars into other assets, particularly oil and gas.
Peter Schiff is the President, Founder and Chief Global Strategist for Euro Pacific Capital. He is widely acknowledged as a expert in international markets, and in global economic strategy. He is a speaker at all the major investment conferences. He is regularly featured on CNBC and Bloomerg TV , and often quoted in the Wall Street Journal, Barron's, New York Times, the Financial Times, Investors Business Daily, and many others. |
