The Canadian Income Trust Debacle

When individual investors learn about Halloween’s Canadian Income Trust Debacle, they’ll shy away from buying Canadian energy trusts for a while. Today, I’ll explain what happened and share one idea for where investors might go next...

Around the office, we’re calling it the Canadian Income Trust Debacle...

Investors in businesses structured as Canadian income trusts had a nice thing going the past few years... big cash payouts and nice capital gains to boot. As long as businesses like these paid us 90% of their distributable cash, they weren’t taxed. You could hold these in retirement accounts and earn huge dividends.

It was too good to be true... really...

In recent years, more and more Canadian companies have been converting to the trust structure to take advantage of the favorable corporate tax situation.

The latest high-profile companies to announce their conversion were Telus and BCE – two massive phone companies. Phone companies are a stretch from the intention of the trust law. This week, the Canadian authorities said they’ve had enough.

Canada said it loses a mountain of corporate tax revenue every time a company converts to a trust. Apparently, in 2006 alone, more than US$50 billion worth of companies have converted to trusts.

So Tuesday night, Canada announced plans to fully eliminate the tax benefits of these trusts by 2011. Instead of no taxes, it appears that Canadians will pay in excess of 30% in taxes. Ouch! Even worse, Canada will likely withhold 41.5% from Americans... said another way, a 7% Canadian dividend will shrink to 4% for Americans, after Canadian taxes.

What I prefer to do now is cut and run... and then watch the drama from the safety of being out of my position. If they are worth going back into, we will. But the only way I see them being worth getting back into is if they’re much cheaper.

It stinks. The Canadian government just killed billions of dollars overnight.

These trusts will probably fall farther in the short term, as investors get angry and leave the sector.

Also, no law has been passed yet. So the shares will probably do nothing during this period of uncertainty. And markets hate uncertainty.

So where might American dollars go in the future that would have headed for the Canadian energy trusts?

When individual investors learn of the Canadian Income Trust Debacle, they’ll shy away from buying Canadian energy trusts for a while. Their brokers will be looking for a place for them to put their money. An easy answer might be, “how about the U.S. version of these things?”

My first thought was U.S.-traded energy master limited partnerships (MLPs)... like Enbridge Energy LP (EEP), Enterprise Products Partners LP (EPD), and TEPPCO Partners (TPP). These folks mainly own pipelines in the U.S. They are not taxed, and they pay dividends in the 7% range.

Once investors hear about that tax-advantaged 7% yield in an energy pipeline, the sale is made.

If I’m right about this, you can now beat ‘em to it.

Good investing,

Steve