I agree with the Canada's decision to effectively eliminate income trusts. The problem with trusts is that too much tax revenue is bled off to others. As a consequence, individual Canadians were left to shoulder the burden. Now that the rules have been changed, corporations and trusts will pay their fair share.
I do not think the prices of the trust units have fully factored the new tax regime. As an example, Canadian Oil Sands Trust (COS-UN) fell C$3.01 to C$27.41 for a 9.89 percent drop. Given that the trust will start paying taxes of 32% in 2011, I think that drop underestimates the net effects.
Some might argue, as CIBC World Markets has, that cash taxes will not be 32%. The following was quoted from a CIBC Equity Research Report issued today.
This best case scenario is supported by looking at the after-tax impact to our NAV estimates under varying current tax rates in 2011 and beyond. Given a view that essentially all of the trusts in our universe will maintain active capital spending levels under the new tax regime (and therefore will reduce the effective corporate tax rate from 31.5% to a lower figure through the generation of tax pools), we estimate that effective tax cash rates will fall in the 15%-25% range by 2011 for the majority of trusts in our universe.
For oil sands companies, most of their capital, about 95 percent, is classified as CCA 41A capital. CCA 41A capital qualifies for immediate write-off subject to certain rules. Essentially, as soon as the project reaches payout, in four to seven years after construction, 41A is depleted and there is very little capital remaining in the capital pools. There will be some CEE and CDE, Canadian Exploration and Canadian Development Expenses, remaining tax pools. But after payout almost all of the capital will have been written off for taxation purposes. Thus, intuitively I would argue that the effective cash tax rate for oil sands companies will be much closer to 32 percent than to 15 percent.
In direct reference to Canadian Oil Sands Trust, I doubt it will exist much beyond 2011. The current management offer absolutely nothing. Until last night, the trust offered tax efficiency and thus a price premium. After 2011, that sole advantage will be gone. Now that the trust will be on a level playing field with similar oil sands companies, I expect some other company looking for reserves will buy Canadian Oil Sands Trust.
In summary, I am not sure that prices have fully factored in the new reality of higher tax rates. And I expect those trusts, which are completely passive vehicles, might become take-over candidates for other companies seeking growth or reserves.
i'm just buying everything.
OK, maybe not, you make good points. I may just slap on small buy-writes and ignore it for a while.
Good luck Adam! :-)
Wasn't that $25B that was eliminated due to this announcement? Where did it go? $25B...POOOF. Gone.
Wasn't that $25B that was eliminated due to this announcement? Where did it go? $25B...POOOF. Gone.
That almost makes it seem as though it was speculative, like the internet stocks in the late 90s. If it was speculative, then it was overdue for a correction?
If there is real value, then it being redistributed. It didn't just vaporize.
I am going to use the Canadian Oil Sands Trust as a demonstration of why I don't like the trust structure.
Suppose you are a foreign investor—can be an American or any other nationality—and you own ExxonMobil, then through its ownership of Imperial Oil in Canada, you own your share interest in Imperial's 25 percent interest in Syncrude. Syncrude is a joint venture. That means, all profits are flowed back to the owner companies that then pay tax. The reason why Syncrude was set up as a joint venture is that, when it was constructed, the owner companies used the capital deductions to offset their net income. In other words, its proportionate ownership of Syncrude is merely an extension of its company.
Going back to our example, any profits generated by Syncrude are treated to normal taxation by Imperial Oil. If Imperial's share of Sycrude generated a $100 worth of profit, it pays normal corporate taxation on that $100, which is about 30 percent. ExxonMobil can then reinvest the rest, pay dividends, buy back shares, or whatever. I think that is fair.
Now Canadian Oil Sands Trust pays its $100 to its shareholders. For those shareholders in Canada, they pay their personal income taxes. For foreign investors, from a Canadian perspective there is no tax except a 15 percent withholding tax. So Canadians have a depleting non-renewable resource, which is owned by both companies and trusts. The companies are paying the corporate tax rates of about 30 percent, and the trusts are paying 0 percent. The Canadian holders of the trusts pay personal income taxes, while foreigners only pay Canada a withholding tax of 15 percent. That does not seem fair to me.
I am not sure why Canada should allow preferential treatment to one class of investors?
And that is the likely reason why the U.S. does not allow the trust structure either. Foreigners effectively get a free gift.
Now this might sound to some as though it is a protectionist anti-American blather. Wrong. Canada wants and needs foreign investment and capital to reach its full potential. We welcome foreign investment, so long as it plays on a level playing field.
Another way to look at this situation is, what value did Canadian Oil Sands Trust management bring to the table? In my view, none. They are simply an artifice for an efficient tax structure. A middleman that takes direction from Syncrude's management for its capital needs and cash flow generation.
I prefer to see investors participate on a level playing field. If an entity generates profits in Canada, it pays its fair share of the taxes. The after-tax cash flow then goes back to the investors. If those investors are Canadian or foreign, no matter. That money is theirs.
Sir, you are simply wrong. The US *DOES* have a royalty trust structure that pays no corporate taxes. In fact, this structure is ideal for companies like Canadian Oil Sands that do no exploration for new reserves. The US also has REITs, MLPs and BDCs, all of which pay little or no tax at a corporate level.
Remember also that US corporations exploiting Canadian oil sands pay their corporate tax to the US Governemtn, not the Canadian Government.
So getting rid of the energy trusts does not really help Canada raise taxes, unless they are all replaced by equally successful *Canadian* corporations, and that doesn't seem likely to me.
Alun, I want to thank you for commenting in my blog, even if I take issue with your comments. And I mean that sincerely. I enjoy good debate.
Quoting from Wikipedia: Income Trust...
Seems very familiar, no? Canada too has REITs. But the much loved royalty income trusts are toast.
And that's the problem Alun—the taxes are going to foreign governments, not Canadian governments. Why should Canadian taxpayers and owners of the resource be giving it away to foreigners, especially when it is extremely costly to install the infrasture to support the workers in remote locations?
Moreover, it does help Canada raise taxes. A lot. Now there is a 32% tax where before there was 0%. That helps pay the bills.
With regard to your comment about successful Canadian companies, I have two responses: One, they were Canadian before and they are Canadian now. Same management remains in place. And two, as I look at the TSE it is continuing to hit new highs. The energy resource sector continues to thrive. Businesses are booming. So what's the problem?
The hard cold reality is that trusts were simply an artificial mechanism to act as a tax dodge. Game is over.
Sir, I have to disagree with many things you said. Your line sounds very similar to the Canadian Government's, but with the Prime Minister being a proven liar I would not be too eager to believe what they say. I number my points:
1. When the US govmt changed the rules for royalty trusts, many energy trusts remained as trusts, paying no corporate tax. Examples would be SJT, HGT, MTR, SBR. The modified rules do not allow these trusts to take on debt, issue shares or otherwise acquire new assets but they can exploit the ones they owned when the trust was established. (incidentally I like SJT and HGT very much).
2. Foreigners, including Canadians, can invest in US royalty trusts and receive income from the exploitation of US natural resources, without paying the US govmt anything more than the withholding tax (15%). This is the same tax-wise (currently) as US investors investing in Canroys, but the new Canadian tax changes will remove this tax fairness. Incidentally, COS would probably qualify as a royalty trust under the US system.
3. A great many energy companies are organized as limited partnerships in the US, and thus pay no corporate-level taxes. Again, foreigners may invest in these, many of which are exploiting US natural resources. The Wikipedia article is wrong to suggest there are only a few of them - there are lots, and new ones are being formed all the time (e.g. EROC was formed a couple of months ago). My favorites are DMLP, EROC, EPD, OKE and TCLP.
4. Many Canadian oil sands assets are gradually being acquired by foreign (i.e. non-Canadian) corporations anyways. For example, Shell Canada was recently acquired by Royal Dutch Shell, so their corp tax won't be paid in Canada any more. Imperial Oil is likely to be acquired by Exon-Mobil, so the same story there. The energy trust structure actually *protected* COS from a foreign takeover, but now I would not be surprised if COS ends up being owned by a foreign corporation. If the Canadian govmt really wants to keep these assets Canadian it will have to basically nationalize them, as Venezuela did.
5. It is not true that Canada does not benefit from the energy trusts exploiting the natural resources there. The energy trusts pay the province a royalty for every barrel extracted (around $8 - $10 a barrel). That may not sound a lot when oil is $60 a barrel, but you have to remember the huge capital and operating costs of extracting, processing and transportation required before it can be sold (oil sands in particular). Canada also gets personal taxes on distributions from Canadian investors (which may be deferred in the case of pension plans, but which will still be paid), and withholding tax (15%) from foreigners. I would guess that the energy trusts also pay some forms of local taxes.
6. The idea that Canada will suddenly get another 31% of what energy trusts are currently distributing is naive to say the least. Energy trusts that become corporations will simply avoid tax by using excess cash to buy back stock (or take on debt to do so - no tax on interest), boosting the share price (e.g. as Encana is doing). The shareholders get a capital gain with little or no tax paid at the corp level, and in the case of foreigners you can't even stick them with the withholding tax on a capital gain.
7. The idea that foreigner investors are currently getting a free ride at the expense of Canadians is very wrong. Investors take a risk when they put capital into anything, and deserve to be rewarded for taking that risk. Oil is a commodity and a very real risk is that oil prices will drop. Many analysts believe that oil is heading back down to $20-40 a barrel and will stay there for a very long time(see EIA forecasts for instance, www.eia.doe.gov). The bumper energy Canroy yields of the last year or so were not typical and were certainly not guaranteed. Investors took on other real risks too - that a trust would do an Enron, or that reserves would run out, or that the world would fall into a depression killing demand.
8. The idea put forward by Jim Flaherty that increasing taxes on the royalty trusts will somehow encourage them to invest more in R&D is ridiculous. Most *corporations* do not spend *any* money on R&D. It is just naive to think that by taxing an organization more you will make them think "Well, if I don't spend this money on R&D it will get taxed, so I better do some R&D!". There are many other ways of spending excess capital to avoid taxes (e.g. share buy-backs) that give more direct shareholder value. Companies (and energy trusts) do R&D when they think they will get a return from it, and many energy trusts ARE doing significant R&D (into improved methods of extraction, e.g. CO2 and miscible floods, fracture treatments, more efficient methods for extracting and processing bitumen, etc).
9. Having said all that, you might think I am opposed to any tax changes for the energy trusts. I am not. It seems to me that something did need to be done, as many of the trusts are little more than Ponzi schemes and a blow-up at some point would have been inevitable. But I very much resent the blundering, ham-fisted, bloody-minded approach taken by Mr Flaherty. It was just a really, really stupid way to do things, and very counterproductive.
10. You might also think that I am a disgruntled US Canroy investor. In fact, I did hold a very small number of units in a couple of Canroys when the Halloween Massacre took place. Then near the peak of the panic I took very large positions in PWE, CNE and COS (never could resist a panic), and I've made money from it. But I feel very much for the large numbers of seniors (and others) who have lost a whole bunch of money in this debacle. The Canadian government screwed up big time.
An interesting article to read is:
http://www.caif.ca/content/IncomeTrustsTax.Fortin.pdf
Alun, I appreciate your well written response. Let's go through your arguments.
Okay, fine.
Okay, but are new trusts allowed?
In the Canadian oil and gas sector, because it is so concentrated, it would be very harmful and unfair to allow some companies a lower cost of capital through the use of a trust and not allow all companies to use the same mechanism. Thus, I support a level playing field.
What is the total combined production of U.S. royalty trusts? And what would have been the combined production for all Canadian royalty trusts. For the sake of this argument, let's assume that EnCana becomes a trust, and perhaps throw Talisman and Suncor in for good measure. If Canada does go on to produce 3.0-4.5 million barrels of day of heavy oil, that's a lot of production.
Similar to my response for point 2, what percentage of American production and what absolute production levels are we talking about?
Your point 4 is simply wrong. When Royal Dutch Shell buys Shell Canada, Royal Dutch Canada will still be paying Canadian income taxes. And a lot of taxes once the oil sands operations reach payout. Revenue less costs equal profits. Corporate taxes are assessed on profits, regardless of the ownership of the company.
The same applies to Exxon and Imperial oil, Conoco, and others. If foreign companies paid no taxes, Canada would not allow foreign companies access to the reserves. Why would they?
Oil sands companies only pay 1% of gross revenue until payout. So at $60 per barrel, that's a mere $0.60 per barrel.
Fort McMurray in northern Alberta is actually trying to defer development of various projects because they lack the infrastructure to accomodate the development. The problem is that the government must pony up its share of the capital first to provide the infrastructure and then wait several years later for payback.
Yes, oil sands operations are large capital intensive projects. But they receive immediate capital write-off and royalties are effectively deferred until they get their money back. Beside mining (which oil sands are), no other industry in Canada receives such a rich return. None.
Not only that, in oil sands, there are no competitors once the company has its leases. Now its main worry is the international price of oil.
Returns for oil sands projects are attractive with the present environment. If we accept that a new oil sands project requires $35-$40 to break even, then the industry is doing very well.
With regard to personal taxes from distributions, yes that applies to Canadians. But not foreigners. And the 15% withholding tax from foreigners is insufficient. Canadians are literally subsidizing the investment by foreigners. No government should do that.
Again, costs in Fort McMurray are huge. I lived there for about ten years. When I was employed by Syncrude Canada Ltd., a large oil sands player, I was instrumental in helping shape the industry's oil sands fiscal regime. Syncrude played a pivotal role and I was Syncrude's key business analyst working the financial models for the industry, Alberta, and Canada.
Local taxes are irrelevant in the scheme of things. If you were to look at a tornado diagram of costs, they do not even factor in.
Buying back stock doesn't avoid income taxes. If Company A has a pretax income of $100, it pays tax on the $100. If it then chooses to use its after tax income of $68 dollars to buy its stock, then it is free to do so.
Many energy trusts already had lots of debt. They are free to arrange their capital structure as they see fit. That's a level playing where every company can arrange its equity and debt structure as it deems appropriate.
One nice thing about buying back stock is that it actually provides more taxable income. When a company buys my shares, I pay capital gains. But again, the capital to buy back share is after tax income, not pretax income.
With regard to foreigners and capital gain, as long as the companies pay their fair share of income taxes, we welcome foreign investment.
Canadian buy shares of foreign companies and foreigners buy shares of Canadian companies.
Your argument here is a non sequitur. Any equity investment involves risk. So what?
Our argument is, do royalty trusts pay their fair share of income taxes? Answer is no.
My own personal thoughts are that any arguments that relate research and development to royalty trusts are simply red herrings.
I disagree. With many other companies in the wings waiting to announce their wanting to become trusts, his hand was forced.
He had to close that loophole. He could have grandfathered existing trusts. I dislike that solution, however, because it allows an unequal playing field. Being an engineer, I like symmetry.
Glad you made money off the panic situation, and I mean that sincerely. I like it when people make money.
Seniors are being compensated through other tax measures here in Canada. For those investors that had only trusts in their portfolio, shame on them. An investor should always be diversified.
I dislike option one intensely. That solution just begs for other countries to retaliate. Option two, equally repulsive. Foreign investment should be allowed and encourged, just not subsidized. Option three, that's what happened. Trusts have effectively become corporations.
Back to you sir.
Sir, you are incorrect in your statement about Crown Royalties. Perhaps your information is out of date. Below is an extract from the latest quarter's results for COS:
"the 2006 three month period, the higher volumes and selling prices were offset by an
increase in Crown royalties, which rose to $115 million, or $13.01 per barrel, in the third quarter of 2006
from $6 million, or $0.77 per barrel, in the comparable 2005 quarter. The increase in 2006 Crown
royalties reflects the shift in royalty rate to 25 per cent of net revenues during the second quarter of the year."
There is an article in the Globe and Mail saying that Mr Flaherty is now considering a reduction in the withholding tax rates for foreigners, so it looks like he may be starting to realise the damage he has done to foreign investment.
On a lighter note, I found the following on a Yahoo message board. It's quite funny.
-----
Flaherty's Brain Found On Mars
TORONTO, Nov 23 (AP) - The search for the missing brain of Finance Minister James Flaherty came to a conclusion on Thursday when NASA scientists detected the presence of a brain-like object in the Tharsis area of the Chryse Panlitia on the planet Mars. The Hubble space telescope was quickly re-scheduled to take a series of high definition images of the area using the Planetary Telescope and scientists were soon able to confirm that the object was, in fact, the missing brain of Jim Flaherty.
KHS: I have edited Alun Jones' remarks. That is, I have italicized his quote. And I have truncated the remainder of his quote. Copyright laws do not permit reproduction of complete articles. If Alun provides a link to the original source, I will happily insert the link so that other readers can follow the quote.
I added the emphasis on the change in royalty rate.
Mr. Alun Jones, no I am completely correct in what I wrote above. Again, the crown royalty is 1% of gross revenue until payout, and then 25% net income thereafter. I should note that payout includes recovery of costs inflated at the long term bond rate. Even your own quote confirms that a change in royalty has taken place. While COS unitholders were reaping large rewards, the crown was receiving a measely 1%.
I have not been following the latest developments. There have been all sorts of rumors flying around. I prefer to simply wait and see. Besides, would foreigners have much confidence in a minority government tax break to foreigners? What happens if they are voted out next election and the Liberals are voted back in?
With regard to quotes, I am always leery of reproducing a long passage from another article or source. That might violates copyright. If you could provide a link to the AP article or to the Yahoo! chat board, I am happy to insert your link in your message for you. What I typically do is copy a few paragraphs and then provide a link. That is known as fair use. You can use the contact information link in the sidebar to reach me.
Thank you for your comments. I enjoy the debate.