Energy trusts may curb U.S. investors

Tax compliance worries result in a marketing shift to Canada

Gary Park

Petroleum News Calgary correspondent

Canada’s energy income trusts continue defying the odds by trading at 52-week highs, but there are some gathering clouds, not least for U.S. investors who have swarmed into the sector, attracted by the cash distributions that averaged 40 percent in 2003.

The proportion of non-Canadian residents owning units of income trusts must average less than 50 percent over a year if the trusts are remain eligible for Canada’s tax-sheltered Registered Retirement Savings Plans.

Some analysts now believe that foreign ownership has climbed from 20 percent a year ago to between 40 and 50 percent, with three of the largest trusts — Enerplus Resources Fund, Petrofund Energy Trust and Provident Energy Trust — indicating that a majority of their units may now be in foreign hands.

Whatever their belief that they are in compliance with tax rules for Canadian content, these trusts are also increasingly nervous that newly installed Prime Minister Paul Martin may intervene in 2004 and tighten the rules for Canadian trusts.

To safeguard themselves against such action, Enerplus, Petrofund and Provident have indicated they are ready to take measures to head off any tax law changes that could rob them of their tax-friendly status if U.S. ownership levels are too high.

Three trusts moving to promote Canadian ownership

They may now ask investors to declare their nationality and those non-residents who purchased units most recently may be asked to sell their units at fair market value.

For Petrofund and Provident, the U.S. unit holders would get 60 days to sell; Enerplus has not set a deadline.

The trusts could also limit or suspend trading of their units on the New York or American stock exchanges, although U.S. investors could still trade on the Toronto Stock Exchange.

In addition, Enerplus and Petrofund have announced “bought deals” of C$142.6 million and C$106.9 million, respectively, with several brokerages that have agreed to buy units outright and sell them to Canadian investors. Enerplus, which is worth about C$3.5 billion on the Toronto exchange, has calculated that its transaction will lower non-resident ownership to 52 percent from 54 percent.

The flourishing Canadian income trust sector, which has a book value of about C$65 billion (compared with C$15 billion in mid-1999) or about 8 percent of the Toronto exchange’s market capitalization and includes 28 oil and gas producers, has also triggered concern in a study commissioned by the University of Toronto’s Capital Markets Institute.

Trusts may be costing governments millions

Study author Jack Mintz said it is clear that businesses with “lower economic performance benefit more from income trust financing.”

He urged the federal government to lower the top personal tax rate on dividends to 20 percent from 32 percent to level the field for companies that are unable to take advantage of the tax-friendly trust structure.

Meanwhile, the federal Department of Finance has been conducting its own examination of the impact of the proliferating trusts, which avoid corporate income taxes. The returns are taxed only once they’re in the hands of investors.

To achieve their twin goals of minimizing their own tax bill and maximizing the return of cash flow to investors, trusts can buy operating companies, then lend those companies money and deduct interest payments on the debt until the taxable income is reduced to virtually nothing.

For energy trusts, the ideal targets for acquisition are those companies with stable, predictable cash flows and very little need for capital. That has allowed the bulk of them to distribute upwards of 90 percent of their cash flow to investors, while avoiding the risks of exploration.