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Starting in 2011, Ottawa will impose a tax on income trust distributions that will put the income trusts on an equal tax footing with conventional taxable corporations. Trusts will pay a 31.5% tax on distributions to unit holders, so your cash flow from those trusts will fall by the same amount.
However, if you hold trusts outside of registered plans such as RRSPs and RRIFs, you will not see a large change in your after-tax position — even though the distributions you receive will likely drop by 31.5%. That’s because the distributions will now be taxed as dividends and Canadians will benefit from the lower tax rates provided by the combination of the dividend tax credit and the dividend gross-up (foreigners don’t quality for the favourable dividend treatment).
For example, in Ontario, investors in the top tax bracket now end up with about $536 after tax on each $1,000 of trust income. Under the new tax proposals, investors holding trusts outside of RRSPs will end up with about $532 after tax. The difference is roughly similar for the other provinces.
If you hold trusts in registered plans such as RRSPs and RRIFs, you will receive a 31.5% lower distribution, but with no offsetting tax benefits on dividends. When you eventually withdraw the distributions from your RRSP, you’ll pay tax at the rate on ordinary income. For an Ontario investor in the top tax bracket, that means after tax income of $367, compared to $536 right now.
A great deal could change between now and 2011. The current government or its successors could change, postpone or drop the new tax rules.
Meanwhile, we still feel you should avoid lowquality or newly issued trusts — and it’s all the more important to continue to keep your income trust holdings below 15% of your portfolio, as we’ve long recommended.
We continue to have a high opinion of all our trust recommendations, including the six we analyze below. Most have dropped enough to reflect much of the impact of the new rules. The exceptions are our real estate investment trust (REITs) recommendations, which have all held steady or moved up in price since the announcement of the new tax. That’s because REITs are exempt from the proposed new tax on distributions.
RIOCAN REAL ESTATE INVESTMENT TRUST $24.49 (Toronto symbol REI.UN; SI Rating: Average) is Canada’s largest REIT. RioCan has total assets of $4.5 billion consisting of ownership interests in a portfolio of 204 retail properties across Canada, including 8 under development. These properties contain over 50.7 million square feet of leasable area.
RioCan is Canada’s largest owner of neighbourhood shopping centres. These are enclosed malls in smaller urban centres. But where it’s showing the strongest growth is as the largest owner of ‘New Format’ malls. These are in the suburbs of larger cities, and are made up largely of ‘Big Box’ stores with lots of parking and room for new building.
RioCan’s revenue in the three months ended September 30, 2006 was $160.7 million, up 7.3% from $149.8 million a year earlier. Cash flow per unit rose 29%, to $0.40 from $0.31. Portfolio occupancy is at an all-time high of 97.5%. RioCan’s annual distribution of $1.32 gives it a current yield of 5.4%.
While the bulk of RioCan’s properties are in suburban areas, it is also pursuing projects in built-up areas. For example, it aims to redevelop a Toronto commercial site into a new retail/condo complex.
RioCan feels the high potential returns of nontraditional projects like this offset their added risk.
RioCan is still a buy.
LEGACY HOTELS REIT $9.43 (Toronto symbol LGY.UN; SI Rating: Extra Risk) owns 25 luxury hotels with over 10,700 guestrooms in Canada and the United States, including The Fairmont Royal York in Toronto and the Fairmont Le Château Frontenac in Quebec City.
In the three months ended September 30, 2006, Legacy’s revenues rose slightly, to $223 million from $221.6 million. Cash flow per unit rose 5.9%, to $0.36 from $0.34.
Legacy’s Canadian hotels get about a third of their revenue from U.S. tourists. Proposed new rules that would force U.S. travelers to carry a passport could hurt its revenue. However, a drop in the Canadian dollar would cut the cost of travel for U.S. tourists, offsetting the passport requirement. Meanwhile, the trust should generate enough cash to maintain its $0.32 distribution, which yields 3.4%.
Legacy may also profit by converting some hotels to condominiums.
Legacy Hotels REIT is a buy.
PENGROWTH ENERGY TRUST $19.42 (Toronto symbol PGF.B; SI Rating: Average) produces oil and gas in western Canada, as well as offshore Nova Scotia.
In the three months ended September 30, 2006, Pengrowth’s revenue fell 5.5%, to $287.8 million from $304.5 million. However, cash flow per unit rose 8%, to $1.08 from $1.00.
Pengrowth’s average daily production of 58,344 barrels of oil equivalent is weighted 44% toward oil and liquids, and 56% to natural gas. In the latest quarter, the company’s average realized price for oil was $72.61 U.S. and $6.29 U.S. for natural gas.
Pengrowth’s long-term debt is low at 24% of shareholders’ equity. The trust has an annual yield of 15.5%. It distributed 92% of its cash flow as distributions in the latest quarter.
Pengrowth is now acquiring Canadian oil and gas properties from ConocoPhillips for $1.04 billion. The purchase will boost Pengrowth’s production by 27%.
Pengrowth is still a buy.
GREAT LAKES HYDRO INCOME FUND $19.08 Toronto symbol GLH.UN; SI Rating: Extra Risk) owns 26 hydroelectric generating stations located on seven river systems in four distinct geographic regions: Quebec, Ontario, British Columbia and New England. Its facilities have 1,015 megawatts of generating capacity.
In the three months ended September 30, 2006, Great Lakes’ revenues rose 19.3%, to $37.7 million from $31.6 million. Cash flow per share rose 31.8%, to $0.29 from $0.22. Strong rainfall and improved operating performance boosted the fund’s power generation throughout its operating systems.
Great Lakes is 50.1% owned by Brookfield Asset Management (formerly Brascan). That enhances its ability to raise capital. Great Lakes raised its monthly distribution twice last year. It now yields 6.6%.
Great Lakes Hydro Income Fund is still a buy.
PEMBINA PIPELINE INCOME FUND $16.03 (Toronto symbol PIF.UN; SI Rating: Extra risk) has interests in 14 feeder pipeline systems with a total length of 8,350 kilometres. This includes the Pembina System, in operation since 1954.
The company also holds a 50% interest in the Fort Saskatchewan Ethylene Storage Limited Partnership.
Pembina’s total network is the largest feeder operation in Canada. These pipelines bring oil and gas from fields in northeastern B.C. and western and northern Alberta to refineries, or feed into major pipelines such as the Enbridge Pipeline System.
In the three months ended September 30, 2006, Pembina’s revenues rose 16.7%, to $85.3 million, from $73.1 million. Cash flow per unit rose 7.1%, to $0.30 from $0.28. Pembina’s units yield 7.5%.
Pembina has a number of projects underway to increase its pipeline operations. One is a $290 million pipeline from Canadian Natural’s Horizon Oil Sands Project to Edmonton, Alberta, due to start up in 2008.
Pembina Pipeline Income Fund is still a buy.
FORDING CANADIAN COAL TRUST $24.06 (Toronto symbol FDG.UN; SI Rating: Average) holds a 60% interest in Elk Valley Coal in B.C., the world’s second-largest supplier of metallurgical coal, a key ingredient in steelmaking. Elk Valley supplies approximately 21% of the global market.
Fording has vast reserves of coal. Mining could continue at current rates for 25 years; with further development, its reserves could last 100 years.
In the three months ended September 30, 2006, Fording’s revenues fell 20.8%, to $451.8 million from $570.8 million. Cash flow per unit fell 44.9%, to $0.92 from $1.67.
Of course, the company’s cash distributions rise and fall with coal prices and with the volume of coal sold. For instance, the company will pay a fourth quarter distribution of $0.95 a unit, up 18.8% from $0.80 in the third quarter. That payment was down from $1.00 a unit in the second quarter. The new annual rate of $3.80 yields 15.8%. Fording is deferring some capital projects, and cutting capital expenditures by 20%, to $40 million. This should free up cash to support its current distribution rate.
Fording is still a buy.
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