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The income trusts ‘Halloween massacre’: handling the fallout one year on
By Barbara Balfour
September 14 2007 issue

A pumpjack with setting sun behind in Alberta; © Penner
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Almost a year after sudden changes in tax rules left them reeling, many income trusts, along with the lawyers who advise them, are still in the dark over what to do next. What some refer to as the great Halloween massacre, or the day last Oct. 31 that Finance Minister Jim Flaherty announced Ottawa’s decision to tax trusts in the same manner as corporations, has hit particularly hard in Calgary.

That’s where the headquarters for six of the country’s 10 largest trusts are located, as this type of structure plays a greater role in oil and gas than in any other sector.

“The nature of our workload as lawyers has changed — from financing deals and acquisitions to trying to answer the question, ‘What the heck do we do now?’” said Ross Freeman, partner at Borden Ladner Gervais in Calgary.

As a holder of income-producing assets such as oil sands or real properties, an income trust pays out its cash flows to investors, who are then taxed on their distributions on an individual basis.

The oil and gas sector has historically been one that is well-suited to trusts. With access to mature producing fields, a harvesting resource operation that maximized production is ideally suited to the yield structure, as you are always going to have revenue and thus will always have something to distribute. The oil and gas sector is reluctant to shift from this structure as these are popular investments with relatively high yields.

“There is a lot of resentment of the recent regulations on the basis that there was no good reason for the government to do this other than bowing to pressure. Rarely has such a major change been thrust upon my clients, where the government mandates a fundamental change in their business. To do the right thing for you and your unit holders is a huge burden, and that is why the royalty trust sector has been slower to respond,” Freeman explained.

Pulling the plug
Before the Oct. 31, 2006 announcement from the federal government, income trusts paid little or no corporate tax, which enabled them to distribute the bulk of their earnings to investors, who were then taxed on an individual basis. A Nov. 1 article in The Globe and Mail quoted Flaherty as saying the market value of companies converting to trusts was approaching $70 billion in 2006 alone and was costing the federal government about $500 million in lost annual revenue.

The decision to start taxing income trust distributions came at a time when telephone rivals Telus and BCE announced their intentions to convert into trusts, which would see federal government losses climb to $800 million annually. Flaherty stepped in to curb this development by announcing a tax rate on trust distributions that start at 34 per cent and will drop to 31.5 per cent by 2011.

While this tax rate is effective immediately for new trusts, there is a four year grace period for existing trusts until 2011. Most trusts in the oil and gas sector are taking advantage of the extra time to assess the situation, said Freeman.

“A lot of trusts have found that the pressure to distribute their cash flow was not working well from a business perspective — there’s no cash flow to reinvest into their assets. So changing the model would go away from needing to distribute all the cash flow; as well, a corporation is a much simpler structure and better recognized by markets and foreign investors.”

Despite a sharp drop in unit prices since Oct. 31, stronger trusts are still able to continue to grow, raise money and make acquisitions, said Freeman. But the smaller royalty trusts with weaker balance sheets or who may be more dependent on natural gas will be pushed towards other options.

“I’ve been practicing for close to 30 years in Calgary and I have never seen an issue handled this badly by the federal government and the Department of Finance,” said Freeman. “They have left a deep sense of frustration among the Calgary bar, who feel that the rule of law and the ability to persuade politicians and governments to do the right thing has been seriously undermined. It shouldn’t have come to this.”

Weighing the options
“Now that the law has passed, it’s clear that trusts need to actively consider their options.”
These options can include sellout transactions to private capital or foreign investors, adjusting their distribution policy or changing their structure to that of a corporation.

Between now and 2011, lawyers across the country are helping their clients to strategically assess all of these options during a period of continued uncertainty as to what a trust can do going forwards.

Many trusts will want to become corporations just because of the certainty in the tax rules for that structure, predicts lawyer Robert Kopstein of Borden Ladner Gervais.

“My sense is that trusts who foresee themselves as being high-yielding in the future are in a holding pattern until the rules on conversion come out. Currently, coming out with these rules is seen by the government as a low priority issue as it is assumed that trusts will want to take advantage of the grandfathering period. Everybody is frustrated by this as they want to be able to make intelligent planning decisions ahead of time.”

There are some more exotic ideas that are floating around on maintaining the trust structure outside of the new regulations , said Kopstein. One of them includes migrating into a stable unit structure, which involves getting rid of what the trust owns and letting the debt and equity trade as a unit so that the new rules don’t apply.

Another option is for the trust to buy back units by issuing debt to pay for them. “This can lead to instability but the trust can get return back from high yielding debt,” said Kopstein.

A third option is called a master limited partnership — a category of publicly traded partnerships which are eligible for tax advantages in the U.S. While the concept of redomiciling a royalty trust into the U.S. and converting it into a partnership has been floated around, Kopstein says his clients are nervous about the anti-avoidance threat posed by the Ministry of Finance.

“It states that if structures are developed that defeat the objectives of the new rules, the government will take action,” said Kopstein.

“Trustees are typically conservative about putting themselves in a position of risk – and should be.

At the same time, they can’t sit back and wait; they must look at strategic alternatives available to them so they can’t be criticized for not preserving or maximizing unit holder value,” Kopstein added.

For now, there is definite value in staying the course as consumer demand continues for a high yield product in their portfolios, says Brian Evans, vice president, general counsel and secretary, Canetic Resources Trust.

“I’m not convinced that you absolutely have to convert to a corporate structure,” said Evans. “We’ve had increased U.S. investor interest — our holdings have almost doubled since Oct. 31. The new regulations bring home the need for lawyers and their clients to be very flexible, to be creative and adapt to changes that are not always anticipated, but this is not necessarily a doomsday scenario. It’s very disappointing, but there are lots of options for continuing the business model. We remain very optimistic about our future.”

When it comes to the future of trusts in Alberta, history has shown the oil patch has always been resilient, said Freeman. “I was here during the National Energy Program, but we survived that and we’ll certainly survive this,” he said.

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