Income trusts: The home stretch

Income trusts are running out of time. There are about six months left before the new tax comes into effect on Jan. 1, 2011 and the trust sector, for all intents and purposes, dies (REITs being the primary exception).

By now, we might have expected most trusts to have announced their plans for dealing with the new reality: corporate conversion, privatization, merger, takeover, or whatever. But some are still dithering, leaving investors in the dark as to what to expect in the way of future status, distribution cuts, share price, etc. This is patently unfair: management and directors have a responsibility to the public to decide on a clear plan of action and announce it at the earliest possible date. Only when this information is available can people can make rationale investment decisions. Without it, everything is guesswork.

Fortunately, many trusts have already acted to clarify their plans and some have already made the conversion to corporate status. These include several of recommendations in my Income Investor newsletter such as Crescent Point Energy (TSX: CPG, OTC: CPGCF), Colabor Group (TSX: GCL, OTC: COLFF), and Exchange Income Corp. (TSX: EIF).

The latest trust to convert was Daylight Resources which became Daylight Energy Ltd. on May 7. It now trades under the ticker symbol DAY on Toronto. (The over-the-counter symbol in the U.S. remains the same at DAYYF.) The conversion was accompanied by a 37.5 per cent cut in the distribution. Going forward, Daylight will pay a monthly dividend of 5c per share compared to a distribution of 8c per share previously.

When we originally recommended Daylight last September, we expected the distribution would be maintained however management decided to go in a different direction and use some of the cash flow to aggressively expand the company. Only a few days after the corporate conversion, Daylight announced the completion of a deal to take over West Energy for $115 million and 29 million Daylight shares. West Energy brings assets that the company says are “highly complementary” to Daylight’s operations in Alberta’s Pembina region.

What is especially interesting about the Daylight situation is that the share price did not fall dramatically as a result of the distribution cut. In the past, such cuts have usually resulted in a decline of 30 per cent or more in the share price but that did not happen in this case. Based on the recent price, the new yield is 5.6 per cent. That still makes Daylight attractive for income-oriented investors although the company now offers more growth potential than previously.

A few flow-through entitities, such as Inter Pipeline (TSX: IPL.UN, OTC: IPPLF) have announced that they plan to retain their existing status (in this case as a limited partnership) after 2011 despite the tax consequences. In announcing first-quarter results recently, management reaffirmed that Inter is “well positioned to maintain its current level of cash distributions to unitholders through 2011 and beyond, despite becoming a taxable entity in 2011. Attractive fundamentals within all four business segments combined with a strong inventory of organic growth projects under development continue to support Inter Pipeline’s positive outlook for future distributions”. Inter Pipeline was recently yielding 7.9 per cent, making it a very attractive addition to an income portfolio, especially in a non-registered account.

One of the reasons that Inter Pipeline is able to maintain its distributions is that some of its operations are outside Canada (it also has assets in the U.K., Ireland, and Germany). This means that some income is already being taxed so the impact of Canada’s new trust tax will be reduced.

Another trust in a similar position is Vermilion Energy (TSX: VET.UN, OTC: VETMF). Vermilion, which has operations in Australia, the Netherlands, France, and Ireland, confirmed in its recent first-quarter report that it will convert to a corporation on Sept. 1 and said it expects to maintain its current payout of $2.28 annually in the form of a dividend after that. This actually works in favour of Canadian investors who hold the shares in a non-registered account as they will now be eligible for the dividend tax credit. Some U.S. investors will also benefit because the conversion means that shares held in qualified savings plans (e.g. IRAs) will be shielded from the 15 per cent Canadian withholding tax. In fact, there are no losers in the Vermilion situation; Canadians who own the shares in a registered plan won’t be worse off because they will continue to receive the same cash flow after the conversion.

As mentioned earlier, real estate investment trusts (REITs) are the only segment of the trust industry that have been given an exemption from the new tax. However, because of strict rules on what actually qualifies as a REIT, there is still uncertainty about which ones will actually be tax-exempt so investors need to be careful.

As a general rule, only REITs that derive most of their revenue from so-called “passive activities” will qualify. This appears to mean that REITs in the hotel and nursing home businesses will get hit as well as those that are active in new development. As a result, some REITs are scrambling to reorganize their business so as to qualify under Ottawa’s tight guidelines.

Northern Property REIT (TSX: NPR.UN, OTC: NPRUF) is one such case. The REIT will spend about $2 million this year to reorganize into a so-called “stapled structure” which will enable it to move non-qualifying income from Execusuites into a separate entity. This will allow the rest of NPR’s business to benefit from the exemption. Watch for other REITs to jump through similar hoops in the final six months of the year.

All this adds up to a period of high activity and uncertainty between now and the end of 2010. To protect yourself against making bad investment decisions and to help you weed potential losers out of your portfolio, here are some general rules to follow in assessing trusts and REITs at this time.

1. Check to see if an action plan is in place for what will happen when the new tax comes in. If no announcement has been made, it may be advisable to hold off on making a commitment.

2. Trusts which derive a significant amount of income from foreign sources will suffer less impact from the new tax. Review the latest quarterly and annual reports carefully.

3. Corporations which trade as stapled units will not be affected. One example is Medical Facilities Corp. (TSX: DR.UN). It was recently yielding around 11 per cent and RBC Capital Markets describes the distribution as “safe”.

4. In the case of REITs, check to see if management has stated the trust will qualify for the exemption. If not, be wary.

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