Canadian trust?

Is the Party Over for Canadian Trusts?
By Mathew Emmert (TMF Gambit)
Advisor, Motley Fool Income Investor

"How do you feel about Canadian Royalty Trusts?"

To say these securities have been hot for several years would be an understatement. The fact is, investors have been lip-locking with these things like Tom and Katie when the cameras are flashing.

But first things first, I suppose: What are these investments, why have folks taken such a liking to them, and why should you care? I'm glad you ask (because, frankly, I wouldn't have an article today if you didn't).

Trusting the Canadians
If you've heard of REITs (real estate investment trusts), you're largely already familiar with the trust structure. And though that structure can vary based on the type of assets in which the trust invests, one thing is fairly consistent: They are all basically pass-through entities that don't pay tax at the corporate level. Instead, they tend to pass profits directly to shareholders.

Though companies that employ the trust structure can be involved in everything from canning sardines to harvesting trees to financing mortgages, the most common are so-called royalty trusts that invest their capital in the energy sector -- typically oil, coal, or natural-gas-producing properties. Thus, Canadian Royalty Trusts, often referred to as CanRoys, are basically pure plays on oil and natural gas prices.

As with REITs, investors tend to seek out royalty trusts to take advantage of their relatively high yields. Because their distributions are mostly based on commodity prices, which can fluctuate wildly, many royalty trusts have yields approaching, or well into, the double digits. The typical trust pays distributions either monthly or quarterly.

The bottom of the well
When it comes to royalty trusts, one feature rules all: whether or not the trust replaces depleted assets. As we've all learned from The Beverly Hillbillies, oil and gas wells have an estimated reserve life, at the end of which they run dry and no longer produce income.

Some trusts are set up with a fixed number of wells that are never replaced. Thus, though these trusts pay dividends while the wells produce, their assets will ultimately be depleted, and the shares will be worthless. These trusts, therefore, are basically valued as you would an annuity or any stream of cash flow with no future return of principal. An example of a trust that will eventually terminate is Cross Timbers (NYSE: CRT), whose shares will eventually approach a zero value as the trust depletes its reserve life over the next 12 years.

Now, this structure is more common in the U.S., where tax rules on trusts can be a bit more burdensome. Most Canadian trusts, however, are so-called actively managed trusts, which raise capital by taking on debt or issuing additional units that can then be invested in new assets. Thus, ideally, the reserve life of these trusts can be maintained indefinitely, which means the shares will always have value and trade based more upon their current yield as determined by oil and gas prices. Examples of this type are CanRoys such as Enerplus Resources (NYSE: ERF) and Pengrowth Energy (NYSE: PGH).

Both of these companies have proved top-notch in their portfolio and distribution management, and investors have enjoyed double-digit yields and soaring share prices. But never forget that when commodity prices fall and distributions are cut, you're effectively hit with a double whammy (i.e., your income goes down, as does the value of your units). So in a declining commodity-price cycle, you can lose money very quickly with these securities.

Still, though values are difficult to find today, at the right price these securities will likely prove solid income investments for years to come -- that is, if the government doesn't rain on the parade.

The Canadian powers that be
As if commodity prices didn't give CanRoy investors enough to worry about, the Canadian government has also been tossing around the idea of eliminating the trust tax structure or possibly limiting ownership of such trusts by U.S. investors.

Again, the trust structure in Canada is more liberal than that in the United States, and its tax advantages have led more and more Canadian companies to convert to this structure to avoid paying taxes at the corporate level. Of course, this trend began to worry some Canadian political authorities, who feared a potential decline in tax revenue. Thus, ideas to curb the popularity of the income trust structure have been considered.

The short story is that though things looked bad for a while, the Canadian Department of Finance decided not to change the tax status of Canadian royalty and income trusts. It also said it has no current plans to introduce a tax on these entities in the future.

Instead, it moved ahead with an effective reduction in 2006 corporate taxes related to dividend payments, which will help level the playing field between trusts and regular corporations and -- it hopes -- decrease the incentive for companies to convert to the income trust structure.

Previously, the government also passed on the idea of limiting the ownership of Canadian income trusts by U.S. investors, though this one was an even more nerve-racking decision. Thus, while you have to be careful because some of the trusts themselves treat U.S. investors as second-class shareholders, the Canadian government appears to be staying out of your investment choices for now.

But unfortunately, the bottom line is that anything remains possible. Recent Canadian elections could still prove undecided if the current party can't gain a majority and pass a budget, and if this morphs into a campaign issue, who knows what will happen?

However, at least for the coming year, it looks like there will be no changes to the Canadian income trust tax code. So at their core, these vehicles should maintain their appeal to U.S. investors.

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Mathew Emmert likes maple syrup, hockey, and Canadian accents but isn't terribly fond of the cold. He's the advisor of Motley Fool Income Investor, and he owns shares of Enerplus Resources. The Fool has a disclosure policy for U.S. and Canadian investors alike.