Canada removes tax benefits for trusts

Nov. 27, 2006
The Canadian government's decision to remove tax advantages from companies doing business as income trusts will mean the end of the oil and gas trust structure in its current form, said a report by Wood Mackenzie Ltd., Edinburgh.

Paula Dittrick
Senior Staff Writer

HOUSTON, Nov. 27 -- The Canadian government's decision to remove tax advantages from companies doing business as income trusts will mean the end of the oil and gas trust structure in its current form, said a report by Wood Mackenzie Ltd., Edinburgh.

Separately, Raymond James & Associates Inc. issued a research note in which it compared Canada's efforts to stem a widespread conversion of companies to trusts with what the US experienced decades ago with the emergence of master limited partnerships.

Canada's new tax structure for all income trusts will reduce the value of the oil and gas trusts, said WoodMac Canada and Alaska energy analyst John Dunn. Trusts account for 20% of western Canadian conventional production.

"We estimate that in the conventional western Canadian oil and gas sector, the removal of the tax benefits could result in a transfer of value from the trusts to the government of $640 million (Can.) in 2011 alone, with up to $2 billion in net present value lost over the expected life of the trusts' assets," Dunn said.

On Nov. 1, the Canadian government announced its Tax Fairness Plan, which includes a tax on distributions paid by publicly traded income trusts.

Canada Finance Minster Jim Flaherty said the plan was designed to "restore balance and fairness to the federal tax systems by creating a level playing field between income trusts and corporations."

WoodMac report
WoodMac's Dunn believes "some of the smaller, more-focused trusts may struggle to adapt to the new regime, especially if they are exposed to the more marginal plays such as heavy oil and tight gas, and could become targets for acquisition."

As for the larger trusts, which benefit from a diverse portfolio, he expects these companies might continue under a new corporate structure or strategy.

"It is possible that their traditional focus on western Canada may shift to other regions, or even other countries, where more attractive fiscal terms are available," Dunn said.

Oil and gas trusts have had to maintain production both through acquisitions and development to provide cash flows to unitholders, Dunn said.

"However, recent cost escalation and labor shortages have made the Canadian upstream operating environment increasingly difficult, with projects becoming progressively marginal," Dunn said. "The new tax structure will only add to these challenges."

US comparison
In a Nov. 21 monthly review on MLPs, RJA analyst Ted Gardner said Canada's Tax Fairness Plan includes a tax on distributions paid by publicly traded income trusts, including large telecommunications, financial, and energy companies.

Some of these companies sought to convert to the trust structure to avoid paying taxes, Gardner said.

He compared this to what happened in the US with the emergence and eventual evolution of MLPs, which have different legal structures, income distribution practices, and tax considerations than a publicly traded corporation.

During the 1980s, US tax authorities realized the trend toward companies forming as MLPs instead of corporations potentially could create a tax shortfall. Hence, the government narrowed the tax code definition of what could quality as an MLP. Today, many pipeline and other midstream companies use the MLP model.

"As a result, the vast majority of today's MLPs are engaged in the energy and natural resources business," Gardner said. "The Canadian and US governments faced the same issue—a potentially dwindling tax base—but arrived at different solutions," he said, adding, "Given the recent push for energy independence and the growing need for energy infrastructure in the US, we do not expect the government to take it a step further and impose a corporate tax on MLPs in the near future."

Contact Paula Dittrick at [email protected].