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Canadian Income Trusts For Yanks:
Big Yields, Big Gains, Big Changes

By Tom Wobker
Pennaluna & Company At Pennaluna & Company, our U.S. customers are showing a burst of enthusiasm for investing in the Canadian stock market. They have an especially strong interest in one particular high-flying segment – Canadian income trusts.
These trusts have turned into red-hot plays in recent years, pushed higher by global energy demand and surging commodity prices, a reviving Canadian economy and stronger Loonie.
Many oil and gas royalty trusts have posted double-digit yields and eye-popping capital gains as energy prices rocket higher. Funds in other industries have been winners as well.
Despite big dividends, large capital gains and favorable tax treatment, these trusts have received surprisingly modest attention here in the States. Now their relative obscurity could be ending. Growing recognition of their fine performance and new developments we’ll mention in a moment may boost their public profile and increase their popularity with U.S. investors.

What They Are

Canadian income funds are business entities that buy assets which generate steady cash flow from operations or royalties – often a lot of cash flow. These cash cows are also called unit trusts, royalty trusts, or income trusts, depending upon their industry and various formal distinctions. We’ll employ the terms interchangeably here.
The trusts use part of their cash flow to pay expenses and make provision for buying future assets to keep the business going. They send the rest out to shareholders. Usually these distributions are the lion’s share of cash flow – sometimes over 80% of it.
The shares, or units, trade like stocks. You’ll find them mainly in the fields of oil and gas, natural resources, electric power, and real estate (REITs), but they’re also becoming common in other fields.
Right now the top performers are oil and gas royalty trusts. These differ from their U.S. counterparts in key ways.
For one thing, they can replace depleted properties and continue to operate indefinitely, while their stateside equivalents can’t. For another, Canadian distributions usually qualify for the reduced 15% dividend tax, while U.S. limited partnerships and royalty trusts don’t. Moreover, large chunks of Canadian distributions are often tax-deferred return of capital. (Canadian trust websites frequently discuss U.S. tax implications in detail. See, for instance, Unit Holder Info at www.primewestenergy.com .)

Fast Growth

Because they promise regular and healthy dividends — plus the possibility of big capital gains — income funds have become one of the fastest growing asset classes in Canada.
In 2003, eight out of every ten dollars raised in Canadian IPO’s went to an income trust. In mid-2004, about 150 trusts traded on the Toronto Stock Exchange, with a combined value of around C$91 billion. Today there are roughly 175 and the total market cap has climbed well above C$110 billion.
A number of these funds trade both in Canada and on major exchanges here in the States. Often these are larger and better-known funds that have many U.S. investors, like Enerplus Resources Fund (NYSE ERF; TSE:ERF) or Primewest Energy Trust (NYSE PWI; TSE:PWI).
Many others funds trade only on Canadian exchanges. These are usually smaller, lesser known, and have fewer foreign owners. Some observers feel they offer more upside potential than the dual listed funds, although with greater volatility.

Big Yields Plus Big Gains

Fat dividends are the trusts’ main draw. Usually paid monthly or quarterly, yields can be real head turners: Prime West Energy (NYSE PWI) was recently paying over 12%; Paramount Energy Trust (TSE PMT) was above 15%; and Harvest Energy Trust (TSE THE) was nudging 20%.
Capital appreciation can be surprisingly strong also. In the past two years, for instance, the price of Peyto Energy Trust (TSE PEY) climbed about 300%; Bonterra Energy Trust (TSE BNE) rose about 150%; and Canadian Oil Sands Trust (TSE COS) more than doubled.
In “Canadian Income Funds”, a guide by Peter Beck and Simon Romano, the authors note that from 2000 through 2003 the income trust market as a whole rang up total returns of 150%. That’s $2.50 for every $1.00 invested.

New Boost?

Besides the factors now driving investment in income funds, three new developments could give these funds an extra boost in the future.
First, theoretical concerns over unitholder financial liability were essentially laid to rest recently when Ontario, Alberta and Quebec passed legislation that gives unitholders the same protection corporate shareholders enjoy. This ends a remote possibility and opens the doors to greater liquidity. Since these provinces are home to the majority of funds, others will be forced to follow suit or lose their trusts to them.
The editors of Roger Conrad’s Canadian Edge newsletter – a good source of news and investment recommendations on income trusts (www.canadianedge.com) – say they expect this change to pave the way for participation by institutions that previously stood on the sidelines, thus magnifying trading volumes. They also think it led to Standard & Poor’s recent decision to start including some trusts in the benchmark S&P/TSX Composite Index later this year.
Second, Canada has tabled a proposal to limit foreign ownership, which most trusts opposed. The idea may not be dead forever, but the victory shows the industry’s growing power to prevent government interference.
Third, U.S. tax treatment has been clarified by the IRS. It appears now that nearly all Canadian trust dividends (except for a small number of passively managed funds and limited partnerships) are considered “qualified”. As such, they escape double taxation and are eligible for the 15% dividend rate granted by the Bush 2003 tax cuts, a significant savings over ordinary income rates.

A Few Thorns

Of course, a few thorns lurk among the roses. Most important of these is risk. All international investing carries currency, political, and economic hazard. And while many income funds are relatively conservative investments, they are potentially volatile. This is especially true of oil and gas trusts, which have enjoyed a magnificent ride recently but can react strongly to pull backs in energy price.
Also, trading the high-flyers available only in Canada isn’t as easy for Yanks as trading in the States. There are manageable but sometimes annoying issues of currency, trade execution, settlement, and tax reporting. These result from the relatively complex logistics involved (one reason why some brokerage firms charge extra for Canadian trades… which, by the way, we don’t).
And in December Canada extended its required 15% dividend withholding to cover U.S.-owned IRA’s. These were previously exempt. U.S. fund owners can take a foreign tax credit for this withholding in taxable accounts, but for IRA’s this doesn’t seem possible. Still, many funds offer yields so sizeable that even with the tax bite they’re well ahead of competing investments.

Editor’s Note: The Author, Tom Wobker holds degrees in journalism and law from the University of Kansas. He is a principal with Pennaluna & Company, a NASD broker-dealer and market maker with its main office in Coeur d’Alene, Idaho, and clients in a number of states. Founded in 1926, Pennaluna trades stocks on all U.S. and Canadian exchanges, Nasdaq, OTCBB and Pink Sheets. Phone 800-535-5329 or visit www.pennaluna.com. For online trading visit www.penntrade.com.
Disclosure: Pennaluna & Company is a NASD broker-dealer and market maker. As such, it frequently buys or sells stocks for its own account, or in order to make a market. Consequently, Pennaluna may at any time buy or sell or make a market in any stock mentioned herein, and associated persons may also buy, sell or hold any such stock at any time. The firm and/or associated persons may also engage in private placements or other investment banking activities with any company mentioned. This publication is intended solely to provide readers with information. Mention of a company does not in any manner constitute a recommendation, unless specifically so stated. Information is believed accurate but accuracy is not guaranteed.