Income Trusts and the Canadian Energy Sector

Finance Minster Jim Flaherty recently gave the income trust sector an unwelcome surprise. Prime Minister Harper had previously promised to "stop the Liberal attack on retirement savings and preserve income trusts by not imposing any new taxes on them", but the government underestimated the momentum towards trust conversion and was facing a very significant loss of tax revenue.

Not satisfied with merely preventing new trust conversions, Flaherty decided to impose retroactive tax measures on existing trusts. Many of these existing trusts happen to underpin conventional oil and gas production in Alberta - in fact the trust structure was initially developed to facilitate production from mature assets in the oilpatch. The proposed tax changes could therefore have a significant effect on energy production and the Alberta economy specifically. Departing Alberta Premier Ralph Klein welcomed the tax measure.

Alberta was hurt by the trust tax loophole. We were losing hundreds of millions of dollars in revenue.

However, he and the rest of Alberta may well be far less pleased once the implications of this experiment in retroactive tax policy come home to roost.

The History of the Income Trust Structure

Income trusts, otherwise known as royalty trusts or flow-through entities (FTEs), were initiated in 1986 in order to allow large multi-national oil companies to pass mature assets, which were no longer growing in production and were producing more cash flow than could profitably be reinvested in them, on to other interests better able to focus on extracting the remaining oil and gas. By setting up a business structure allowing virtually all income to flow through to trust unit-holders on a monthly or quarterly basis, corporate taxes could be alleviated or eliminated and sufficient capital could be raised from investment to continue exploration. Canadian oil and gas trusts now produce approximately a million barrels of oil equivalent per day, or one in every five barrels of production in Western Canada.

According to Canaccord Adams (pdf warning),

Royalty trusts are the most efficient harvesters of mature assets and, through acquisitions, provide capital to senior producers, juniors and investors to recycle into Canadian frontier exploration, development and resource plays.

Since 2001, royalty trusts have raised approximately $20 billion in public markets and acquired $27 billion in oil and gas properties. Of that, 50% has been the acquisition of juniors which reinvest into exploration opportunities.

For a mature industry, the royalty trust structure is not a scheme to avoid tax, but a legitimate mechanism to create value where it would either never occur or be deferred into the future.

Although initially treated as a dubious gimmick, the trusts have since become extremely popular and the idea has spread far beyond its origins in the energy sector. Much of the growth occurred in the mid-1990s and again strongly after 2000, and the consistently high yields have attracted many investors. Taxation at the level of the business has been replaced with taxation at the level of the individual unit-holders receiving the disbursements. On average, 39% of units are held by taxable Canadian investors, 22% are held by non-residents and 39% are held by tax-exempt investors. Tax exempt investment is mostly through RRSPs, although pension funds are also involved.

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Income Trusts and the Cost of Capital

Currently because they're paying almost all of their profits to shareholders, trusts must continuously raise additional cash to fund expansion....Although many Canadian trusts have in-house exploration and development capabilities, most grow principally by acquiring additional operating companies....Since royalty trusts distribute most of their income to unit-holders, they must raise cash to fund acquisitions either by borrowing or by selling more units.

It is generally agreed that the trust structure has lowered the cost of capital for businesses which have access to it, giving relatively small Canadian businesses a competitive advantage. The vast majority of income trusts have capitalizations under a billion dollars, and without access to the low-tax trust regime capital would be prohibitively expensive. Trusts have allowed these businesses to be competitive on a global platform and to extend the commercial life of their mature assets through investment of the capital they have been able to access.

The WCSB is a mature basin that requires a lot of low cost capital (pdf warning) to harvest. The low cost of capital environment for royalty trusts has resulted in a general increase in capital development activities by royalty trusts that has allowed the development of what would have been unexploited opportunities due to inadequate rates of return. This in turn has moderated the rise in prices for oil and natural gas by sustaining supply that would otherwise experience decline in the absence of favourably priced capital.

The competitive advantage in cost of capital bestowed by the trust structure has facilitated increased Canadian ownership in the energy industry. Until trusts became established, the dominant purchasers of energy assets were American companies with access to larger pools of capital. In recent years, however, trusts have been able to repatriate some of these assets, giving Canadians greater control over their own energy endowment and allowing them to benefit from the wealth it produces.

Victims of Their Own Success

The market capitalization of energy income trusts has increased dramatically in this decade as investors have increasingly sought the cash distributions they provide. From $1.3 billion in 1995, it grew to $5.8 billion by 2000 and to $41.9 billion by the end of 2004 on the back of low interest rates and high commodity prices. Income trusts as a whole increased from $18 billion in 2000 to $118.7 billion by 2004, as the popularity of the structure increased outside its initial niche in the energy market. Of the 2000 securities traded on the TSX, 255 are income trusts, up from 234 at the end of 2005. Their combined market capitalization is $210 billion, or approximately 11% of the TSE. Of the 255, 34 are oil and gas trusts and a further 21 are power and energy trusts. Three quarters of all IPOs in the last year were income trusts.

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More and more companies were opting to become trusts in order to gain a competitive edge against their rivals or remain competitive as rivals converted. In 2006 almost $70 billion trust conversion announcements were made and a domino dynamic was taking root. According to Roger Conrad of the Canadian Edge investment newsletter, classic signs of froth had been appearing in the market for energy trusts in particular as a result of recent high profile oil sands hype, high oil prices and low interest rates. Along with a flood of IPOs and trust conversions, the irrationally exuberant public seemed increasingly willing to bid up trusts indiscriminately so that price increases were running ahead of dividend growth. Apparently, an increasing number of investors were of the opinion that trusts were guaranteed by the Canadian government.

Concerns have been expressed that investors may have been underestimating the risks involved in trust investments. Trusts are not corporations, which means that, in theory at least, unit-holders have unlimited liability for the actions of the trust. Trust distributions are not fixed or guaranteed and are subject to change at any time. The performance of the sector in recent years has probably led to an unwarranted degree of complacency amongst investors, especially seniors who rely on high dividend payments to fund their retirement. With the prospect of both generous dividends and capital gains, an unsustainable having-your-cake-and-eating-it-too scenario had developed. Dependency on the long-term continuation of such circumstances is a risky strategy, and indeed the trust sector had begun to experience problems in the second half of 2006, due to higher interest rates and lower commodity prices, before the tax issue came to a head.

From: The Rude Awakening - Broken Trust

Canadian politicians of various political allegiances have become increasingly concerned about tax avoidance. The decision to take action was finally made as BCE and Telus, with a combined market capitalization of $45 billion, announced their intentions to undertake trust conversions. According to tax expert Jack Mintz, tax revenue forfeited to the income trust structure would have risen from $500 million to $1.1 billion per year if the BCE and Telus conversions had taken place. EnCana, which made a profit of $5 billion (US) in first nine months of 2006 and was due to pay $1.5 billion in taxes, was also moving toward becoming a trust under strong pressure from its shareholders. An application had been made by EnCana to the Canadian Revenue agency for a ruling in the summer of 2005, giving the government a year to ponder the implications. The prospect of such a large a hole in tax revenues prompted Flaherty to pre-empt EnCana's trust conversion announcement by issuing his tax legislation. EnCana's plans were promptly shelved with the elimination of the competitive advantage.

Minister Flaherty's Tax Proposals

Finance Minister Flaherty's proposals attempt to address the differential taxation of FTEs and corporations, and do so retroactively. Currently corporations are taxed at the entity level and corporate dividends are also taxable in the hands of their recipients. ('Double dipping' taxation is addressed for Canadian investors through dividend tax credits.) FTEs are not taxable at the entity level, and their distributions are only fully taxable in the hands of taxable Canadian residents. There is a lesser witholding tax on payments to foreign investors, and tax-exempt Canadian investors, of which there are many, pay no tax at all on trust distributions. The impact of trust structure on tax revenues is therefore dependent on the number of foreign and tax-exempt investors in a trust. Although Taxable Canadian investors have no tax justification for preferring to invest in trusts, both foreign investors and tax-exempt Canadians pay little or no tax on trust income in comparison with corporate dividends.

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Under the old system a taxable Canadian would pay 46% on either FTE income or corporate dividends, where as a foreign investor would pay 42% on corporate dividends and only a 15% withholding tax on FTE income. The effective rate tax rate on dividends paid to tax-exempt Canadian investors is 32%, while no tax is payable on FTE income. In contrast, under the proposed system the effective tax rate would be the same for FTE income and corporate dividends for all classes of investor. Taxable Canadians would pay 45.5%, foreign investors would pay 41.5% and the effective rate for tax-exempt Canadian investors would be 31.5%. New trusts would be taxed under the new system from the 2007 tax year, while existing trusts would begin to be taxed under the new system as of 2011.

Tax-exempt seniors would be significantly affected under these proposals, so Minister Flaherty has introduced an age-based tax credit and has also decided to allow income splitting for seniors as of 2007 (previously this was permitted only for Canada Pension Plan payments). These measures would reduce the impact of the tax equalization of FTE income and corporate dividends. Stephen Harper and Minister Flaherty justify their policy reversal over trust taxation by saying that what they had promised to do was to protect retirement income for seniors, not to protect the profits of large corporations and foreign investors. They argue that age-based tax credits and income splitting provide retirement income protection without allowing tax revenue losses to continue.

As the government of Stephen Harper is in a minority position, the opposition could bring down government over this policy, but if they do they would revive trust industry tax loophole and its concomitant tax revenue hemorrhaging, while doing nothing to decrease the aura of political risk now attached to the trust structure. This could well achieve the worst of both worlds and is unlikely to happen for that reason.

Retroactive Tax Law and Political Risk

Changing rules of game in middle is a dangerous political practice prone to backfiring unpleasantly. It has the unintended, though obvious, consequence of creating a great deal of unwelcome uncertainty with regard to a wide range of business decisions - uncertainty which increases perceived risk and therefore the cost of capital. When a government breaks a very specific promise in such a definitive way, the danger of a backlash from those who had relied on the promise in good faith and made their investments accordingly is likely to be particular severe. When those investors represent the natural constituency of the part in power, the sense of betrayal is likely even worse and the party making the retroactive change is even more likely to pay a high political price.

There were billions of dollars bet by ordinary people, companies, executives on the strength of this promise. To have this result, to have billions of dollars lopped off, seems to have struck a raw nerve.

Canada's rationale for doing this is that they are missing out on too much revenue as the income trust sector expands. But this rationale is self-defeating; because of the message Canada's government sends with the arbitrary change: If you do business in Canada, you are liable to confiscatory changes in tax policy at government whim -- even if we promise no such changes beforehand.
From: The Rude Awakening - Broken Trust

Reactions from at home and abroad have been pouring in. Many Canadians are of the opinion that something had to be done to stop the loss of tax revenues, arguing that foreigners and the rich should not benefit at the expense of the masses. However, there is a significant difference between preventing any new trust conversion, which would have halted the lion's share of the revenue loss, and retroactively eliminating the advantages of existing trusts. Investors and trusts themselves are not impressed.

From: The Rude Awakening - Barbarians at the Border

The newly formed Coalition of Canadian Energy Trusts - a 40 member group which produces 20% of Canada's daily oil and gas production, has invested $10 billion in the energy industry in the last five years and has paid $5 billion is distributions since 2005 - is seeking a meeting with Minister Flaherty in order to argue that their industry should be grand-fathered. They intend to point out that they exploit oil and gas reserves corporations would consider uneconomical and therefore have a unique role as developers of mature properties that is under threat. Flaherty has been unequivocal that his changes will be implemented as planned.

The opportunity costs for the country of Canada could run into the tens of billions of dollars, if not hundreds of billions. When foreign investors scout around for opportunities, for example, they do not often seek countries that enact capricious, punitive and retroactive tax laws.
From: The Rude Awakening - Broken Trust

Control Over Energy Resources

The proposal to impose retroactive taxation on trusts is likely to have significant consequences in terms of control of Canadian energy resources. Energy trusts had been able to compete on a global basis, despite their relatively small size, due to the cost of capital advantage they enjoyed. Marcel Coutu, CEO of the Canadian Oil Sands Trust, is worried that his trust - with a 35% stake in the Syncrude Canada Ltd oilsands plant - is vulnerable to foreign takeover and that Canada could therefore lose control of a key national resource.

Anything that lowers your stock price increases your takeover vulnerability, and nothing has lowered our stock price more than this event.

According to the Canaccord Adams report (pdf warning):

If the tax proposal is enacted as presented, we believe that Canada will lose control of its energy sector and investment activity will decline in conventional oil and gas production. This tax proposal puts a 'for sale' sign on Canadian energy resources by removing a competitive cost of capital advantage - a wave of foreign takeovers is likely to emerge. As a result, Canadian energy decision will be made outside our borders. If ever a sector needed a responsible tax policy to foster stable domestic investment, it is the Canadian energy industry. These businesses have funded a significant percentage of total investment in Canada and that investment activity is now at risk.

Although many foreign investors may be deterred by the prospect of capricious tax law, there are others who are not, largely due to their shorter time horizon. Investors who would normally plan to stay the course and maintain mature properties need to have confidence in a stable tax regime, but private equity investors planning to strip value and flip the remains back to the public are less likely to be concerned about the long-term. These 'vulture investors' are highly unlikely to contribute to the growth and vitality of the Canadian energy sector.

The global economy is still awash in a sea of cash and private equity firms have literally tens of billions to throw around. They are bigger, badder and hungrier than ever before. What are a private equity guy's favorite two words in the world? "Cash flow." What do Canada's income trusts have in spades? Cash flow. Put the two together and it's not hard to see: the barbarians are coming.

All the Canadian energy trusts put together have a market value of $60-80 billion. That's a drop in the bucket... a mere two or three mega-deals by today's standards. The barbarians are sitting on so much investor cash that they are literally desperate to deploy it. They are no doubt drooling over the situation Flaherty created.

When an energy trust goes private, for one thing, public investors no longer get to participate in the revenue stream. Instead of enriching Canadian citizens and other
small-scale investors, the cash flows to bigwigs in L.A. and New York. Flaherty got brownie points for offering tax exemptions to Canadian senior citizens; those exemptions
won't matter much if the trust distribution streams no longer exist.

Minister Flaherty's retroactive tax proposals have not only made relatively small Canadian firms vulnerable to takeover by removing their cost of capital advantage, but may also have demoralized current investors sufficiently to encourage them to sell out. Estimates of the losses suffered by the trust sector vary, but are generally agreed to be in the tens of billions of dollars. Trust takes a long time to establish and very little time to lose, and it may be a very long time before Canadian investors are prepared to trust their government again. Cashing out what remains of their wealth before anything worse can happen may begin to look like a good idea.

Price and Supply

Even before Minister Flaherty's tax law reversal, several major energy companies had recently announced billions of dollars of cuts in their spending on exploration due to high and rapidly increasing operating costs and lower commodity prices, especially in the case of natural gas. Adding political risk and an increase in the cost of capital to that mix may well cause that trend to continue.

According to Canaccord Adams,

An increase in the industry's cost of capital requires an increase in the required hurdle rates to justify investment in future development, thus reducing the amount being spent in the WCSB in general. In its simplest form, a 20% reduction in capital in the basin would likely erode $7 billion in annual investment (the industry investment is about $35 billion a year) and impact annual industry oil and gas cash flow by about $3 billion in our view. This is only the beginning as other related industries such as oilfield services and other businesses will also suffer.

Analysts are not currently expecting the impact on the oilpatch to be as great as that which followed the advent of the Pierre Trudeau's National Energy Program in the early 1980s, but some are concerned about aggravating the boom and bust dynamics that have characterized the industry.

It's going to harder for larger companies to take their mature properties and sell those to energy trusts, then take the cash for that and go do exploration," said Bill Schulz, who teaches strategic management at Calgary's Haskayne School of Business.

Reduced investment and exploration will have the effect of reducing supply over time, which would in turn cause the price of energy to rise. Conventional oil and gas supplies were already declining rapidly due to the depletion of mature fields. Continued exploration could mitigate that decline to some extent, but if investment in exploration is cut back significantly, the decline could accelerate dramatically. If trusts are subject to private equity buyouts, the effect could be far more significant due to shortening of the investment time horizon. Justice Litle of The Rude Awakening has a timely warning for Canadians regarding the implications of the recent policy change:

Private equity firms used to take pride in shaping the companies they acquired. The old way was to really clean up a company, improve its efficiency and make a mint by way of genuine value creation. That still happens, but it's more and more rare these days. The new model is more akin to strip-mining: load the target with debt, extract as much cash as you can and flip it back to the public as quickly as possible. Under the old-fashioned way, polishing up a company took years. Not any more. The new record for a private equity strip 'n' flip is an astonishing three weeks.

Private equity guys don't care about the world's energy future. The name of the game is fees and cash flow, end of story. They view their acquisitions in the same way credit
card companies view subprime borrowers - as assets to be leveraged and exploited. If the barbarians can snap up these trusts like barracudas eating minnows, what do you
think their focus will be? Will they be worried about growing operations, expanding capex to meet future demand? Heck no. They'll be cutting costs left and right, forgoing
expenditures wherever they can. If you thought Exxon and BP were stingy on the capex side, you ain't seen nothing yet.

The Alberta Economy - Bust Follows Boom?

The oil boom of recent years has made Alberta an engine of economic growth envied by its provincial peers. The province is debt-free, has produced enormous budget surpluses and sends its citizens prosperity cheques. However, the resource revenue that has fueled government spending has been declining as reserves of conventional oil and gas have been depleting. The province receives royalties of up to 40% on exploitation of these resources - revenue that was already threatened by depletion and announcements of drilling cutbacks, and will be further impacted by the fallout from the trust taxation decision.

The oil sands developments, which are expected to account for 90% of Alberta's output within ten years, fall under a very different royalty regime. In order to increase production from unconventional source, the provincial government of Ralph Klein negotiated a deal in 1996 with the oil sands companies, and other producers of unconventional supplies, which allows them to pay only a 1% royalty until they have recovered their enormous capital costs. It has been observed by the provincial opposition leader that the revenues accruing to Alberta from the oil sands were less than those from lotteries. It is clear that this revenue stream will not be able to replace the diminishing returns to the province from conventional production.

Even once the capital costs of unconventional production have been covered, the royalties - set to rise to 25% of net revenues - are payable on either the raw bitumen or on the upgraded synthetic crude. Naturally, most operators choose to pay royalties on the much less valuable bitumen. There is now a considerable debate in Alberta about whether to offer incentives for companies to upgrade in the province, rather than allow exports of raw bitumen. Whatever the outcome of that debate, provincial revenues from the oilpatch are set to decline with the fortunes of the conventional oil and gas industry. The anger that is likely to flow from this circumstance will probably be focused on the federal finance minister for his attempts to stem the losses to the federal treasury, even though trouble was already on the horizon before he imposed retroactive taxation on the industry sustaining Alberta's provincial finances.
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Wow. How could you get one of the most basic facts about this story completely wrong, in your Headline? Ottowa did not impose a retroactive tax. Existing Trusts have a four year grace period, until 2011.

I appreciate the coverage you are doing on the subject, and all the good info you provided. But your headline is flat out incorrect. Ouch.

Good luck.


Ottawa imposed taxation, albeit with a delay (as is covered in the article), on the existing trust sector. This is a retroactive change in taxation law that impacts adversely on trusts now despite the delay until the tax will actually be payable.
Failing to grandfather existing trusts and abolishing them in just 4 years is retroactive.

I bought a business model and future income streams when I bought three Canadian Hydro Income Trusts (Great Lakes, Innergex & Algonquin).  The Tories had been elected on an explcit promise not to disrupt these.  They have retroactively taken away the future income streams that I was promised.


I'm not defending the Tories on this, and I agree what they did is nasty and counter to your expectation of future income, but it is not retroactive!  Retroactive means "taking effect from a date in the past".  The change in taxation of existing trusts takes effect in the future.  Past != future.  It's not retroactive.  Period.

Look, this sort of tinkering with the tax system happens all the time.  There used to be a lifetime $100,000 capital gains exemption in Canada.  It was repealed in 1994, just before I had a chance to use it.  Annoying, yes, but not retroactive!  (As I recall it wasn't retroactive, anyway.  The point is that changing the rules may change what people expected to get and how they may have behaved in the past had they known what would happen, but that doesn't ipso facto make it a retroactive change).

(There is still a $500,000 capital gains exemption on the sale of "qualified small business corporation shares", I'm talking about an exemption that applied to any capital gain.)

It's very unusual to make new policies which suddenly alter market value of major, widely held investments by declaring their fundamental business model to be illegal.

For instance, if the Federal government suddenly declared all extant municipal bonds to be subject to tax, what would the reaction be.

It's very unusual to make new policies which suddenly alter market value of major, widely held investments [..]

Right.  I'm with you.

[..] by declaring their fundamental business model to be illegal.

Ummm, perhaps we need to buy everyone here a dictionary.  They did no such thing.  I sure hope income trusts aren't "illegal", anyway, because I own units in a bunch of 'em.

Last time I checked, the value of ALL financial assets is, the present discounted value of EXPECTED future cash flows. You don't buy stock for past earnings, but for future earnings. The fomula is: PV = cf1/(1+r1) + cf2/(1+r2) +...+ cfn/(1 +rn)

where PV = present value
cf1 = cash flow received in period 1
r1 = risk free interest rate (ie Tbill rate for example) in period 1

In case anyone thinks this is a just a theoreretical exercise, let me tell you what happened to a prominent Canadian energy trust when word of the retroactive taxation hit the wires. The Enerplus Resources Trust closed at $54.30 per share on October 31, the last pre-announcement day. Two days later on November 2 it closed at $39. Similarly the PennWest Energy Trust closed at $37.52 pre announcement and $29.80 on November 2. Slashing expected future returns slashes current value.

While my point about slashing future value equals slashing current value still stands, I need to correct the formula quoted above.

PV = cf1/(1+r1) + cf2/(1+r2)*2 +...+ cfn/(1+rn)*n

where the double asterisks denote "raised to the power of." Thus the divisor of the second term to the right of the equal sign should read, (1+ r2), squared.

Slashing expected future returns slashes current value.

Yes, so?  The same thing happens when the trust itself announces a cut in distributions.  Is such an announcement "retroactive"?  Of course not - it affects distributions in the future.  The proposal to start taxing distributions in four years is also something that takes effect in the future.

Why is this concept so difficult to understand?

When you invest you accept a number of risks.  I have been affected by the proposed changes to the tune of ... oh probably more money than anyone else who is whinging about it here.  Yes, it's a bitch, but you can't say you weren't warned:

From Enerplus' March 7 2006 prospectus, page 2:

The actual amount distributed will depend on numerous factors including: the financial performance of the subsidiaries of the Fund, debt obligations,
commodity prices, production levels, working capital requirements, future capital requirements, applicable law and other factors beyond the control of the Fund.

(I added bold face to highlight critical words)

Or how about their 2005 annual report, page 86:

Government royalties, income tax laws, environmental laws and regulatory requirements can have a significant financial and operational impact on Enerplus. [..]

[..] In the January 2006 election, the Canadian Liberal government was replaced by a Conservative government.  Both parties are on record as stating that they do not intend to change the tax treatment of trusts. Nevertheless, there is always a risk that the Canadian government may reconsider its position and propose changes to the tax regime that could negatively impact the Fund.

(I added bold face to highlight critical words)

I was seriously whacked by this as well.

The assertion by the Canadian government that the US doesn't allow these structures is not true at all.

There is something in the US called a "master limited partnership" with the same flow-through income principle---you get a K-1 form attributing income and return of capital etc to the unitholders.   These trade on US exchanges---you can buy production from, e.g. Prudhoe Bay (BPT), etc.

Perhaps the right message wasn't that the US and Australia had "banned" this trust structure (not really true) but that they might have been better to follow Canada and increase use of this.

The result was a class of investments which in practice were intermediate between bonds and common shares, and clearly filled a need.  

Failing to grandfather existing trusts and abolishing them in just 4 years is retroactive.

Not by any normal definition of the word "retroactive" it isn't.

Enacting a tax means it applies to future revenue.

Enacting a retroactive tax means it applies to future and past revenue.

If the new tax was applied to income trusts starting in 2005, then it would be retroactive.  It doesn't, so it isn't; it's just a normal tax, much like any other tax.  It may or may not be a bad tax, but calling it "retroactive" seems like little more than misleading rhetorical hyperbole.

Sorry, guys, but I just can't help it:

"You keep on using that word.  I do not think it means what you think it means."

taking effect from a date in the past

I have not argued that the tax is retroactive, but that the law itself is retroactive in its effects. This legal change wrong-foots previous investments made in good faith by invalidating the assumptions they were made under, not only with no warning but in the face of an explicit promise to the contrary. For investors who relied on this very specific commitment - and there are many of them - this change is retroactive.

the law itself is retroactive in its effects

No it bloody well isn't.  Of course expectations of future cash flow are a part of current valuations.  When conditions change the current valuation changes.  The government's (proposed) changes affect current values, but they do not affect anything that happened in the past.  They just don't.  It is not retroactive.

Or perhaps when a trust announces a change in the distribution to be paid in the next month that is a "retroactive" change?  When the prime interest rate changes that is a "retroactive" change applied to all bonds?

Whether the change was right or not is irrelevant to this question.  The law is not "retroactive in its effects".  Arguing it is, and placing such an absurd statement right in the title of the article, discredits it.  If you can't see that, then... well, that is enough, I shall say no more.

So what?  You've been living high off Canadian resources hog; now we're stopping the imperialist expoitation.  Get it?
The Canadian companies I invest in own hydroelectric dams on both sides of the border AND they continue to improve them and build and buy more.  Algonquin recently built the first wind farm in Manitoba (99 MW).  Great Lakes recently got a contract to build a 49.9 MW run-of-river hydro plant in BC in co-operation with a First Nation. etc.

So my investments in Canada helped expand the supply of renewable energy.

Exploitation ?

The alternative is to let the wind & water go past and burn more fossil fuels instead.


"The alternative is to let the wind & water go past and burn more fossil fuels instead."

Or, alternatively, find another mechanism of capital formation.

Any suggestions ?

These hydro income trusts picked up a portfolio of "dogs & cats" that, in most cases, had been ignored by their prior owners or operated & maintained by non-professionals.

So pre-existing capital sources had not done a good job.  What successor type will ?


Didn't you read the part about how most trust ownership is Canadian?  You're exploiting yourselves?  
Whoa, for a minute there I thought I popped up the site of the Republican National Committee by accident.  Who'd have thunk we'd hear arguements against taxing oil companies on the Oil Drum?

The Canadian government had their hands forced by the fact that a major Canadian company (Bell Canada?, I forget) announced they were going to convert to a trust.  And why not?  Why pay more taxes than you have to.  This would have been the start of a major loss of tax income for the government.

So they want to change the law, for everybody, with a 4 year grace period for existing trusts.

Oil is at $60, high enough to coax a lot of marginal production from old fields.

Seems a little incongruent to argue "Peak Oil is coming, oil prices are gonna skyrocket!" and, "Hey, you tax my oil trusts and the oil is gonna stop flowing."

Gregor is right, the new tax regime is not retroactive.  Take this from a tax lawyer, which I am.
Guys, he's saying it's a (retroactive (tax law)), not a ((retroactive tax) law).

The law itself is retroactive in that it applies to trusts set up in the past, not just to new trusts set up in the future.  He's not saying that the tax is applied retroactively to past income.

So, every law enacted by every government in the world that affects existing people and legal entities is "retroactive"?


Yes, the Tories should not do the exact opposite of what they said they would do, but the government sets the laws, and can change those laws at any point.  Tax laws change.  Heck, I believe if you read the legal documents issued with the securities you will probably see this mentioned as one of the risks!

As others have pointed out below, it's most definitely a retroactive change.  The worst part about this whole mess is that it could have been entirely avoided.  The Canadian government has claimed they were focused on future trust conversions.  Full grandfathering of existing trusts, with maybe some limitations on M&A activity would have been perfectly fine.  Instead, the government lashed out like some paranoid, cornered rat.  There is no nice way to describe what happened.  

Rules were established on what was legal business and investment relationships, and an additional pledge was made that such relationships would not be changed.  Granted, conditions change and sometimes governments need to make policy changes.  Fine.  But if their claim that they were worried about future trusts was true, a wide range of other options were available.  The finance minister even lied while attempting to justify his decision, noting that it was just discovered that major oil and gas companies were thinking of converting to the trust model.  Encana admitted this month that in 2005 it submitted to the finance ministry a proposal to convert into a trust.   I discussed some of these issues in an article I wrote about two weeks ago:

During the last couple of weeks I've spoken with analysts and executives.  The overwhelming feedback I've found has been dismay and frustration.  To be perfectly blunt, I don't think the Canadian government has a clue how much damage this will do to secondary recovery efforts in the oil and gas industry.  For a couple of years, we'll be going through a period of capital constriction, and oil and gas production is going to fall.  It'll likely be a "temporary" problem because eventually, attractive assets will be put into production within viable business organizations.  But the transition period is going to extend over a period of years and will be anything but smooth.  

It's really hard to try nail down estimates.  Something like 20% of Canada's oil and gas is produced by income trust companies, and much of this production is focused on secondary recovery efforts ideally suited for the trust business structure.  Maybe we're looking at a situation where some ten percent of this 20% figure will fall temporary victim to business organization transition?  I don't know.  Time will tell.  Other wrinkles are clear as well.  Many small E&P juniors could get seed funding and run viable exploration efforts given the role trusts played as an "exit strategy."  Take the trusts away and part of the exploration ecosystem is damaged.  Large companies like Encana don't have time to deal with small reserves and if the pool of ready buyers for the junior E&P market economy shrinks, the net exploration activity will eventually shrink as well.

Many analysts make convincing arguments that trusts did not pose a threat to net taxes receipts.  Even in the business trust arena, a great deal of productive economic enterprise blossomed as small and midsize companies were able to tap the equity market for the first time through the trust model.  The finance ministry would like Canadian's to believe that Canada was at risk of becoming an "income trust economy," and that productivity was going straight down the toilet.  That's hyperbole, at best.


Canadian oil and gas trusts now produce approximately a million barrels of oil equivalent per day, or one in every five barrels of production in Western Canada.

This is a very interesting twist on the Westexas' Export Land Model (WTxLM). Rather than the producer redirecting supply from export markets to satisfy growing internal demand, we have a producer altering the tax regieme resulting in the potential elimination of 1 mbpd.

Throw that figure into Kehbab's charts and look where we end up.


Ummm.... elimination of production?  Not.  The production is still wildly profitable, why would anyone stop producing?

As for 1 million barrels per day being 1/5 of Western Canada production - I think not!  Canada does not produce 5 million barrels of oil per day!

I also think the headline is incredibly misleading.  The change in the law is NOT retroactive.  By this argument taxation law can never be changed because if people had known what the law would be changed to they would have behaved differently.  That's true, but irrelevant - no one can know the future.  It is particularly ironic to apply the word "retroactive" to a change that will not actually impact the operation of the trusts in question for four years.  Usually taxation changes are immediate or apply within a short time span in the future.  Sometimes they apply to the past taxation year, in which case the word "retroactive" does apply.

That is not to say I think the government's action was a good idea, or that I think it reasonable for the government to do exactly what they promised to NOT do, but please: the headline discredits an otherwise interesting article.

What's interesting about it?  It's just a rehash of American Imperialistic free market horse bleep.  They won't be able to steal from Canada, and they're squawking!
This action is going to have the desired investment effect I want. I do not want the existing oil companies to invest in new oil fields unless there is clear evidence for returns. If there is clear evidence, then they should be able to raise capital elsewhere.
Peak Oil says it -- you waste your money on exploration when the oil is not there you are depleting share holders wealth. Just cut me the dividend cheque and don't drill where there is no oil. The money just ends up as big pay cheques to some oil service company or some grand research scheme that will tell them that they should not be drilling.
Many of the trusts have been quite good at growing reserves, so, in fact, the reserves are there, they are just marginal or depleted fields.  Fields like that won't stop Peak Oil, but removing development of such fields certainly won't help matters.  
An all around excellent article, and frankly, an excellent decision by the Federal Government (and please, no grief about your wallet being impacted.. mine was too.  When people begin to abuse the rules of the game you've got to be an idiot not to recognize that the rules are going to get changed to put a stop to it.)

As for future o&g production, I agree, it will have a negative impact in the short term.  But this is good RE: PO.  I'd much rather have a few mature fields that still can have some life squeezed out of them in the future when oil is scarcer, then squeezing them dry now for essentially no benefit other than the bottom line.

I agree that Flaherty had no choice but to remove the tax advantage for new trusts in order to forestall a domino effect. However, changing the rules in the middle of the game for existing trusts, especially after explicitly promising not to, is much less defensible. Personally, I think making that promise in the first place, evidently without thinking it through, was extremely rash. If the promise had never been made, there would now be fewer disillusioned investors.

I would also argue for energy trusts as a special case. Trusts have facilitated much greater Canadian ownership of our own energy resources than would otherwise have been the case, and taxing them in this way threatens that ownership and the revenue stream which enriches Canadians as a result. I find it ironic that I am accused (in an earlier comment) of advancing an American imperialist agenda, when I am concerned about protecting, and making best use of, Canadian assets for Canadians. The last thing I want to see is for the Canadian energy sector to be raped in a series of private equity strip'n'flips, but that is exactly what this legislation could end up achieving.

By the way, I should point out that I am not personally affected financially, either directly or indirectly, by the Canadian government's decision to end the tax advantages for income trusts and therefore have no axe to grind. My interest in this matter is intellectual.

can we give the um   ....... canadians credit   they are at least taking a stab at fiscal responsibility     a concept  completely foreign to our brilliant leaders in the u s of a    and i have stated in other forums     bush's fiscal irresponsibility is the physical equivalent of anal sex without a condom   and the american public is the penatratee
Who was abusing anything?  Look at the chart linked above.  It shows where the big problem was: business trust conversions.  Oil and gas trusts were just doing what they were set up to do.  Business trusts were an abuse of the system, but oil and gas trusts were not.  
Great review.

Canada last changed its tax rules on energy trusts allowing more US investment as recently as mid 2005.  Here we are a little over a year later, and the rules have changed again.  Something investors might possibly expect in Russia or South America - but not from Canada.

In additon, the 15% rate of tax paid by US citizens is set by treaty with Canada.  Canadian residents also benefit from this treaty.  I don't think that when taking all investments into consideration by both countries, that much tax revenue is 'lost' by Canada.

Under the terms of NAFTA, trade disputes are to be settled by negotiation.  Granted this is not a trade dispute, but a kind of taxation without representation imposed on US residents.    


_"Granted this is not a trade dispute, but a kind of taxation without representation imposed on US residents."

I'm surprised that you would expect otherwise. This is the case for anyone making investments in foreign markets. Being an investor does not automatically give you the right to vote in another country's elections. I very much doubt US citizens would be willing to grant such rights to foreign investors.

I think you've missed my point that this kind of event is covered by treaty.

If you check out the US-Canada tax treaty
either country is prohibited from imposing large changes in their tax system, and also, imposing additional new taxes on the residents of either country.

I don't know if Canada intends to abide by the treaty, but I ma going to inform my representatives to pull out of the treay unless its fairly implemented.  

I believe that you are misinterpreting the intent of the treaty, which is to eliminate double taxation and provide a lower rate of non-resident tax withheld on taxable income. If the US were to withdraw from the treaty, then a flat 25% withholding rate would be applied by Canada on your Canadian source dividends and intest payments prior to your receiving them -- probably not what you want.

If the treaty truly means what you suggest, I'd say by all means go ahead and ask your representatives to pull. I would find the implied loss of Canadian sovereignty appauling and would ask our government to do the same.

Oh goody, then the United States will be returning the $5 billion in duties on softwood lumber that were assessed contrary to the treaty?  Glad to hear it.
Oh boy... red rag to a Canadian bull.

'under the terms of NAFTA, trade disputes are to be settled by negotiation.'

Would that be the Softwood Lumber negotiation then: aka the US decides, and ignores whatever tribunals and courts have to say about it?

If domestic politics can drive the US on Softwood Lumber, then crocodile tears for US investors.

I must admit I saw this one coming miles off, and was screaming high and low to my Canadian rellies that the tax leakage was too large, more and more dodgy trusts were being stuffed by greedy investment banks into the hands of naive investors, etc....

Since 'I told you so' are the 4 most irritating words in the English language, you will be relieved to know that my father ignored my advice ;-).

Ok, so the income trust model is great for the oil and gas industry. How is it for renewable energy companies like a wind energy company?

To me, it seems like income trusts would make it hard for growth oriented corporations to compete for capital.

Algonquin Income Trust developed the first Manitoba wind farm of 99 MW, as well as hydro projects.  Great Lakes & Innergex also were developing new small hydro projects.

The small (some as small as 2 MW) hydro projects are not very attractive for many investors.  But these income trusts bought up a large number, used professional management and improved them as needed (many were neglected and lost effiency/generation as a result).  They also developed small sites at existing dams where no one had bothered to install, say, a 6 MW hydro power plant. They have a decent % south of the border.

I thought of these investments as doing good as well as giving a good return with a decent long term inflation hedge.  Risk of dry weather of course, which I accepted.

But I did not realize that I was just exploiting Canadian natural reosurces !  (And US hydro resources as well).

A loss for renewables as well.


The whole change has been nothing but bad.  Canada had a problem, that there were no limits on trust conversion or what sort of companies could operate as trusts.  Rather than sensibly address that problem the Canadian government decided to throw the whole trust structure into the trash bin.  To make matters worse in justifying the change they outright lied about things (ie: there not being a similar structure in the U.S., a blatant lie).  

What really irks me is the people who don't own any investments who dance around gleefully whenever someone else is screwed over, and accuse them of only caring about their pocket book.  You know, most of us are small time investors, who are trying to do the best we can within the system as it stands.  We're not big money billionaires with palatial estates and not a care in the world.  If we were, then we wouldn't be complaining about this, we'd be the ones planning to buy up trusts and take them private.  Big money investors were not harmed by this in the least, it's us small fries who have gotten hurt.  

I am all for fairness in terms of business and taxation.  I am perfectly willing to vote against my own interests in order to advance the common good.  I would be willing to accept a change in the trust structure if it made sense, but this far crosses the line into idiocy.  Anyone owning trusts has simply gotten screwed without there being any longterm benefit whatsoever.  

Thanks for the all the information as a Yankee Imperalist Trust owning Dog (married to a Canadian) I really appreciate the information contained in this post and the solid analysis of the impacts.  I also agree that destroying the Trust and Trusts by the Tories was a blatant act of war on the individual investor community. It appears that Trust conversion by the non-energy sector should be addressed and further conversions stopped.  However by not grandfathering the existing trusts or providing a more realistic conversion period say 10 years instead of 4 the government has destroyed 20% of our wealth.  There are enough other market risks for investors without the government throwing additional bombs at us.  
By offering this incentive to smaller companies Canada continues to maintain production from their depleting assets that would otherwise not be properly managed.  I can think of many transactions and some pending sales to the Trusts from the Multi National Oils that have or will improve and extend the life of those assets. In reference to Alan's posts the investment by the Hydro and Wind trusts into assets that otherwise would not be productive and thereby gleaning additional clean sustainable energy provides a valuable service not only for its investors but to society as a whole.  It seems like a no brainer for me.  The trust vehicle could be a way to further encourage production in the States and should be tool that we employ to encourage renewable energy.
I fully endorse Nagoraks post and take offense at those that seek to punish the small investor for choosing to  invest their assets in investments versus over consuming cars, lake houses, boats and other material goods.
Your second paragraph seems to support my thinking.

Let's say I wanted to start a small wind farm project, but couldn't promise the kinds of dividends required to qualify as an income trust. My company would be taxed as a conventional company. A huge income trust could develop such a small project at a reduced cost for capital. To me, this seems to push the balance in favour of large income trusts rather than small companies. (Obviously, one could develop a small company with the hopes of it being bought up by a large income trust.)

And I'm not grinding an axe here. I'm more or less agnostic on the income trust issue (although I did take a  hit on this, but since my investments are quite broad, it was small).

Given the large number of potential wind sites in Canada, the actions of Income Trusts take nothing away from small (or large) companies.  By increaasing demand for cranes, extending transmission, etc. they may help other players.

I trust that Manitoba has room for more than one 99 MW wind farm.  If you want to build the second one, please do so !


It's not a good move for the energy sector.  And I mean renewables as well as O&G.

Indeed there is at least one wind income trust.

Actually I think a wind farm project might be pretty ideal for an income trust as it provides a fairly reliable return after the initial installation costs.  There is no fuel and only minimal maintenance, so that should result in a lot of free cash flow to pay a dividend.  

I am no expert, but I am not certain there is a requirement in terms of the size of the dividend for a trust.  The requirement, as I understand it, is that most of the profits need to be passed on to the unit holders.  It's a system that benefits some types of companies much more than others.  Oil and gas trusts are one of them.  Restaraunts are one that do not benefit from it.  You can see this in many trust conversions that have really bombed nad been forced to suspend their dividend entirely.  

I think the income trust model is beneficial for certain companies.  To that extent it may create some competition with other similar sized companies which do not benefit from the trust structure.  At the same time, I think a larger impact is it makes these certain smaller companies competitive with much larger corporations.  I believe that was the whole point behind the trust structure in the first place, especially in regards to oil and gas trusts.  

To me it seems like the problem was there being no limits on what could be a trust, rather than the whole thing being bad.  If the trust structure had been properly viewed as an incentive for certain kinds of businesses and restricted to them (such as oil and gas, oil service and also alternative energy generation) then that would have been fine.  Getting rid of trusts entirely seems like an extreme overreaction.  

Great tax dodges never last forever.

This is not great for the energy industry (renewable and O&G).

I would have liked to have seen the government simply narrow the scope to what the trusts were originally intended to do ie industries with depleting assets:

-depleting natural resources (such as oil and gas)

The actual measure strikes me as confiscatory.  But see above.

Of course the other guy (aka the Federal Liberals) got slated for leaking insider information during the election campaign on this very issue.  Since I 'voted for the other guy' in this one, I feel a certain sense of schaudenfreude.  Harper's bulletproof armour, ain't.

Wonder if we'll ever see him admit there is global warming.  Now that would be a reversal.

I agree with you, it seems like just narrowing the trust structure to encompass certain companies would have solved the problem.  Personally I wish that was what was done.  
For those who objected to the title of this piece, I have altered it in order to avoid courting unnecessary controversy. I have not changed the substance of the article in any way, but I felt from the comments that the title seemed to be deflecting attention from the real debate.
Thank you.  Right at the start the article still makes the same claim, however:

"this experiment in retroactive tax policy"

Whatever.  I know the definition of "retroactive".

Now, in the interest of accuracy and to be the opposite of difficult :-) I should apologize for initially missing the word "equivalent" in

Canadian oil and gas trusts now produce approximately a million barrels of oil equivalent per day, or one in every five barrels of production in Western Canada.

I commented that Canada does not produce 5 million barrels of oil per day, which is true but irrelevant.  The difference is natural gas.  The figures I see at are 2005 production of 2.51 million barrels per day of crude oil and equivalents, and 17.1 billion cubic feet of natural gas.  Six thousand cubic feet is energy equivalent to one barrel of oil, so 17.1 billion cubic feet would be 2.85 million boe, making total Canadian production of oil ("conventional" and oil sands) and natural gas 5.36 million boe/day.

Did I get that right?