Flaherty explains why he won't change rules on Income Trusts

"It's the law now" Jim Flaherty's reason for not revising IT double taxation rules that destroyed $35 Billion of Canadian's savings on October 31, 2006.

"It may be the law, however the full destructive effects don’t kick in until 2011. There’s still time to avert disaster. Meanwhile it's pathetic how bad laws, based on Lies and Myths, are easy for Tory's to uphold but good laws like Election Timing are easy to break." Brent Fullard, CAITI




Related:
Flaherty refuses the $50,000 debate challenge - CAITI

$50,000 offered in scholarships if Flaherty will debate income trust tax - The Green Party

Flaherty's proof, 18 pages of blacked out documents

The Conservatives are more focused on saving face and not admitting they made a mistake - John Dielwart, Arc Energy Trust

"I personally and we collectively were quite naive a year ago at this time. We thought the facts mattered. We thought getting it right was the most important thing.

Our coalition has delivered a report that clearly refutes every single reason the government gave for acting against energy trusts and any objective viewer sees that we have an incredibly strong case including their own witnesses at the finance committee hearings. But quite frankly they are more focused on saving face and not admitting they made a mistake although clearly they have.

Therefore with this government, with this finance minister...

We're optimists, if we weren't we wouldn't be in this business. You always think there is hope, but there's more hope with a different party in power."
John Dielwart, October 31 2007



Additional Information:
How the Conservative decision impacted Arc Energy Trust

Nov 1, 2005 - Oct 31, 2007

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Do Energy Trusts Cause Federal Tax Leakage?

No. Federal and provincial government revenues are actually enhanced by the energy trust structure. During the past five years, CCET member trusts have generated greater taxes both provincially and federally than would have occurred had they been structured as corporations.

In 2005, the oil and gas trust sector generated over 30 percent of the tax revenue collected from publicly-traded Canadian entities in the oil and gas sector while representing only 16 percent of the revenue. Oil and gas royalty trusts have also generated over 40 percent more taxes than Canadian publicly traded senior independent producers on a unit-of-production basis.

The capital intensity of oil and gas exploration and production generates significant tax pools. As a result, oil and gas exploration and production corporations have historically paid minimal corporate taxes. In contrast, distributions from energy trusts generate:

• current personal income taxes from Canadians;
• additional tax from compounding investment in tax-deferred accounts; and
• a 15 to 25 percent withholding tax from foreign investors.
  

Because most CCET unitholders live outside Alberta, where all energy trusts are based, Canadians throughout the country share in the distributions paid and their provinces of residence benefit through hundreds of millions of dollars of increased tax revenues. Alberta, in turn, receives the benefit of additional
royalties on mature oil and gas producing assets, spending on goods and services in the province, employment and associated taxes, and all of the ancillary economic spin-offs associated with increased activity.
Source: Canadian Energy Trusts: An Integral Component of the Canadian Oil and Gas Industry

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A perspective on U.S. Flow-Through Structures

In support of its decision to tax trusts, the Department of Finance (DoF) stated that other countries (in particular the U.S. and Australia) had previously taken steps to shut down similar flow-through structures. We do not believe that this is an entirely accurate description. In the U.S., there are approximately 214 publicly traded flow-through entities, including master limited partnerships (MLP), limited liability corporations (LLC) and trusts, with a combined market cap of over $465 billion.

In this report, we provide some background on flow-through structures in the U.S. We also look at how U.S. flow-through valuations compare to Canadian trusts. In our opinion, these U.S. flow-through entities could become acquirers of Canadian trust assets over the coming years given the former’s significant cost of capital advantage and the suitability of the Canadian trust assets for their structure.

U.S. flow-through structures are essentially the same as Canadian trusts. The majority of pre-tax income is passed through to individual investors in the form of distributions and each investor pays personal tax on his or her distributions.

While the income of these entities must come from specified sources to qualify, the definition of these sources covers a broad range of industries, including oil and gas (production, transportation and refining), mining, fertilizer, propane distribution, timber and real estate.
Source: Digging Deeper

“Halloween massacre‘‘ still horror story for oilpatch one year later

TORONTO _ Major oil patch players say Finance Minister Jim Flaherty‘s “Halloween massacre‘‘ has turned into a full-blown horror story a year later, with oil and gas income trusts more prone to foreign takeovers and less able to access capital.

“We‘re not just a bunch of spoiled brats concerned because a toy has been taken away. This is something that is an enormous mistake,‘‘ said John Dielwart chief utive of Arc Energy Trust.

Dielwart, whose company was among the first to adopt the popular investment model, has been one of the most vocal opponents to Flaherty‘s plan to impose a 31.5 per cent tax hike on income trusts by 2011.

Dielwart said Flaherty made a big mistake in interfering in capital markets, which helped a $100-billion energy trust sector.

“It wasn‘t a gimmick, it wasn‘t based on artificial tax advantages. It was based on a very solid business model,‘‘ he said. “This was, if not the optimal model, it was pretty darn close.‘‘

Eilat warns that Canada‘s oil and gas sector _ owned and operated and run by Canadians _ will get back into foreign control “and I don‘t think anybody wants that.‘‘

One key example is PrimeWest Energy Trust, which Abu Dhabi-based state-owned energy firm TAQA is proposing to take over for $5-billion.

“We‘re going to see a lot more of them fall into foreign hands,‘‘ said Ross Freeman, a partner in Calgary‘s Borden Ladner Gervais LLP, but he adds that most of the activity won‘t happen until the four-year grace period comes to an end.

“The vast majority of the royalty trusts are still out there. They‘ve hung in there. They‘re trying to take advantage of the remaining grand fathering period. But they‘re under increasing pressure to do something and certainly there‘s a lot of pressure from overseas,‘‘ Freeman said.

He says the biggest losers from the income trust decision have been junior producers.

“Killing income trusts was a very, very severe blow, not just to the income trusts themselves, but to the whole junior sector, and that‘s where the impact, I think, was grossly underestimated by a lot of people,‘‘ he said.

With the weakening of that structure, juniors are getting less investment and fewer are being “gobbled up‘‘ by other trusts.

“The amount of financing the juniors were able to be doing just crashed. They just couldn‘t get investors any more,‘‘ Freeman said.

The majors, on the other hand, are doing ok, he said.

“They were never in the model of distributing their cash flow. They were not a yield investment. Even the very largest ones pay only very modest dividends. So clearly they‘ve been the winners of all of this.‘‘

They majors have also done well in the face of the income trust decision because it‘s brought their operating costs down, Freeman said. The cost of drilling has plummeted by more than 50 per cent over the past year, leading to the creation of far fewer wells.

“From an oil and gas company‘s perspective, that‘s a positive, it‘s cheaper to drill. Not so good if you‘re a drilling contractor,‘‘ he said.

Les Stelmach, an analyst with Bisset Income Fund agrees larger players may not have so much to lose in the short term.

“They‘re large, they have diversified asset portfolios, so they‘re less sensitive to changes in commodity prices or changes to royalty rates. They‘re certainly a viable business 2011. For smaller trusts, they, too can be very viable,‘‘ Freeman said.

He says smaller energy companies can also remain viable if they carve out the right course.

“The crux of the matter is they can‘t pay as much for property so they‘re less likely to be as acquisition focused as they were in the past,‘‘ he said, adding producers that have carved out specific niches will do better than ones that rely solely on acquisitions.

As the chief of one of the so-called “majors,‘‘ Dielwart said he disagrees that the bigger companies aren‘t taking as much of a hit. He said his company saw a 25 per cent decrease in capital from pre-Oct. 31, 2006 levels.

He also takes issue with the argument that values have somewhat recovered since the initial blow. Arc Energy units are trading about $7 below what they were a year ago, which Dielwart blames on the income trust decision.

“One one who suggests that values have recovered are just not doing their homework,‘‘ he said.

Meanwhile, ripples are being felt south of the border, too.

A Chicago couple, saying Flaherty‘s move has cost Americans and Canadians billions of dollars in lost investments, is using a provision of NAFTA to challenge the Conservative government‘s move.

“The Halloween 2006 income trust decision by the Government of Canada has had a massive financial impact on thousands of investors in Canada and the U.S. and we believe that it breached Canada‘s NAFTA obligations,‘‘ Marvin Gottlieb said in a statement Tuesday on behalf of himself and his wife.

“Because of this decision, more than $30 billion has been lost by individual investors in Canada and more than $5 billion has been lost by energy trust investors, including Elaine and me, in the United States.‘‘

Source: Oilweek Magazine - Canadas Oil and Gas Authority

Harper and Layton’s made in Abu Dhabi policy of raiding seniors’ nest eggs

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Canada Under Seige: Thanks Harper and Flaherty - Diane Francis

Canadian policies are facilitating the buyout of Canada. Canadian energy trusts are bought with 100% financing borrowed from foreign lenders or entities. Interest payments are made from Canadian cash flow which used to be distributed to trust unitholders and taxable.

The interest payments to foreigners are also exempt from the 15% withholding tax. This means that taxable cash flow has become tax-free mortgage payments to buy energy assets. More...

Related:
Jim Flaherty's Folly

Primewest Energy Trust -Bought for Nothing Down & No Income Taxes

The TAQA deal structure uses two corporations, both private, one to lend the funds and the other to own the equity. This permits the entire amount of cash flow to be pulled out of Primewest and directed thru the Canadian corporation to a non-resident entity to eliminate Canadian income tax. Flaherty has just signed an agreement with the US permitting interest payments to leave Canada without withholding taxes. His intention is to extend this agreement with other major tax jurisdictions. The withholding tax removal by Flaherty validates the use of debt by non-residents to purchase Canadian resident businesses.
Source: IncomeTrustResearch.com

Primewest - The First of the Majors to Go

The first of the large cap Canadian energy trusts is in process of being acquired by TAQA North Ltd. a subsidiary of Abu Dhabi National Energy Company for $C26.75 per unit. The update reviews the pricing of the deal and provides valuation parameters for Bonterra, Pengrowth, Canetic, Trilogy, Fairborne, Arc, PennWest, Enerplus and Crescent Point.

Our valuation approach has been to establish a lower end value based on the price a purchaser would pay for the proved plus probable reserves. This price is $2.50 per mcf for natural gas and $18 per bbl for conventional oil and $1 for undeveloped oil sands reserves. The Primewest transaction provides an arm’s length actual transaction for the large cap energy trusts to compare and validate our valuations. As an additional benchmark I consider the cash flow that was being used to pay distributions, which is now available to the purchaser to fund the before tax interest cost on borrowings should they decide finance the transaction. The cash flow from distributions is adjusted, if necessary for the potential need for distribution reductions. This number is supported by our revenue and cost per boe analysis which has been the backbone of our valuation methods for 3 years.

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The estimated replacement cost values have been listed on a table accessible under Energy Trusts on the front page of IncomeTrustResearch.com. These values have been available since Q4-06 following the release of the income trust taxation legislation.

On a replacement cost approach we valued PWI.UN at $23-$24 including the reserves acquired following the merger with Shiningbank. Just prior to the acquisition announcement units were trading at $20 which makes the offer appear to be at a large premium. Alberta oil and natural gas producer values declined last week following the announcement by the provincial government of a report recommending an substantial increase to crown royalty rates. As are result of the decline from the pending royalty review the offer from TAQA appears somewhat generous and the timing is very interesting.

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TAQA is a foreign purchaser with government ownership that could run afoul of Canadian regulators. Primewest has been very active in the Canadian trust lobby with senior executive George Kesteven as the President of the Canadian Association of Income Funds. It was just a matter of time until one of the major Canadian energy trusts would enter into a sale transaction to escape the impact of the trust legislation. It is interesting that Primewest who have been an aggressive advocate against the trust tax are the first to go, giving the appearance they are testing the waters and just before a possible federal election.

On a mcf basis TAQA paid $2.15 or $13.30 per boe. Primewest reserves are 70% natural gas and by this measure they paid less than the $2.50 going rate. The distribution which was being paid to unit holders totals $435M annually and is at risk of a 30% reduction. Even at the reduced amount the distribution would fully pay the interest on a 6%, $5B loan. TAQA is buying Primewest for nothing down should they choose to borrow the funds or they can use the distributions for reinvestment.

By our estimates TAQA paid a 13% premium to our replacement cost value and on a free cash flow basis the deal was priced at a 6% cap rate. As a result of this transaction we are including a free cash flow based value using a 6% loan rate to determine how much debt the purchase price can support. This establishes an upper end value. The TAQA deal structure uses two corporations, both private, one to lend the funds and the other to own the equity. This permits the entire amount of cash flow to be pulled out of Primewest and directed thru the Canadian corporation to a non-resident entity to eliminate Canadian income tax. Flaherty has just signed an agreement with the US permitting interest payments to leave Canada without withholding taxes. His intention is to extend this agreement with other major tax jurisdictions. The withholding tax removal by Flaherty validates the use of debt by non-residents to purchase Canadian resident businesses.

Another interesting aspect of the deal is that Primewest is weighted to natural gas where prices have been weakest in comparison to oil. The purchasers have elected to buy the commodity with the weak price trend in expectation of better days ahead, if not this year then within 3-5 years. TAQA has deep enough pockets with $800B in assets to be patient with the $5B purchase of Primewest. There is also the uncertainty about the Alberta government’s review of crown royalties that could increase royalties by up to 50%. This is another risk that TAQA is prepared to accept. Despite reports in the Globe that TAQA is flush with cash and is overpaying for Primewest, the numbers do not support this conclusion. TAQA appears to know exactly what they are doing and have made a very good purchase that includes bargain priced reserves and an excellent management team.

We are in the process of updating the table on energy trust values which reconfirms the lower end value ranges and adds an estimated upper end cash flow based value. The buzz from the Primewest deal will likely fade setting the stage for another possible purchase. If unit prices approach the lower end replacement cost values accumulation is recommended.

Pennwest has agreed to buy Vault Energy Trust paying $14 per boe, $2.33 per mcf including land. Vault is 68% weighted to natural gas. The metrics on this transaction are attractive to Pennwest and supportive of our $2.50 per mcf natural gas value benchmark.

We will be updating the replacement cost and cash flow based values for all energy trusts and advising as updated.

Recommended Prices by Trust

As comparables, replacement cost values for PWT, ERF and CPG are $30, $48 and $17-18 respectively. Our next most favourably priced recommendations are Pennwest Energy (PWT.UN)at $30.25 or lower, Enerplus (ERF.UN) at $48 or lower, Crescent Point Energy Trust $20 or lower.

This also brings into play Peyto Energy (PEY.UN) with a replacement cost of $20 and current price of approx. $18.50

Bonterra Energy Trust (BNE.UN)

Replacement cost value is $25 per unit, and on a cash flow approach using a 6% cap rate they are valued at $30 per unit. Crown royalty costs jumped in Q2 due to retroactive adjustment, however they still have one of the lowest crown royalty rates in the energy trust sector. Recommended at $28 or lower.

Pengrowth Energy Trust (PGF.UN)

At $18 per boe, total enterprise value is $4B net of debt , approx. $17 per unit at replacement cost. On a cash flow distributions should be reduced by 75% which still allows for approx. $250-$300M of free cash flow providing firm support to the $17 per unit replacement cost. Recommended at $18 or less.

Canetic Energy Trust (CNE.UN)

Canetic made a several expensive acquisitions to quickly build reserves during 2004-2006 when reserves were expensive. This has increased their average FD&A to $25 per boe among the most expensive of the energy trusts. On a replacement cost Canetic is worth $10-$11. Free cash flow is thin and we expect up to 80% cut in distributions which is supporting the $15 value. Appreciation above the $15 level is expected to be limited.

Trilogy Energy Trust (TET.UN)

On a replacement cost Trilogy is worth $7.50 per unit and free cash flow provides a value as high as $12 per unit. There appears to be considerable upside appreciation based on the $8 price as of Sept-25-07

Fairborne Energy Trust (FEL.UN)

On a replacement cost Fairborne is worth $6 per unit and free cash flow provides a value of $4 per unit. FEL is expected to cut distributions by up to 80%.

Arc Energy Trust (AET.UN)

Replacement value $20 per unit and cash flow is $26. Cash flow value includes a reduction of distributions by 30%.

PennWest Energy Trust

On a replacement cost for conventional reserves PennWest is worth an estimated $30 plus up to $6 additional for the 1B bbls of potentially recoverable oil sands reserves. On a cash flow basis after reducing distributions by 30% their value is estimated at $40 per unit. The recent acquisition of Vault Energy added 27M boe of reserves at a favourable cost of $14 per boe included land leases and increases total reserves by 5%.


A complete list of energy trust with estimate replacement cost values is accessible from the front page of IncomeTrustResearch.com under Energy Trusts.

Related:

Canadian Energy Too Cheap to Ignore - greenfaucet.com

Jim Flaherty's Folly - Diane Francis

The Abu Dhabi Put - The Motley Fool

Perpetuating the Big Lie

The Big Lie: If you repeat it frequently enough people will sooner or later believe it. Source: Wikipedia

Dan Miles is the Director of Communications in the office of the Federal Minister of Finance, Jim Flaherty. So it's no surprise that Dan Miles would attempt to spin a tale to make Jim Flaherty look good. Today's Regina Leader-Post quotes Mr. Miles:

"When he [Garth Turner] says the markets lost $25 billion in value following the income trust announcement on Oct. 31, 2006, he fails to mention the market subsequently recovered much of that value."

The problem is the market-based facts don't match the Department of Finance fantasy. Since Jim Flaherty announced a surprise 31.5% tax on October 31/06, Income Trusts continue to lag the broader market. Where is the 'value recovery' Dan Miles is talking about?

The following two charts tell essentially the same story:

• The TSX index is up 12.1% since October 31/06.
• The TSX Income Trust Index is down 10.5%, lagging the TSX by 22.6%.
  
• REITS have fared somewhat better, only lagging the TSX by 13.0%. Notice that after the March Federal budget, REITS began their Flaherty-induced descent as well.
  
• The most damage is in the TSX Energy Trust sector,down 16.3% and lagging the TSX by 28.4% since October 31st last year. This at a time when oil prices are nearing $80 US a barrel.

At best Dan Miles doesn't understand the issue or hopes nobody will verify his story. At worst he is a yet another practitioner of 'Big Lie' tactics.

You know the 'Big Lie' strategy I'm talking about, perpetuated by a failed politician from another era:

• Never allow the public to cool off;
  
• Never admit a fault or wrong;
  
• Never concede that there may be some good in your enemy;
  
• Never leave room for alternatives;
  
• Never accept blame;
  
• Concentrate on one enemy at a time and blame him for everything that goes wrong;
  
• People will believe a big lie sooner than a little one; and
  
• If you repeat it frequently enough people will sooner or later believe it. Source: Wikipedia

One thing is certain, and that is an informed voter can figure out what a DoF Director of Communication cannot. And that makes it easy to conclude who has a credibility deficit and who does not.

Related:

PerfChart ($TSX,$RTRE,$RTEN,$RTCM) Interactive Performance Comparison Chart

Critic's flipflop on trusts - Leader Post

Income Trusts and Canada’s Energy Sovereignty . . . . Past, Present and Future.

The following is a look at the impact of income trusts (royalty trusts) on Canada’s energy sector from the vantage point of the past, the present and the future. The purpose of this review is not to argue that the energy sector receive special exemption per se like REITs, to the exception of business trusts. Our association’s position on Income Trusts calls for the repudiation of the Tax Fairness Plan in the name of fairness and good governance. As such, all existing income trusts should be fully grandfathered and free of growth constraints. Measures should be taken for a transition period to protect these companies from the takeover frenzy that this policy has induced. Future conversions should be the subject of further study and policy evaluation involving stakeholder input through public consultation.

Tax Leakage:

No discussion about income trusts can begin without first discussing the claim that income trusts result in a loss of tax revenue, or so-called tax leakage. The notion that income trusts cause tax leakage has taken on urban legend status. The inconvenient truth is that income trusts do not cause tax leakage, in fact the reverse is true. The highly guarded and secretive analysis that Finance performed that underlies its assertion of tax leakage fails to acknowledge ANY of the taxes paid by the 38% of income trusts that are (according to them) held in RRSPs and retirement accounts.To quote Jack Mintz: “Finance was wrong to treat the impact of [pension and RRSP accounts] as ZERO.” Proper inclusion of these taxes would result in tax neutrality. In any event, these theoretical analyses are only as good as their assumptions, data and methodology. Clearly Finance uses the wrong methodology. A more definitive and unassailable analysis can be had by simply looking at the real world. BMO Capital Markets performed such a real world exercise by looking at all 126 companies that converted to income trusts in the period since 2001. Here are the summary results:

Avg Tax Paid pre Conversion to Income Trust: $3.3 million x 126 companies = $415.8 million / year

Avg Tax Paid after Conversion to Income Trust: $6.1 million x 126 companies = $768.6 million / year (excluding deferred taxes)

Avg Tax Paid After Conversion to Income Trust: $9.8 million x 126 companies = $1.234 billion / year (including deferred taxes)

Therefore this comprehensive real world analysis demonstrates the vastly more effective tax generation associated with businesses formed as income trusts versus businesses formed as corporations. The tax raising effectiveness is improved by a factor of 3 times for all taxes and 1.8 times if, like Finance, one totally ignores the present value of deferred taxes. This reality is a major contributing factor to the surpluses that Canada has been reporting in recent years, that Finance considers “strange and unexplained”, in their attempts to obfuscate the inconvenient truth about income trusts.

Cost of Capital Advantage of Income Trusts

As graphically demonstrated above, income trusts do not cause tax leakage. In today’s protracted low interest rate environment, Canadian retail investors prefer a business that is organized as an income trust relative to the same business structured as a corporation. There are many reasons for this, the primary one being that these investors are seeking monthly income at returns higher than those afforded through investments in life annuities, GICs, bonds or high yielding stocks. Further, these very investors are more comfortable with the management discipline associated with management having to meet monthly distribution payments to unitholders. This investor preference manifests itself in higher market valuations for income trusts. This is the market’s decision. As a result of this valuation enhancement, income trusts have a competitive advantage in the form of a lower cost of capital. This is an important strategic advantage that allows income trusts to compete on a global basis, where a cost of capital advantage can be a significant competitive advantage. This cost of capital advantage has been conferred on these companies by the capital marketplace and not through any “tax loophole” as Flaherty is so fond of saying, which implies it is being subsidized by Ottawa. Saying so amounts to a patent falsehood, as the absence of tax leakage can hardly support the existence of a tax loophole. Meanwhile PricewaterhouseCoopers has concluded income trusts are efficient at investing and growing.

Income Trusts and Canada‘s Energy Sector: Past

Before the emergence of the trust sector, many of Canada's intermediate oil and gas companies were being acquired by international corporations, predominantly from the U.S. The expansion of the Canadian energy trust business halted this tide of foreign takeovers and succeeded in reversing the trend. In the five years ended 2005, trusts purchased over $8.9 billion of oil and gas properties from foreign-owned corporations. Pengrowth's 2006 acquisition of assets from ConocoPhillips pushes this total close to $10 billion. This is made possible by income trusts’ competitive cost of capital and ready access to capital markets (before Flaherty).

As a result of this repatriation, head offices and the key decision making functions remain in Canada. Decisions surrounding capital investment, jobs, safety, and the environment are driven by Canadians. Many of these acquired assets are being aggressively optimized by Canada's energy trusts, providing additional production and reserves with minimal impact to the environment. The environment is important to all Canadians and is benefiting from the capital decisions that the low cost of capital income trusts are making, specifically with respect to CO2 sequestration also known as greenhouse gas injection. Canada's greenhouse gas (GHG) challenges are well documented. As the Western Canadian Sedimentary Basin has matured, ownership and control of the vast majority of Canada's legacy conventional oil reservoirs has transferred to the oil and gas trust sector. The large corporations chose not to retain control of these properties and to not pursue enhanced oil recovery activities through CO2 injection, instead selling the majority of these large “in-place” oil reserve assets to the trusts. The oil and gas trust sector's low cost of capital and business model has allowed these projects to become more attractive economically, such that trusts are now at the forefront of CO2 sequestration initiatives. In two large fields alone, Pembina and Redwater, CO2 Enhanced Oil Recovery (EOR) projects could reduce emissions of GHG to the atmosphere by 30,000 tonnes per day, or 11 million tonnes annually. These projects represent the only truly meaningful opportunities to dramatically reduce Canada's GHG emissions in the near term. This is a rare win-win-win situation for business, the environment and Canada’s energy security. Unfortunately these projects would be targeted to come on stream around 2011, just as the government’s revised tax treatment for trusts would come into effect. The proposed changes will drive energy trusts back into a corporate model. As history has shown, the corporate model and its growth-oriented investor base are not aligned with the pursuit of CO2 EOR projects in Alberta. At the very least these projects will be delayed but more likely many may not proceed at all.

Income Trusts and Canada’s Energy Sector: Present

At present 20% of Canada’s oil and gas production is produced by Canada’s 31 oil and gas royalty trusts, representing more than 1 million barrels of oil equivalent per day. The combined market capitalization (pre Flaherty) was almost $100 billion. In 2005, the oil and gas trust sector generated over 30 percent of the tax revenue collected from publicly traded Canadian entities in the oil and gas sector while representing 16 percent of the revenue. In 2006 the energy trust sector will generate payments of an estimated $5.7 billion to governments in Canada including royalties, property and capital taxes, and the estimated $2.4 billion in personal taxes to be paid on distributions. In 2006, energy trusts will reinvest approximately $7 billion of capital into Canada’s Western Sedimentary Basin and operating and administrative expenditures are expected to total almost $6 billion annually. However the picture following Flaherty's tax is much bleaker as evidenced by drilling activity which is down by over 60% since Halloween.

Flaherty’s income trust tax regime is designed to shut down income trusts. In that regard, it is certain to succeed. In doing so however, his actions have left all 250 income trusts highly vulnerable to hostile takeover. Most of this takeover activity will be foreign based and largely driven by foreign private equity investors. This takeover frenzy has already begun and will multiply in intensity once the tax is passed into law. Flaherty’s misguided policy announcement has created what is known in the business as an “event driven” buying opportunity. This is where an event artificially depresses the value of a publicly traded security to a level below its true worth. Flaherty has inflicted this situation on all 250 income trusts. True value in this context means the value that a private equity fund or other investor would be willing to pay for the business. In the normal course, income trusts traded at their true value. However, Flaherty’s actions have created an artificial discount, that these private equity funds are keen to exploit as they scour the world looking for such opportunities. Private equity is flush with capital and ready deployment of capital is their only major constraint. Flaherty has handed them a $200 billion capital deployment bonanza representing $140 million per trust of value arbitrage to be captured by foreigners. Canada’s incredibly lax takeover rules just makes this task even easier and more effortless for them. The $40 billion acquisition of BCE by U.S.-based KKR or Cerberus is a perfect case study.

Upon purchasing these vulnerable income trusts, these foreign buyers will revert them to corporate form and in doing so achieve two advantages. First as corporations they will now be free of the arbitrary growth restrictions that Flaherty imposed on the Canadian ownership of trusts as the second leg of his trust crackdown. Second these foreign investors will structure their investments in the form of debt in order to take full advantage of the corporate deductibility of interest. As such these interest payments will be made from pre tax cash flows and will flow to foreign tax jurisdictions free of any Canadian taxation. Flaherty's Budget 2007 assures foreign investors of this tax free outcome as the budget contains a foreign investor tax loophole that eliminates the 15% withholding tax previously paid by them. Overall, this strategy is known as “income stripping”. The consequence of this inevitable outcome is that it will induce tax leakage. This is the ultimate irony of Flaherty’s policy. The very policy that was designed to stem tax leakage which did not exist in the first place will actually induce tax leakage through the hollowing out of a growing and vibrant sector of the Canadian economy. Taken to the max, this strategy would result in a loss of the $1.2 billion in annual taxes paid by the 126 trusts referenced above and $6 billion per annum for all 250 trusts. $7.5 billion if BCE and Telus are included. Prior to becoming income trusts, most of these companies were private companies and were therefore protected from this opportunistic vulture takeover that has been induced by Flaherty. The combination of Flaherty and the fact that they are public makes them highly vulnerable. Takeovers will precipitate the $35 billion loss in Canadians life savings well before Flaherty’s 4 year phase in, which is nothing more than a mirage. Making 4 years into 10 years is simply another mirage, as it will only marginally slow down the inevitable takeout of these trusts.

When Flaherty announced his income trust crackdown, he indicated that the U.S. had done so themselves in 1987. This is just another in a long list of falsehoods advanced by Flaherty. What Flaherty did not tell Canadians is that the comparable market in the US to income trusts is today a $480 billion dynamic and growing market where the scope of eligible investors is being broadened by new U.S. regulation. A large part of this vibrant market is the Master Limited Partnership (MLP) market. $80 billion of MLPs are oil and gas infrastructure companies. These energy infrastructure MLPs are extremely well positioned to acquire key Canadian oil and gas infrastructure assets that are held in income trusts. There are no less than 10 such Canadian infrastructure income trusts. Given the higher values at which these U.S. MLPs currently trade relative to the Canadian infrastructure income trusts, there is considerable economic incentive for them to make a hostile bid for this low hanging Canadian fruit, not to mention considerable strategic value not just to these MLPs themselves but to overall U.S. energy security as well. These infrastructure assets control a large percentage of the delivery of Canada’s energy resources including ultimately, the direction, the flow rates, and the building of new pipelines.

These 10 Canadian infrastructure energy trusts with a combined market capitalization of $12.5 billion are responsible for:

• delivery of over 1 million barrels per day of conventional oil and oil sands – 50% of Canada’s oil production
• delivery of more than 0.5 million barrels per day of natural gas liquids – 70% of Canada’s NGL production
• transport over 2.7 billion cubic feet of natural gas per day – 25% of Canada’s gas production
• process over 6.4 billion cubic feet of natural gas per day – 63% of Canada’s gas exports • produce over 160,000 barrels of ethane per day – 66% of Canada’s supply
• operate over 10 million barrels of product storage
• spent $1.1 billion with planned expenditures of $2.0 billion over the next three years
• acquired $3.1 billion of assets of which $1.0 billion was from foreign owners

Income Trusts and Canada’s Energy Sector: Future

As noted above, the emergence of income trusts has resulted in a repatriation in ownership of Canada’s energy sector while at the same time creating a “triple bottom line” result. Flaherty’s policy will make Canada’s existing energy trusts vulnerable to foreign takeover and eliminate this triple bottom line result in the process. Furthermore, much of our strategic energy infrastructure assets are likely to fall into U.S. hands. Beyond that, we are leaving other sectors of Canada’s energy sector more vulnerable to foreign takeover as well. For example it was just recently announced that Western Oil Sands is putting itself “in play” and looking to maximize shareholder value. Western Oil Sands is the 20% owner and operator of the Athabasca oil sands project that produces 155,000 barrels of oil equivalent a day and is currently expanding its project. Western Oil Sands is a corporation, not a trust and has a market value of $5.5 billion. Now that Flaherty has effectively killed the income trust market, two made-in-Canada alternative value maximization alternatives that would otherwise have been available to Western Oil Sands have been eliminated, making it more likely that it will fall into U.S. hands at prices lower than would otherwise be paid. By killing the trust market, Western Oil Sands is unable to convert itself into a trust as a value maximization/disposition strategy alternative. This conversion alternative would have led to a high level of ongoing Canadian ownership. It would have left operatorship of the Athabasca project in Canadian hands. Second, because of the restrictive growth constraints on existing trusts imposed by Flaherty, Canadian Oil Sands which is a trust and which has been an aggressive consolidator of interests in oil sands, will not be in a position to acquire Western’s 20% Athabasca interest. Canadian Oil Sands is a majority Canadian owned income trust. Given that these two value maximization alternatives have been frustrated by Flaherty’s actions, there is a greater likelihood that Western Oil Sands is now easy prey for foreign takeover and at prices lower than would otherwise have to be paid. $5.5 billion is a “price point” that almost assures this foreign owned outcome in the post Flaherty capital market world. Western Oil Sands provides a real time example of how the elimination of income trusts will cause ongoing dilution to the Canadian ownership and head office control of this important and strategic sector of the Canadian economy.
This is widely understood and acknowledged by those in the energy industry, for example this from the February 12, 2007 Barron’s article concerning Canadian oil sands; “We are absolutely convinced the big players there, Suncor Energy Canadian Natural and Nexen are likely to be acquired by the big (oil) companies. It is not surprising that Suncor is now starting to show up as rumored target for BP.” or this from the U.S. Oil and Gas Investor from December 2006: “Asset prices in Canada are expected to soften now as the trusts’ access to lower-cost capital dissolves. This means U.S. Producers can compete for assets in the region again. Now in play, the trusts are up for grabs by traditional U.S. producers.”

One has to wonder how premeditated such an outcome is in light of the fact that the The Security and Prosperity Partnership of North America agreed to between Stephen Harper, George Bush and Vincente Fox in June 2006 had identified as its top priority the North American Energy Security Initiative, whose goal is “a secure and sustainable energy supply is essential for our economic prosperity in North America”. Whose prosperity? Whose security?

Other Unintended, Yet Infinitely Foreseeable Consequences:

Whenever major changes are made to government policies without consultation of affected parties, unintended consequences result. In this case, these include:
• massive capital losses to millions of individual investors, on the order of $35 billion, and the associated lost tax revenue;
• reduced or lost income for millions of investors, many of whom depend on this income to live and maintain a decent standard of living in retirement;
• major irreversible flight of Canadian investment capital to other markets which offer sought after income-trust-like investment attributes, such as the U.S.High Yield Market, U.S. Tax Free Municipal Bond Market and U.S. MLP market;
• loss of confidence in the integrity of the Canadian capital markets on the part of Canadian and foreign investors, and the resultant loss of foreign and domestic investment capital;
• a ripple effect of reduced income for economic spending and lost investment value for millions of Canadians, including charitable organizations;
• exposing Canadian corporations to leveraged buy-out groups seeking to acquire intermediate-sized corporations;
• loss of head office jobs as management control leaves the country;
• a shifting of focus from implementing improved, energy-efficient optimization methods on existing developed pools to less energy-efficient, grassroots mega projects.

This in turn imposes tremendous strain on infrastructure, available labour and project costs; and ultimately reduced production and lower recovery of Canada's oil and gas reserves.

The good news is none of this has to occur, as Flaherty’s folly is a man made problem. It will only take a majority of thoughtful MPs to veto this self-inflicted economic malfeasance and to recognize that Canada’s future energy and economic sovereignty is otherwise very much at stake.



The Hill Times, Energy Policy Briefing, p.30 - June 4/07