Published:
July 31, 2007
In 1979, the founder and CEO of
America's largest independent oil
company faced a serious problem.
Although he'd built his company,
Mesa Petroleum, from a small Texas
operator into one of the world's
largest global oil producers, it was
becoming increasingly difficult to
expand the firm's oil reserves.
You see, Mesa's once-prolific Texas
oilfields were now mature -- these
fields produced safe, reliable cash
flows with little need for
investment, but it was
next-to-impossible to grow
production or boost reserves. And
without growth, Wall Street just
wasn't interested in the stock. In
short, Mesa desperately needed to
unlock the value of its mature
fields and raise cash to fund
exploration and expansion.
Meanwhile, America was in the early
stages of a demographic sea change.
The nation's population was already
ageing and older Americans were
desperately in need of regular
income. Unfortunately though,
ultra-high inflation in the late
1970s ravaged returns from most
traditional income investments.
Meanwhile, corporate tax rates were
sky-high, greatly reducing corporate
America's ability to pay dividends.
As a result, millions of investors
were in need of other investment
opportunities that could throw off
not only high yields, but also
steady, predictable income.
Enter the income trust. In the late
1970s, trusts were a relatively new
type of business organization.
Simply put, a trust is a unique kind
of company that is designed to pay
out large distributions to its
shareholders (in trust lingo shares
are known as units and
dividends are dubbed distributions).
Trusts allow income and cash flows
to be passed directly to investors
as distributions with absolutely no
corporate tax -- individual
investors simply pay taxes on any
distributions received as if those
distributions were regular stock
dividends.
Energy Trusts Flood the Corporate
Landscape
Although a variety of companies in
different industries -- including
utilities and real estate -- have
set up their corporate structure as
trusts, in recent years energy
trusts have been by far the most
popular type. The typical energy
royalty trust holds production
rights to a series of oil and/or gas
fields. Generally, the oil and gas
fields held in a trust are mature;
such fields will gradually be
depleted over a number of years. But
until the fields are fully exploited
they continue to produce solid cash
flows with minimal need for
investment -- infrastructure to
pump, store and transport oil is
already in place. It's these safe,
stable cash flows that back up the
trust's large distributions. In
essence, owning a trust is like
owning a piece of a continued stream
of oil and gas production.
The royalty trust structure solved
Mesa's growth problems and quenched
investors' thirst for income in one
fell swoop. In 1979, Mesa's intrepid
founder -- famous oil billionaire T.
Boone Pickens -- formed the nation's
first royalty trust, dubbing the
entity the Mesa Trust. Pickens
spun-off nearly half of Mesa's
reserves into Mesa Trust -- the
trust ended up holding 8 million
barrels of oil and 800 billion cubic
feet of natural gas reserves. The
vast majority of these reserves were
part of Mesa's older, mature fields
and had years of proven, profitable
operating history.
By selling Mesa Trust to
shareholders, Pickens raised
billions to fund an aggressive
exploration program. Moreover, Mesa
shed its slow-growing mature
reserves and was able to concentrate
further investment on developing
younger, faster-growing fields. As a
result, Wall Street got the growth
that it so desperately sought from
Mesa's regular common shares.
Meanwhile, Mesa Trust unitholders
received an almost unheard-of stream
of income in the form of quarterly
distributions -- far superior income
than was available from most
comparable investments at the time.
Capital raised by Mesa Trust allowed
further investment in the company's
mature oilfields that might
otherwise have been abandoned. The
result: Mesa and Mesa Trust soared
-- by 1981, less than two years
after Pickens formed the first
energy royalty trust, the value of
his two companies had tripled.
Royalty Trusts Migrate North to
Canada
Although some U.S. royalty trusts
still exist today, the trust
structure that Pickens put together
didn't last long in the U.S. By the
mid-1980s Congress had reformed
trust legislation, severely limiting
the types of assets trusts could
hold. Even worse, U.S. trusts were
no longer allowed to fund new
acquisitions by either issuing new
units or raising debt capital. Once
a trust is formed, reserves are
gradually depleted and cash flows
are paid out to unitholders.
Eventually, when the reserves run
dry, U.S. trusts have no value and
are therefore dissolved. In
addition, U.S. trusts' distributions
are no longer taxed like regular
dividends -- they don't qualify for
the reduced 15% dividend tax rate.
But a handful of savvy income
investors have been following
billionaire T. Boone Pickens' lead,
even after U.S. trust law changed in
the 1980s. Specifically, a cadre of
Canadian income trusts has been
paying out generous, tax-advantaged
cash flows to investors for nearly
two decades. Better still, Canadian
trust law never changed as
drastically as in the U.S. As a
result, many Canadian royalty trusts
now pay double-digit percentage
yields while offering income
investors exposure to the
fast-growing energy market.
Benefits of Canadian Trusts
As we noted earlier, U.S. trusts
aren't allowed to borrow money or
raise cash to fund the purchase of
new reserves or to undertake new
drilling and exploration programs.
Because they cannot replace their
existing reserves, every U.S. energy
trust will eventually deplete its
oil & gas reserves and the trust
will be dissolved.
Canadian trusts don't have that
limitation. Instead, they are
actively managed just like normal
corporations. As a result, Canadian
trusts are allowed to borrow money
or issue new shares; they can then
use this cash to fund new
exploration efforts or to acquire
additional oil & gas reserves.
Because they're able to continuously
purchase new reserves to make up for
depletion of existing fields,
Canadian trusts can more easily
maintain their distributions. In
addition, Canadian trusts never have
to be fully dissolved.
For American investors, another key
benefit is taxes. Distributions from
U.S. trusts are generally classified
as either return of capital or
regular income -- neither is subject
to the reduced 15% tax rate on
dividends. Instead, part of the
distribution from a U.S. trust is
considered regular income and is
charged at the full tax rate. For
most investors, this regular income
tax rate is far higher than 15%. The
remainder of the distribution from a
U.S. trust is not taxable until the
trust is sold. As you can imagine,
tax implications for U.S. trusts can
get complicated, even for investors
with limited exposure to the group.
By contrast, the vast majority of
Canadian trusts are considered
normal operating companies by the
Internal Revenue Service (IRS) in
the U.S. For the most part, that
means U.S. investors only have to
pay a flat 15% tax on their
distributions.
You should also be aware that most
distributions to unitholders are
subject to a 15% Canadian
withholding tax. The good news is
that you can claim a foreign tax
credit on IRS form 1116. By doing
so, you should be able to offset any
taxes paid to the Canadian
government against your U.S. tax
liability. However, the situation is
murkier if the trusts are held in a
tax-exempt IRA account -- it's much
more difficult to claim the foreign
tax credit from tax-advantaged
accounts. As such, U.S. investors
should consider holding Canadian
trusts in their regular brokerage
accounts, not in tax-advantaged
accounts like IRAs.
Canadian Government Proposes
Tax Changes
Although Canadian trusts continue to offer advantages over
their U.S. counterparts, this could all change in the coming
years. Specifically, in a move reminiscent
of the U.S. tax law changes of the 1980s, on October 31, 2006,
the Canadian government laid out a proposal to tax Canadian
trusts as corporations. The proposed changes are intended to
stop the loss of tax revenue from the income trust structure,
which currently allows trusts to avoid paying corporate tax.
However, given that the proposed legislation has a four-year
grace period before existing income trusts are taxed, the
changes shouldn't affect near-term cash flows or distributions.
Meanwhile, existing trusts will continue to pay out solid distributions, otherwise the trusts will face punitive tax
rates. You can think of these trusts as essentially having a
four-year-tax holiday during which investors should continue
raking in an above-average income stream.
This realization has led to a strong rise in Canadian trusts
over the past few months. However, stock selection is key, and risk-averse
investors should be choosy. That's where StreetAuthority's
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trusts, including how the proposed government legislation could
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