Oil Falls a Little and Canadian Oil Trust Collapse Completely; Uncertain of 2011 Canadian tax act to blame.

I count myself among the pool of investors who believed that oil could spike higher and bought some Canadian oil trusts - pwe and erf - only to find that they now trade at the same price that they did when oil was at $80 a barrel. The catch is the new Canadian tax act that will affect these things differently in 2011 and stop them from moving up no matter what happens to oil until then.

Canadian oil trusts are able to pay huge dividends is because they are not taxed at the corporate level and pass all of their income to shareholders. This is going to change in January 2011 when the new Canadian Tax Act comes into force. Further uncertainty related to the 2011 tax law changes make it difficult for trusts to expand.  Since many trusts pay all of their income in distributions to unit holders, they expand their operations through sales of additional units and trusts that were formed before October 31, 2006 cannot sell more than a certain amount of new units (stock) or will lose their preferential tax status even earlier than 2011.

Under the existing provisions of the Tax Act, income trusts can generally deduct in computing their income for a taxation year any amount of income that they distribute to unitholders for the year. According to the new bill, introduced in 2006, Income trusts will not be able to deduct certain portions of their distributed income (referred to as specified income). However, pursuant to draft legislation, the distribution tax will only apply in respect of distributions of income and will not apply to returns of capital. Some trusts have substantial tax pools that could be applied to reduce the impact of the new tax for several years post-2011.

Under the new legislation the proposed tax will be 29.5 percent in 2011 and 28.0 percent in 2012, based upon a 13 percent provincial tax rate and a federal tax of 16.5 percent reducing to 15 percent in 2012. Add this to the 15% tax that U.S. investors already pay on income trust distributions, and the higher yields might not look so good.

Under the budget released by the Minister of Finance on February 26, 2008, the 13 percent provincial tax will be replaced under an allocation formula with the applicable provincial income tax rates for each province in which the income trust has a permanent establishment. Trust are likely to continue to take advantage of growth opportunities with an increased focus on assessing international acquisition opportunities given that revenue from outside Canada will likely not be subject to the new tax. In addition, trusts will likely continue to carefully manage their substantial tax pools to mitigate the impact of the new tax on unitholders.

Jason Rodgers
Jason Rodgers: Jason Rodgers was an experienced research analyst for a major bank prior to retiring to run his own investment consultancy in beautiful Lihue, Hawaii. Jason contributed articles to BestCashCow from 2008 to 2014.

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  • Babble

    July 09, 2008

    You should have just bought oil futures. Why take on country and company risk?

  • Jocardan

    September 21, 2010

    Does anyone out there have a complete list of the Canroys that are converting to corporations or are they all converting right across the board.

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