Trust and The Canadain Dollar

The main shock in recent days was the announcement from Canada’s Finance Minister, Jim Flaherty, that the trust form of corporate organization would no longer enjoy its tax exempt status. This was a bolt from the blue. This past spring Flaherty promised that the coalition government would not tamper with the trust’s status. The previous Liberal government had become concerned about the issue after there was some musings from an executive of one of Canada’s largest banks about the attractiveness of the trust form.

Canadian trusts have avoided corporate taxes by paying out all or most of the cash flow to investors, often in the form of monthly dividends. In effect, in Canada, the trust form shifts the tax liability from the corporation to the share holders. In this process, the Canadian government loses tax revenue and this consideration appeared of paramount concern.

Jack Mintz, a tax expert at the University of Toronto’s Rotman School of Business told the Financial Times that over the last several years, as the trust form gained in popularity, personal and withholding taxes increased by C$1.1 bln, but corporate tax payments fell by C$1.8 bln. In explaining his reversal, Flaherty said, that the conditions had changed from when the promise was made. The key change was that Canada’s two largest telephone companies, BCE and Telus, had indicated they too would convert to a trust. Mintz indicated projected that this would have increased the shortfall in the government’s revenue by 50% to C$1.1 bln from C$700 mln.

The trust form was initially adopted by real estate and energy companies. Companies in that space typically invest only a small fraction of the cash flow back into their existing businesses. However, the trust form has been adopted by many companies in industries that typically do reinvest a greater share of their cash flows. This is especially true of the telephone companies.

Capital investment and productivity improvements tend to be a weak suit for the Canadian economy and the trust form, especially as it spread out of energy and real estate, aggravates this problem and appears to be another reason why some policy makers have been increasingly concerned.

There are now more than 250 trusts and they account for about 11% of the Toronto Stock Exchange market capitalization. They got whacked in response to Flaherty’s announcement in the afternoon of October 31. The significant declines posted by the trusts on November 1 and November 2, helped drag down the TSE composite index by 3% before recovering today.

There is good reason to suspect that the sell-off of the trusts was panic-driven and that as cooler heads prevail, many of the trusts will likely continue to recover. As outlined by Flaherty, new trusts, those that did not exist at the end of October, will be taxed like conventional corporations as of January 1st. This will cause the initial public offering market for trusts to dry up. Trust IPOs accounted for nearly a third of all Canadian IPOs this year (~C$17.4 bln). This had been an important source of revenue for some of the investment banks.

However, existing trusts will enjoy their current tax status until 2011. As a small and I mean small consolation, the Canadian government announced that the corporate tax rate will be ruse to 45.5 % at the start of 2011 from 46%. That means that on the margin, the sell-off in the trusts may turn out to be a buying opportunity. The game can continue for the next four years. And the decline in share prices translates into higher yields, which of course if one of attractions of trust shares.

Some observers played down the significance of the Flaherty’s announcement, arguing that the measure still have to become a law. But this does not appear to be a significant obstacle even though the Conservatives do not have a majority in parliament. The Conservative Party holds 124 of the 308 seats. Their two legislative coalition partners, the Bloc Quebecios (50 seats) and the New Deomocrats (29 seats) have indicated they will support the Conservatives. The head of the Liberal Party indicated it would oppose the government, but this seems to be more an issue political maneuvering and positioning than principled opposition. The political calculus suggests the bill will become law.

Industry figures suggest that foreign investors own a little more than a fifth of what had been C$900 bln market cap of trusts. So when the news first broke and the Canadian dollar sold off (more than 1%), it seemed as if foreigners were getting caught up in the panic. But the situation is more complicated. Several of the larger trusts, especially in the energy space, trade as ADRs (American Depository Receipts) and therefore the impact of their sales in the foreign exchange market is more complicated. Rather a more compelling explanation is that speculators in the foreign exchange market anticipated foreign shares sales and sold the Canadian expecting others to do so afterwards.

In addition to the fact that these trusts will still enjoy their favorable tax status until 2011, there is another consideration that is likely to support prices and the Canadian dollar over the intermediate term. Under the current rules, if non-Canadians acquire a majority of shares in a trust, the trust loses its tax exemption. This has discouraged foreign acquisition of trusts. This seems especially true in the energy space. The trusts themselves have been gobbling up energy producing assets. One industry report calculated that trusts accounted for 60% of the C$22.7 bln energy producing assets purchased this year, which is nearly twice last year’s pace.

For their part, foreign companies already are responsible for half of Canada’s oil and gas output, according to the Canadian Associated of Petroleum Producers. Trusts control account for about 14% of Canada’s oil and gas production. If trusts lose their tax exemption, the risk is that they become take-over targets for foreign companies. Such bids could help support share prices and the Canadian dollar, on a medium term view.

There is another current that dovetails with this one. There is a large country that is awash with capital and has a nearly insatiable appetite for raw materials, commodities, and especially energy. China. China’s State Council, the country’s top governing body launched a new initiative at the end of October to encourage domestic companies to invest and expand more overseas. This past April, China began relaxing the restrictions on foreign exchange outflows and created the QDII—Qualified Domestic Institutional Investors. Thus far the government has approved about $11.6 bln of outflows for investment purposes. The goal is to boost this to about $60 bln a year by 2010.

Chinese outward bound investment rose by 26% in 2005 to $6.9 bln. This includes equity investment as well as the reinvestment of earnings from those investments. The investments have been concentrated in four industries, mining, manufacturing, telecoms and transportation. Chinese investors would seem to have the desire and the means to consider investing in Canada’s energy belt. While foreign purchases of Canadian dollars to buy trust assets may help support prices, it would seem to reduce the amount of tax revenue that Flaherty seems to think can be made up by eliminating the tax advantage for trusts.

In assessing the near-term outlook for the Canadian dollar, one can, for the most part ignore this trust brouhaha. Canada reported stellar jobs data earlier today. The consensus had expected the Canada to have created 15k jobs in October. Instead the government reported that 50.5k jobs were created, helping to drive the unemployment rate to 6.2% from 6.4%. The Canadian dollar rallied, helped, some would suggest by the firmer price of oil and the generally firm US dollar. The Canadian dollar recovered a little more than half of the ground it lost in the wake of Flaherty’s announcement and now appears poised to consolidate. Look for the US dollar to trade between CAD1.1225 and CAD1.1425 in the days ahead. In the larger context and over the longer-term, the Canadian dollar is consolidating it’s roughly 50% appreciation against the US dollar over the last 4 years. The broader range appears to be roughly CAD1.10 to roughly CAD1.15