The Rude Awakening
Wall Street, New York
Thursday, November 2, 2006 ----------------------------------- - Tax on investment trusts destroys investor trust in Canada,
- Indolence vs. zealousness in the political arena,
- How does this effect your money and is this a time to buy or sell the
embattled “loonies”?
----------------------------------- Eric Fry, reporting from Laguna Beach, CA… Politicians are supposed to do stupid things. We expect it. That’s why most of us voters prefer an indolent politician to an energetic one. The energetic one will certainly try to do something for the public good, which guarantees that he will do something for the public bad. The Canadian Finance Minister, Jim Flaherty, is no different. (We liked him a lot more when we didn’t know who he was). Yesterday morning, we became acquainted with the man…and with his lame-brained proposal to tax all the heretofore untaxed investment trusts in Canada. Though the catalogue of idiotic political acts throughout history is quite considerable, Flaherty’s maneuver warrants special recognition. (Perhaps a Darwin Award is in order). Flaherty hopes to impose a hefty, retroactive tax on one of the largest sectors of the Canadian stock market: the investment trust sector. The shocking announcement erased about $25 billion dollars of shareholder wealth yesterday, as every investment trust in Canada plummeted. Does yesterday’s washout signal a buying opportunity…or merely the first phase of a spectacular selling opportunity? Let’s try to figure it out… -------- Special Investment -------- A one-time opportunity to turn every $2,600 you invest into
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By Eric J. Fry When I first gazed at my Bloomberg screen yesterday morning, I saw a stock quote that didn’t look quite right. One of the Canadian investment trusts that I monitor opened down 15% on the very first trade. “Must be a bad quote,” I thought to myself. But it wasn’t a bad quote. It was just bad news. A wacky tax proposal from the Canadian Finance Minister, Jim Flaherty, triggered a massive rout of the country’s investment trust sector. We are inclined to view the rout as a buying opportunity – perhaps a phenomenal buying opportunity – but before jumping to rosy conclusions, let’s examine a few pertinent facts. 
Under current Canadian tax laws, investment trusts pay no corporate taxes, although distributions to shareholders are taxable. Under the Finance Minister’s new proposal, dubbed the “Tax Fairness Plan,” this tax exemption would disappear. According to the proposal’s gruesome details, newly formed investment trusts would pay standard corporation taxes of 34%, dropping to 31.5% by 2011. Existing investment trusts would receive a 4-year holiday from taxation, but would begin paying standard corporate taxes in 2011. Flaherty also plans to raise dividend tax rates for pension funds and foreign investors that own trusts.
Why did Flaherty propose the shocking tax change? Because a couple of large Canadian telecoms were planning to convert into investment trusts, thereby dodging the taxes they would otherwise owe. “This year alone,” he gripes, “there’s been almost $70 billion in new trust conversion announcements. We have seen a growing trend toward corporate tax avoidance.” Understandably, Flaherty had grown tired of watching one Canadian company after another convert itself into a tax-free entity. Less understandable is why he did not merely end the policy instead of proposing major retroactive changes to the tax laws. If he had merely ended the investment trust mechanism, he could have halted the erosion of the Canadian tax base, without also destroying $25 billion of shareholder wealth in a single day, shutting down the existing investment trust apparatus, violating the trust of every investor in Canadian assets, imperiling future investment in the country, eroding the Canadian government’s credibility, undermining the Canadian dollar and looking like an incompetent buffoon. 
If enacted, this proposal will not merely bite the hands that feed the Canadian economy, it will amputate them. Flaherty’s proposed retroactive tax reneges on longstanding agreements between investors and the Canadian tax authorities. As such, it is just as much an appropriation of capital as anything conceived by Venezuelan President, Hugo Chavez. (The Venezuelan president, you may recall, reneged on contracts with several foreign oil companies, causing them to pay much higher royalties and taxes, or abandon their projects). The policy seems so ludicrous and counter-productive that we wonder if it might be retracted. The sheer stupidity of the proposal, therefore, is reason number one for buying an investment trust. Reason number two for buying the battered investment trusts is that a fully-taxed investment trust is still an investment trust. In other words, it still offers a very high dividend yield, especially after yesterday’s shellacking. Hundreds of trusts now offer yields over 10%, and many offer yields of 13% and higher. Therefore, even after accounting for a tax hit as high as 34%, most trusts offer pro-forma yields between 7% and 10%, if our back-of-the-envelope calculations may be trusted. What’s more, the current yields are still the ACTUAL yields until 2011, when existing trusts must begin to pay the tax man. So the owners of a trust like Trinidad Energy Services (TSE: TDG-U CN) would still receive this stock’s indicated yield of 11.8% for the next four years. And even after 2011 arrives, investment trusts will not suffer equally under the new tax regime. Some will fare much better than others. Using Trinidad as an illustration, Canaccord/Adams, a Canadian brokerage house, calculates that the company’s effective tax rate would only increase slightly, producing no worse than “a 12% reduction in distributable cash flow.” In which case, Trinidad’s yield would drop from 11.8% to about 9.8%, all else being equal. Trinidad’s attractive yield, however, offers no guarantee that its share price will not tumble again today or tomorrow. Investors might sell just because the investment trusts are falling. They might swear off of Canadian investments like an AA newbie swears off Jagermeister shots. The Canadian dollar might also suffer more abuse, like it did today. The “loonie,” as it is sometimes called, fell about 1% yesterday. No prudent investor can afford to ignore these risks. In fact, most prudent investors will probably toss their hands in the air, shrug their shoulders and ask themselves, “Why bother?” We have no ready answer. But we suspect the selling has been overdone and that rewards awaits those who take the plunge. -------- Special Investment -------- Urgent Trading Alert: An Unprecedented Opportunity to Make 768% Gains in 6
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By Justice Litle The term "political risk" usually brings to mind Third World countries. It's what you think of when mining companies take on projects in the Congo, or exploration and development guys get kidnapped in Nigeria. Russia has also been a poster child for political risk in recent years, as the Kremlin tightens its grip on the energy sector, plays up Cold War sentiments and destroys "uncooperative" players (like YUKOS) by any means available… including criminal ones. But now we are reminded of an unpleasant reality: Political risk applies to First World countries too. Canada's "Conservative" government recently announced a surprise change in the tax laws that could have come straight from the Kremlin's playbook. As The Washington Post reports, "The total secrecy in Tuesday's announcement, as bankers and parliamentary staffers left early for Halloween, caught everybody off guard." The tax change regards a new plan to tax Canada's income trusts. Not only does it come out of the blue, it breaks a pledge made by Canada's Conservative government not to change the trust taxation rules. 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. I read The Economist every week. Frequently, I see business development ads for Ontario and Toronto, touting their advantage as desirable places for corporations to set up shop. Canada's new message rips that business-friendly ethos to shreds. Bill Holland, the CEO of the CI Financial Income Fund, calls this out-of-the-blue move "a bizarre, Third-World policy"… and I agree. It is just plain stupid, and Canada's government could lose more from business foregone than it gains in tax revenues as a result. If so, the knuckleheads deserve it. How does this affect the Outstanding Investments portfolio? Our two Canadian investment trusts, Westshore Terminals (WTE: TSX) and Peyto Energy (PEY: TSX), took a hard hit on the news. They are down substantially today. But Westshore Terminals is still above our entry price -- and for those of you who don't own Peyto, I think Peyto is a buy at these depressed levels. (If you do own Peyto, take a deep breath and sit tight. Now is not the time to panic!) Here is my rationale. For one thing, this "get me out of trusts" stampede is a blatant overreaction. Canada's finance minister has said that only new trusts will be immediately subject to the change, while existing trusts will get a four-year "transition period," whatever that means. So we don't even know how substantially, or how soon, Westshore's and Peyto's distributions will be affected. On top of that, there is still a possibility the idiots in Canada's government will get a clue and back off. This decision smacks of bureaucratic bungle -- the colossal error of some pointy-headed bean counters with no understanding of business climates, and how important it is to maintain a consistent stance. A severe backlash could make them think twice. What's more, recall that natural gas is a SCREAMING long-term buy at these levels… and Peyto is a natural gas player par excellence. Even if a hefty resource tax goes through -- which it may not -- and even if it were implemented immediately -- which it won't be -- Peyto is stupidly, ridiculously cheap when you consider the longer-term natural gas fundamentals. It could pay tax through the nose and still double or triple in the next few years. I absolutely love Peyto below $20… the situation makes me think of Buffett and Munger loading the boat with KO after the '87 crash. So there you go. On a broader level, this is a good reminder. Political risk is no respecter of boundaries, and First World country politics could get increasingly ugly in the coming years as demagogues come to power and Western welfare regimes implode. That means we'll have to absorb some volatile swings… but it won't stop us from making good money. ------------------------------------ Here’s How We Turned $5,000 into $1Million…Join Us For The Next Round Here
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