Canadian Royalty Trusts

Canadian Royalty Trusts

Canadian royalty trusts (CANROYs) are oil and natural gas producers. They grabbed dividend investors’ attention because of their high dividend (distribution) payouts. The trusts pay those dividends because they don’t have to pay corporate income taxes if they distribute their income to unit holders (shareholders). Now, that is changing.

Alarmed when major corporations began converting to the trust structure to avoid paying income taxes, the Canadian government changed the rules. As a result, starting in 2011, all existing trusts will pay taxes at the same rate as regular corporations (newly formed trusts would immediately pay corporate rates).

The tax changes could hurt many trusts well before 2011. Every drop of oil or natural gas pumped out of the ground reduces a trust's reserves by that amount. Historically, the trusts compensated by adding to reserves via acquisitions, using their shares as currency. Now, given their uncertain outlook, it will be harder to make new acquisitions. Trusts without sufficient reserves in the ground may be unable to maintain their current distribution levels.

Once 2011 rolls around, without the tax incentives to pay the money out to investors, many trusts will opt to use their profits to fund expansion. Thus, starting in 2011, we think energy trust distribution yields will be in line with other energy corporations, say in the 2% to 4% range.

That leaves open the question as to what happens between now and 2011. Probably some trusts will convert to regular corporations during that period. Others will be forced to cut their distributions as their reserves deplete. However, some will likely continue substantial payouts until 2011. Which ones are those?

The best prospects are trusts with adequate reserves, strong balance sheets, and existing cash flows that cover current distributions with a minimum 30% margin of safety. Those in a position to substantially increase production from existing reserves get extra points.

Background
Canadian royalty trusts are different from U.S. royalty trusts. The U. S. trusts pay out the cash flow generated by their oil and gas properties, but they are not allowed to acquire new properties. Consequently, their cash flow declines over time as their assets are depleted. Canadian trusts, as mentioned above, try to replenish depleted properties with new acquisitions, and in theory, could operate indefinitely.

In terms of structure, a royalty trust typically controls an operating company, which purchases oil and gas properties using the trust’s capital. The trust then receives royalty and/or interest payments from its operating company.

Since Canadian trusts distribute most of their income to unitholders, they must raise cash to fund acquisitions either by borrowing or by selling more units. So although an acquisition grows a trusts total cash flow, it may not result in increased cash on a per-unit basis.

U.S. Tax Considerations
For U.S. investors, the tax treatment of a Canadian royalty trust’s dividends depends on whether the trust is registered in the U.S. as a foreign partnership or as a corporation. The differences are too complicated to detail here.

Also, the Canadian government applies a 15% non-resident withholding tax on distributions to U.S. investors. However, U.S. citizens can apply for a refund for at least a portion of the amount withheld.

Many Canadian trusts provide information for income tax filing instructions for U.S. unitholders on their Websites. Nevertheless, it can be a complicated process and U.S. investors should consult with a qualified tax advisor before investing.

Unitholder Liability
Canadian trusts are not corporations, and in theory at least, unitholders have unlimited liability for the actions of the trust. In practice, however, most experts consider it unlikely that individual unitholders will ever be held liable for the trusts actions. However we are not experts on the subject, and you should contact a trust regarding unitholder liability before investing.

Canadian Royalty Trusts Listed On U.S. Stock Exchanges

Most Canadian royalty trusts are listed only on the Toronto stock exchange. However, the following trusts are also traded on either the NYSE or AMEX.

Advantage Energy Income (AAV)
Baytex Energy Trust (BTE)
Enerplus Resources Fund (ERF)
Enterra Energy Trust (ENT)
Harvest Energy (HTE)
Pengrowth Energy Trust (PGH)
Penn West Energy Trust (PWE)
Provident Energy Trust (PVX)

Royalty Trusts Listed on the Toronto Stock Exchange

Here are the major oil and gas royalty trusts listed on the Toronto exchange.

Advantage Energy Income Fund (AVN.UN)
ARC Energy Trust (AET.UN)
Baytex Energy Trust (BTE.UN)
Bonavista Energy Trust (BNP.UN)
Bonterra Energy Income Trust (BNE.UN)
Canadian Oil Sands (COS.UN)
Crescent Point Energy Trust (CPG.UN)
Daylight Energy Trust (DAY.UN)
Enerplus Resources Fund (ERF.UN)
Enterra Energy Trust (ENT.UN)
Freehold Royalty (FRU.UN)
Harvest Energy Trust (HTE.UN)
NAL Oil & Gas (NAE.UN)
Paramount Energy Trust (PMT.UN)
Pengrowth Energy Trust (PGF.UN)
Penn West Energy Trust (PWT.UN)
Peyto Energy Trust (PEY.UN)
Progress Energy (PGX.UN)
Provident Energy Trust (PVE.UN)
Trilogy Energy Trust (TET.UN)
True Energy Trust (TUI.UN)
Vermilion Energy Trust (VET.UN)
Zargon Energy Trust (ZAR.UN)

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Trusts Missing In Action

If you can't find a trust, it may have been acquired or converted to a regular corporation. Here's a list of trusts that have recently disappeared.

Acclaim Energy and StarPoint Energy merged to form Canetic Resources.
Canetic Energy was acquired by Penn West Energy.
Esprit Energy was acquired by Pengrowth Energy.
Fairborne Energy converted to a regular corporation.
Find Energy was acquired by Shiningbank Energy.
Focus Energy was acquired by Enerplus.
Ketch Resources was acquired by Advantage Energy Income.
Petrofund Energy was acquired by Penn West Energy.
PrimeWest Energy was acquired by Abu Dhabi National Energy.
Sequoia Oil & Gas was acquired by Daylight Resources.
Shiningbank was acquired by PrimeWest Energy.
Sound Energy was acquired by Advantage Energy.
Thunder Energy was acquired by a private equity firm.
Vault Energy was acquired by Penn West Energy.
Viking Energy was acquired by Harvest Energy