Tuesday, March 27, 2007

Canadian Royalty Trusts -- Will the Elimination of Tax Free Status be Repealed?

Certain investment advisors have been suggesting that the proposed elimination of the tax free status of royalty trust proposed on Oct 31, 2006 will not pass. Is this an accurate assessment of the situation? Analysis below.

The new tax on income trusts -- a tax to eliminate the Canadian Royalty Trusts' tax free status -- was proposed on Oct 31, 2006, and voting will probably come this year (2007). After the annoucement of the proposed alienation of the tax free status, the trusts market values dropped anywhere from 20 to 30%. If the new law eliminating the tax free status of the trusts does not pass, then it is likely that the trusts will regain some or all of their lost market cap, possibly making them good current investments. The key question then is how likely will the new law concerning income trusts be repealed?

The most important issue is whether the Canadian parliament has enough votes for it to pass. The Lower House of Commons is the branch of government in Canada that has the most influence (the Senate usually rubber stamps the Lower House, according to the description of Canadian politics in the wikipedia, much different system than the US).

A simple majority is needed to pass laws.

Lower House members:
(X means on board with the tax, - means against, ?
means undecided)
Conservative Party (Tories): 125 members X
Liberal Party: 125 seats -
Bloc Quebec: 50 seats ?
New Democratic Party: 29 seats X
Independent: 2 seats ?
Vacancies: 2 (I don't really know how to interpret
"vacancies") ?
Total: 308
Seats from the official Canadian Parliament website.

The Conservative Party and the New Democratic Party have publicly stated that they are for the measure, so that totals 154 votes (50% exactly), assuming they do not change their position, which appears unlikely as the Conservative Party has proposed the tax and the New Democratic Party is left-leaning. Reference: http://www.canada.com/nationalpost/news/story.html?id=9f67a23b-fb01-4639-a1a9-c091800956f6&k=18304

Apparently breaking party ranks and voting against the party is rare in Canada so it looks that the taxes have 50% support.

Bloc Quebec is for the measure but would like to extend the transition time to 10 years, and would also like more evidence of the need to transition. The Liberal Party has proposed a different measure, no new income trusts but income trusts allowed if they can show a positive impact on Canada -- this is the most reasonable proposal in my view, but they only have 100 votes, approximately 32%.

But in summary, the most important factor is that the Conservatives and New Democratic Party are on board and that is (almost nearly) enough to get the measure passed. I suppose an investment advisor can say "50% is not 51%" but 50% is close enough to 50% with Bloc Quebec still up in the air and independents and vacancies that it appears the tax is likely to go through.

It seems to me, if I were to put percentages on the passing of the tax (from my judgment only, albeit analyzing the issue for a few days), it would be: 60% passed as proposed, 30% passed with some/minor modifications and 10% passing the Liberal Party's recommendation (the passing of the Liberal recommendation would be the main driver of improved investor interest). A 10%-odd chance of the law not being passed does not make investment into the trusts on this basis very attractive -- what would be interesting is an analysis of the trusts assuming the elimination of the tax free status -- perhaps a change to a corporation, and valuation in this form -- but this subject is beyond the scope of this post.


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