The Best Canadian Companies Are About to Go on Sale
By Tom Dyson
March 17, 2008
Earlier this month, two Canadian income trusts said they might give up their trust structures.
Aeroplan is the air-miles marketing company for Air Canada. TransForce is a large trucking and oil-services business. Both said they are considering becoming corporations again.
Two weeks have passed since these companies broke the news. Aeroplan's stock is down 18%. TransForce's stock is down 26%.
When I saw the market's harsh reaction to these announcements, I immediately knew I'd found an opportunity for investors. Let me explain...
Canadian income trusts do not pay corporate taxes. Thus, they are able to return almost 100% of their earnings to owners in dividends. It's such an efficient structure, every company in Canada wanted to become an income trust, it seemed. Canada could not tolerate the tax loss and so, on October 31, 2006, the government announced it would tax income trusts, starting in 2011.
Here's the thing: In the early 1980s, Australia went through the same ordeal. Real estate and resource investments had already formed trusts. But in the early 1980s, Australian bankers realized any business could save tax and increase shareholder returns by converting into a trust. Dozens of firms converted... and the trust market turned into a bubble. One company's share price, Queensland Coal, tripled the day it announced conversion to trust structure in 1984.
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In 1985, the Australian government changed the laws to win back its tax revenues. It gave trusts three years to find an exit strategy or start paying the highest corporate tax rates. Most trusts converted back to corporations. Once the government had taken away the tax advantage, they had no use for the trust status. In fact, trust status was a major hindrance to most businesses. Most businesses need capital to grow. Trust structure makes you pay everything out in dividends... so there's never any capital available for growth.
Now Australia taxes all trusts... even resource trusts and real estate trusts.
The United States also had "income trust fever" in the early 1980s... except investors called the tax-free models "Master Limited Partnerships" or "Publicly Traded Partnerships."
Wall Street bankers started rolling all kinds of businesses into the trust structure when they noticed how much money a business could save when it didn't have to pay tax. Between 1981 and 1987, more than a hundred companies converted to MLP status in the United States. They even converted the Boston Celtics basketball team into an MLP.
This loophole was costing the federal government $245 million in annual tax revenues, so in 1987, it changed the law, just like the Australians had done two years earlier. Most of the MLPs converted back to corporate status... and the sector became the sole domain of pipeline and real estate companies once again.
Having seen how the trust structure turned out in Australia and the U.S., I don't think there's any doubt about what's going to happen in Canada:
In 2010, most Canadian trusts will convert to corporations again. They will cut their dividends and begin to act like regular public companies.
Judging by the reaction to Aeroplan and TransForce's announcements this month, investors have no idea that most Canadian income trusts will become corporations in less than three years. This makes me reluctant to invest in most Canadian income trusts right now.
However, I think there's an opportunity here too: buying Canadian trusts after they announce conversion.
The high-yield investors will all jump ship at the same time and push the prices of these businesses too low... just like they did with Aeroplan and TransForce. Wait for the income crowd to dump their shares, then scoop 'em up at bargain prices. You'll make a quick profit when the market figures out what these businesses are really worth. Plus you'll own a basket of top-quality Canadian corporations for your long-term portfolio.
One more thing: I see some other fantastic opportunities in Canadian income trusts right now. The trick is, you have to find the trusts that won't disappoint their income investors over the next three years. I know where to find these trusts. I'll explain in my next column...
Good investing,
Tom
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