One of the biggest hurdles facing income investors for years has been the fact that dividends were treated as taxable events. In the past year, the U.S. federal government took a more tax-efficient approach, allowing investors to treat their dividends as taxable gains, not as ordinary income. Although this is not the most ideal solution to encourage companies to pay dividends (as opposed to, say, getting rid of the tax on dividends on the corporate side), it did have the impact of fostering a higher valuation of dividends among investors in the U.S.
In Canada, legislators seem to be going in the opposite direction, and this could have an impact on the amount of net yield that both Canadian and non-resident investors get from income-producing Canadian equities, especially the high-yielding royalty trusts.
The result has been a sharply down day for all of the largest Canadian Royalty Trusts, including Enerplus (NYSE:ERF), Pengrowth Energy (NYSE:PGH), Petrofund (AMEX:PTF), Provident Energy (AMEX:PVX), and PrimeWest (NYSE:PWI). Each of these trusts has a dividend yield exceeding 10% per year, and the income is a large reason many investors buy them.
Under the proposed amendments to the Canadian Income Tax Act, the trusts would be required to withhold tax not only on the dividend component of their payouts to investors who do not live in Canada, but also for their "return of capital," which presently is not taxed. Enerplus' return of capital component for 2003 approached 15% of all monies returned to shareholders, where other trusts' percentage was substantially higher, up to 100%.
Another component of the proposed amendments to the Income Tax Act would be to remove an exception to the requirement that trust ownership by non-Canadians be no more than 49% of total outstanding shares. Enerplus disclosed in a letter to shareholders today that its foreign ownership is 64%. Should the exception be removed, the trusts would either have to compel foreign shareholders to sell, or sell the shares on their behalf. That would create an enormous amount of selling pressure. If this component of the existing law is removed, the funds would have several years before they would have to comply. So, this is not something that will harm the companies or their share prices, say, tomorrow. Still, this is a risk to shareholder capital that I'm sure they'd rather not have.
I find the definitions here somewhat baffling, particularly the requirement that the funds withhold tax for a return on capital. These are not gains: They are a method of returning the investor's committed funds to him or her. Why on earth would this be a taxable event? The Canadian government seems to be playing the "hold and obfuscate" game that seems popular with governments throughout the world. It gets to sit on the money and enjoy the float from the time it is paid to it until the time it must refund it, and the process to put in a claim on those refunds is just complicated enough that many investors won't bother, so Canada gets to keep the money for good.
As for the trusts, this isn't particularly a drain on their operations, but they are structured to pay out to shareholders. And such actions by the Canadian government necessarily reduces the value investors place on those future cash flows.
Bill Mann's second-least favorite sport is "track." His least favorite is "field." He holds none of the companies mentioned in this story. Bill notes that Mathew Emmert offers some excellent income-bearing investments each month in his newsletter Motley Fool Income Investor .
