In recent years, master limited partnerships have taken the income-investing world by storm, granting energy- and natural-resource-related companies a tax-favored vehicle with which they can give their investors a big advantage over regular corporations. With Washington on the prowl for additional sources of income and a ready source of profits available, will tax-policymakers in the U.S. take a lesson from their neighbors to the north and do the same thing to MLPs that Canada did to royalty trusts?
Why investors love MLPs
It's no big secret why investors have become so enamored with master limited partnerships. Most MLPs pay sizable distributions to their unitholders, and much of those distributions typically goes untaxed as return of capital, deferring liability until investors sell their MLP units.
Moreover, on top of that income, strong prospects in hot areas like pipelines and energy storage facilities have led to capital appreciation for those assets as well, giving investors double returns. Pipeline giant Kinder Morgan Energy Partners (UNKNOWN:KMP.DL) has seen its unit price rise almost 20% in the past two years, adding to its annual dividend yield of around 6% as it has incorporated assets from its general partner's massive acquisition of El Paso. Similarly, Enterprise Products Partners (NYSE:EPD) has added a nearly 30% rise in unit price to its 5% yield, as projects like its Seaway Pipeline to carry energy products from the Cushing hub to the Gulf Coast have gained traction.
Too much of a good thing?
Countless times in the past, when irresistible tax breaks have been available, people have used them more and more. That may be what's happening with MLPs right now.
In a recent Barron's article on MLPs, one expert noted that companies are increasingly creating MLPs with assets other than the traditional midstream infrastructure plays. With MLPs getting formed that do business in areas from downstream operations like refining and gas-station operations to ancillary industries like fertilizer production and sales of sand used for hydraulic fracturing, businesses are clearly seeking to take advantage of the tax benefits of MLPs as much as possible.
Halloween Massacre, Part 2?
In the past, when companies overuse a tax benefit, Congress has often stepped in to limit or eliminate its use. In that regard, Congress could take a lesson from what Canada did to its own tax-favored energy structure, the Canadian royalty trust, also known as the Canroy.
Rich in resources, Canada has always had a concentration in energy and mining companies. In order to encourage activity in the industry, Canadian law provided for royalty trusts that could pass their income directly to shareholders. Although the structure started out being used for energy-related businesses, slowly but surely, Canadian companies sought to expand their use to include other types of companies. When telecom giant BCE considered converting to Canroy status, Canadian lawmakers got the message that they needed to clamp down on misuse of the corporate form.
As a result, in what has now been dubbed the Halloween Massacre, Canada announced back in 2006 that it would phase out favorable tax treatment for Canroys. The law's provisions gave the royalty trusts five years before they would take effect.
In response, former high-flying Canroys Penn West Petroleum (NYSE:PWE), Enerplus (NYSE:ERF), and Pengrowth Energy eventually converted to corporate status, accepting the tax disadvantages of ordinary tax laws for Canadian businesses. With the added entity-level tax burden, in combination with weak fundamentals, these entities all dropped their dividend yields precipitously following the move. Although all three of these companies continued to make payouts after their conversions, Precision Drilling (NYSE:PDS) wasn't as fortunate, having to eliminate its dividends entirely for years before just recently reinstating them at a lower rate.
Could it happen here?
At this point, most MLPs are still at least peripherally related to energy and natural-resource production, so we're likely not at a critical juncture just yet. But at some point, Congress may look longingly at MLP profits and decide that they're just too attractive not to take a bigger piece of the pie, and investors will need to be ready in order to avoid another Halloween Massacre.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Precision Drilling and recommends Enterprise Products Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.