Caution Is Rewarded Again

This week, a group of high-yielding stocks from Canada got hammered. Josh Peters, who runs Morningstar's Dividend Portfolio for our DividendInvestor newsletter, sent the following alert to his subscribers.

Dear fellow investors,

Tuesday brought some unfavorable news for investors in Canadian income trusts like  Pengrowth Energy Trust  and  Primewest Energy Trust . The Canadian government--already smarting over hundreds of millions of dollars in lost tax revenue from these trusts--has moved to equalize the tax treatment of income trusts and traditional corporations. The finance ministry's proposal would give existing trusts until 2011 to adjust to the new tax rules, while trusts forming right now (such as  BCE (BCE) and  Telus (TU)) would have to start paying taxes right away in 2007. The New York-listed trusts were down more than 10% across the board early Wednesday.

This validates, at least in part, the skeptical attitude we've had toward these securities. My primary concern has been the dependence of the bulk of these trusts on high oil and gas prices to maintain current distributions--at $40 a barrel, their payouts would be substantially lower. We've already seen distribution cuts from several trusts as natural-gas prices have plunged. Small wonder most of the trusts we've covered thus far have earned no better than a 1-star Morningstar Rating for stocks.

But it's also been hard for me to escape the tax-driven nature of these income trust conversions. Governments obviously need revenue to provide services to their citizens, and if corporations are paying less, ordinary folks must pay more. Recent plans by Canada's dominant telephone carriers to slash their tax payments via this paper maneuver apparently proved too much for the Conservative government to tolerate.

Moreover, I've always been wary of an investment whose main selling point is to minimize taxes: While no one likes paying taxes, and it makes sense to employ strategies to defer or reduce one's tax burden, it's equally true that there's no free lunch: Taxes are what we "get" to pay when we've made successful, profitable investments.

Fortunately, I see little parallel between these developments in Canada and the fate of U.S. tax-favored entities like real estate investment trusts and master limited partnerships. Unlike the Canadian loopholes that allowed virtually any business to operate as a trust, MLPs and REITs are tightly restricted in what kind of assets they can own.

* MLPs are only allowed to operate in energy production, transportation, and processing. Their favorable tax treatment is designed to encourage investment in these fields, and it has. Though their tax treatment has been and continues to be challenged in court cases, MLPs' entitlement to receive tax allowances in regulatory rate cases has stood up for 20 years. Moreover, unlike in Canada, MLPs are largely prohibited from tax-deferred accounts--meaning that the Internal Revenue Service does eventually get to tax MLPs' profits.

* REITs are meant to allow ordinary shareholders the tax advantages available when wealthy individual investors own real estate directly. Like MLPs, REITs have been around for a very long time and have a well-established tax status.

The only group of U.S. securities that I see at risk--and it's a very small group--are income deposit securities. These critters, like Coinmach Service , Otelco , and B&G Foods , attempt to disguise part or all of their dividends as tax-deductible interest payments. The IRS has not yet stepped in to address the matter, and these securities have been far less popular than their Canadian peers ($1 billion or so of total market capitalization, compared with C$200 billion for the Canadian income trusts). Nevertheless, I would stay far, far away from these investments.

I have few encouraging things to say about the fate of the Canadian income trusts. It remains to be seen how individual Canadian investors will react (most likely with anger) and how that will influence the government's final position. But many, if not all, of these trusts' current distribution rates may be at risk within the next few years.

Morningstar.com Premium Members can  click here to read a note from Morningstar's point man on Canadian income trusts, Kish Patel. He'll be updating his views on the sector as this situation develops, and analyses regarding individual trusts will be available on Morningstar.com. For my part, I'm sure I'll have additional commentary regarding the Canadian income trust sector in upcoming issues of DividendInvestor.

Best regards,

Josh Peters, CFA
Equities Strategist
Editor, Morningstar DividendInvestor