With changes to the taxation of income trusts coming in 2011, oil and gas prices far off their peaks and political uncertainty the order of the day, there’s some concern that the cash-paying days of Canada’s royalty trusts are over.

Analysts aren’t worried, however. They suggest that some trusts will convert to corporations to escape the new levies. They will continue to pay dividends on an after-tax basis in amounts similar to what they would have paid out as distributions under the income trust structure.

“Some people think that trusts or their payouts will cease to exist on Jan. 1, 2011, [that] it’s Y2K all over again,” says Gordon Tait, managing director of royalty and income trust research for Bank of Montreal’s capital markets division in Calgary. “Payouts may take a different form to adjust to the tax change, but it’s still business as usual for oil and gas trusts.”

To discover which royalty trusts might successfully convert to corporations while continuing to provide investors with comparable cash outlays, he suggests you look for these balance-sheet traits:

> A Payout Ratio That Isn’t Causing The Business To Spend More Than It Earns. The payout ratio is a measure of the amount of cash a trust pays to its unitholders compared with the amount it has available to distribute.

To determine if a company can maintain its payouts, Tait suggests splitting the amount of distributable cash flow into two parts: capital spending and distributions. “Distributions to the investor should range between 40% and 60% of cash flow,” says Tait. “Expenses going to maintain the business or production might take another 40% to 50% of the business’s cash flow.”

Ideally, says Tait, capital spending and distributions to inves-tors should not total more than the company’s annual cash flow.

“A company should be paying for its maintenance expenses and distributions using its annual cash flow,” he adds, “not debt.” In fact, unitholders should worry if a company is borrowing to maintain its existing level of business.

However, says Tait, “If it is trying to grow the business, it’s acceptable to fund capital expenditures using both debt and equity.”

> Size And Quality Of A Trust’s Tax Pools. When a royalty trust reinvests in its business and acquires assets to do so, the federal government generally provides tax incentives in the form of credits or deductions. Over the years, these incentives have accumulated on the balance sheets of Canadian royalty trusts; collectively, they now total about $23 billion, according to BMO. These tax pools are crucial to royalty trust payouts, because they allow a trust to write down taxable income, thus leaving more cash to distribute to unitholders.

As a result of these accumulated tax pools, says Tait, the combined federal/provincial corporate tax rate a trust will pay is more likely to be in the neighbourhood of 10% for several years after 2011, until these tax shelters are used up.

“From a long-term perspective,” says Harry Levant, owner of Vancouver-basedwww.incometrustresearch.ca, “the dollar value of a company’s tax pools are only meaningful when you compare them to the actual value used for accounting purposes.”

Different writeoff rates occur for accounting and tax purposes. “Tax pools can be used as a marketing tool,” he adds. “That’s why it’s important for investors to understand these discrepancies.”

Companies use generally accepted accounting principles to calculate income tax expenses for their financial statements but use Income Tax Act rules to calculate the amount of taxes they actually pay. For example, let’s say that under GAAP, a company has a tax pool on its books of $200 million; in fiscal 2008, it writes off 10% of the pool, leaving $180 million on its books going into fiscal 2009.

Under the income tax rules, however, the company can write off 20% of the $200 million, which would make the tax pool worth $160 million in 2009 — less than the amount stated in the financial statements.

“In any event, the benefit is relatively temporary,” says Levant, “unless reserves can be substantially increased through exploration or acquisitions.”

At least one trust has increased its exposure to tax pools via an acquisition. Earlier this year, Calgary-based Superior Plus Income Fund boosted its unused tax pools by $900 million by acquiring those of Burnaby-based Ballard Power Systems Inc. for $46 million.

@page_break@“That was, flat out, $46 million for $900 million of brand new tax pools,” says Levant. “That’s a totally different deal than relying on tax pools that depend on timing differences in reporting accounting vs taxable income.”

> Commodities Prices. “The biggest influence on the distributions or dividends of royalty trusts is commodity prices, not taxes,” says Tait, and price is a market variable no one company can control. “The cash a company has to distribute goes up when commodities prices go up, and cash payouts fall when commodities prices go down. That provides both opportunity and risk to investors.”

It was in the late 1990s that royalty trusts gained a foothold in the financial markets as a way for businesses operating in the low-growth natural resources environment to access capital by attracting income-oriented investors.

But in 2006, the federal government, concerned about the large number of companies opting for the trust structure and the resulting reduction in federal tax revenue, announced the imposition of a new levy on income trusts (excluding real estate income trusts) beginning in 2011.

Originally, the specified investment flow-through tax was to be equivalent to the federal corporate tax rate of 31.5%. However, in 2007, Ottawa said the federal corporate tax rate would fall to 15% by 2012 from 19.5%, and later — in February 2008 — the feds decided that trusts would be subject to the combined federal/provincial corporate tax rate in the jurisdiction in which each trust is based.

But regardless of what tax rate applies to oil and gas trusts in the future, these trusts are in a better position than other business trusts to adapt to tax changes, says Tait.

“Every dollar oil and gas trusts spend generates tax writeoffs,” he says, “as the oil and gas industry demands that, every year, they have to spend about 30% to 50% of their cash flow simply to maintain production.”

Because of these royalty trusts’ ongoing stream of writeoffs, they can better sustain their payouts compared with other business trusts; they have more ways to shield their income from taxes and put more into the pockets of unitholders.

In the event an income trust converts to a corporation, inves-tors may find themselves better off, from a tax perspective, receiving dividends rather than trust distributions because dividends are eligible for special tax treatment vs other forms of income.

For example, if XYZ Trust converts to XYZ Corp. and continues paying unitholders — now shareholders — $1 in annual dividends, a typical Ontario investor would receive an enhanced dividend credit and keep 74¢ of his or her payout after taxes. If he or she had received a $1 trust distribution, only 54¢ would remain after taxes.

However, with this calculation, there are two caveats. The first is that the investor isn’t holding the investment in an RRSP or in a registered retirement income fund. The second is that the trust has the income stream to sustain the level of cash it pays out, once the effective corporate tax rate is tacked on. IE