Tempting Fate in Canada and the United States

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

October 31, 2006 is a date that is engrained in the minds of those who owned Canadian Royalty Trust. That was the day that the Canadian government decided, literally, overnight to tax a previously tax advantaged corporate structure. The market's response was, indeed, swift and painful, earning the event the nickname The Halloween Massacre.

Even the largest and most established CanRoys got hammered, including Enerplus (NYSE: ERF) and Penn West Petroleum (NYSE: PWE).  The selling was indiscriminate and was a scary example of throwing the baby out with the bathwater. While, several years later, many of the companies have recovered, to some degree, the drama of that event still lingers.

Why?
The Canadian Royalty trust corporate structure was designed to allow select businesses to avoid taxation by passing income directly to shareholders. This allowed the companies to pay large dividends and expand rapidly via acquisition (a factor based on the ability to pay higher prices for assets because of lower taxation). While the CanRoy structure was originally intended to support energy projects, it was slowly, but surely, used by other types of companies to avoid taxation at the corporate level.

Watching this, the Canadian government had been discussing the tax issue for years. Having seemingly dismissed the idea, news that BCE (NYSE: BCE), one of Canada's largest telecoms, was planning to convert to the tax advantaged structure turned more than a few heads. While this wasn't the only thing that led to the decision to tax Canadian Royalty Trusts, it certainly helped break the camel's back.

Taxes, Taxes, Taxes
The CanRoy structure wasn't the only tax advantaged structure in existence at the time, but it was the only one that the Canadian government decided to tax. There are still real estate investment trusts (REITs), publicly traded limited partnerships (LPs), and business development trusts (BDCs). These three entities are largely found on U.S. exchanges. However, the REIT structure also exists in Canada.

There has been a wave of completed and announced REIT conversions in the United States, including paper companies, cell tower owners, billboard owners, and, most recently, Penn National Gaming (NASDAQ: PENN). It seems that every company that announces a conversion experiences a price surge.

With taxes taking center stage of late, particularly tax loopholes, the trend of companies looking to avoid corporate taxation can't be viewed in a positive light in Canada any more than it is in Washington. Indeed, the double taxation of dividends (at the corporate and individual level) may seem wrong to shareholders, but it just adds up to more dollars to those collecting the taxes. Add the socially touchy subject of gambling to the mix can only make things worse. It doesn't take much to imagine more stringent oversight of the REIT industry in the United States or, worse, the loss of pass through status. Precipitated, of course, by too many companies stretching the rules to change their corporate structure.

A Grocery Store REIT?
Now, back in the Great White North, Loblaw (NASDAQOTH: LBLCF) has announced plans to convert into a Canadian REIT. The shares rallied strongly on the news. However, this could bring a great deal of unwanted attention to the REIT structure and its inherent tax advantages. While the structure of the U.S. government makes it hard to change rules overnight, Canada's rules are a bit different. It takes even less imagination to foresee the Canadian government making tax rule changes when one of its largest grocery chains decides to convert to a REIT, ostensibly, to avoid corporate taxes.

It's hard to imagine the REIT structure going away, but it could become much less beneficial. Moreover, if such an event were to take place in Canada, it would provide cover for a similar move in the United States. True, the limited partnership structure in the United States survived the Halloween Massacre (the two entities are similar in many ways), but LPs are also under the microscope today for potentially moving beyond their originally intended purpose.

There is nothing imminent that I know of, but tax issues are a major topic of discussion today as governments look for more ways to fund their operations. Watching a flood of companies convert to a tax advantaged corporate structure that may or may not be a good fit just to avoid the tax man doesn't help me sleep at night. There could be a domino effect if Canadian leaders feel the same way.

Yours,


ReubenGBrewer has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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