Key Market Facts

November 3, 2005

You have probably read numerous articles in the paper over the past six weeks on income trusts. They have definitely been the topic of many conversations. This article will summarize for you my view on the issue, its impact on the sector and my recommendation on what to do.

Income trusts have been an asset class available in the market for a number of years however in the past three years the sector has been growing in leaps and bounds. In early 2004 the Department of Finance considered capping the amount of income trusts that pension funds could own as they were, and still are, concerned about the tax leakages surrounding them. After some strong lobbying on the part of pension funds this idea was dropped however the problem of how to stop the tax leakage was still on the mind of the Minister of Finance.

In early 2005, the limited liability legislation was clarified which paved the way for the pension funds to start investing in these securities. Around this same time, their future inclusion into the TSX was also announced for later in the year.

On September 19th the Department of Finance announced that effective immediately it would postpone any advance rulings on Income Trusts and Flow through entities until the Government identifies a clearer policy solution. This came shortly after a comment by the Royal Bank that they may consider converting part of their business to the income trust structure.

When the income trust structure was first created, I believe it was meant to help smaller companies who were having difficulty raising capital in the market due to the infrequence of their need or size of their business. However it was not the intent of the Government for all currently trading public companies to convert to income trusts. This is what has been happening because of the tax advantage to the corporation and the retail investor’s need for income and this is what the government believes it needs to stop.

This announcement and the white paper release had a negative impact on all income trusts, but in particular the business trusts as individuals and institutions speculate as to what the Government is going to do to the sector. There are a number of ideas being discussed in the market places right now such as:

1. impose a tax on trusts
2. reduce corporate taxes
3. reduce the dividend tax rate
4. limit tax exempt investments into the sector
5. prohibit existing publicly traded companies from converting to trusts
6. limit deductibility of interest
7. do nothing

Most likely, there will not be an announcement as to what they are thinking of doing until the Spring of 2006. It is a difficult decision for the Department of Finance to make as these securities are important to aging Baby Boomers planning for retirement and to retirees, all of who go to the polls to vote. As well, part of the decision to change the tax treatment must address the social implications.

What does this mean for those of you invested in these securities? As you all know I have been cautious about this sector since the beginning, but in particular with the business trusts. I have always been skeptical as to how a number of the business trusts would be able to sustain their cash flow and therefore distributions.

My belief is that Government will do some combination of taxing business trusts and reducing corporate dividend taxes. They may even restrict the conversion of publicly traded companies to trusts. In any case I recommend that all clients reduce all remaining positions of business trusts or funds with business trusts in them by December 2005 / January 2006.

For conservative clients I would also recommend that you lower your exposure to all energy trusts, even if it is just until the Government has made a decision. I believe the oil & gas trusts will come out of this OK, provided energy prices stay strong, but they could also correct if there is panic selling.

I believe that if a tax is imposed on the trusts it will be specific to business trusts and will exempt oil & gas trusts but there is still a risk there and I would hate to see all the gains achieved over the years wiped out. If I am wrong and the government does nothing we can always go back in and raise exposure again but I would not recommend clients take that risk.

The area of the market that I believe will benefit the most from any tax changes the Government impose on the trust or corporate sector will be good quality, dividend paying common shares. This is where I would look to places some or all of the proceeds of the income trusts. To find out what would be the best solution for you please contact me directly at 604-257-7055.

Oil Prices & Equities

I want to comment briefly on the volatility of the market as it relates to oil prices, interest rates and equities. I have had a number of conversations with individuals over the past few months on this topic.

There is significant speculation on what is going to happen to the price of oil. This leads to extreme volatility in its price. Concerns about supply, refining capacity and disruptions to distribution coupled by a global increase in demand makes investors uncertain as to what is real and what is a short term shock.

Today, given how high oil prices have moved over the past year, central bankers are concerned about inflation and to what extent the increased energy prices are going to effect it. For this reason, I believe we will continue to see higher short-term rates in the US and Canada over the next 4-6 months as a preventative measure.

Higher interest rates and higher energy prices both lead to a slow down in economic growth. This will be even more pronounced if long-term rates do not move up with short-term rates.

I believe the next 6 months will bring significant challenges to the market and that clients should be defensive in their positions of both equities and fixed income. I do however also believe that clients should have an appropriate exposure to the energy and resource sector as it will continue to be an important part of the market in the years to come. The amount will depend on your risk tolerance level and your ability to tolerate volatility. Please contact me directly to discuss what would be appropriate for you.

Did You Know?

• Effective October 3, 2005, Proctor & Gamble acquired Gillette. Clients holding Gillette received 0.975 shares of Proctor and Gamble for each Gillette share.
• Petro Canada Split 2 for 1 on September 15th
• Fording Coal split 3 for 1 on August 31st

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