GUEST COLUMN — How to make a royalty trust

It seems that everyone wants to buy royalty trusts involving mining or oil and gas because interest rates for those trusts are low compared to investor expectations, and there are few alternatives for the investor who is seeking yield.

The conventional mining or oil and gas royalty trust buys royalty interests from producers. The producer has to want to sell an interest in its properties, and has to accept full taxation of the proceeds either by using available tax pools or paying cash taxes. There are not enough sellers with quality properties to satisfy the soaring demand.

On the other hand, there appear to be a number of potential vendors of mining and oil and gas companies who would be interested in any arrangement that increased the sale proceeds for their shares. But buying shares of a company has very different tax results from buying assets.

If the corporation for sale has reasonably stable production and relatively long-term reserves, it can be converted in to an artificial royalty trust.

The key is to create a structure where the income stream from production will be subject to only one level of tax, at the investor level (and no current tax at all, if held in an RRSP or pension plan). Further, the structure must ensure that a high-level of the cash flow is in fact distributed to investors and not diverted to corporate adventures; this is, after all, designed to appeal to the investor seeking yield.

The offering of units of the Luscar Coal Income Fund illustrates the process.

Luscar, a private company, is one of Canada’s four major coal producers. More than 50% of its coal production is sold to Canadian utilities under long-term contracts. The family group that owned Luscar wished to sell the company. The following are the steps taken to create the Income Fund:

* A single purpose trust (the Income Fund) was formed and issued trust units to investors for net proceeds of $441 million.

* The Income Fund invested $350 million in 12.5% debt and $91 million in special shares of the acquisition corporation formed by the group that will continue to manage the operations.

* The acquisition corporation purchased the shares of Luscar from the selling shareholders for $441 million.

* The acquisition corporation amalgamated with its new subsidiary to form amalgamated Luscar (Amalco).

The results of this are as follows:

* A high proportion of the operating cash flow is extracted from Amalco as deductible interest expense (leaving just one level of tax).

* Amalco’s after-tax cash flow in excess of debt servicing will be distributed as taxable dividends.

* Interest and dividend income of the Income Fund will be flowed out to the investors (and taxed to them).

* Payments of debt principal received by the Income Fund, as well as cash payments equivalent to the Income Fund’s deductions for issue costs, will be distributed to the unit holders as returns of capital.

This is an investment with all the attributes of a royalty trust. Evaluating the investment merits of the units requires careful analysis, as would an investment in any of the royalty trusts or income funds. In the Luscar Income Fund, there is a combination of a higher yield debt instrument and a straight equity investment, both of which are dependent on a particular business operation. The tax costs of distributions to investors will depend upon the components of the distributions each year. In an economic sense, a portion of each distribution has to be considered to be a return of capital, and the yield computed with that factor in mind. As with any yield instrument, the market value will be very sensitive to interest rates. Pay your money and make your choice.

— the author is a tax principal with KPMG’s Mining Group in Toronto.