After markets closed October 31, the Canadian government's department of finance announced sweeping changes in the taxation of income trusts, imposing taxes on distributions for new trusts in 2007 and grandfathering in existing trusts in 2011. Canadian tax-exempt investors would have their effective rate rise from 0% to 31.5% in 2011. U.S. investors would have their effective tax rate rise from 15% to 41.5%.

The government's announcement has led to a dramatic decrease in trust-unit prices and has longer-term implications that are positive for U.S. companies looking for crossborder exposure.

The trusts have existed in Canada since the late 1980s but became a dominant force since early 2000, growing from 12 trusts at that time to 37 by year-end 2005. The trusts have enjoyed a cost-of-capital advantage, which has made it difficult for U.S. or even non-trust Canadian firms to compete in property and corporate acquisitions. The result has been an increasing dominance by trusts in the M&A marketplace, as evidenced by their growing share of Western Canadian conventional production, up from 2% in 1996 to nearly 20% in 2006.

This advantage has also contributed to some of the most expensive transaction metrics in the world and spiraling service and land costs. This unequal playing field was a factor in many U.S.-based companies eventually exiting from Canada and encouraged many non-trust Canadian companies to sell properties or to take advantage of the enhanced multiples by converting into trusts.

Following the October announcement, the trust market fell sharply and continued to decline during the next few weeks as the market digested the news. The sector was down as much as 23% before regaining ground, stabilizing at 12% below pre-announcement levels as of December 6. The implications of the October news are myriad.

Cost-of-capital advantage gone. The trust sector has enjoyed a significant competitive advantage during the past several years, as their non-taxable status-coupled with the market's desire for income product-meant they typically traded at premium multiples, translating into a cost-of-capital advantage over the rest of the E&P market. This advantage has largely evaporated, as the trust sector has sold off and access to capital has been impaired.

Asset values down. Early indications in the M&A and divestitures market are that transaction metrics will be 10% to 15% lower in a taxable-trust environment. The trusts have dominated the acquisition market and have effectively been able to bid on a pre-tax basis. With the change in taxation and the trust sector's increasing cost of capital, acquisition metrics will need to reflect their new taxable status. This competitive change will give U.S. and foreign companies a reason to consider reentering the Canadian market.

Resource play/consolidation. The environment for crossborder M&A will still be fairly challenging for most U.S. companies looking to acquire in Canada. However, the playing field has become more competitive for resource play assets/corporations. The consolidation of companies with gas-resource plays is increasingly attractive to U.S. producers, given less competition from trusts.

Valuations for resource-play companies in Canada are still relatively high. Long-life gas-resource plays in Texas, Louisiana and the Rockies are being acquired at aggressive premiums, which suggests U.S. and other foreign companies should have renewed opportunity and interest in acquiring Canadian resource plays.

Hurdles to reentering the Canadian E&P landscape remain, however.

Weaker U.S. dollar erodes purchasing power. The exchange rate has eroded since the U.S. company dominated the M&A cycle in 2001. U.S. producers enjoyed a US$1-to-C$1.56 exchange rate in the $27-billion M&A cycle in 2001. The exchange rate of US$1-to-C$1.15 as of December 13 erodes the currency advantage enjoyed in the last cycle.

U.S. valuation gap has closed. There has been a convergence of multiples between U.S. independents and Canadian senior producers since early 2000. In addition, trusts that are desirable from both a scale and inventory perspective still trade at a premium to most potential U.S. acquirers.

Trusts expand focus. Trusts with premium assets will still command high multiples and could expand their universe of potential acquisition targets beyond the Canadian border, evaluating assets in the U.S. and internationally on an after-tax basis. In effect, the Canadian tax advantage has been eliminated but well-managed trusts will still be able to compete globally.

In summary, U.S. E&P companies slowly exited Canada in the last few years in part as a result of the competitive advantages the trusts enjoyed in terms of cost of capital and resulting higher transaction multiples.

Given the new tax landscape in Western Canada, the marketplace will become more attractive to U.S. and foreign companies looking to compete, given lower transaction metrics and a less competitive environment. There are still substantial hurdles, but at least the playing field has been leveled and opportunities will exist for those companies willing to take a second look to the north.