It was a good ride while it lasted. But when Canada’s federal government decided it was time to stop, the income trust market came to a crashing halt. And the financial services sector — and, indeed, the capital markets — are bound to feel its impact for some time.

For the second time in the past 12 months, the income trust sector was rocked by a government determined to plug tax leakage and to correct the market distortions that income trusts create. While the first effort ended somewhat benignly, with a dividend tax cut, the second brought the hammer down, with Ottawa determined to tax trust distributions directly.

The recent approach is perhaps the bluntest and most unequivocal way to put an end to the tax arbitrage that companies have enjoyed by structuring themselves as income trusts rather than as corporations. In time, it may lead to the end of the trust structure entirely.

In the short term, however, the surprise announcement by federal Finance Minister Jim Flaherty roiled the markets as investors scrambled to figure out the implications of the decision. Under the proposal, any new trusts will be subject to the new tax immediately, and existing trusts will have four years prepare for it — meaning they will pay up starting in 2011.

So, the primary reason for a company to structure as a trust is eliminated. This is expected to halt any new trust conversions immediately, including those planned by giants BCE Inc. and Telus Corp. Moreover, the valuation premium enjoyed by existing trusts because of their tax advantage, and the speculative premium in prospective converts, will also evaporate. Some existing income trusts probably will change their structure. CI Financial Income Fund “will almost certainly convert back to a corporation at the end of 2010,’’ says CEO Bill Holland.

Ultimately, the trust vehicle could retreat into obscurity. In a special report on the government’s move, TD Bank Financial Group notes that, without the tax advantage, there’s little reason for any company to adopt or retain the trust structure. Disclosure requirements may be a little less onerous, but securities regulators are working to close that gap, as well.

And, TD points out, trusts face restrictions on how they can use their profits. If shareholders really want to impose discipline on management by having companies pay out most of their income, companies can do so with dividends — and still have flexibility. Therefore, TD suggests, the income trust sector may not be around in 10 years.

To soften the blow of his potentially devastating decision, Flaherty has also promised a modest corporate tax cut of 0.5%. He also has proposed a few measures to give some tax relief to seniors, some of whom saw income trusts as a regular source of retirement income and loaded up. Flaherty’s plan allows seniors to begin income-splitting in 2007, and raises the age credit by $1,000 (see page 6).

Not only do these measures take a bit of the sting out of the trust decision, but they may also help ensure that the proposal gets passed. Any significant new policy measures by a minority government are vulnerable to Opposition intransigence. There is also a possibility that the government can fall on some other issue before the new tax measures work their way through Parliament.

TD suggests that the tax changes will probably be introduced as a package early next year, making it hard for the Opposition to vote against welcome tax reform for seniors, even if it would vote against the distribution tax idea on its own. In fact, one party has already voiced support for the government’s decision. So, a tough vote on the issue may not be a problem.

Still, the government may yet fall for any number of reasons, including its next budget. The TD report predicts that, unless the government is toppled over its budget, the proposed new tax regime will take effect.

Assuming the plan goes ahead, there are numerous implications for the markets. Not only do trust conversions stop and existing trust share prices fall, but investors in search of income may well turn back to traditional high-yielding securities, such as bank stocks.

Although increased investor interest in their stocks may be a positive for the banks’ trading multiples, the flip side is that many financial services firms’ revenue could be hurt by the end of the income trust party. Trust conversions and trust issuance have been a strong source of fees for investment bankers in recent years. Moreover, funds that invest in income trusts have been one of the few strong-selling sto-ries in the asset-management business. The impending doom of the sector spells trouble for trust-related businesses on both the buy and sell sides.

@page_break@In a recent research report, CIBC World Markets Inc. suggests that a worst-case scenario would be a fall-off of 2%-4.5% for overall bank revenue in fiscal 2007 as a result of lost investment banking and asset-management fees.

In time, the report says, the shortfall may well be made up in other ways as issuers grapple with the impact of the change. Some companies will again raise capital in the traditional debt and equity markets, rather than in the trust market, and increased advisory fees will be generated as the affected trusts pursue mergers, acquisitions, privatizations and other transactions.

All of which makes forecasting the fallout exceptionally perilous. The CIBC report, however, takes a rough shot at it, pointing out that the banks’ capital markets-driven businesses represented about 30% of their earnings in the past 12 months. It also estimates that trusts have accounted for about 35% of all equity issuance in Canada in the past few years.

“Issuance activity and lending volumes will, in our view, clearly decline and, to the extent that overall trading business declines, we believe the banks’ capital markets arms will experience a short-term decline in earnings,” the report says. At worst, Flaherty’s decision could chop between 1.5% and 4% from the banks’ earnings. The possible negative impact on the banks’ wealth-management arms — through lower fund values and slower sales — could cut a further 0.5% from overall bank earnings, the report suggest.

The banks aren’t the only ones that stand to suffer. BMO Capital Markets says TSX Group Inc. will be hurt by the move, too. The income trust business, along with strong commodity prices, has been a key driver of TSX growth in recent years.

The mutual fund industry also faces the prospect of lower revenue, as the trust valuation premium evaporates and funds feel the effects on their portfolios and overall sales. In a separate report, CIBC estimates that the new tax environment could seriously affect mutual fund industry asset growth. Before the trust news, it was predicting 12% asset growth, comprising 8% market appreciation and 4% net sales. Now, it has chopped its market growth estimate to 6%, and predicts that net sales growth with be replaced by 1% in net redemptions, for overall asset growth of just 5%.

CIBC notes that in the past 12 months, income-oriented funds (bond, balanced and dividend funds) have accounted for a significant amount of industry net sales, much of it driven by the popularity of income trusts. “We do not believe the industry can replace the popularity of these products in the short term to retain all of the assets,” the report concludes. “Our dilemma is determining where retail investors will direct their future fund flows.”

CIBC predicts that the initial market uncertainty might drive some investors to money markets and bond funds.

There might also be some flows into equity funds. “Although, given that these are higher-risk asset classes and that many Canadian equity funds invest in income trusts, we are not overly optimistic about the future potential of these asset classes,” CIBC reports.

One of the reasons for the popularity of income trusts with fund investors in the first place is that they were perceived, rightly or wrongly, as a safe haven after the market meltdown in technology stocks. In their place, the report suggests, structured products, particularly those that are principal-protected, might pick up some assets.

The sales trends should favour the bank-owned fund companies, CIBC says, and the expected sales slump and lower market returns could hit the independents companies’ EBITDAs.

Although the financial services industry looks sure to be thumped by the government’s sudden policy shift, it is not alone. The energy industry may take an even bigger blow. There is some fear that the elimination of trusts’ capital cost advantage will cascade throughout the oilpatch, eroding capital efficiency in that industry.

A bigger concern is opportunistic investors such as private equity players, hedge funds and foreign companies taking advantage of the large price drop to acquire Canadian assets on the cheap.

According to an RBC Capital Markets report: “To many, the next few weeks or months may provide an opportunity, perhaps of a lifetime, to acquire great Canadian businesses at potential fire-sale prices. In particular, Canadian oil and gas trusts, some with incredible assets, could find themselves very, very vulnerable.”

Analysts at Canaccord Adams Inc. echo the concern, warning: “If the tax proposal is enacted as presented, we believe that Canada will lose control of its energy sector and investment activity will decline in conventional oil and gas production. This tax proposal puts a ‘for sale’ sign on Canadian energy resources by removing a competitive cost of capital advantage — a wave of foreign takeovers is likely to emerge.”

Whether trusts can adequately defend themselves against such a wave is not clear. Despite the unequivocal nature of Flaherty’s proposal, there is some uncertainty about its details.

One point that analysts have focused on is whether existing trusts that try to capitalize on their capital cost advantage (by making large acquisitions) over the next four years might be blocked. The proposal only says government won’t interfere with “normal growth,” but may react to “undue expansion.” It is not clear what constitutes “undue expansion.”

Ultimately, some fear that the policy shift could even erode confidence in the Canadian capital markets.

“By reducing the level of confidence in Canadian capital markets, foreign investors and pension funds may look to other, more stable jurisdictions to invest their assets — potentially starving certain sectors and industries in Canada of the capital needed to develop fully our resources base,” cautions BMO.

Moreover, Canaccord suggests, the proposal could significantly hamper the standard of living for those retirees who have relied on the trusts to generate income: “Unless we remove the negative tax policies that discourage corporations from paying higher dividends and distributing non-productive capital, Canadians without trusts will have to sell their nest eggs to fund retirement. This retirement funding problem cannot be underestimated.” IE