Markets hate uncertainty, and there are few asset classes facing more uncertainty right now than income trusts. The federal government has made it clear it intends to change tax rules in a way that’s almost sure to curtail their appeal. But that doesn’t mean investors should shun these products.

The income trust phenomenon has long bothered the government. Specifically, it worries that its corporate tax revenue is in jeopardy as more and larger public companies opt to organize themselves as income trusts. In the 2004 budget, the government proposed to deal with this problem by restricting pension plans from owning so-called “business” trusts. This idea was met with howls of protest and so the government backed down, although it promised further consultation on the issue.

Those consultations began on Sept. 8, when Ottawa issued a discussion paper that lays out its worries and proposes several solutions (please see sidebar). But the paper’s release apparently didn’t engender the reaction the government sought.

Several commentators scoffed at its seriousness. A handful of companies didn’t read the paper as a meaningful threat to the viability of the sector, as they declared their intention to convert to the trust structure in the near future. The industry was buzzing with speculation about other future converts — going so far as to speculate that parts of the big banks could be efficiently spun off into trusts — and the leading candidates saw their stock prices jump in anticipation.

The government moved to quell much of this talk on Sept. 19, when Finance Minister Ralph Goodale asked the minister of national revenue, John McCallum, to stop issuing advance tax rulings on trust conversions. These rulings aren’t strictly necessary for most companies looking to convert, but are popular with cautious boards of directors because they provide some comfort that the transactions will pass muster with the tax authorities.

The moratorium on these advance tax rulings throws proposed conversions into some doubt and may deter companies contemplating a conversion from proceeding. The immediate effect of this is to kill speculative trades based on the possibility of imminent trust conversions.

Companies that are viewed as attractive trust conversion candidates, such as AGF
Management Ltd., TSX Group Inc., Canaccord Capital Inc. and even BCE Inc., generally saw their stocks run up in the days following the release of the consultation paper as other prominent companies, such as CI Fund Management Inc. , announced their plans to convert.

However, much of that air came out of those stocks when advance rulings were banned. And, until the issue is resolved, it’s likely the trading in anticipation of conversion is largely dead.

That said, it’s possible some companies may go ahead with conversions anyway. CI,
for example, which was seeking an advance tax ruling, has said it will consider going ahead without one. While it’s a much riskier trade now, some investors may still be willing to make this play. In a recent research report, Canaccord counsels: “Investors might want to look at all of the trust conversion stocks and ask themselves how much of the current price reflects long-term equity value, and how much can be characterized as a trust conversion premium. If the conversion premium is low enough, there might be merit in buying an equity with a cheap call option on a trust.”

However, both prospective trust converts and existing trusts face an uncertain future in terms of their tax treatment. Will the government make changes to the tax treatment of trusts? If so, when? And just what will those changes be?

The government certainly appears committed to doing something to minimize the tax advantages trusts enjoy compared with traditional corporate structures. However, it hasn’t signalled a clear preference on just how it would like to do that. It simply may not know how it wants to proceed. More important, the government may face an election, and it’s impossible to predict how that will play out.

So, what’s an investor to do amid all of this uncertainty? Tax experts warn against overreacting to the government’s apparent intention to burst the trust bubble. For one thing, it seems far from committed to a particular course of action. Given its willingness to listen to the diverse range of market players that have an interest in these decisions, the sheer size and number of such players — including issuers, retail and institutional investors, and investment dealers — and their collective influence, it’s hard to imagine the government pushing through any drastic, wildly unpopular changes to the tax treatment of trusts.

@page_break@Indeed, this consultation may drag on for a year or more, suggests Kim Moody, a chartered accountant and partner with RSM Richter LLP in Calgary. He suggests it will take some time for the government to come up with a solution. In the meantime, this new uncertainty about future tax treatment is no reason for investors to shun trusts.
“You don’t let the tax tail wag the dog,” says Moody.

Paul LeBreux, chairman of the Society of Trust and Estate Practitioners (Canada) and president of Global Tax Law Professional Corp. in Toronto, agrees. He suggests investors in the market for income trusts should still be evaluating them based on their fundamentals, such as their ability to pay distributions and generate yield. The possibility of a change in tax treatment shouldn’t deter an otherwise sound investment decision. “If you base your decisions on [what the Finance Department may do], you may end up owning nothing because you’d just sit back and wait every day,” he points out.

Avoiding trusts for the sake of uncertain future tax policy changes could be a costly decision. Investors may be forgoing some strong returns. In fact, the huge spike in oil prices has some of the energy royalty trusts flush with cash, and perhaps able to raise their distributions. Becoming gun-shy about tax policy risk could represent even greater opportunity cost.

Existing trusts may also benefit from the government throwing up obstacles to future conversions. Indeed, Canaccord suggests: “The most likely near-term beneficiary in this environment is the established trusts in a position to consolidate while corporate entities are trapped as corporations.”

That said, if the government is determined to do something to reduce income trusts’ tax advantages, ultimately their appeal will suffer. LeBreux notes that while the trust phenomenon has been fuelled by a perfect storm of macro and micro factors, it’s possible that we could witness the perfect storm to quell the trust sector, too.

He suggests that if the government truly wants to plug the tax leakage from trusts, it will have to do more than simply cut dividend taxes; he sees taxing distributions as the more effective solution.

Also, economists generally expect interest rates in Canada to rise gradually. If rates do
rise, dimming the appeal of trusts generally, and the government tinkers with the tax system to take away trusts’ inherent structural advantages, LeBreux suggests the trust vehicle could largely disappear — apart from the traditional royalty trust. Yield-hungry investors would be pushed back toward more traditional investments. IE