The tide of trust conversions has overwhelmed many naysayers and doubters, but the structure still can’t shake the spectre of government or regulatory intervention, which could yet spoil the party.

Until recently, the fear of the federal government doing something to upset the income trust sector had seemingly abated. The Liberal government backed off the idea late last year after its consultation concerning possible changes to trust taxation produced plenty of outcry from both Bay Street and voters. The Conservative government adopted the Liberals’ policy on the income trust issue, cutting dividend taxes to improve the relative tax treatment of corporations and trusts.

However, the issue is alive once again. The solution of cutting dividend taxes didn’t eliminate the tax advantage that trusts enjoy. And now, some very big companies — Telus Corp. and BCE Inc. — are planning to convert to trusts, moves that threaten to exacerbate whatever worries the government has about the proliferation of trusts.

While it may legitimately have some idealistic concerns about the distorting effects of trusts on capital markets and corporate decision-making, the government’s plainest worry is the tax revenue loss it suffers when a company chooses the trust structure over the traditional corporate structure. The current revenue loss through income trusts is about $700 million annually, according to Jack Mintz, professor of business economics at the Rotman School of Management at the University of Toronto. When the BCE and Telus conversions take place it will be about $1.1 billion.

For taxable investors, who control an estimated 39% of trust units, the trust phenomenon is a wash. In Mintz’s calculations, the corporate tax burden avoided by trusts is simply shifted onto their unitholders. It’s the tax-advantaged investors that matter.

Pensions and RRSPs account for about 39% of trust ownership. Mintz estimates that for these investors, the government will lose $1.1 billion in corporate tax revenue (assuming the Telus and BCE conversions go ahead), but it will gain back $300 million in the form of increased revenue from taxpayers due to increased retirement income. Non-resident investors represent the remaining 22% of trust ownership. The loss in corporate tax revenue for these investors is an estimated $600 million, whereas the withholding taxes they pay adds about $300 million to government coffers. So the greatest source of tax leakage is the tax-free investors — pensions and RRSPs — accounting for $800 million of the estimated $1.1 billion in overall lost revenue annually.

The recent dividend tax cuts mitigate the overall size of the revenue loss, so the shortfall isn’t as large as it would have been had these conversions taken place back in 2004. But it’s the trend that may bedevil the government.

In 2004, Mintz estimated the revenue shortfall at about $500 million a year. With the proposed BCE and Telus conversions, that shortfall will have doubled. If more big companies join the party, the pressure to close the loophole could grow.

So far, the government has remained conspicuously obtuse on the issue. Federal Finance Minister Jim Flaherty has been quoted expressing “concern” about the trust issue generally, but he has also stressed the importance of tax cuts in maintaining economic growth.

In news conferences held since the telecom conversions were announced, Flaherty has assiduously avoided taking any position. “As I’ve said before, I won’t comment on any particular conversion or proposed conversion involving any particular corporate entity in Canada. We do remain concerned about the issue and we do continue to monitor the situation,” is all he would say at a recent news conference in Vancouver.

In a report following BCE’s announcement, UBS Securities Canada Inc. suggests that it’s unlikely the current government will want to tinker with the trust issue. It points out that the previous government probably suffered political harm when it tried to deal with the issue. That administration was soundly criticized by the opposition, now the government, for its handling of the issue. And the new government didn’t address the issue in its first budget.

“Only nine months ago, the Conservatives strongly criticized the Liberals for their handling of the income trust issue and promised to stop the Liberal attack on retirement savings and preserve income trusts by not imposing any new taxes on them,” the UBS report says. “Reneging on their promise within such a short period could significantly undermine the Conservative government’s credibility.”

@page_break@Mintz agrees that the current administration doesn’t want to open this can of worms if it can help it. “I am sure the last thing the government would like to do, aside from visiting the dentist, is to deal with income trust conversions,” he says.

“However, it may have difficulty containing this issue if more large conversions are down the pike,” Mintz continues. “At some point, they will reach a tipping point. So for now, the government holds tight.”

Just where that tipping point lies is anyone’s guess. In the context of total tax revenue, $1 billion is not a lot of money. For example, the recently implemented 1% GST cut cost an estimated $3.5 billion this year, rising to $5.2 billion next year.

“Overall, the revenue loss is not large compared to the almost annual $500 billion of federal and provincial revenue raised today,” Mintz notes in his report. “However, as the income trust sector grows, it will be important to evaluate as to whether this tax cut is more efficient compared to other growth-oriented policies.”

As it is, the estimated tax revenue loss due to income trusts represents less than 1% of the business trust sector market cap. At that rate, even if all of corporate Canada converted — $1.8 trillion worth — the lost revenue would be slightly less than $15 billion. So even in that highly unlikely circumstance, the loss wouldn’t be devastating to government revenue.

Assuming that the government doesn’t want to fiddle with income trusts’ tax advantages, the other risk facing the sector is regulatory. That risk is certainly more tangible, as securities regulators have pledged to address the quality of the trust sector’s financial disclosure — one of its fundamental weaknesses.

Earlier this year, the Canadian Securities Administrators published a report detailing its latest review of income trust disclosure. It found that most of the trusts it reviewed had problems with their disclosure, and a number of them were required to file additional or improved disclosure. “Income trust issuers need to significantly improve the nature and extent of their disclosure and, in particular, their distributable cash disclosure in the management discussion and analysis,” the CSA concluded.

This conclusion echoed earlier research from Standard & Poor’s Corp. , which criticized the overall quality of trusts’ disclosure and previous regulatory scrutiny.

In 2004, the CSA conducted a review of trusts’ disclosure that singled out distributable cash reporting as a potential problem. The CSA also published a staff notice on the subject in August 2005, outlining its expectations and warning that it may not approve prospectuses with inadequate disclosure.

The regulators have resolved to come up with rules to improve trusts’ disclosure practices. While it is a CSA initiative, the Ontario Securities Commission is taking the lead. It indicates that it plans to have a proposed rule out for comment by the end of the year.

At this point, it’s unclear just what form that rule-making effort will take. The regulators could go as far as prescribing how trusts are to report their distributable cash, although this could be a devilishly tricky exercise. Alternatively, it could devise rules that set out more rigorous disclosure obligations.

Most of its complaints relate to the reconciliations trusts make between their financials and distributable cash reporting, and whether the information provided about these adjustments is detailed enough to inform prospective investors fully. Tougher requirements about what these adjustments must include may prove enough to improve disclosure and satisfy regulators.

Whatever form the regulators’ efforts take, they are unlikely to pose nearly the threat to the trust sector that an overhaul of the tax code could. New disclosure rules will surely be an annoyance, but a new tax regime could be fatal. IE