Professionals in the income trust field may be inclined to divide their industry's history into two periods — the time before Oct. 31, 2006, and the time after. That's because it was on this Halloween evening that Finance Minister Jim Flaherty changed the tax rules governing income trusts, removing much of the incentive for companies to convert from a corporation to an income trust.

To understand why the trust clampdown sent such shockwaves through the markets, it's necessary to step back and take a look at why so many Canadian businesses became trusts … and why Ottawa felt it finally had to step in to stop the stampede.

The early days

Income trusts have actually been around for decades. Some of the first were real estate investment trusts (REITs). The trust would own a portfolio of apartment buildings, or shopping malls or office towers, and would collect rents and funnel them directly to investors who owned units in the trust. Trusts also caught on in the energy industry, where trusts could flow through their steady stream of income to unitholders.

Until recently, they were a relatively minor player on the stock markets. In 2000, for example, there were just 70 trusts listed on the TSX. But in the early years of the new millennium, a new kind of trust emerged — the business trust. There are now income trusts that flow through income from sales of everything from mattresses to peat moss. Some trusts get their juice from Yellow Pages advertising, hamburger sales, newspaper advertising, customs brokerage fees, even coffee and jam. Any business with a strong and steady cash flow was a potential candidate.

By 2006, the number of TSX-listed income trusts had grown to almost 250 and their assets had ballooned to almost $200 billion. The announcements in the summer and fall of 2006 that two giant telecom companies — Bell Canada and Telus Corp. — would convert to trusts appeared to have been the tipping point. If Bell Canada could convert to a trust, what would stop any other big company like a bank from doing the same? That prospect alarmed the federal government and directly led to the Halloween crackdown.

Why trusts proliferated

An income trust allows a company to avoid the double taxation that now applies to its income - first, the corporate taxes it pays, and then the personal taxes on dividends it pays out to its shareholders. Trusts manage to pay little or no corporate tax because they aren't corporations. Income trusts are simply vehicles that "flow through" interest, dividends and capital gains directly to their investors (called unitholders) as distributions.

The unitholders then pay tax on the income that is distributed to them every month or every quarter.

There are several reasons companies began jumping on the income trust bandwagon. First, there were the tax benefits for the corporation. By flowing through income directly to unitholders, it could avoid paying corporate tax at rates of up to 35 per cent. For instance, BCE estimated that its proposed trust conversion of Bell Canada would have saved corporate taxes of $800 million in 2008.

Investors loved it when a company said it was "going trust" because the value of the company would get an instant lift when the trust conversion was announced. When Telus, Canada's second biggest phone company, announced its intention to become a trust in August 2006, its stock price jumped almost 14 per cent to an all-time high. That boosted the stock market capitalization of Telus by $2.5 billion.

Trusts are also about yield — the return investors get from placing their money in a particular investment. And those yields made them investor favourites.

Let's look at the current investment climate. Guaranteed investment certificates now pay three or four per cent at the big banks. There's no risk. But for many people who count on their nest egg to generate a monthly income, that just doesn't cut it.

There are stocks that generate dividends: banks, utilities, pipelines, that type of thing. Those dividends are typically two to four per cent. And while dividend payments face less tax than interest, they're still not the gravy train some have been anticipating.

The yields on income trusts, on the other hand, can be six per cent, eight per cent, 10 per cent, often more.

"Tax-exempt" investors, such as RRSPs and pension funds, like investing in income trusts because the company they're investing in doesn't pay corporate taxes and, as tax-exempt investors, they don't pay tax themselves on the distributions. It should be noted that investors would ultimately pay tax on the payments they get from their matured RRSPs and other "tax exempt" pension plans, so Ottawa would recapture some of that foregone corporate tax.

Why Ottawa shut the door

When companies can manage to avoid paying corporate tax, both the companies and their investors are understandably happy. Governments, on the other hand, are not. They rely on corporate tax revenue to help pay the cost of running the country.

When former federal finance minister Ralph Goodale announced a review of the income trust sector in 2005, the Finance Department estimated that trust conversions cost the treasury $300 million in tax revenue in 2004. The figure kept growing. When Finance Minister Jim Flaherty brought in his new tax trust policy, he estimated the tax loss at $500 million. A 2006 study by Jack Mintz of the Rotman School of Management estimated that the federal and provincial governments would lose $1.1 billion annually in tax revenues once Bell Canada and Telus completed their trust conversions.

Faced with the prospect of further "tax leakage," Ottawa felt it had no choice but to staunch the flow. In his Halloween announcement, Flaherty imposed a new tax on trusts. Corporations converting to trust status would have to pay tax on the income they distribute to investors. Existing trusts won't have to pay those taxes until 2011. He also cut the corporate tax rate by half a percentage point, effective 2011. Flaherty said that would "level the playing field" between trusts and corporations.

The trust sector, for its part, disputes the "tax-leakage" figures that the federal Finance Department has cited. The Canadian Association of Income Trust Investors says there are fundamental flaws in Ottawa's claims of a $500-million annual loss if the tax rules for trusts were not changed. The association says Flaherty's numbers don't take into account the taxes that will eventually paid by trust investors in RRSPs and other tax-deferred accounts. "Income trusts do not cause tax leakage," the association says. "The Department of Finance's analysis causes tax leakage." The federal Liberals say they want to see the numbers, too.

In any event, the controversy will get a thorough airing in early 2007, when the House of Commons finance committee begins hearings on the issue. Flaherty is the first witness.

The clampdown also tried to address complaints by some economists that companies that shouldn't be trusts were making the conversion, solely for the tax breaks. Flaherty said Canada was rapidly becoming an "income trust economy" — a bad thing, he said, because trusts pay out so much of their income to investors that many don't make the internal investments necessary to build their businesses.

Bay Street didn't like the Flaherty announcement. The TSX fell; corporate Canada grumbled about changing the tax rules in mid-game; companies put their trust conversion plans under review. But Flaherty made no apologies, noting that the U.S. and Australia had clamped down on trust conversions long ago.

For the estimated one million Canadians who directly hold trust units, the question of whether to stay invested may require a call to their financial advisers. Income trusts are no longer the slam-dunk investments they once seemed to be. Investors may want to take a second look at a sector that has become a fixture in many portfolios.

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