Canadian Trusts Eyeing New Tax Loopholes

Last fall, Canadian income trusts were hit over the head with Ottawa’s huge, and for some, rather deadly tax bat. I wrote about this extensively, but the issue tends to pop up now and then, considering how important income trusts have become to Canadian investors.

As many of you are already painfully aware, existing income trusts will have to abandon their current structures by the end of 2010. This means that the days of high-yield income streams — tax-free for issuers and generally tax-beneficial to investors as well — are soon going to be over.

Let’s leave aside issues that economists have long had with income trusts, such as loopholes in GAAP reporting of capital expenditures for trusts; or concerns that yields were high because they were just as much returns on assets as they were returns on income streams to and from those assets.

In hindsight, I find it worrisome that income trusts always remind me of a schoolgirl getting ready for the prom. But instead of her prom dress, trusts “dressed” their feature sheets with fat income streams; instead of a corsage on her hand, trusts “wore” high yields; instead of smiling faces on a group photo… well… how about them tax breaks?! I get it, every product comes with a sales pitch, but enough is enough. When something is good, you don’t have to make it look too good to be true. Unless it isn’t true.

Judging by the buzz on the Street, income trusts are again on the lookout for loopholes. It is a fact of life that many trusts will not be able to conform to new tax obligations, which means a chunk of them will be forced to convert into corporations. But instead of going back a step and paying additional taxes again for converting, some income trusts are trying to back into a corporate status via something that auspiciously looks like a reverse takeover.

How? Well, the idea is to find a company that is drowning in debt. Once income trust takes control of it by buying its debt, the taxman is satisfied as to the trust’s structure, and the trust is happy because it just avoided (again!) paying a whack of money in taxes. Trusts are likely to target defunct tech and mining companies that are easy to clean up in order to merge and become corporations once again. This works sort of like a reverse takeover, only we are talking about backing into a different corporate structure rather than backing into a public shell.

Sounds like a neat idea, doesn’t it? But, unlike the “easy years,” income trusts no longer have the benefit of being sheltered investments. A number of U.S. private equity funds are on the lookout for deeply discounted Canadian income trusts. For U.S. buyers, buying our trusts can reduce their taxes on both sides of the border, which is why Bay Street is bracing itself for another new round of foreign takeovers.

But what about our income trust investors? Well, it has again become a complex question. One of the most difficult decisions for any investor is determining when it might be time to call it quits. If you haven’t abandoned ship yet, perhaps it is time to consider that option. Although, in case your trust was prudently managed, you just might continue enjoying steady income streams.

However, if your trust was one of the good ones, it might also become a takeover target by foreign private equity. While takeovers typically push prices of target companies up immediately preceding the transaction, in the end, going private means you will no longer be a shareholder. And only you know whether this will be a “good riddance” kind of transaction.