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Regaining the trust

Canada's income trust market has experienced trying bouts of turbulence amid taxation uncertainty.

Canada's Minister of Finance Ralph Goodale gained notoriety in September when he offered a warning that the thinly taxed income trust would be under review. The consultation process was hatched to look into how the Canadian government could ensure a balance between the celebrated structure and the country's non-income trust corporations, which have played second fiddle to the income trust's Stradivarius.

In a statement, Goodale reasoned, ?We launched consultations because of our concern about how the increased use of this type of business vehicle may affect economic growth. We have a viable and productive corporate sector that invests, creates jobs and contributes its fair share of tax.?

A collective gulp could be heard echoing from the office towers on Toronto's Bay Street. Just the prospect that the income trust market could be in the government's taxation crosshairs was enough to cause upheaval. The Goodale Effect, as it was soon dubbed, put potential new income trust issues in a holding pattern and left existing income trusts susceptible to fleeing investors. It was a trying time for a market that had been the darling of the Canadian investment community for the past couple of years.

The Goodale Effect, as it was soon dubbed, put potential new income trust issues in a holding pattern.

To private equity, the income trust has served as the industry's binkie in Canada, with investor groups regularly embracing the robust market as an accommodating and reliable exit. Kohlberg Kravis Roberts and Teachers' Private Capital demonstrated just how flush the market could be when they realized a $1.6 billion windfall through the floatation of the former Bell Canada Yellow Pages. That was the beacon, and many other groups have since followed the same path.

The beauty of an income trust is that the vehicle flows income directly to shareholders, bypassing taxes at the entity level. Normal corporate dividends, meanwhile, are passed on to investors only after the companies pay their income taxes. So the ensuing tax on the corporate dividend represents the second bite from the government.

To nobody's surprise, buyout investors were understandably bristling over Goodale's consultation process. At the recent Insight Information Canadian Private Equity Summit held in Toronto mid-November, there were declarations that the income trust play had shifted from an exit to a buyout opportunity. The optimists in the crowd articulated that the upheaval could at the very least help restrain what was shaping up to be a bubble. One attendee reflected during a panel, ?We've gone from a period when a rising tide floats all boats to more of a selective phase.?

The consultation process enacted by Goodale could have had several outcomes, including the status quo and the dreaded increased taxation option. What Goodale ultimately decided was perhaps a best-case scenario for all investors. In November, he cut the personal income taxes on corporate dividends, making the tax treatment on investor profits from Canadian corporations ?more comparable? to those rewarded by income trusts.

The Canadian market rejoiced and for private equity, it was a return to the favored norm. ?Absent any changes or external factors, it should be business as usual,? says Teachers' Private Capital senior vice president James Leech.

There are still some lingering questions. If the playing field between the income trusts and traditional corporations has been leveled, that would theoretically curb income trust vim. But based on recent activity, this wouldn't appear to be the case. The Globe & Mail reported a couple days after Goodale's decision that the market is expecting as much as C$4 billion in new income trust issues and conversions, with secondary offerings adding another C$2 billion to the income trust market's capitalization.

Meanwhile, there is also the debate over how much of the initial pullback was a result of the tax threat versus how much was due to fading fundamentals. When Goodale made his initial income trust pronouncement, interest rates were rising while energy prices were slumping, two factors that traditionally weigh on the market and could again.

What is not lost on some, though, is that now the income trust players can say they have weathered at least one storm. If the income trust was indeed just a prolonged fad, the damage could have been worse. As it stands, the uncertainty surrounding the Goodale effect has established staying power.

?One thing the pause did do was refocus everybody's attention back onto the vehicle, and give the market a more acute awareness of what sorts of businesses should be organized as trusts,? Leech says. ?I think the vehicle is maturing.?