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All eyes on Ottawa's next move
The federal government has sent an unequivocal message to Bay Street: The income trust party is over. But just how it levels the playing field is an open question, DEREK DeCLOET, STEVEN CHASE and SINCLAIR STEWART write with files from reporter Andrew Willis

TORONTO, OTTAWA -- With the spotlight on him in a conference room at Toronto's Fairmont Royal York hotel, Gordon Nixon broke the cardinal rule of government relations: Don't get on the wrong side of the Prime Minister.

It was an honest mistake for the chief executive officer of Royal Bank of Canada. Someone asked him whether he would consider using an income trust, the popular vehicle used by dozens of companies to cut or eliminate their corporate tax bills. "I'd be surprised to see a bank convert to an income trust . . . but there are parts of our operations that, depending on what happens with the rules in the future, it would make sense for us to look at," Mr. Nixon told the analysts who'd gathered to hear him talk.

To the casual observer, it was an innocuous, even sensible response. But to Paul Martin, who had duelled with the banks over mergers in his prior life as a Finance Minister, it was one step too far.

The Prime Minister's Office had begun to exert influence over the income trust file months earlier. Mr. Nixon's public comments -- sprayed across the business section of the country's newspapers -- may have been the final straw. Sources say Mr. Martin was jolted by the headlines.

"I think it was a wakeup call. That it was a holy shit . . . This thing is out of control." said a source close to the Prime Minister.

Five days later, Finance Minister Ralph Goodale delivered a swift kick to the trust movement, stating that the Canada Revenue Agency would cease, for now, giving advance tax rulings to help companies become trusts.

Within an hour of Mr. Goodale's announcement, Ottawa's state of anxiety over the mushrooming trust sector was the talk of Bay Street. Within a week, investors slashed $9-billion in market capitalization from trusts. Income trusts, once a mere annoyance to Finance Department bureaucrats, have become a preoccupation at the highest political levels.

Figuring out the government's next move has also become an obsession for parts of the financial community. It's a tale of high-stakes politics, billions of investment dollars, with a dollop of big-ego Bay Street and regular folks on Main Street thrown in for good measure. With more than $160-billion in market capitalization, trusts are now very big business in Canada. And trying to figure out what to do next is one of Ottawa's pressing financial challenges.

The income trust is a curiously Canadian phenomenon. Although it's a very common structure in real estate, it did not spread to other industries until the 1980s when it slowly took hold in the oil patch. Over the past five years trusts have boomed, however, as companies and investment bankers fell in love with a structure that allowed corporate tax bills to disappear.

Simply put, a trust allows a company to distribute all of its cash flow directly to investors -- the corporation does not pay tax, because the money is fully taxed in the hands of its unitholders.

Ottawa estimates it lost $300-million in corporate tax revenue last year, while estimates are sketchy of just how much tax investors are paying. Trusts have been considered the refuge of the small investor, and no wonder. They offer yields of around 9 per cent, an attractive return compared with rates of 2 per cent available from guaranteed investment certificates or less from savings accounts.

The controversy surrounding trusts is about more than their tax status, however. Some economists are concerned that a trust structure reduces a company's willingness to invest in its business, and thus in the economy, a concern that is shared by Finance mandarins.

The smart money is betting that a major policy announcement is only months away, perhaps in a February budget. One source who has talked with Mr. Goodale in recent weeks said he is "definitely . . . negative" on income trusts. "He wants to do something about them. He's very much against them. It's unmistakable."

The growth of the trust sector didn't become a major concern within the Finance Department until about three years ago, as investment banks became increasingly bold about expanding trusts' original purpose of holding oil and gas wells and real estate property. The $1-billion initial public offering in 2003 of Yellow Pages Income Fund -- a former BCE Inc. unit that would, as a corporation, pay a high rate of income tax -- was a watershed event, proving that large trusts could gain acceptance from pension funds and institutional investors.

Ottawa's shift in attitude -- from indifference to worry -- was at first imperceptible to most of Bay Street. Those deeply in touch with the thinking and machinations of Finance could sense that change was coming, though. "I had been expecting Finance to do something for a long time," said Tim Wach, a seasoned tax lawyer at Gowling Lafleur Henderson LLP who worked in the department in the 1980s.

But policy change was -- and is -- a tricky proposition, even more so after Prime Minister Paul Martin came to power in late 2003. Trusts were crucial to bringing investors back to commercial real estate after the property bust of the early 1990s, and they fuelled a capital explosion in the oil patch that has led to the creation of dozens of new exploration companies. Mr. Martin declared that he wouldn't consider his time as Prime Minister a success unless he could soothe western alienation; his government could hardly use its first budget to lower the boom on energy trusts.

A middle-ground solution, crafted and sold to Mr. Goodale for his maiden budget speech on March 23, 2004, was to target pension funds and business trusts. The government said pension funds could invest no more than 1 per cent of their assets in business trusts and could own no more than 5 per cent of any one. (The measures against energy trusts were minor by comparison; they targeted foreign investors by levying a withholding tax on their distributions and limiting their ownership.) The policy was written in such secrecy that it surprised almost everyone, including the economists brought in for closed-door, prebudget briefings with Finance officials.

The pension funds were furious, and launched a counterattack led by Jim Leech, head of merchant banking at the Ontario Teachers Pension Plan and one of the biggest investors in Yellow Pages. Mr. Leech and Teachers CEO Claude Lamoureux went to Ottawa to press their case and landed in front of Kevin Lynch, then the deputy finance minister. Mr. Lynch had his own message: We're holding firm. "It was very clear they [Ottawa] weren't going to move," said a person familiar with the discussions.

The advice Mr. Goodale was getting from investors was by no means unanimous. One significant but low-profile player in the debate was Greystone Managed Investments Inc., a large pension manager with $23-billion in assets.

Greystone's influence comes from its status as one of the only large financial services players in Saskatchewan, its base in Mr. Goodale's home city of Regina, and its Liberal connections. Donald MacKay, son of Prairie Liberal stalwart Harold MacKay, is a senior vice-president at Greystone. Don Black, the firm's CEO, is said to be close to Mr. Goodale; as minister of agriculture in the mid-1990s, the politician appointed Mr. Black chairman of Farm Credit Corp.

But Greystone's specialty is managing large portfolios of growth stocks, and it got no particular benefit from the explosion of slow-growth trusts, most of which were small. The firm bent the minister's ear and continues to do so. "I would support a move that levels the playing field," said Greystone president and chief investment officer Robert Vanderhooft. "If we want to get to a zero corporate tax rate, let's have that discussion. But as a policy decision, that was never made."

As a spring election approached, some Liberals were getting nervous. Mr. Leech met with Joe Volpe, the new Human Resources Minister and a senior MP from Toronto, and argued the policy would hurt the pensions of 250,000 retired and active teachers, no small constituency of the Liberals in key Toronto ridings where the New Democratic Party is competitive. Ontario's new Liberal government, meanwhile, chimed in with its opposition, led by Finance Minister Greg Sorbara.

Then, on a Friday afternoon in May 2005, a woman named Gayle McDade spotted Mr. Goodale at Toronto's Pearson International Airport.

Ms. McDade runs a $950-million pension plan for the City of Regina and lives in Mr. Goodale's riding. She was waiting for the same flight back to the Saskatchewan capital and decided to use the chance meeting to buttonhole the minister. In a 10-minute exchange, she argued that investment restrictions on pension funds cost retirees money and urged him to scrap not only the new trust rules but the long-standing restriction on foreign investments.

Some believe the McDade encounter was significant because it drove home the point that trusts were not simply the concern of a few large Ontario pension funds. "I think the department thought this was a Teachers' issue," said a person involved in the pension lobbying effort.

On May 18, 2005, five days before the start of the election campaign, the government put the trust ownership rules on ice, saying it would do more consultation. (Mr. Goodale later granted her other wish, killing the foreign investment limits in this year's budget.)

If the decision to suspend the effort against trusts was taken for political reasons, it did not assuage the concern of Finance bureaucrats that the revenue cost of the trust loophole was about to soar. Provincial governments in Ontario, Alberta and Manitoba were preparing laws to clarify that trust investors enjoyed the same limited-liability protection as corporate investors, a move that opened the way for some institutions to buy trusts for the first time.

One of the key federal bureaucrats on the file was Len Farber, general director in the department's tax policy branch. He was joined last fall in Finance by senior associate deputy minister Mark Carney, a former investment banker who left Bay Street to become a deputy governor of the Bank of Canada. Mr. Carney, a wiry, dark-haired policy wonk whose father was a university professor, earned his spurs at Goldman Sachs in the 1990s in the firm's Moscow office, where he advised on the privatizations that, for better and for worse, transformed Russia's state-owned industries into private enterprises.

He returned to Canada after 2000 and, after Goldman cut back its Canadian operations, opted to leave for Ottawa in 2003. The Oxford-educated economist did not buy the line that income trusts are good for productivity because they encourage corporate managers to be more disciplined when making investments. (Mr. Carney declined an interview with The Globe.)

Margaret Lefebvre, executive director of the Canadian Association of Income Funds (CAIF), went to see him shortly after his appointment to Finance last year and said he "seemed to be quite tough in his view of income trusts." One trust executive, speaking on condition of anonymity, said: "I would say Mark Carney's the hawk. Len is probably a little more neutral."

Mr. Carney, who is considered by many to be the heir apparent at Finance to deputy minister Ian Bennett, was a key bureaucrat in the drafting of Mr. Goodale's 2005 budget in February. The speech itself said nothing about income trusts, but the government promised a discussion paper on the subject "shortly after the budget."

By spring, it looked as though the Martin government might fall and the budget would die an early death. Belinda Stronach's last-minute shift helped the Liberals survive a crucial non-confidence vote, Parliament's summer recess soon followed, and the department's consultation paper on trusts didn't see the light of day until Sept. 8, 2005.

At that point, trust mania had reached new heights, and the debate began to take on a new colour.

Precision Drilling Corp., the country's largest driller of oil wells, broke itself up by selling its international and technology divisions and announcing plans to convert the rest to a trust. Founder Hank Swartout said it wasn't his preference, but "the multiple of the trust is so overwhelming, it forces us to evaluate what we do long term." In August, investment dealer GMP Capital Corp. announced its own plans to convert, and chief executive officer Kevin Sullivan declared that "every CEO has to consider converting to an income trust." GMP's move opened the door to other financial companies, and a Wall Street hedge fund began to beat the drum for TSX Group Inc. to follow.

The consultation paper itself was balanced to the point of being bland, but by hinting at action -- including the possibility of imposing corporate-like taxes on trusts -- Finance officials hoped it would cool off the frenzy. It had the opposite effect. On the morning of the paper's release, CanWest Global Communications Corp. confirmed it would create a newspaper income trust and CI Fund Management Inc. had announced its own conversion plans. CEO Bill Holland made no bones about his motivation. "We're paying 25 per cent more tax as a corporation if you are distributing all your income," he said.

Some members of the trust lobby feared the brash attitude would antagonize senior officials in Finance.

"There are all these guys like Holland saying, 'Hey, I'm just about to spin this company in' and he kept on saying he was doing it for tax reasons," said Steve Probyn, chairman of CAIF and CEO of the Clean Power Income Fund. "Every time I saw that kind of quote, I was thinking, 'No, don't say that because you're going to regret it.' It might be true -- but, advertising that you're taking a financial services company into a trust, and you're already a seriously rich guy on Bay Street and it's going to make you a lot richer because of tax considerations?"

Mr. Probyn probably has not helped matters with his own blunt arguments about the need for trusts -- "You've got to be a civil servant to get a really good pension scheme these days," he sniped -- but he was right. The Street's tin ear had failed to pick up the subtle message of the consultation paper.

"I think the paper was almost dismissed as something that the government had laid out and it was not taken very seriously," Mr. Farber told the Senate banking committee in late September. "You continued to see articles about potential corporate conversions and everything was happening as if nothing had really taken place."

Mr. Nixon's comments on Sept. 13, 2005 confirmed their fears that no one in downtown Toronto was listening. Mr. Goodale, with the support of the Prime Minister's Office, decided to prick the balloon with a 226-word press release on Sept. 19. He announced that government tax authorities would stop giving advance tax rulings for trusts until the consultation process is over at the end of the year. As a result, some companies may delay plans to convert.

The statement was a direct shot at CI, which needed such a ruling to carry out its conversion, but it rocked the entire trust sector because it showed the government wasn't just blowing hot air. Privately, Finance bureaucrats tried to reinforce that impression, just in case anyone missed the message.

"One of the senior guys [in the department] told one of our people, 'It's over,'" says a trust executive. "He took it to mean the income trust party, so to speak, is over." And the bureaucracy, in a subtle way, has also tried to prepare the market for policy change that might not be favourable to trusts.

Several commentators have tried to argue that Bay Street's preferred solution -- a reduction in dividend or corporate taxes to eliminate corporations' tax disadvantage to trusts -- would cost the government only $1-billion. But "Finance . . . is putting out feelers that the numbers could be much more expensive than that," said Don Drummond, chief economist at Toronto-Dominion Bank and a former associate deputy minister.

Senior government officials, speaking on condition of anonymity, insist that no decision has been taken on what to do about income trusts, and that they are sincere about hearing all sides during the consultation. But most clearheaded observers agree the Martin government will eventually have to do something, or risk a significant piece of Ottawa's $29-billion corporate income tax base.

"I don't think they have much choice," said Mr. Wach, the tax lawyer. "No matter how you slice it, there is clearly, in my mind, tax leakage that's going on. If there weren't leakage and there weren't tax advantages, you wouldn't have people converting into income funds at the rate that they're doing it."

The potential solutions range from the benign -- cutting dividend taxes -- to the punitive -- taxing trusts like corporations or even prohibiting their use for certain businesses.

A combination of several measures is possible, even likely, but it's not clear what will be politically acceptable. Income trusts have a large constituency of retail investors, but so long as the controversy remains confined to the business pages, it won't capture the same audience as less-esoteric matters, like employment and taxes.

And while it's fashionable for brokerage house analysts to opine that a minority government wouldn't dare hurt trusts, there's not yet an obvious coalition willing to turn trusts into a major political issue -- not even the pension funds, whose main objection to the 2004 budget rules was that they discriminated against one group of investors.

"The average citizen does not have a degree in public finance," said Geoffrey Hale, a political scientist at Alberta's University of Lethbridge who specializes in fiscal policy. "The first question is, 'What's in it for me?' The second question is, 'What are they giving to business or people with investments that I am not getting?'

"I think if the government can build a reasonable consensus . . . this [issue] is remote enough from the reality of the average Canadian that they can implement something sensible."

As for the business community, it is far from united on trusts, and there are even conflicting interests within individual companies.

The banks, for example, have been great beneficiaries of the trust boom through their investment banking arms. But their shareholders would probably benefit even more if the government's policy answer includes cutting dividend taxes -- even if the result is fewer trust deals for their underwriting departments.

The oil patch is similarly torn. Energy trusts represented about $60-billion of the $150-billion in trusts on the Toronto Stock Exchange as of June 30, 2005, yet some of the biggest names in Calgary -- including oil patch financier Murray Edwards and Precision's Mr. Swartout -- have expressed reservations about the trust proliferation, even as their companies converted. Then chairman Mr. Edwards abstained from the shareholder vote in May 2005 that converted Penn West Petroleum Ltd. into an income trust and, in a parting shot, called on Ottawa to close the tax gap between trusts and corporations.

The lack of a united front in favour of the status quo has apparently persuaded senior Liberals in Ottawa that the trust mess won't do serious political damage -- not yet, at least. "Trust funds are not an issue for the elderly; for the modest income [crowd]," said one Liberal official. "It shouldn't be a voter issue. How many people really invest in trusts? I don't think it's the end of the world."

Canada has had income trusts since the mid-1980s, a nifty corporate structure that allows a company to forego paying corporate income tax, while the proceeds are taxed in the hands of investors. But with the loss of $300-million to the federal coffers last year alone, and the boom in trust conversions, the market got Ottawa's full attention this year. It was one thing to use the trust structure as a way to generate capital for the oil and gas industry, but when Bay Street financial firms began musing about cutting their tax bills, the government wanted to slow things down.

Finance Minister Ralph Goodale wasn't willing to sit quietly by and see the income trust boom continue. In September 2005, his department released a consultation paper that clearly laid out the problem, and asked for help with a solution. But rather than cooling Bay Street's ardour for trusts, the paper seemed to have no effect. He followed that up quickly with a surprise announcement that trust candidates could no longer get advance tax rulings and that put a chill on the market.

Bill Holland, the president of CI Funds Management Inc., turned up the volume and declared that the tax advantages were so alluring that the company had to consider whether it should convert to a trust. Some think his statements were too provocative, drawing unwanted attention to the sector. Now unable to get an advance tax ruling, CI's conversion plans are on the shelf.

Hank Swartout, founder of Precision Drilling Corp., wasn't an immediate convert to trusts, but after carefully examining the options he had to concede that 'the multiple of the trust is so overwhelming, it forces us to evaluate what we do long term.'

Mark Carney, senior associate deputy minister of finance, doesn't believe that income trusts help the Canadian economy because they don't encourage reinvestment. The former investment banker is said to be a key figure in determining which way Ottawa turns next.

Canada's trust businesses have grown quickly to a dominant position over the past five years. Market capitalization now tops $160-billion, with the bulk of that growth coming from energy trusts. The number of trusts listed on the Toronto Stock Exchange has more than doubled in that time, while volume has grown sixfold. Performance has also been strong.

Income trusts don't pay corporate income tax, and that has Ottawa looking for ways to level the playing field. Should the government cut taxes on dividends, or seek other solutions? B7

Canadians like the regular cash payments from income trusts, pointing out that low interest rates don't offer many competitive alternatives. And regular folks tend to buy and hold.

Australia and the U.S. have flirted with trusts, but quickly shut them down. Canada's trusts are rooted in the oilpatch, where they have helped attract needed capital and revitalize the industry.

Do trusts discourage investment and starve the economy? Or are they just like any other business, dependent on the smart decisions made by capable managers?