On Halloween night 2006, Canadian Finance Minister Jim Flaherty announced a new tax on all income trusts beginning January 1, 2011. Since then, the specter of that new tax has hung over Canadian trusts like a very dark cloud.

Part of the reason has been misinformation about the tax itself. This is no direct levy on either Canadian or American investors. Rather, it’s a prospective tax at the corporate level. As long as an individual company elects to maintain its dividend, there’s no impact on investors whatsoever.

Second, there’s a lot of confusion about what individual trusts will do to cope with the tax. When Mr. Flaherty made his announcement, a well-known accounting firm in the country stated that there would be just as many corporate responses to the tax as there were trusts. There would be similarities, but as every trust’s underlying business is different, so would be their response to the new tax.

That’s exactly what we’ve seen to date. Most income trusts have elected to remain in their current form until sometime in 2010, when they plan to convert to corporations. Some have offered specific details about future dividend policy, mainly assurances they’ll maintain current dividend levels.

Thus far, Portfolio picks stating they’ll hold dividends in 2011 are Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF), Great Lakes Hydro Income Fund (TSX: GLH-U, OTC: GLHIF), Energy Savings Income Fund (TSX: SIF-U, OTC: ESIUF), Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) and Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF).

Atlantic Power Corp (TSX: ATP-U, OTC: ATPWF) is a corporation and therefore not affected by the tax. Neither are the four real estate trusts, Artis REIT (TSX: AX-U, OTC: ARESF), Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF), Northern Properties REIT (TSX: NPR-U, OTC: NPRUF) and RioCan REIT (TSX: REI-U, OTC: RIOCF).

A handful of Portfolio trusts have decided they’re better off converting early to corporations: Advantage Energy (TSX: AVN-U, NYSE: AAV), Ag Growth Income Fund (TSX: AFN-U, OTC: AGGRF), Newalta Corp (TSX: NAL, OTC: NWLTF), TransForce (TSX: TFI, OTC: TFIFF) and Trinidad Drilling (TSX: TDG, OTC: TDGCF).

Finally, the two Portfolio funds aren’t trusts. The only issue they face is what dividends will be paid by their holdings.

The upshot: Roughly half of the current 33 Portfolio holdings effectively have no further 2011 trust tax risk. They may falter as businesses if this recession goes on long enough, but that’s an entirely different issue from dividend cuts in response to the tax alone. And as we get closer to 2011, that distinction should translate into much higher share prices.

The Other Half

That leaves the other half to consider. For our nine oil and gas producer trusts, energy prices are a far greater consideration than trust taxes. In fact, they’re really the whole ballgame.

For example, Advantage Energy’s decision to convert last month came at the end of a long string of dividend cuts in response to tumbling natural gas prices. Gas, in fact, hit a new low this week of just USD3.15 per million British thermal units. Continuing to pay a dividend would have made it impossible for the company to develop its Montney Shale reserves. Note my view is to hold Advantage Energy for now, as it trades at only about a fifth the value of those reserves.

Even producer trusts whose need for development capital is far less and financial power much greater have cut distributions. And only Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) has maintained the same dividend it paid last summer, thanks to virtually no debt and access to much healthier gas markets around the world.

On the other hand, all of the producers except Advantage have stated they intend to be high-dividend-paying corporations after 2011. Only Vermilion has stated unequivocally that its dividend won’t be affected by 2011 taxes, owing to the fact that so much income is earned outside of Canada.

But the rest have touted their “tax pools”–or expenses carried forward to offset future tax expenses–as the means to cut their future taxes and by extension to preserve their dividends. Again, what these trusts can pay will be determined far more by the level of energy prices than by what they’re taxed.

As for the non-energy trusts, there’s a lot more reason to hope that current dividend levels can be preserved in 2011, as long as their underlying businesses stay healthy. One reason: Ag Growth’s announcement last week that it would convert early.

As highlighted in last week’s Maple Leaf Memo, Ag Growth plans to maintain its current monthly dividend after its conversion. The method of conversion follows the pattern set by Superior Plus (TSX: SPB, OTC: SUUIF). Ag Growth will be officially acquired by a shell company, Benechee Resources, which will subsequently change its name to Ag Growth Industries Corporation. Investors in the trust will receive one share of the corporation per trust unit they now hold on a tax free basis. Ag Growth will be freed of capital constraints now carried by trusts and 2011 uncertainty, even as shareholders will continue to receive their full distributions.

As I stated in the aftermath of Advantage’s conversion last month, even trusts that gut their dividends will eventually attract buyers, provided their underlying businesses are sound. Income investors will depart, driving down the share price.

But sooner or later they’ll be replaced by bargain hunters and other growth investors. That, in fact, has proven to be the case with Advantage, which has surged despite the continued decline in natural gas prices this spring.

On the other hand, when trusts have converted without cutting payouts, the market reaction has been immediately positive. That’s likely to make such dividend preserving conversions a lot more attractive to management, provided they can still run their business plans after absorbing 2011 taxes.

We may even see a growing number elect to remain trusts and absorb the tax. As I’ve pointed out, Colabor Income Fund (TSX: CLB-U, OTC: COLAF) has been paying the trust tax for two years now, and at a rate much higher than the 28 percent envisioned for 2011.

This week, Northland Power Income Fund (TSX: NPI-U, OTC: NPIFF) executed a highly unusual move by actually absorbing its parent into the trust to cut costs. That may or may not presage a move to convert or simply remain a trust after 2011. But it’s definitely a sign that management has its sights on preserving a high dividend going forward, and that’s the bottom line.

A New Law

Of course, it remains quite possible that the trust tax itself will be overturned before it takes effect in 2011. A blog post by popular business writer Diane Francis this week–and reader response to it–makes it pretty clear that the issue isn’t dead for many people, particularly savers who have been decimated by the financial crisis.

A revival of trusts’ preferred tax status may not salve every wound. But it would surely create a tidal wave of interest for Canadian trusts from investors around the world by removing the dark cloud of 2011.

I’ll certainly be in the front row on my feet applauding if that happens. On the other hand, as I said in my very first Flash Alert following Flaherty’s tax announcement, this isn’t something anyone should place bets on. There’s just too much that has to happen, and politics are inherently unstable.

The Liberals, Bloc Quebecois and Greens are still for keeping trusts, the ruling Conservatives and left-wing New Democrats are not–and they have the majority in Parliament now. That means the only way the politics changes in trusts’ favor is if there’s another election and the first three parties pick up a majority, or if enough Conservatives and New Democrats change their minds. That’s certainly possible, particularly considering the damage done to Canadian savers in this financial crisis. But again, it’s not something anyone should be counting on.

The best news, however, is that we don’t have to count on a legislative change. Not only has 2011 risk been priced in for trusts since mid-November 2006, but as we get more details on individual trusts’ responses to change, 2011 uncertainty will fade away. That alone should mean higher share prices for the best trusts, which continue to weather the financial crisis as businesses.

Remember, what we’re in this for is high yields and capital appreciation. Whether a business is organized as a trust or as a corporation is irrelevant, as long as it performs. And my focus remains on making sure our holdings’ solid performance continues, particularly as we move into first quarter earnings season in coming weeks. That’s what’s important now.