It’s now been a year since the Canadian government issued its Halloween surprise: a plan to begin taxing income trusts as corporations beginning in 2011.

The market’s initial response was predictable. In the first two weeks of November 2006, income trusts on average lost more than 20 percent of their pre-Halloween value. The Canadian dollar was dragged down as US money fled the country. And many, if not most, investors from south of the border swore off the country altogether, as another example of socialism run wild.

What’s happened since, however, has been anything what conventional wisdom forecasted on either side of the border. And investors who didn’t cut and run after the post-Trick-or-Treat onslaught have been well rewarded for their patience, as one upside surprise has followed another.

In fact, in US dollar terms, 22 of the 29 Canadian Edge Portfolio picks are up at least double digits since the beginning of 2007. Only three are lower for the year, all in the natural gas patch where lower prices have triggered the biggest drop in activity in decades.

No Rush to Judgment

Immediately following the Conservative government’s trust tax announcement, opponents swung into action. The trusts and their investors organized coalitions that began petitioning the government to either eliminate the tax or else dramatically modify it.

Pulling a proposal to tax trusts is, of course, exactly what the formerly ruling Liberal Party did in late 2005, following widespread opposition. That didn’t prevent them from losing the election in January 2006.

In fact, the Conservatives were able to capitalize by promising not to tax trusts, as well as by charging the Liberals with illicit profiteering by allegedly leaking the news to certain Bay Street allies that they would pull their plan.

Unlike the Liberals of 2005, however, the Conservative Party government in Ottawa has steadfastly refused to shift its stance one iota on trust taxation. And by early summer, their plan was the law of the land.

In fact, the government dealt with opposition from both the Bloc Quebecois and the Liberals in very hardball fashion, i.e., by attaching trust taxation to a federal budget they had loaded with goodies for Quebec that was literally impossible for the Bloc to oppose.

Here in late 2007, the issue is still alive. The Liberal Party’s official line is to reduce the tax on trusts from the statutory corporate rate of 31.5 percent to just 10 percent. And the leadership has also expressed willingness to lift the moratorium on new trusts in some cases.

The Bloc Quebecois, meanwhile, is still officially supporting extending the tax holiday all the way to 2017. And there’s now a well-publicized lawsuit originating in the US under North American Free Trade Agreement (NAFTA), with a goal to force Canada to “grandfather” existing trusts through the courts.

The three years-plus to 2011 is an eternity in politics, and literally anything can happen in this case. One thing that has become crystal clear over the past year, however, is the Conservative Party is unlikely to change its mind on this issue. As a result, nothing is likely to happen unless they’re removed from power, which is extremely speculative.

None of this came as a surprise to the market. Many trusts, for example, actually rallied in the wake of the final passage of the tax plan in June.

Investors had already priced in the full impact of corporate taxation and then some. Actual passage of legislation, consequently, had the impact of removing any remaining uncertainty, and the market took it as a positive.

What’s been surprising to some is the reaction from trusts’ management as the tax increase has become official. Basically, there’s been no rush to judgment—i.e., no mass wave of shareholder-crippling conversions to corporations. Rather, trusts are still assessing their future plans and what makes the most sense for long-run shareholder value.

Some have chosen to put themselves on the market and have fetched premiums of up to 50 percent above pre-deal prices. To date, there have been some three dozen trust takeovers, most at substantial premiums and virtually all outside the energy patch.

The most prolific buyers have been private capital consortiums. These were largely shut out of the trust buying market before Halloween 2006. The reason had more to do with trust managements’ desire to remain independent, rather than price. Now with 2011 in the picture, there are willing sellers and private capital is willing to pay up.

In other industries, the takeover of one company triggers appreciation in its peers. Remarkably, however, trust prices to date haven’t risen to reflect the takeover interest. As a result, each successive deal goes off at a high premium to pre-deal prices.

That state of affairs won’t last forever. But it does make it very low risk to bet on takeover targets in the sector. In fact, virtually any quality trust—including all those in the Canadian Edge portfolios—can be considered a takeover play. And quality trusts meet the most important criterion for every takeover bet: You don’t mind owning them even if no deal emerges.

The takeover of PrimeWest Energy Trust (PWI.UN, NYSE: PWI) by Abu Dhabi’s energy company in late 2007—at a 40 percent premium to the pre-deal price–signals two new hugely bullish developments for income trusts.

First, takeover mania has spread to oil and gas producers, and every pick in that sector is now in play. Second, there are a number of entities willing to pay top dollar. Abu Dhabi, for example, has announced plans to spend CD20 billion in Canadian energy investments in coming years.

Building for the Future

Not every trust is takeover bait. Some have seen their future as becoming prolific acquirers of other trusts, including Canadian Edge Portfolio member Penn West Energy Trust (PWT.UN, NYSE: PWE). This week, Penn West announced the buyout of Canetic Resources (CNE.UN, NYSE: CNE) to create the largest conventional oil and gas producer trust.

The new entity will have annual oil and gas production of 200 million to 210 million barrels of oil equivalent per day. It will be oil-weighted, with approximately 45 percent light oil and 13 percent heavy oil, with the balance from natural gas. It will also have numerous raw land resources and growth opportunities in the oil sands as well.

Most important, the combination is very well positioned for what many oil and gas producer trusts consider their end game: converting to high dividend-paying intermediate producers when the tax holiday ends in 2011. That’s a big reason why I’m still a buyer of Penn West Energy Trust  up to USD 38.

Thus far, only two trusts—both in the oil and gas sector—have attempted to convert to corporations ahead of 2011. The rest, it seems, have decided to take advantage of an effective tax holiday and to wait to change structure only when it makes the most sense.

That could change at any time. Speculation has swirled that some trusts may consider converting to US-based limited partnerships in order to dodge 2011 taxation. And odds are many trusts won’t make it to 2011 as independent, investor-owned entities, either being taken over or going bankrupt.

The vast majority of managements, however, appear to have decided that their destiny lies in being big dividend payers, no matter how they’re organized. In other words, whether they’re trusts or something else, there’s life and superior shareholder returns after 2010.

In addition, many trusts have discovered there are plenty of ways they’ll be able to keep their effective tax rates well below the statutory 31.5 percent rate. For producers, the primary dodge is “tax pools”–noncash expenses associated with oil and gas production that essentially can be written off dollar-for-dollar against tax liability. In addition, income earned abroad by trusts isn’t taxable under the new law.

Last month, the Alberta government opened up a potential new avenue to boost trusts’ cash flow for dividends. In 2009, royalty rates paid to the provincial government will decrease for the mature reserves that are trusts’ bread and better. And trusts like ARC Energy Trust (AET.UN, AETUF), Enerplus Resources (ERF.UN, NYSE: ERF) and PennWest stand to be major beneficiaries.

In the words of one trust executive, final tax liability is likely to be far closer to the average 6 to 7 percent rate paid by the typical Canadian corporation than it will be to the statutory 31.5 percent rate. That leaves a lot more room to pay big dividends, particularly if the underlying business is steady.

Of the two trusts that have elected to convert, one has already pulled its plan, True Energy Trust (TUI.UN, TUIJF), after vehement opposition from shareholders. The other, Fairborne Energy (FEL.UN, FELNF), has couched its move as a way to rev up growth via a combination with another player.

The reality is that, as a small, gas-dependent trust, it’s simply unable to sustain itself and pay a big distribution. Conversion—and a subsequent gutting of Fairborne’s dividend—is hardly a positive, but it may be the only way out.

Small trusts in general have been pushed to the edge over the past year. Several have failed or been bailed out by mergers at very low prices. And more will likely fail in coming months.

That’s to be expected, considering the huge wave of new trust issues that hit the market in the months before Halloween 2006 suspended new conversions. Much of what was launched then was basically junk and could only be sustained in an environment of cheap capital, i.e., with trusts basically able to issue as many shares as they wished.

With capital now very expensive, many trusts have been virtually cut off from new funding for a year, other than what they generate internally. In fact, the entire sector has been subjected to an enormous stress test that few US corporations have: Having to answer the question, can they survive on their own as businesses only?

The good news is trusts that are now posting healthy results have measured up. As a result, we can have a great deal of confidence investing in them for income, growth and as takeover targets.

If there’s a change in Ottawa on taxation, we’re in for a windfall. The point is, however, a change isn’t necessary to make a great deal of money in trusts, ranging from oil and gas production to power generation to real estate. And provided we pick good businesses, the profits will keep flowing well beyond 2011.

Commodities and Currencies

When the Canadian government announced its Halloween 2006 surprise, I freely admitted being as surprised as anyone. However, I also cautioned investors not to jump to conclusions.

I advised taking the opportunity to clear out any weaker positions, largely to take advantage of tax write-off season. But I also urged readers to hang on to positions in the stronger trusts that were the backbone of the Canadian Edge portfolios.

My reasoning was basically twofold. First, good businesses will prosper no matter how they’re taxed. From the first issue of CE, I’ve emphasized buying trusts with good underlying businesses that will support long-run cash flow and distribution growth. Conversely, I’ve advised avoiding chasing “the highest yield.”

My second rationale for sticking in there was that Canada is one of the world’s premier growth stories and will almost surely remain so for years to come. That’s based on one major factor: the natural resource bull market that’s driving up the value of the country’s businesses (including those not involved in energy, its economy, its markets and its currency, the long-suffering Canadian dollar).

Over the past year, we’ve seen some ups and downs in the country’s key commodity exports and its currency. Today, however, both sit at much higher levels than they did on Halloween 2006.

There’s a notable exception—natural gas—which remains in the doldrums. That’s hurt some Canadian Edge Portfolio positions, most notably Precision Drilling (PD.UN, NYSE: PDS), which has been bashed by falling activity in the gas patch. I’m sticking with it as an aggressive play, though third quarter earnings are pretty clear proof that it will be a while before things really improve for the trust.

By and large, however, rising commodity prices have improved business conditions for the vast majority of CE positions. Meanwhile, the jump in the Canadian dollar to parity and beyond has boosted the US dollar value of trusts’ share prices and distributions. In fact, since Jan. 1, we’ve gotten what amounts to a 17 percent dividend increase just for holding on.

In my view, the commodity/currency bull market in Canada will have more ups and downs but will continue until we see the same factors that ended a similar boom in the 1970s. That’s permanent demand destruction through conservation, the use of alternatives and the discovery of significant conventional oil and gas reserves.

As of yet, we’ve seen some moves on the demand front in this country, as hybrid auto sales have picked up. Unlike in the ’70s, however, China has emerged as a major gas guzzler. It’s going to take a lot more action in the US to have the same impact on demand, and that looks a long way off.

Meanwhile, the only new reserves of oil and gas coming on stream lately are nonconventional like oil sands—which need very high oil prices to be economic.

Oil may come off of its current high levels, particularly if there’s a recession. But the impact will be only temporary unless there’s real demand destruction and new reserve development. Otherwise, prices will move to higher highs still, just as they did following every temporary slowdown in the ’70s.

As long as the long-run resource bull market lasts, Canada will remain a premier growth story. The Canadian dollar will stay strong, and trusts backed by good businesses will produce superior returns.

Looking back over the past year, we’ve had some setbacks, particularly in the gas patch. But more important, we’re still seeing trusts with sustainable businesses trading for huge discounts to equivalent corporations, both in yield and price-to-book value terms.

Clearly, investors still aren’t expecting much out of Canadian trusts going forward. That means we can still buy good trusts cheaply. And it means it won’t take much to generate a whole lot of upside.

I never recommend overloading on a particular sector. I didn’t advise doing that with trusts before Halloween 2006 and I don’t now. But in terms of value, yield and upside, there’s not a lot out there to match good-quality trusts.

And that’s what I’m going to focus on going forward. Note your next issue of CE will be e-mailed Nov. 9.