If they do, the ball will be squarely in the court of the Liberals, Bloc Quebecois and the Green Party, all of which have professed a desire to overturn–or at least severely alter–the Conservatives’ pending 2011 tax on trusts. If they follow through, the result will be windfall gains for trusts across the board.

As investors no doubt recall, trusts dropped like a stone in the weeks following Flaherty’s Halloween night 2006 trust tax announcement. Since then, the prospective levy has been more than priced into the market.

Taking it off the books—or even cutting the rate to 10 percent as the Liberals have proposed—would almost certainly trigger a buying frenzy. My conservative projection would be a rise in the broad-based S&P Toronto Stock Exchange Trust Composite well past 200, from its current range of 160 to 165.

That’s certainly possible. Unfortunately, there are too many ifs for anyone to bet on it. The good news: As I’ve said since November 2006, it doesn’t have to happen for us to make big money in trusts before and after 2011. All we really have to do is stay focused on well-run businesses that are gaining value.

If there’s a favorable change in the tax law, there won’t be many people celebrating as heartily as Canadian Edge associate editor David Dittman and myself. But the key to winning returns will still be buying and holding strong businesses that continue to weather the stress tests of rising raw material costs, tight credit conditions and a weakening US economy. And the best candidates are right in the CE Portfolio.

The article below focuses on the two key aspects of the 2011 trust tax issue for investors. First, I analyze the upcoming election and political prospects for repealing or substantially altering the tax. Second, I look at how trusts are adapting their strategies to maximize shareholder value in the event the trust tax isn’t repealed.

The table “Beyond 2011” sums up how CE Portfolio picks stack up. I’ll be reporting intentions, strategies and possibilities for other trusts in the How They Rate table and elsewhere, as data becomes available. Note the fourth column of How They Rate already indicates the chief advantage available to each trust for minimizing its own effective tax rate.

First, let’s take a look at the political situation and the odds of reversing the trust tax as enshrined in the so-called Tax Fairness Act. Our view remains that the Conservative government took the dramatic action of taxing trusts—reversing its position in the 2006 elections—when it began to fear large corporations would go trust and drain the government coffers of corporate taxes.

Since then, the government has publicly stuck by its policy. For example, this week Mr. Flaherty gave a flat “no” to the suggestion he might soften the prospective tax in advance of the election, asserting the “decision was for the good of the country and for future generations.”

At the same time, however, the government has been tinkering around with the details. The first step was liberalizing the rules for real estate investment trusts (REIT), making it much easier for them to remain tax exempt beyond 2011. The second was cutting the top trust tax rate for 2012 from 31.5 percent to 28 percent, with a similar move to cut the provincial tax rate as well. And although rules for converting corporations are still being formalized, early switchers have encountered no real problems from regulators in the process.

The implication seems to be the Conservatives took a very harsh step, and simultaneously gave themselves enough time and flexibility to make adjustments as needed to avoid crippling the Canadian economy. With 2011 still more than two years away, they’re likely to make further favorable adjustments to the Act, including incentives to convert to corporations such as cutting corporate tax rates again. In fact, any action the government takes is likely to benefit the remaining trusts, as it’s already done its worst by passing the act in the first place.

That strategy, of course, depends on remaining in office. As of this writing, Harper appears likely to dissolve his Conservative Party government in the next few days, ending the longest serving minority regime in the country’s history. That would trigger an autumn campaign, with voters going to the polls Oct. 14.

The trust tax remains deeply unpopular with investors on both sides of the border. The two largest opposition parties—the Liberals and Bloc Quebecois—are on record favoring scaling it back dramatically. So is the country’s fifth largest party, the Greens.

Since the trust tax was first announced Halloween night 2006, investors have fantasized about a defeat of the Conservatives. And that remains the best hope of overturning or dramatically altering the trust tax.

It would be foolish to count on such a scenario, however. Mainly, all election results are highly uncertain, and this one is even more so than usual. The map shows the current breakdown of Canada’s parliamentary system. Districts colored in red are controlled by Liberals and blue by Conservatives.

As the picture shows, the Canadian electorate is highly regionalized. Despite being out of power, the Liberals still have the most national presence, holding at least some seats in virtually every region of the country. The Conservatives, in contrast, are mostly a western province party, though they’ve recently scored some gains in Atlantic Canada and along the US border. The New Democratic Party’s (NDP) stronghold is the far west, particularly very liberal British Columbia, while the Bloc Quebecois’ power base isn’t surprisingly exclusive in French-speaking Quebec.

The map makes the clear point of just how difficult it’s become for Canadian political parties to forge majorities. Rather, success is tactical and depends a great deal on outfoxing your opponent to pick off enough key “ridings.” Winning at least 40 percent of the national vote has long been considered critical to capturing a majority of seats in parliament. That’s been a bridge too far in the last two elections, and it appears to be shaping up that way this time around as well.

A new poll conducted by Strategic Counsel for the Toronto Globe and Mail and CTV reports 37 percent of Canadians currently favor the ruling Tories, versus 29 percent for the Liberals, 17 percent for the NDP (the country’s fourth largest party) and 9 percent for the Green Party. Those are virtually identical numbers to the results of the 2006 election, when the Tories gained power by polling 36 percent to the Liberals’ 30 percent, the NDP’s 18 percent and the Greens’ 5 percent.

On the other hand, a poll by Nanos Research for Sun Media—conducted at the time when Harper floated the idea of an early election—shows the Liberals at 35 percent nationally, with the Conservatives at 33 percent. They also show the NDP still at 17 percent and the Greens at 7 percent. They’re virtually the same numbers recorded in this poll since late 2007.

One advantage for the Conservatives is that their voters are generally happier with Harper as a leader than Liberal voters are with Stephane Dion. That’s pretty consistent with what we’ve reported the past couple years in CE’s companion weekly e-zine Maple Leaf Memo, as Harper has consistently outmaneuvered Dion in parliament since winning power.

That may be enough to carry the Conservatives to another minority government. But the numbers thus far are undeniably ambiguous and point to a very tight, tactical election—one that’s unlikely to land the Conservatives their long-coveted majority and the right to rule for up to five years without calling a national election. Even the chief analyst of the Strategic Counsel poll, which shows the Conservatives with a bigger lead than the 2006 vote, opines “a majority is within the reach of the Conservatives, but not yet in their grasp.”

So why call an election now and not wait until October 2009 as current law permits? We can see two very real advantages for Harper.

First, polls indicate a strong campaign could leave the Conservatives at least very close to a majority. Second, Harper can avoid calling an election next year, when the Canadian economy may be weaker depending on what happens in the US. He’ll also avoid having to cope with the possibility of an “Obama bounce” for the opposition Liberals.

Some Canadian pollsters close to the prime minister, for example, have estimated a victory by the Democrat in the race for the US White House could boost the Liberals’ share of the electorate by as much as 4 to 5 percentage points. That would be more than enough to take control and quite possibly to engineer a Liberal Party majority, if the Sun Media numbers are to be believed.

In sum, holding an early election is the best chance Harper has to hold onto power. And with enough luck in the campaign—and sufficient gaffes from his chief opponent Dion—he may yet win enough seats for a long-desired majority.

Will he succeed? We’ll leave handicapping the ultimate results to the pros, who incidentally get it wrong all too often. But the fact that Harper’s Conservatives have an excellent chance of retaining power for some time after Oct. 14 is enough reason not to bet on a new government overturning the 2011 trust tax.

The good news for the Liberals is an electoral defeat would almost certainly spell the end of the Stephane Dion era. No party leader has ever been deposed before leading at least one election effort. But defeat would provide the excuse for more aggressive leadership. And a resurgent Liberal Party could well dethrone even a newly-elected minority Conservative government before 2011.

Even under this scenario, there’s no guarantee the trust tax would be overturned. Politicians are famous for “forgetting” campaign promises when they reach office. And again, there are other issues—the economy, Afghanistan, global warming, etc.—that resonate more with the average Canadian voter than tax policy. Trust executives are skeptical of any follow through, and so are we.

The bottom line: We can’t count on the outcome of the Oct. 14 election to kill the 2011 tax on trusts. If it happens, we’ll welcome the windfall. And with the tax long priced in, there’s no risk if it doesn’t happen, either. The key to success in trusts, however, is still to stick with those that can succeed no matter how they’re taxed. And happily, this market offers them in abundance.

Running a strong business is the most important criterion for a worthy trust. No. 2 is the intention to continue paying generous dividends no matter how they’re taxed beyond 2011.

On Nov. 1, 2006—the day after the trust tax was announced—one prominent Canadian analyst observed that virtually every one of the then 250-plus income trusts traded would have a different 2011 tax strategy. That statement has proven particularly prescient in the months since, as managements have recognized one size truly doesn’t fit all.

Since Halloween 2006, roughly four dozen trusts have shopped themselves to the highest bidder, some capturing premiums as high as 50 percent to pre-deal market prices. Others such as Pengrowth Energy Trust (TSX: PGF, NYSE: PGH) have publicly declared their intention to remain trusts long after 2011, despite government opposition. And some have simply pledged to outgrow any future tax burden.

The trust tax included an addendum limiting the total number of shares a trust could issue before 2011 to 100 percent of 2006 levels. Specifically, the rules allowed a “safe harbor” of a 40 percent increase in 2007 and 20 percent boosts in 2008, 2009 and 2010, respectively. Exceeding those limits immediately triggers the “SIFT” tax on trusts. The top rate is currently at 34 percent and slated to fall to 28 percent in 2012.

To date, most trusts have stayed well within those limits, including more than a few that were in the habit of doubling equity on an annual basis before November 2006. Last year, however, Colabor Income Fund (TSX: CLB-U, OTC: COLAF) elected to trigger the tax by completing a major acquisition to expand its business dramatically. The trust has since absorbed the tax, while continuing to pay its hefty distribution.

When the trust tax passed, some doomsayers predicted a wave of value-destroying early conversions by trusts to corporations. To date, only five have elected to actually make the change, and four did so to fund aggressive growth plans that would have been impossible to execute as trusts.

Rather, most trusts haven’t been in a hurry to do anything, instead electing to see how events play out to determine their best course of action. That’s likely to remain the case going forward as well. In fact, more than a few may elect not to do anything before 2011, before they can first gauge what the impact of paying the SIFT tax would be on their business prospects.

Of course, going slow makes a great deal of sense for most trusts. The chief negative of not stating clear intentions is that it’s created a great deal of uncertainty in the market place regarding what will happen to trust prices and distributions in 2011 or, more accurately, by late 2010 when most will probably elect to take action.

Don’t Fear Conversions

The greatest point of concern right now involves prospective conversions from trusts to corporations. When the tax was first announced on Halloween night 2006, most investors assumed all trust conversions would entail massive dividend cuts. That, more than anything else, was why trusts sold off so dramatically in the first two weeks of November.

By early 2007, it had become crystal clear that there would be no early wave of conversions. In fact, True Energy Trust’s (TSX: TUI-U, OTC: TUIJF) proposal to convert into a very low dividend-paying corporation was rejected by unitholders, forcing management to reverse course.

As 2011 approaches, anxiety levels have risen again. Fortunately, we now have some pretty clear trading histories for converted trusts, and the results are very encouraging indeed.

The first conversion involved CE Aggressive Portfolio pick Trinidad Drilling (TSX: TDG-U, OTC: TDGCF). In mid-January, the trust announced it would convert immediately to a corporation, slashing its distribution by 56.5 percent.

Management stated its primary reason for the move was to shepherd cash in order to execute an aggressive expansion plan to build out its rig fleet. Its goal was to take advantage of robust demand growth for its specialty deep drilling services, which was impeded by its inability to raise capital easily as a trust.

Trinidad had covered its distribution handily with cash flow, so the steep dividend cut came as something of a surprise. Although the business continued to post solid results, the shares took an immediate dive, hitting a low of around CAD8 in late January.

That, however, proved to be the bottom for Trinidad. With the uncertainty of 2011 taxation no longer hanging over the shares, investors began viewing the company for its business value. The result was a near doubling of the shares by late June. Investors didn’t like the dividend cut. But anyone who stuck around past the initial selloff—as we did in Canadian Edge—has since realized gains that dwarf any lost current income, despite the selloff in the energy patch since late June.

The second trust to announce a conversion was another CE pick, trucking and transportation outfit TransForce (TSX: TFI, OTC: TFIFF). Unlike Trinidad, this trust wasn’t covering its distribution comfortably, as cash flows were hit by the US economic slowdown and management’s aggressive strategy of acquiring smaller transportation companies amid weak market conditions.

As with Trinidad, TransForce’s management professed that it needed to shepherd cash flow to keep growing, and announced a simultaneous 75 dividend cut. The shares, which had been weak for some months, dived again, slipping to a low of around CAD6.50 a share in late June.

Like Trinidad, however, TransForce soon began to prove the value of its strategy, posting solid second quarter earnings and continuing its expansion. With 2011 tax uncertainty gone, investors began to take note of its progress. The result: The shares have rebounded well above their pre-conversion announcement level and are working their way higher.

Those who bailed because of the disappointment of a dividend cut and change in strategy ate a big loss. Those who paid attention to the underlying business and held on now have the opportunity to cash out some 40 percent above the low, with the prospect of fetching an even better price down the road.

The third conversion to date—Groupe Aeroplan (TSX: AER-U, OTC: GAPFF)—was only completed in June and, therefore, has only a brief post-move trading history. A glance at the graph shows its shares are following the same trading pattern as Trinidad and TransForce. The removal of 2011 uncertainty has allowed investors to focus on business strength. The result is losses in the wake of the announced 40.5 dividend cut have been erased, and shares are rising.

As I point out in the Dividend Watch List section of Tips on Trusts, BFI Canada Income Fund (TSX: BFC-U, OTC: BFICF) looks like a lock to follow the same trajectory. The waste services provider had been covering its distribution handily with cash flow before its announcement, which included a stiff 73 percent payout reduction.

Its shares were then dumped en masse by investors, hitting an intraday low of around CAD17 in mid-August, after trading in the mid-20s only a couple months earlier. They now appear to be climbing again, despite two immediate downgrades from Bay Street firms.

The lesson from all four of these examples is—even when they’re accompanied by steep dividend cuts—trust conversions pose little long-term risk to shareholders. Even if we’re caught unawares by them, we can make back our money and then some by patiently waiting out the initial selloff and hanging on as investors focus on their businesses.

All we really have to do is to make sure the underlying businesses of our holdings are sound. And as second quarter results proved, that’s certainly true of all of CE Portfolio holdings.

Most encouraging, we now have our first example of a trust converting to a corporation without cutting its distribution. Last month, oil and gas producer trust Bonterra Energy Trust (TSX: BNE-U, OTC: BNEUF) announced two binding agreements. The first was to buy Alberta-based oil and gas company Silverwing for a combination of shares and cash. The second was to buy shell company SRX Post Holdings, gaining tax advantages to ease the conversion process.

Bonterra’s strong recent results in the wake of rising oil prices pushed its second quarter payout ratio down to just 67 percent. Combined with tax pools and the increased access to capital, that adds up to the ability to maintain a high dividend rate.

Bonterra’s conversion and the market’s positive reaction to it is a big plus for its shareholders. It’s also very good news for trust holders across the board, as it’s likely to encourage more to limit distribution cuts as they convert to corporations. Not everyone has the means or desire to completely avoid cuts and pay new taxes. But we’re likely to see more trusts cutting less.

Of course, until a trust’s management makes its strategy clear, all we can do is speculate on future actions. And with most electing to move only very deliberately, there are likely to be unanswered questions and uncertainty for some time.

Fortunately, a number are starting to give investors at least some idea of what to expect, including a number of CE Portfolio recommendations. The table “Beyond 2001” displays the results of what we know so far.

The good news is all of them apparently intend to pay dividends well after 2011. Those that see themselves as growth companies are logically more likely to make significant payout cuts in order to shepherd cash flow. But more than a few managements have also stated a belief that current distribution rates can be maintained after taxation, simply by growing the trust’s earnings and pushing down payout ratios.

That was the conclusion of Ken Hartwick, CEO of High Yield of the Month Energy Savings Income Fund (TSX: SIF-U, OTC: ESUIF). And I’ve heard the same sentiments expressed by top executives at its co-High Yield of the Month AG Growth Fund (TSX: AFN-U, OTC: AGGRF), as well as Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF).

Atlantic Power Income Fund (TSX: ATP-U, OTC: ATPWF) is immune from trust taxation because it’s organized as an income participating security. My other power trusts have stated that dividends are the key to how the market values them, a clear sign they intend to remain big payers. All four REIT holdings are also exempt, though Artis REIT (TSX: AX-U, OTC: ARESF) has made clear it must resolve a “technical issue” to be in compliance.

Of the energy producer trusts, Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) is the most likely to follow Bonterra’s lead of converting without a dividend cut. That’s because of the low payout ratio, management’s goal of “maintaining the dividend at current levels” and the 70 percent of its cash flow generated outside Canada and not subject to the 2011 tax.

All of the rest of our holdings in the sector have stated dividends will remain a key element of their financial strategy. And they have the wherewithal to make good on that pledge, thanks to tax pools, low payout ratios and debt reduction. Energy prices will be key to how much they can do. But all are also pricing in much lower levels of oil and gas, limiting risk.

To be sure, we don’t have all the information yet. The good news is what we know so far is quite positive, for both trusts’ ability and intentions to pay big dividends well past 2011, no matter how they’re taxed. And all of them are still pricing in a great deal of 2001 uncertainty and risk. That means little downside risk almost no matter what happens and a lot of upside as uncertainty is gradually reduced in coming months.