The two-and-a-half years since have been a colossal stress test for trusts. Some have proved less than equal to the task, folding up shop. That’s certainly been the case for many of the closed-end funds holding trusts, which at one point outnumbered the trusts themselves.

In early 2007, a couple dozen were bought out at lofty premiums to pre-deal prices, before the credit crunch brought the reign of private capital abruptly to a close. And a handful elected to convert to corporations ahead of 2011, mostly to save cash.

Most trusts that were around before Halloween 2006, however, are still very much in business today. And as 2011 approaches, speculation is running wild about what they’ll do, particularly with their heretofore very generous dividends.

In one major way, trust conversions are bullish for US investors. Mainly, every year at tax time, we’re faced with the same problem: Several major brokerages continue to slavishly follow an updated Ernst & Young report classifying trust distributions as ordinary income on the 1099s they send to clients, rather than qualified dividends.

Our advice at CE has been to file trust dividends as qualified anyway, just as you would any foreign equity. Trusts’ statements posted on their websites provide backup, as the IRS requires. Web links to those statements are accessible from the Income Trust Tax Guide. Even that method, however, has become more complicated, as some trusts have insisted on breaking down their distributions into classifications that have little meaning for US investors.

As corporations, there will no longer be any question that 100 percent of dividends paid are qualified for tax purposes. That’s likely to be a strong attraction in coming years, as the Obama administration raises taxes in the US.

The key question, however, is what converting to a corporation means for dividends. Immediately following the Halloween announcement, you couldn’t cut through all the bad information with a chain saw, particularly concerning how the tax would impact US investors. Some “analysts” worked up formulas showing US investors being directly assessed an additional 31.5 percent tax to the 15 percent withholding already in place, for assessments of over 40 percent.

Were that true, no sane individual would have purchased Canadian trusts. Fortunately, such calculations were utter fantasy. Unfortunately, such falsehoods were a big part of the selling panic that gripped trusts in November 2006, as well as the black cloud that’s hung over these investments ever since. And they continue to sow confusion in the marketplace today.

The truth is no additional tax is being levied on US investors. The 15 percent withholding remains in place, except on debt interest such as that paid by Atlantic Power Corp (TSX: ATP-U, OTC: ATPWF). Atlantic and others issue income participating securities (IPS) that combine a debt security with equity into one high-yielding security. Part of the dividend is withheld at 15 percent, and part is exempt.

But the trust tax–sometimes referred to as the SIFT tax–is imposed at the corporate or trust level. Again, there’s no additional levy on US investors. Instead, decisions on how to absorb the tax, and how or even whether dividends will be affected, are entirely up to management.

Under Mr. Flaherty’s original plan, the SIFT tax was to be 31.5 percent. Since then, however, the prospective top rate has been reduced to 28 percent, with a commensurate drop in the provincial rate as well. And that rate will only apply only to trusts that elect not to convert. And those that convert to corporations will face a much reduced corporate tax rate that will fall to less than 20 percent for many businesses. The upshot: The prospective tax burden to be carried by trusts is far less than 28 percent.

In fact, as is the case in most countries, Canadian corporations on average pay an effective tax rate of less than 10 percent of income, thanks to a wide range of deductions, from depreciation to goodwill. Those advantages will also be available to converting trusts, and there are other ways to cut taxes as well. For example, foreign-earned income is not subject to the trust tax, and energy producers enjoy numerous “tax pools,” which are basically expenses from producing energy that can be carried forward to reduce future burdens.

When Mr. Flaherty first announced trusts would be taxed, we cautioned investors not to bet that his Tax Fairness Plan would be repealed. Rather, we noted that the market was actually already pricing in far worse than a 31.5 percent tax, so investors had little to lose even if there was no repeal. And we advised viewing any change in the law as a potential bonus that could create windfall gains.

As it’s turned out, the political situation for trust taxation has changed little since Halloween 2006. The Conservative Party remains strongly pro-business but strangely committed to seeing trusts disappear in 2011. The party won a plurality in the fall 2008 elections, but again failed to capture an outright majority, making another set of elections certain before 2011.

Meanwhile, the Liberal Party, the Green Party and the Bloc Quebecois are all still on record favoring some rollback of the Tax Fairness Act. The Liberals are the only party of the three with a hope of forming a ruling government. They lost seats in the fall vote and refused to participate in a coalition government that could have toppled the Conservatives.

However, the Liberals now have an infinitely more effective leader in Michael Ignatieff. And they’ll be much better competition in the next election. Moreover, Mr. Ignatieff specifically mentioned income trusts in the opening lines of the announcement of his candidacy for Liberal Party leader.

The upshot is it’s still possible the trust tax will be overturned or at least softened before it becomes effective, or that some form of the structure will be preserved even if the tax does take effect. But a lot of things have to happen for any changes to the Tax Fairness Act to become reality, and investors need to proceed now as though it will be law.

Their Call

That means the ball is squarely in the court of trust managements. And there’s awful lot we still don’t know about what they’ll do.

What we do know is post-switch dividend policies have varied widely for the conversions made to date. When the Tax Fairness Plan was first announced, an analyst at one of Canada’s larger accounting firms noted that there were as many potential strategies for dealing with the new tax as there were trusts. That statement has certainly proven prescient thus far, as every conversion has taken its own unique route.

The two early conversions in the energy patch, for example, could scarcely have been handled any more differently. Bonterra Energy Trust became Bonterra Oil & Gas (TSX: BNE, OTC: BNEFF) last year without any dividend cut by essentially combining with a shell company. Advantage Energy Income Fund (TSX: AVN-U, NYSE: AAV), meanwhile, last month completely eliminated its payout when it announced its conversion.

Outside energy, we’ve seen several trusts swap monthly for quarterly payouts as part of an overall reduction in distributions. That’s likely the first step to going corporate, and it follows the model of most of the early conversions so far, including those of CE Portfolio members Newalta (TSX: NAL, OTC: NWLTF), TransForce (TSX: TFI, OTC: TFIFF) and Trinidad Drilling (TSX: TDG, OTC: TDGCF).

These trusts all trimmed distributions substantially as part of their big switch. So did other early conversions, such as waste hauler BFI Canada Corp (TSX: BFC, OTC: BFCFF) and bonus miles marketer Aeroplan Group (TSX: AER, OTC: GAPFF), both of which I also reviewed in my September 2008 Feature, Beyond 2011.

In stark contrast, Superior Plus (TSX: SPB, OTC: SUUIF) continued its full dividend with nary a scratch when it converted early to a corporation last year. In fact, after posting strong fourth quarter and full year 2008 profits, the new corporation’s next move could well be a dividend increase.

That leads us to the first real takeaway we have from the early conversions from trusts to corporations: With the exception of Advantage, all chose to stick with a dividend-paying model. And continuing to pay at least some distributions is also the stated intention of every other trust that’s commented to date on its fate when the curtain goes up on 2011.

Buying the strong businesses has always been my primary goal in the Canadian Edge Portfolio. Since the Tax Fairness Act passed the Canadian Parliament in mid 2007, however, I’ve been especially favorable to strong trusts that have also, as much as possible, guaranteed a big dividend after 2011.

The original poster child was Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF). The trust declared in November 2006 that it would be able to “grow” its way into absorbing the SIFT tax and thereby avoid any dividend cut. And despite intense skepticism in the investing public and particularly the blogosphere, it’s stuck to that pledge, and backed it up with robust numbers as well.

Since then, several other trusts’ managements have indicated they would be making no changes to distributions on the basis of 2011 taxation, either. Their ranks in the CE Portfolio include Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF), Energy Savings Income Fund (TSX: SIF-U, OTC: ESIUF), Great Lakes Hydro Income Fund (TSX: GLH-U, OTC: GLHIF), Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) and Vermilion Energy Trust (TSX: VET-U, OTC: VETMF).

As for the rest, however, the statements have been more opaque, and we’re still waiting on management to make the call. Unfortunately, we may well be waiting until December 2010, or even later for some of them. But as the table “Assessing 2011” shows, all of them have the ability to shield themselves from taxation, and therefore hold distributions steady. And most important, as their fourth quarter 2008 earnings again show, their deeds continue to match their bold words.

Importantly, food services trust Colabor Income Fund (TSX: CLB-U, OTC: COLAF) is already paying the SIFT tax, which is currently assessed at a statutory 34 percent. The reason is the trust decided to complete a transformational merger that increased its shares outstanding more than the limit prescribed in the Tax Fairness Act, triggering the tax. Fortunately for Colabor management and shareholders, the gambit has more than paid off. Fourth quarter revenue grew 42.6 percent, and the trust’s payout ratio fell to just 53 percent of distributable cash flow, despite the tax.

The upshot: The trust was able to absorb the tax, while continuing to pay its hefty distribution. Colabor Income Fund is a buy up to USD8. And its example is a clear indication that some trusts will be able to stay trusts and pay huge dividends, despite the SIFT tax.

Consequently, the second real takeaway from conversions thus far is the SIFT tax doesn’t necessarily mean dividend cuts. That begs the question, why are some management teams choosing to convert early and effectively gut their dividends?

It all boils down to cash. Colabor, Yellow Pages and the other trusts affirming their dividend-paying power to date haven’t been spared the carnage in the markets of recent months. In fact, some have taken particularly hard knocks since the fall of Lehman Brothers brought chaos to the market in mid-September 2008. But they’ve continued to generate rising cash flow in this environment because they run conservative, debt-light businesses in recession-resistant industries.

As a result, they’ve been able to take a wait-and-see attitude regarding conversions and future taxation. Some trusts, like Bonterra and Superior, calculated they could convert to corporations without cutting dividends, and thereby remove the specter of 2011 then hanging over their share prices. But most of those prepared for the big switch are content to continue reaping the tax advantages trusts now offer until they’re taken away.

In contrast, virtually all of the trusts that have moved early to convert to corporations have been in need of cash. For some, the need has been tied to a strong desire to grow in a weakening economic environment at a time when issuing stock as a trust was uneconomic. That was certainly the case for TransForce and Trinidad Drilling when they converted in 2008. Management of both trusts specifically stated it would apply the saved cash to boosting growth. And robust fourth quarter revenue growth at both companies–despite a deepening recession–proves they’ve been true to their word.

Funding growth was also the primary motivator for Newalta’s conversion this year. Since inception earlier this decade, the trust has been consistently building a presence throughout Canada in cleaning up and recycling the waste for everything from conventional oilfields and oil sands projects in Western Canada to heavy industry in the East. Though the conversion has only recently occurred, that strategic shift is already paying off well, as revenue continues to grow despite weakness in all of its target areas.

As for other trusts that converted in early 2008, BFI’s waste business remains a major bright spot for the Canadian economy, even as the company has used saved cash to further build dominance. And even Aeroplan has been on the move, though its sensitivity to the economy could prove difficult to compensate for this year.

With the exception of Aeroplan, all of these trusts remain solid buys at prices listed in How They Rate. As for Aeroplan, it’s now a sell, given recent share price gains, insider selling and the potential vulnerability of its business to the recession.

According to CEO Andy Mah, Advantage Energy’s decision to convert early to a corporation well in advance of 2011–and eliminate its dividend in the process–was also due to the desire to fund growth. Of course, as I point out in Dividend Watch List, there was also a major element of necessity involved.

Mainly, natural gas prices have fallen off a cliff since last summer. And unlike oil, which had definitely bounced up, gas is still languishing near its lows for the cycle.

Since 70 percent of Advantage’s production is natural gas, this has knocked cash flow off a cliff. Ironically, at the same time ongoing drilling at the company’s Glacier play in the Montney shale area has revealed reserves that are more promising than even management had imagined when it began to ramp up development last year.

According to management estimates, realizing that value will require some CAD2.5 billion in capital to fully develop the reserves. And given the trust’s modest size, making that nut with gas prices this low was simply going to be impossible, even if any dividend were paid. That left only one logical course of action, which was to marshal all available cash flow to get Glacier going and completely scrap the distribution.

In my view, the Advantage situation is unique, as it combined a compelling need for cash with devastating lack of it. The situation facing most trusts is nowhere near that extreme. Most have had to cut capital spending as well as dividends. But they’ve been large enough to do enough of both to remain viable.

In Advantage’s case, it’s quite possible that if gas prices hadn’t collapsed the trust would have elected to pay at least some dividend even as it developed Glacier aggressively. In fact, were natural gas prices to rebound strongly, Mr. Mah has replied in the hypothetical that he would “never say never” about paying some form of dividend.

But again, given where the company is now and where it wants to be, it needs all the cash it can get to plough into Glacier. Converting early and eliminating the dividend were the only course of action that made sense.

Should natural gas and oil prices continue to plummet in coming months, other trusts may decide the Advantage model is their only way out. And unfortunately, we’re not going to know about their actions until they move.

The bad news is radical moves like suddenly converting to corporations and eliminating dividends are virtually certain to trigger an initial negative reaction in the marketplace. In Advantage’s case, the reaction was swift, as the trust fell in two trading days from a high of over USD3 to a low of barely USD2.

Fortunately, there is good news even in Advantage’s case: Its shares have already rebounded swiftly off their lows, and in fact back to levels before the conversion/dividend cut announcement.

Clearly, selling income investors have been replaced by buyers with a more growth-oriented, value-seeking bent. Advantage is clearly not attractive for income, as it’s not likely to pay a dividend until Glacier is developed, even if gas prices surge. But its assets in the ground are conservatively worth CAD14.03 per share, according to rater Sproule. And drilling results at Glacier indicate that value may climb steeply in coming years.

Shares of Advantage as a corporation won’t break out until energy prices again show signs of life. And energy, in turn, isn’t likely to recover until the global economy perks up. But just getting back to a market valuation equal to reserve value–a perfectly normal condition when the public doesn’t have a Depression on the brain–boost Advantage’s share price by factor of more than a 4-to-1. And that potential is attractive to a lot of people.

The thesis that growth investors will replace departing income investors in converting trusts was certainly borne out in the first half of 2008. Trinidad Drilling was the biggest winner, as its shares surged 60 percent plus to its mid-2008 high. Other early converters also scored gains from their transitions. Simply, they called the market’s bluff, making their 2011 tax adjustments in one fell swoop. As a result, the cloud of uncertainly abruptly blew away and investors began to finally concentrate on the core strengths of the underlying company.

All that ended, of course, when Lehman Brothers fell and the global stock market went into a power dive. And not surprisingly, converted corporations have generally fared worse than companies that elected to remain trusts. High yields didn’t save even the strongest trusts from heavy selling when the gloom was thickest in October and early November. But those that converted didn’t even have a high yield to attract or hold investors. And the result, logical or not, was a full-scale meltdown.

The silver lining is the best of the converted corporations are still very much in the game for recovering most or all of their lost ground when overall conditions improve. The key is that their underlying businesses stay solid. In fact, that’s the critical element for the recovery of any trust or corporation going forward.

Good Businesses

We don’t have all the information on how trusts will deal with 2011 yet. The good news is that we do know, beyond the shadow of a doubt, that good businesses will fare well no matter what happens on the trust tax front. Moreover, all of them are still pricing in a great deal of 2011 uncertainty and risk. That means little downside risk again no matter what happens, and a lot of upside as uncertainty is gradually reduced in coming months.

We don’t have to try to guess what trusts’ managements are going to do for 2011. We may not be happy with those that elect to convert early and cut distributions. As shareholders we can actually vote against their plans. But we are likely to suffer in the near term, if enough income investors vote with their feet all at once.

But as long as the converting trusts have solid underlying businesses, their shares will ultimately recover the lost ground, as growth investors replace the sellers. In fact, removing the specter of 2011 is likely to unlock value, producing capital gains that dwarf whatever loss of income we suffer. At the very least, that will give us a much better opportunity to sell.

Again, the key isn’t how a business is organized. It’s whether or not that it’s still healthy and growing. That’s what’s going to build wealth for us in the long term, as well as recover the losses sustained since this bear market began so long ago.

Since Canadian Edge was launched in 2004, our primary mission has been to highlight and recommend good businesses. That’s differentiated us ever since from the scores of other advisors and investors tracking trusts, who’ve been mainly if not exclusively focused on the highest yield. In fact, we’ve consistently advised against yield chasing, in favor of focusing only on high dividends backed by good businesses.

In the 22 months since this bear market began, we’ve seen again and again the perils of a yield-first strategy. What we’re going to see over the next 22 months, however, is just what kind of powerful returns the strong businesses can produce. Getting the most out of that means lifting up our eyes, more than ever, to the opportunities that exist in Canada outside the trust universe.

In 2004, the CE coverage focused exclusively on income trusts. Record issuance gave us no shortage of opportunities to buy all manner of businesses, though quite frankly most were pure junk and not worth our money.

We quickly found, however, that many of the best businesses in Canada–including many that paid generous dividends–were not trusts but corporations. As a result, with the advent of the Tax Fairness Act we began to expand our coverage to both converted trusts and companies that had never been trusts. Quite a few now populate our portfolios, particularly in the communications and banking sectors. And quite a few now rate buys.

Below is the latest iteration of our expanding coverage of the best of all of Canada’s businesses: The addition of a truly “magnificent seven” companies with superb growth credentials, as well as strong total return potential. None are trusts or have ever been organized as trusts. But all are weathering this recession well. Better, several are trading at their best buying prices in years. Note that all are now tracked in How They Rate in the sectors listed below.

Brookfield Asset Management (TSX: BAM/A, NYSE: BAM), a new entry for the Financial Services sector, is actually an investment company that holds stakes and controlling interests in a wide range of enterprises. For example, it owns 51 percent of CE Conservative Holding Great Lakes Hydro (TSX: GLH-U, OTC: GLHIF), and runs Acadian Timber Income Fund (TSX: ADN, OTC: ATBUF) and Brookfield Real Estate Services (BRE-U, OTC: BREUF). Management’s skill in managing these operations has consistently produced strong returns.

We’ll know more about how the company’s far flung pieces are faring after it announces earnings on April 28. But yielding 3.5 percent and trading for just 68 percent of sales, Brookfield Asset Management is a buy up to USD18.

Canadian Natural Resources (TSX: CNQ, NYSE: CNQ) has rapidly emerged as a leading player in the development of Canada’s oil sands. The company’s Horizon facility recently began producing synthetic crude, transported over a pipeline system owned by CE Conservative Holding Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF). Falling crude oil prices and mounting environmental scrutiny have recently stalled oil sands growth. That’s a potential deathblow to smaller players, but consequently an opportunity for large players that can turn it to their advantage. The company has relatively high operating costs, particularly for its oil sands projects. But it’s clearly a survivor with solid scale and no real credit worries, ensuring it will be on top again when energy prices rebound. Down from a mid-2008 high of well over USD100 a share, Canadian Natural Resources is a buy up to USD50.

EnCana (TSX: ECA, NYSE: ECA) is the closest thing Canada has to its own Super Oil, with far-flung drilling opportunities in both conventional and unconventional energy throughout the Western Hemisphere. The company has reliably increased its production and held down costs to boost profitability, and there’s plenty more ahead. Management has also consistently shown its savvy by trading in and out of properties to maximize shareholder returns.

Unlike Canada’s other energy giants, EnCana is far less wedded to oil sands development. That makes it a somewhat safer bet than other energy producer selections, particularly now that the shares are trading at less than half recent highs and at just 1.4 times book value. Buy EnCana up to USD50.

Nexen’s (TSX: NXY, NYSE: NXY) revenue mix is actually quite close to that of Super Oils. Annual production of oil and gas is a bit less than 200,000 barrels of oil equivalent a day, putting it only slightly above the output of the largest trust, Penn West Energy Trust (NYSE: PWT-U, NYSE: PWE).

But the company also conducts production business in Australia, Colombia, Indonesia, Nigeria and Yemen, as well as chemicals operation in Brazil and the US. As a result, it’s the most international of Canada’s energy giants, a fact that should help leaven out earnings in coming quarters despite unprecedented energy price volatility. The stock is also a takeover target, trading at less than half its 52-week high and a price/earnings ratio of six. Buy Nexen up to USD20.

Potash Corp (TSX: POT, NYSE: POT) is the world’s leading producer of potash, a key element in fertizer and catalyst for the global agriculture boom. The stock was on everyone’s buy list in early 2008 but has since crashed back to earth, giving growth investors a second chance to buy in at a third the price that prevailed less than a year ago. Ironically, management continues to affirm that the underlying conditions for its business as strong as ever, making its price-to-earnings ratio of less than 8 seem ridiculously cheap. Buy Potash Corp up to USD100.

Research in Motion (TSX: RIM, NSDQ: RIMM) is Canada’s closest thing to a technology industry national champion. The company is best known for its development of the BlackBerry, a device that continues to dominate the business space despite the enormous popularity of the iPhone. In any case, there’s more than enough room for two dominant devices with wireless data revenues growing 40 to 50 percent at major telecoms like AT&T (NYSE: T) and Verizon Communications (NYSE: VZ). The stock once traded for nearly $150 a share and now sells for barely USD40. Buy Research in Motion up to USD50.

Suncor Energy (TSX: SU, NYSE: SU) made its creds as a leading developer of the oil sands second only to Syncrude, the partnership of major oils that’s operated by a unit of ExxonMobil (NYSE: XOM). Now Suncor is on the move again, announcing a blockbuster takeover of PetroCanada (TSX: PCA, NYSE: PCZ) last month.

The deal will dramatically expand the company’s refining capability, a major need for any producer of heavy oil. That should enable it to control costs far more effectively operation-wide, and ultimately increase profitability greatly. Regulators are slated to review the deal, but with no lesser personage than Finance Minister Jim Flaherty already expressing support, approval looks assured. And with energy prices this depressed, Suncor’s hardly paying top dollar for its prospective prey.

In the past, I’ve shied away from this one, on the basis that the oil sands are a volatile place to invest and prone to mindless hype. This deal, however, graduates Suncor to the ranks of the majors. Buy Suncor Energy up to USD25, a price less than a third of its 52-week high.