When Canadian Prime Minister Stephen Harper came to power in early 2006, he promised to leave income trusts’ tax status alone. His breaking of that pledge on Halloween 2006 reminded investors once again why no one should ever count on politicians to be either honorable or rational.

Ironically, with less than 18 months to go until Jan. 1, 2011, the prospective trust tax is less of a risk than ever to investor returns. In fact, it’s shaping up as a bullish event, even a potential windfall.

One reason is low expectations. When Harper’s Finance Minister Jim Flaherty announced his infamous tax, he mainly sowed confusion. More than one well-known advisor mistakenly told clients that US investors’ dividends would be directly assessed a new tax, rather the truth that the new tax would be applied entirely at the corporate level.

But the better informed saw 2011 as a day of destruction for trusts, where prospective losses would dwarf even those of early November 2006.

Since then, many income trust owners have pinned their hopes on politics. Attempting to take advantage of voter anger at the Conservatives, the opposition Liberals and Bloc Quebecois pledged to overturn Harper/Flaherty’s “Tax Fairness Act” and restore trusts’ favorable tax status.

That remains their platform today, and they’ll almost certainly get their chance to dethrone the Conservatives again at the ballot box before trust taxation kicks in.

For the record, counting on politicians to set things right has never been my approach. To be sure, I’ve been hopeful that either the Conservatives would relent on the tax or that the opposition parties would succeed in overturning the law. I still believe such an event would trigger windfall gains for trusts across the board, as well as for the entire Canadian market as income investors returned to drive up valuations.

As many in the industry have pointed out to me since, however, even a Liberal victory wouldn’t guarantee income trusts’ restoration. After all, it was the Liberals themselves who first proposed taxing trusts, albeit at a rate of just 10 percent. And election promises are all too often forgotten in the heat of victory. Moreover, the Liberals have thus far failed to field a leader able to even remotely challenge Harper’s acumen and charisma.

Rather, my approach has been to concentrate on the underlying business health of individual trusts. Growing businesses build wealth no matter how they’re organized for tax purposes, just as weak ones eventually falter no matter how governments advantage them.

With trusts already pricing in dividend cuts of 50 percent and more since mid-November 2006, they reflect absolutely no expectation of a change in the law. That means only upside if one does occur and no downside if the status quo prevails.

Under the Tax Fairness Act and the Conservative Party’s subsequent clarification of the rules, real estate investment trusts (REIT) are exempt from trust taxation. So are the remaining income participating securities, such as Atlantic Power Corp (TSX: ATP-U, OTC: ATPWF).

Aside from those exceptions and a handful of trusts that derive most income from outside Canada, however, virtually all trusts are going to convert to corporations on or before Jan. 1, 2011. But there is most definitely life beyond that point for strong businesses.

Additional taxes will no doubt be a nuisance. Corporate tax rates, however, have been repeatedly reduced by the Conservative government, and numerous potential deductions are available. Consequently, trusts backed by financially strong and growing businesses have the ability to absorb them and continue building wealth.

Moreover, even dividend cuts aren’t a foregone conclusion. Whether as trusts or corporations, management has the ability to set dividend levels. Some, like Advantage Oil & Gas (TSX: AAV, NYSE: AAV), will choose to completely abandon dividends. A growing number, however, are finding they have the wherewithal and desire to keep paying, even at the lofty levels they’re dishing out now.

How trusts fare as investments after Jan. 1, 2011 depends squarely on the health of their underlying businesses. The strong will continue to build shareholder wealth, either as corporations or by remaining trusts.

And with investors still expecting the worst from the conversion process, anything short of disaster has the potential to be rewarded with windfall capital gains.

Conversions So Far

In the first months after the Halloween massacre, many panicked at the rushed-to conclusion that trusts would mass-convert to corporations, gutting dividends and collapsing shareholder value in the process.

Not surprisingly, these fears proved vastly misplaced, as most managements chose to remain trusts while they worked out their future status in a rational way.

By early 2008, several of the more aggressive decided they would convert early, in large part to eliminate the restrictions on new equity issues that were limiting their ability to grow.

Two of the first to make a move were CE Portfolio picks TransForce (TSX: TFI, OTC: TFIFF) and Trinidad Drilling (TSX: TDG, OTC: TDGCF).

They’ve since been joined by 16 others tracked in the How They Rate universe, as shown in the table “How Converters Have Fared.”

The table features four columns describing these trusts’ conversions to corporations and their aftermath. Starting from the left, the first is the date of the initial conversion announcement. The second is the total return since that date, capital gains/losses plus total distributions.

The third provides a point of comparison with non-converting trusts, as the total return of the S&P/Toronto Stock Exchange Income Trust Index. Finally, column four highlights management’s decision on what to do with the trust’s distribution at the initial time of conversion.

Several points are worth considering from this history. First, almost all of the early conversions involved substantial distribution cuts.

In contrast, the vast majority of conversions this year have been of the pain-free variety, i.e. management has elected to maintain the pre-conversion dividend rate after becoming a corporation.

Second, 12 of the 18 converting trusts sell for higher prices now than they did before they announced their conversions. In fact, despite the toughest stock market in a generation, the average gain for converters is 18.9 percent.

Converting trusts have actually fared far better on average than the broader trust index.

The only exceptions have been trusts in particularly cyclical industries, such as oil and gas drilling and energy services, CE Portfolio picks Newalta (TSX: NAL, OTC: NWLTF) and Trinidad Drilling among them.

Notably, however, both of these newly converted corporations have performed at the top for their battered sector, besting rivals that remained trusts.

Of course, there’s a wide divergence between performances of individual converting trusts. For one thing, including Newalta and Trinidad there are six converting trusts that are still underwater since announcing their move.

Others, like TransForce, were deeply underwater until recently, as the North American economic slump hit their sector hard. The monster gains in Advantage since its March 2009 conversion announcement, moreover, came only after a wholesale meltdown in its share price due to collapsing natural gas prices.

These are the exceptions that prove the rule. Mainly, the differences in their share price performance were determined by the health of their underlying business as they responded to historically difficult conditions. After their conversions, changes in their taxation had a relatively insignificant impact on returns.

Trinidad, for example, actually doubled off its January 2008 pre-conversion announcement price when energy prices had their run in summer 2008. Its losses since are entirely due to the depression hitting its industry.

Even if it were still organized as a trust, it would not recover until those conditions improve, as they inevitably will.

We don’t yet have enough price history to determine whether or not trusts that maintain pre-conversion distributions will ultimately fare better than those that have made cuts.

We do know one thing, however: Thus far, they’ve definitely been far less volatile.

That even goes for oil and gas producer Bonterra Oil & Gas (TSX: BNE, OTC: BNEFF), which was subsequently forced to trim its payout four times over the past 12 months due to crashing energy prices.

In a real sense, the ability to maintain distributions after converting to a corporation is the ultimate test of strength for a trust’s underlying business. Only the exceptional have thus far been able to accomplish the feat, and only if they’ve been able to weather this recession with a strong balance sheet and steady, growing revenue. Consequently, it should be no surprise if the cut-free converters have and continue to outperform.

Underlying business strength didn’t prevent even the strongest trusts from selling off sharply in the worst of the panic late last year. But it did hold down losses to at least a manageable level then. More important, it’s been the key to their comeback this year, as it is to the promise of a full recovery in coming months.

It’s no secret that of the six CE Portfolio recommendations now selling above summer 2008 levels, all have continued to post strong operating results. One has already converted to a corporation without cutting dividends, Ag Growth International (TSX: AFN, OTC: AGGZF). Another, Colabor Income Fund (TSX: CLB-U, OTC: COLAF), is in the process of a no-cut conversion.

Atlantic Power Corp is immune from 2011 taxation as an income participating security. Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF) announced with its second quarter earnings that it will convert to a corporation in late 2010, also without reducing its current payout.

Just Energy Income Fund (TSX: JE-U, OTC: JUSTF) has made similar statements and repeatedly backed them up with the necessary numbers. Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF) is in excellent shape to hold its payout steady as well.

Having a strong underlying business doesn’t guarantee a no-cut conversion. It is by far the surest indicator, however, that a cut-less conversion is a strong possibility.

The most important conclusion from the data in this table is simply this: Contrary to the fears that continue to prevail among many investors, the conversions from trusts to corporations that we’ve seen thus far haven’t been the harbingers of doom.

In fact, conversions have created wealth by removing the uncertainty that’s been overhanging the trusts in question since Halloween 2006. And in the case of the growing number of no-cut conversions, investors have realized immediate windfall gains.

As we approach Jan. 1, 2011, the number of conversions will inexorably grow. And just as one well-known accounting firm commented in late 2006, there will be just as many strategies for dealing with the new taxes as there are trusts today.

The results of the early converters, however, are without doubt a bullish portent for the remaining trusts. And if we keep our eyes on the ball and buy only the best businesses, we’re definitely going to see some major windfalls.

Where We Stand

I’ve run the “Tax Strategies” table several times previously in Canadian Edge. Each time, I’ve been able to fill in more information, as more and more management teams have confirmed their 2011 plans.

Starting from the left, the first four columns outline how the various CE Portfolio members will reduce their bills when the new taxes start to kick in.

“Exempt” describes companies tht will face no additional taxes in 2011, either because they’re still fully exempt from corporate income tax like REITs or because they’ve already converted to corporations.

Note that part equity/part debt security Atlantic Power faces no new taxes, though management may still buy back and cancel the debt portion of its income participating securities.

Income earned outside Canada is also not taxed for trusts, which may be a major incentive for Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF) not to convert, but will be a plus for any entity going forward that has global operations.

“Tax Pools” are basically non-cash expenses that can be carried on energy producers’ books and written off against income to cut taxes.

Many trusts have accumulated large tax pool reserves, which they may elect to use in the first years of the tax in order to completely avoid taxes. Non-cash expenses, however, are constantly being incurred by producers, so a converting corporation will be able to continue to use them as long as it stays in business.

Finally, the ability to depreciate assets like pipelines, power plants and even telephone lines is a time honored way of lowering essential service company tax bills. And it’s one reason why trusts like Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) have stated their confidence in maintaining their distributions for at least five years after trust taxes kick in, with future payout levels dependent on asset performance.

The remaining two columns in the table really cut to the chase. “Likely Post-2011 Structure” shows how the trust will be or is likely to be organized, based on management actions and statements to date.

“Potential to Cut 2011 Tax Rate” further clarifies each Portfolio recommendation’s plans, based on its various strengths as well as management actions and statements to date.

Here’s where we stand now with Portfolio recommendations.

Of the Conservative Holdings, the four REITs will remain tax exempt and unaffected by 2011 trust taxation: Artis REIT (TSX: AX-U, OTC: ARESF), Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF), Northern Property REIT (TSX: NPR-U, OTC: NPRUF) and RioCan REIT (TSX: REI-U, OTC: RIOCF).

The initial draft of the Tax Fairness Act carried some concerns that certain REITs wouldn’t qualify for tax-exempt status. That appears to be the case for REITs involved with senior housing such as Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF) as well as those in the lodging business such as InnVest REIT (TSX: INN-U, OTC: IVRVF) and Royal Host REIT (TSX: RYL-U, OTC: ROYHF), which as it stands now will be socked with new taxes starting January 1, 2011. In contrast, all of the REITs in the CE Portfolio will remain exempt.

A year ago, Atlantic Power seemed to panic some investors when it stated it was considering retiring the bond portion of its income participating securities (IPS) before its maturity date in 2016. Since then, it’s made steady purchases of its IPS on the market when prices have dipped.

Full retirement of the debt portion still looks likely at some point. Based on the IPS’ current price, however, it would benefit Atlantic Power shareholders, as the bonds will have to be retired at face value.

In any case, this is not a 2011 concern for investors. Atlantic Power in fact increased its distribution in late 2008 and has repeatedly stated it can maintain the current payout at least through 2015 based on its current portfolio of projects and contracts.

One of the Conservative Holdings has already converted to a corporation, TransForce, and therefore faces no additional 2011 taxation risk. Its fate, rather, is tied to the health of the Canadian economy, though it looks healthy and hunkered down enough to survive the current difficult environment with ease.

Food distributor Colabor was already paying taxes at a rate higher than most corporations before its decision last month to convert from trust to corporation. That’s because of a major acquisition dubbed “undue expansion” by the Canadian government. As a result, its conversion will likely save cash when it’s completed later this year, a big reason why management has elected not to cut distributions.

High Yield of the Month Great Lakes Hydro Income Fund (TSX: GLH-U, OTC: GLHIF) also announced a no-cut conversion in July. It has yet to set a specific timetable for the move, which it intends to undertake after completing the purchase of assets from parent  Brookfield Asset Management (TSX: BAM/A, NYSE: BAM).

Keyera Facilities announced this week that it would convert to a corporation in January 2011 and “is positioned to maintain current distribution levels.” Pembina Pipeline management, meanwhile, stated again with its second quarter earnings announcement that it was comfortable affirming the current dividend rate for the next five years at least, “based on the projects we have on file.”

Finally, AltaGas Income Trust (TSX: ALA-U, OTC: ATGFF) has further clarified its post-2011 strategy, with an expected conversion to a corporation “in the second half of 2010.”

Until that point, management expects to continue paying the current distribution of CAD0.18 a month. Thereafter it intends to reduce the payout by a third to a half, to an annual rate of between CAD1.10 to CAD1.40 a share, in order to shepherd more capital for faster growth.

The obvious bad news here is that AltaGas’ dividends will be reduced to a rate of 6.5 to 8.3 percent, based on its current share price. That’s down from the current rate of nearly 13 percent.

On the other hand, the move eliminates any remaining 2011 uncertainty surrounding this otherwise strong energy infrastructure trust. This move was apparently already expected, as the shares actually rose slightly on the news. As a result, I still rate AltaGas Income Trust a buy up to USD20 for conservative investors.

That’s what we know about Conservative Holdings thus far, and by and large it’s positive.

Elsewhere, Bell Aliant Regional Communications and Just Energy remain good candidates for no-cut conversions, though no definite plans have been set.

Just Energy’s management’s most recent statement on the subject is “our goal and planning and budgeting believe that we will be able to grow through the tax issue and maintain our distribution.”

That leaves Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF), CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF), Consumers’ Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF), Innergex Power Income Fund (TSX: IEF-U, OTC: INGRF), Macquarie Power & Infrastructure Income Fund (TSX: MPT-U, OTC: MCQPF) and Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF) as trusts where 2011 uncertainty still exists.

Taking them one by one, Bird Construction’s huge backlog, low debt and low payout ratio should be more than enough to enable a cut-less conversion at some future date.

CML Healthcare has a budding US presence and a low payout ratio that should protect its cash flow and dividend.

Innergex Power enjoys many of the same advantages Great Lakes Hydro does when it comes to dodging taxes. So does Macquarie Power & Infrastructure, though it remains noncommittal on the dividend after 2009.

Finally, both Consumers’ Waterheater and Yellow Pages have made repeated statements in the past that they intend to absorb future taxation and maintain current dividends.

Earlier this year, Yellow was forced to backtrack on that statement in the face of the weak economy. Management now maintains it can hold the reduced rate, but challenges remain.

Consumers’ fate, meanwhile, depends heavily on Ontario regulators allowing it to grow submetering operations, an iffy proposal at best.

All of these trusts are likely to convert to corporations, probably by late 2010, and maintain at least the lion’s share of their current distributions. In fact, all are capable of doing so, and when their intentions are made clear any or all could generate a windfall gain. But until we get hard facts in, uncertainty is going to hang like a cloud over their share prices, and we’re going to have to be very patient waiting on them to pay off.

Commodity Prices Are Key

Turning to the Aggressive Holdings, Ag Growth International, Newalta and Trinidad have already converted.

Ag Growth continues to thrive as the market for corn handling equipment remains solid. The other two are set to survive the tough times but depend entirely on a revival of the energy business to get going.

Oddly enough, the same is true of the eight energy producer trusts in the Portfolio: ARC Energy Trust (TSX: AET-U, OTC: AETUF), Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF), Enerplus Resources Fund (TSX: ERF-U, NYSE: ERF), Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF), Penn West Energy Trust (TSX: PWT-U, NYSE: PWE), Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF), Provident Energy Trust (TSX: PVE-U, NYSE: PVX) and Vermilion Energy Trust (TSX: VET-U, OTC: VETMF).

Of this group, Vermilion Energy has stated it sees little impact from 2011 taxation, mainly because nearly 80 percent of its current income is generated outside Canada and is therefore not subject to the tax.

That’s also true of High Yield of the Month Chemtrade Logistics. Both could convert to corporations or remain trusts in 2011 with little or no impact on distributions from taxes.

On the other hand, even Ag Growth, Vermilion Energy and Chemtrade Logistics are at the mercy of commodity prices when it comes to how much cash flow they can generate, and therefore what level of distributions they can pay.

In fact, a growing number of energy trust managements are starting to state consistently that the level of energy prices will ultimately prove far more important to profits, cash flow and dividends than how they’re taxed.

Clearly, all of them–with the possible exception of Vermilion–will ultimately elect to convert to corporations, most before 2011, the rest by 2013 when favorable conversion rules are slated to run out. That will mean an additional tax burden, though at least some of the prospective levy will be neutralized by the use of tax pools.

Note that converting to a limited partnership (LP) is no longer a viable option for energy trusts, as it would incur a higher withholding rate for US investors of 25 percent under a tax treaty change. That’s up from the standard 15 percent that currently applies to trusts and ordinary common stocks, and it’s why Pengrowth Energy Trust (TSX: PGF, NYSE: PGH) elected last month to convert from an LP to a trust for US tax purposes.

What happens to dividends when the new taxes kick in, however, has nothing to do with the Canadian government. It’s entirely at management’s discretion, which means lingering uncertainty until they make their moves.

To be sure, there’s the clear possibility that some will elect to follow the route of Advantage Oil & Gas. That company in the end abandoned its distribution entirely to focus all its cash flow on developing its promising Glacier project in the Montney Shale find.

If more trusts follow its lead, it won’t be the end of the world, as Advantage’s phoenix-like rebound since its conversion announcement clearly shows. But more often than not, trusts are going to choose to remain big dividend payers, just as managements are increasingly affirming now in their public statements.

The main reason is virtually all trusts were set up to produce from mature wells, rather than to explore and develop new reserves as much of the industry does. Focusing on the mature means trusts have extremely reliable geologic knowledge for tapping into what they have.

This allows them to generate large, reliable cash flows with a minimum of capital costs, and with a regularity that’s simply impossible for companies developing new reserves, including super oils.

Paying out a significant portion of cash flows as dividends in turn allows trusts to attract and hold investor attention and thereby raise capital when needed. Obviously, all else equal, those distributable cash flows will be less in 2011 when they’re taxed as corporate profits than they are now as tax-advantaged trust distributions.

However, all else is rarely equal in the energy business, where all hangs on the prices of extremely volatile commodities.

Put another way, if on Jan. 1, 2011 oil is trading at USD30 a barrel and natural gas at USD2 per million British thermal units, it won’t matter one iota whether the trust tax is repealed or not. Trust dividends will be far lower than they are now. So incidentally, will be the Canadian government’s share of taxes.

Conversely, if oil moves back over USD100 and gas can get back to USD6 to USD7, the converted corporations will be paying much higher distributions than they are now, regardless of whatever new taxes they owe.

In one sense, the best example to consider now is what’s happened to Bonterra Oil & Gas since it converted in August 2008. The small, oil-weighted producer announced its conversion to a corporation when oil and gas prices were near their peak, maintaining its distribution at the pre-conversion level.

As oil prices crashed over the next several months, however, it was forced to trim distributions no fewer than four times. Finally, oil prices bottomed and headed higher and the trusts boosted its payout in June.

Bonterra has now been organized as a corporation for nearly a year. Over that time, energy prices not taxes have dictated how much it can pay in distributions.

That’s how it’s going to be for all energy producer trusts, both before and after they convert to corporations in coming years. And it’s why we need to keep our eyes focused on energy prices in the coming months.

Let the fearful and uninformed fret about a prospective tax that’s shaping up as a total non-event at worst, an opportunity for windfall profits as long-held, overblown fears are at last swept away at best.