In the six years prior to Halloween Night 2006, the ranks of Canadian income trusts soared from a handful to some 255. Market value reached a peak of CAD200 million, as income investors globally were drawn to lofty monthly yields of 8 percent and more.

In short, Canada’s trust boom was one of the most successful examples of rapid capital accumulation in stock market history. Even the federal government made out: Lost corporate taxes were more than made up for by added tax revenue garnered from suddenly income-flush investors.

Few saw the end before it was upon them. Spooked by threats that even energy giant EnCana (TSX: ECA, NYSE: ECA) was on the verge of going trust, the government reneged on a campaign promise, announcing new taxes that immediately squelched conversion activity.

Existing trusts were essentially given four plus more years to live, with the new tax kicking in Jan. 1, 2011. Meanwhile, they faced new limits on equity issuance that would trigger higher taxes if breached.

Markets always price in the future, never the past. So when the new taxes were announced, the impact was immediate: A CAD20 billion-plus haircut in income trusts’ market values across the board. Trust advocates continued to fight, even going so far as to back opposition Liberal Party candidates in a bid to unseat the Tories–despite the latter’s historically pro-business bent.

By the time the so-called Tax Fairness Act passed in mid-2007, however, it was fairly clear odds of repeal were rapidly diminishing. Meanwhile, the Conservative Party government of Stephen Harper continued to cement its hold on power. In fact, the longest serving minority government in Canada’s history is today closer than ever to gaining a long-coveted majority in government. That would guarantee it at least five more years in power, and ability to shape the country’s future for generations.

When the Tax Fairness Act passed, the consensus was there would be a massive and immediate wave of trust conversions to corporations. The assumption was that this wave would be extremely destructive to shareholder value, as companies slashed dividends and shareholders dumped shares en masse. Moreover, the perception of those that didn’t convert immediately was they would only postpone an even more devastating day of reckoning in 2011.

Reality turned out quite differently. A number of trusts did disappear in 2007. That wasn’t due to forced early conversions, however, but to some three-dozen takeovers. Some deals went off at premiums of up to 50 percent above pre-deal announcement prices.

At the height of the issue boom in 2006, Canadian Edge How They Rate tracked less than half the income trusts then in existence. I followed an even smaller portion of the closed-end mutual funds holding them, whose ranks were even larger.

The primary reason was quality control. My view was that many if not most of the new issues were simply over-hyped junk. These were not operating businesses well-suited to paying out large amounts of cash in distributions. Rather, they were assets packaged together with a marketable yield slapped on that would never hold if conditions became even slightly more averse.

Conditions did become significantly more averse very quickly, and much of the junk did fall apart. Some of the companies I didn’t cover have proven themselves, and we’ve steadily added them to coverage. But being exclusive has resulted in a higher overall degree of quality for How They Rate covered companies than the overall universe. And that’s spared us from some of the least favorable trust conversion stories.

In early 2008, however, some of the stronger companies began to make their moves. The first Canadian Edge Portfolio members to go were Trinidad Drilling (TSX: TDG, OTC: TDGCF) and TransForce (TSX: TFI, OTC: TFIFF). Both cut dividends deeply, Trinidad by 57 percent, TransForce by 75 percent.

Rather than fall off a cliff, however, these stocks rallied in earnest. Trinidad, for example, surged more than 60 percent in the first half of 2008 following its conversion announcement. For strong companies at least, clearing the air about what conversion meant for the underlying business proved to be the most important factor for stock valuation.

Then came decisions by Bonterra Energy Corp (TSX: BNE, OTC: BNEFF) and Superior Plus Corp (TSX: SPB, OTC: SUUIF) to convert to corporations without cutting dividends. Their moves vindicated several positive notions: first, that there were just as many potential strategies for dealing with 2011 taxes as there were trusts; second, that some companies could absorb the new taxes without cutting dividends at all; and third, that at least some companies weren’t abandoning the dividend-paying model just because of erratic government policy.

In addition, the strong performance of their stocks in the aftermath of the conversions reinforced what any sentient market observer already knew: Dividends were still very popular with investors. Any converting trust that managed to preserve its dividend would command a premium multiple.

Continuing to pay a big dividend despite the new taxes meant there would be less cash from operations to invest in the business. But the negative impact on growth would be dwarfed by the positive impact of improved access to capital. Companies could boost growth by paying out more cash to investors. In fact, they could grow much faster than companies that paid out less–and therefore paid the price in the stock market.

The only trusts to convert during the late 2008, early 2009 debacle did so out of desperation. Advantage Oil & Gas’ (TSX: AAV, NYSE: AAV) move, for example, was rumored to be the result of a giant margin call by its lenders, who demanded it reduce debt and cease dividend payments. Aggressive Holding Newalta Corp (TSX: NAL, OTC: NWLTF) likely faced similar pressures in late 2008, though it elected to maintain at least a portion of its dividend.

By early 2009 the strategy of growth through post-conversion dividend preservation was catching on across all sectors. Crescent Point Energy Corp’s (TSX: CPG, OTC: CSCTF) focus on light-oil production in the Bakken Shale region enabled it to avoid a dividend cut during the 2008-09 meltdown, one of only three How They Rate Oil and Gas producer trusts to do so. But it was the company’s decision to hold its dividend at conversion in 2009 that triggered the more than doubling of its share price. That, in turn, slashed the company’s cost of capital and enabled it to more than double production with a series of acquisitions in subsequent months.

By the time Jan. 1, 2011, rolled around more than a third of CE How They Rate income trusts had announced they wouldn’t cut their dividends at conversion. A handful even announced increases.

Meanwhile, companies that cut generally did so just enough to cover new tax levies. Management of even the shakiest outfits has taken pains to emphasize the importance they attach to paying dividends. Ditto executives of companies like Penn West Petroleum Ltd (TSX: PWT, NYSE: PWE), which for a long time intimated it favored paying little or no dividend to devote all operating cash flow to growth.

Just Saying No

That once-dreaded trust conversions and 2011 taxation have proven so benign is still sinking in for many. That includes media personalities and overly skeptical analysts, as well as investors on both sides of the border.

No doubt the biggest surprise to the doomsayers, however, is the large number of companies that have elected to remain trusts, rather than convert to corporations. Those tracked in How They Rate are shown in the table “Not Converting.”

That real estate investment trusts (REIT) have by and large maintained their structure is no great surprise. The Tax Fairness Act of 2007 explicitly excluded them from the 2011 taxation.

The Act committed the government to write new rules about what qualified as allowable REIT activity, and what would open up companies to new taxes. And it literally waited until the last minute to release the final details.

Most REITs, however, were able to come into compliance with only minor restructuring and no impact on shareholder wealth.

Even Northern Property REIT (TSX: NPR-U, OTC: NPRUF) was able to avoid taxes by spinning off non-complying operations into a new entity and restructuring as a “stapled unit,” paying a dividend consisting of both debt interest and equity distribution.

As a peculiarity of the transaction, US investors will be assessed additional withholding of CAD0.0535 per unit, recoverable outside an IRA using a Form 1116.

Debt interest paid to US investors by Canadian companies is, however, not withheld, whether securities are held in an IRA or outside of one.

As a result, the amount of Northern Property’s staple-share dividend that’s debt interest will no longer be subject to 15 percent Canadian withholding tax, a savings that over time will exceed the immediate tax by a wide margin. Northern Property REIT is a buy up to USD28.

REITs, however, are only 16 of the names in the table. The remaining 21 enjoy no such preferential tax treatment. Rather, they’re elected to meet the Tax Fairness Act head on by remaining trusts, or SIFTs (“specialized investment flow-through” entities).

Under the minority Conservative government Canadian corporate taxes have been slashed to the lowest level of any developed nation. In fact, they’re less than half the levies imposed on US corporations and heading lower still. And that’s not including the methods big companies can use to cut what they actually pay.

Low corporate tax rates are yet another reason to be bullish on Canada. The SIFT tax rate, in contrast, remains at much higher–even punitive–rates. The initial rate of 31.5 percent imposed in 2007 has gradually been reduced and will hit 28 percent in 2012. But the message from the government is clear: Convert to corporations or else suffer higher tax burdens into perpetuity.

Faced with that choice, it’s no wonder most trusts wound up electing to convert to corporations once the new taxes kicked in. The 21 non-REITs in the table, however, have at least for now chosen a different route.

Why? For one thing, restructuring costs money. Converting companies have had to hire lawyers, accountants and managers to move from trust to corporate accounting, even when there’s been no real change to the underlying business.

Trusts with complex ownership structures have had even more to weed through. Many, for example, were set up basically to collect royalties from partial ownership of an operating entity, usually organized as a limited partnership. That was the case with High Yield of the Month IBI Group (TSX: IBG, OTC: IBIBF).

In sum, the decision of whether or not to convert has basically come down to this: Are the benefits of going along with the government–a lower official tax rate being the main one–worth the expense of turning the organization upside down?

For most of the 255 trusts that existed in late 2006, the answer has been “yes.” Even Enerplus Corp (TSX: ERF, NYSE: ERF), the oldest of income trusts with a more than 20-year history, elected to convert to a corporation. The company saw value in unlocking capital markets by simplifying its structure. And it was able to maintain its distribution after converting thanks to conservative financial policies.

For these 21, however, the answer has been no, at least thus far. One big reason: Despite the onset of the SIFT tax it’ll basically owe nothing to the government in 2011.

For shareholders, the biggest advantage of not converting is the savings of not having to do a transaction. Other issues are basically a wash, including taxation. Unlike REITs, SIFTs pay taxes just like converted corporations. As a result, US IRA investors won’t be assessed 15 percent withholding tax and their dividends are qualified for tax purposes outside IRAs as well.

The key is that by not converting, these companies are positioning themselves to be as profitable as possible. That maximizes the chances their underlying businesses will thrive, which is the key to shareholder returns.

As I’ve said many times over the past four years, the important thing for investors has never been whether a company was organized as a trust, corporation, income participating security or something else. It was the dividend they paid, and whether or not it was backed by a healthy and growing business.

For some companies the best way to get there is to convert to corporations. For others, such as those discussed below, it’s staying right where they are–organized as trusts/SIFTs despite the new taxes.

Lovely Loopholes

When the Tax Fairness Act was passed, one of the first readily apparent loopholes was that it didn’t affect income earned outside of Canada. That’s enabled management of Aggressive Holding Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF), for example, to categorically state it will owe no SIFT tax in 2011. As a result, there was no advantage for the company in converting to a corporation, and it’s elected to remain a trust/SIFT for the foreseeable future.

We’ll know more about how this diversified refiner and marketer of chemicals for industry is doing when it releases earnings on Feb. 24.

At this point, however, the company has weathered both new taxes and the worst recession/credit crunch in 80 years in one of the most economically sensitive industries around, thanks to a secure niche and conservative financial policies.

Both are strong votes of confidence for the company’s 8 percent-plus yield paid monthly.

Buy Chemtrade Logistics Income Fund up to USD15 if you haven’t yet.

Note Chemtrade’s decision not to convert is the opposite course taken by Vermilion Energy (TSX: VET, OTC: VEMTF), a company that also avoided new taxes by relying on extensive foreign operations. Vermilion elected to convert, presumably to boost its access to capital. But with a CAD4.2 billion market capitalization–versus Chemtrade’s CAD450 million–it had a far easier time absorbing the cost.

New How They Rate addition Boyd Group Income Fund (TSX: BYD-U, OTC: BFGIF) also elected to remain a trust without cutting its dividend. Like Chemtrade and Vermilion, its secrets are conservative financial policies and deriving the vast majority of cash flows outside Canada.

An operator of automobile collision and repair shops in Canada and the US, Boyd Group has increased its distribution two consecutive quarters and 14 times since restoring it in November 2007. That offsets the relatively low current yield of around 5 percent, as does the generally steady nature of results and business expansion opportunities via acquisitions on both sides of the border.

Boyd is slated to report fourth-quarter and full-year 2010 earnings on Mar. 25. The stock has enjoyed a boost from the passing of 2011 uncertainty and now trades at its highest level since 2005, before it omitted dividends for two years.

I’ve been skeptical in the past about the ability of businesses like this to pay out large amounts of cash in distributions over time, but this company has proven me wrong in the worst of times. Buy Boyd Group Income Fund up to USD8.

Beset by legal problems resulting from alleged market fixing in the packaged ice industry, Arctic Glacier Income Fund (TSX: AG-U, OTC: AGUNF) has had the luxury of worrying about SIFT taxes lately, as legal fees have generally exhausted profits. 

The company, which suspended dividends indefinitely in September 2008, is still not out of the woods yet. But it has managed to settle its investigation by the US Dept of Justice (DoJ) without substantial penalty to its business.

Meanwhile, most recent operating results show definite signs of improvement in the core business. Expansion into new markets in the US–notably Arizona and Colorado–is pushing up revenues and profitability. That’s somewhat offset by competition in West Coast markets and uncertain transport costs, as well as higher financing costs made necessary by the legal stresses of the past two plus years. But the trend is definitely up.

Before it reduced its distribution for the first time in August 2008, Arctic Glacier was a Canadian Edge Portfolio Holding, largely because of its steady operations and lack of exposure to the SIFT tax. The latter remains the case today, thanks to more than 80 percent of cash flows coming from the US.

The dividend cut triggered definite warning bells for me, particularly as management had previously assured us its emerging legal troubles were not severe enough to threaten profitability. As a result, I took the loss and unloaded Arctic; happily, we avoided the pain that followed when management soon eliminated dividends entirely.

At one point it looked as though Arctic might not make it, but rather would succumb to bankruptcy as a way to protect itself from an escalating DoJ investigation that seemed without end. As it turned out, however, management has stayed in the trenches, and the company appears to be winning its battle to survive.

The key now is an ongoing board and management review of “financing and strategic alternatives available to the fund.” This week management announced the review was moving to its next phase, which appears to basically be seeking out potential partners and possibly a takeover of the existing company.

We’ll know more on Mar. 18, when the company is expected to announce its fourth-quarter and full-year 2010 earnings and hold its regular conference call. For now, however, Arctic is again a worthy speculation for patient investors who don’t mind the temporary lack of a dividend. Buy Arctic Glacier Income Fund up to USD2.

Arctic Glacier’s not the only company on my list to suffer from a lack of profits. In fact, it’s likely several of these companies won’t exist within a year, as they’re either rolled up or acquired. Newport Partners Income Fund (TSX: NPF-U, OTC: NWPIF), Priszm Income Fund (TSX: QSR-U, OTC: PSZMF) and Tree Island Wire Income Fund (TSX: TIL-U, OTC: TWIRF) are closest to death’s door, locked in negotiations for survival with anxious creditors and trading at less than CAD1. All are definitely still sells.

Exposure to the SIFT tax or no, they and the rest of the companies on the list that don’t pay dividends have little to attract investors. Any of them could become attractive again should they resume dividends.

For now, however, the best idea is to stick with those paying dividends, with the exception of Arctic Glacier for speculators.

One of these is Extendicare REIT (TSX: EXE-U, OTC: EXETF), which was a High Yield of the Month and new Conservative Portfolio addition in January. The company’s business of managing long-term care facilities didn’t meet the tighter restrictions for REITs enacted with the Tax Fairness Act, and management has remained focused on growth.

Both of these objectives ran head-on into the government’s moves against trusts. As a result the company was among the first to trigger the “undue expansion” penalty and start paying SIFT taxes. When 2011 rolled around it was already adjusted and was therefore able to maintain its generous monthly yield of more than 8 percent.

With bright prospects for growth and backed by conservative financial policies, Extendicare REIT is a buy up to USD11.

Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF) was all set to convert to a corporation on Jan. 1 without cutting its distribution. That was the result of strategic repositioning by parent Brookfield Asset Management (TSX: BAM, NYSE: BAM) in mid-2009, which dramatically boosted the hydro and wind power producer’s size and ability to expand.

Late last year, upon further reflection, management discovered it wouldn’t owe any SIFT taxes in 2011. That was a positive change from earlier estimates that its effective tax rate could be as much as 14 percent and induced management to reconsider its move. As a result, Brookfield Renewable Power Fund remains a trust for now, pending further review on what its ultimate structure should be.

Our next indication of what management plans will be could come as soon as Feb. 16-17, when the company will release its fourth-quarter and full-year 2010 earnings and hold its conference call. Either way it leans, however, shareholders look set to win, as the company continues to build out its renewable energy fleet, adding cash flows while largely dodging taxes as either a SIFT or corporation. Buy Brookfield Renewable Power Fund on dips to USD20.

One last group to consider is the growing ranks of “stapled shares.” These aren’t technically income trusts, as they combine ordinary corporate equity with a debt portion to create a high-paying security. The debt portion limits taxation, which in turn allows the company to pass on more income.

I’ve had some of these in the CE Portfolio in the past, notably Atlantic Power Corp (TSX: ATP, NYSE: AT) which later converted the debt portion of its income participating security (IPS) into common equity. As I point out above, Northern Property REIT is now also this type of security, though by far the largest portion of its distribution is still an equity dividend.

Of the rest, my favorite at current prices is New Flyer Industries (TSX: NFI-U, OTC: NFYIF), a maker of advanced buses covered under Transports in How They Rate. The company boasts a monthly yield of more than 10 percent for its more complicated structure as well as investor skepticism about the health of bus manufacturing as a business at a time of squeezed municipal budgets.

US states, cities and related agencies are indeed the company’s largest customers. And it’s absolutely true that many are being forced to deal with major fiscal crises, largely as the hangover from the severe 2008-09 recession. New Flyer’s orders, however, remain remarkably resilient.

Fourth-quarter orders, for example, totaled 268 buses for a total of USD139 million. Approximately 34 percent of these were clean-propulsion vehicles–i.e. hybrid or compressed natural gas vehicles–in which the company has a clear competitive advantage in manufacturing.

The orders were form a wide range of entities, a further indication of a superior marketing operation as well. Meanwhile, overall backlog remains steady at CAD3.68 billion, only slightly below the CAD3.8 billion as of Oct. 3, 2010.

Maintaining financial health and the dividend ultimately depends on keeping those orders coming, which is likely to be more difficult in the US in the immediate future given the focus on budgets.

New Flyer’s buses, however, over time represent significant infrastructure improvements for those who buy them, improving efficiency and cutting costs (particularly maintenance and fuel expenses) as much as helping with pollution concerns. That’s a powerful business driver that will only get stronger as the US economy gets back on its feet. New Flyer is not without risks, mainly the volatility of any manufacturing business.