Canadian income funds face new restrictions in the budget announced by the Canadian government at the end of March.

The main restriction is a limit on the extent to which Canadian income funds can tap into Canadian pension plans as a source of future capital.

Canadian income funds are trusts formed in Canada that raise money in the capital markets to pool for  investment. Many US power companies have been looking at them as a possible source of financing for
acquiring distressed assets and cashing out existing projects in the United States. The trusts have seen phenomenal growth in Canada. They accounted for 86% of all the new capital raised through initial public
offerings in Canada last year and now represent 7% of the aggregate capitalization of the Toronto Stock Exchange. Canadian businesses organized as trusts face only one level of taxation — to the unitholders in the trust — and, to the extent the unitholders are pensions, there is no current tax. The same math works when the trusts invest across the border into the United States. The tax advantage means that Canadian income funds can afford to pay at least 27% more than competing bidders for operating businesses.

The Canadian government is worried about the loss of tax revenue in Canada if pension fund managers move to invest large sums of money in the trusts. They have been slow to invest so far because of  concerns about potential liability if the trustee of a trust were sued and were viewed, under Canadian law, to have been acting merely as an agent for the unitholders. Ontario and Alberta are moving to limit the liability by statute. After that happens, pension plan and other institutional money is expected to flow freely into the income funds. 

The new budget would impose two new measures starting in 2005. First, business trusts would be defined as restricted investments. Tax-exempt entities, including pension plans, are barred from holding more 
than 1% of the book value of their assets in restricted investment property. Second, any one pension fund could not own more than 5% of the interests in any one business income trust. These limits would not apply to the types of trusts that invest in oil and gas and real estate. The finance minister, Ralph Goodale, released the budget on March 23.

Reaction in the market was muted. The prices for units in some prominent income funds were down slightly after the announcement.