October 01, 2005 | By Keith Martin in Washington, DC

Canada has stopped issuing tax rulings for Canadian income trusts and other flow-through entities.

Some project developers in the United States have looked at the trusts as a way to raise cheaper money for their projects or as a potential buyer for existing assets that they want to sell. A Canadian income trust can afford to pay at least 27% more for US assets than can a taxable US bidder. The trusts look for businesses with predictable cash flows. Some have bought US independent power plants, particularly ones with long-term contracts to sell their electricity to creditworthy utilities.

The Canadian government is concerned about the loss of corporate tax revenue as more and more Canadian businesses convert to trust form. The trusts are not taxed. Investors in them are in theory, but a significant percentage of the money raised by such trusts comes from retirement savings accounts. The government estimated in a consultative paper released on September 8 that the conversions cost the government C$300 million in corporate tax revenue in 2004. The market capitalization of Canadian companies organized as pass-through entities was only C$18 billion in December 2000, but it had jumped to C$119 billion by the end of 2004. Income trusts accounted for 70% of the C$2.6 billion raised in the Canadian capital market in the first half of this year. Another C$3 billion in trust offerings are currently in the pipeline.

The government had hoped that release of the consultative paper on September 8 — with a list of possible tax changes to discourage businesses from converting to trusts — would be enough to slow the market. When it did not, the finance minister, Ralph Goodale, announced on September 19 that the government would stop issuing tax rulings on pass-through structures until it decides what to do about the situation. The process is expected to take at least a year.

Prices for trust units on the Toronto Stock Exchange dropped roughly 5% after the announcement, but they had rebounded by early October. The announcement has put a chill on conversions of Canadian companies to trust form, but “doesn’t seem to have materially affected the ability of existing trusts to raise capital,” according to one manager whose income fund has been active in the US energy market. One fund raised money in late September to acquire a natural gas storage facility in the United Kingdom. Most trust investments to date have been in North America, but as private equity capital drives up the cost of energy assets in the United States and Canada, the trusts have been looking farther afield.

In another development, Canadian utilities are exploring whether they can use the North American Free Trade Agreement to force their way into “renewable portfolio standard” programs in states along the US-Canadian border. The utilities want to supply electricity from large hydroelectric projects. Some border states exclude such projects from the definition of what qualifies as a “renewable.” RPS programs are state-level programs in the United States that require utilities to supply a certain percentage of their electricity from renewable energy. The utilities can either generate the electricity themselves or buy it from other suppliers.

The North American Free Trade Agreement bars discrimination, on grounds of national origin, against Canadian and Mexican companies trying to compete in the US market. The Canadian utilities charge that the RPS definitions favor small local suppliers.

Keith Martin