CANADIAN INCOME TRUSTS lost value after the finance minister announced plans to subject their earnings to higher taxes. US private equity firms are now scouting for bargains among trust assets.

Finance Minister James Flaherty announced plans on October 31 to subject income trusts to taxes on distributed earnings and to tax investors as if they received corporate dividends. The new taxes will not take effect for existing trusts until 2011. They take effect in 2007 for new trusts organized after October 2006. The new taxes will apply to “specified investment flowthroughs.” The category covers not only income trusts but also limited partnerships. The action is expected to increase taxes on US investors in such entities from roughly 15% to the 42% that applies to earnings received through corporate shareholdings.

The government acted in the face of plans by two large telecommunications companies — Bell Canada Enterprises and Telus Communications Corp. — to convert to trust form. The government estimates that it is currently losing C$500 million a year in revenue on account of the trusts. The loss would have increased by another C$300 million a year after conversion of the two telecom companies. The government feared the erosion of the corporate tax base would turn into a stampede.

Trust units in the aggregate had lost 12% in value by the first week in November. The latest action breaks a campaign promise made just last year by the conservative government not to change the tax treatment of income trusts. A DOUBLE-DIP INTEREST structure works, the IRS confirmed in an internal memorandum.

The IRS national office analyzed a transaction among a US parent company and two offshore subsidiaries in a memorandum to the field. Both offshore subsidiaries are in the same country. The IRS made the memorandum public in late September.

The US parent company owns each subsidiary directly. One subsidiary — X — is “disregarded,” meaning that it does not exist for US tax purposes. The other — Y — is a corporation for US tax purposes.

X borrowed from a bank and relent the proceeds to Y. The loan from X to Y requires Y to pay interest in the form of shares in Y and then to pay all the principal in cash at maturity. Simultaneously with the making of the loan, the US parent entered into a forward contract with Y to buy more shares in Y for a dollar amount that is exactly the principal amount of the loan that will have to be repaid at maturity. The forward contract requires the US parent company to buy the Y shares on the loan maturity date — in other words, provide Y with the money to repay the loan from X.

The IRS said there was essentially no trans- action for US tax purposes. It combined the two instruments since they are so closely linked in amount and timing and, for US tax purposes, they are just a circling of cash between the US parent company and Y.

The loan from the bank was real and should produce an interest deduction for the US parent company; the loan by the bank to Xisaloanto the parent company for US tax purposes since X does not exist. However, for tax purposes in the foreign country where both X and Y were based, Y has the interest deductions. It is viewed as the ultimate borrower. The memorandum is AM 2006-001.