Income trusts have been more like a roller coaster than an investment over the past few months. The index gained about 25% from January through September, dropped 15% through October and then recovered about 15% through November. What has driven this wild ride? The credit goes to a little bit of knowledge, some help from politicians in Ottawa and perhaps a touch of hysteria.

First, a quick review of income trusts. They have been around for some time, but have become popular investment vehicles only over the past few years. They are businesses set up under the provincial trust acts rather than incorporation laws. An important feature of the trust structure is that income paid out to unit holders is not taxed in the hands of the business. Payouts are taxed instead at the unit holder level, usually as income, which attracts the same tax rate as interest payments.

Corporations, on the other hand, pay tax at the business level, and any dividends paid out were again taxed in the hands of shareholders. This &ldquo:double taxation” was a sore point with investors, and made it less efficient than trusts at distributing cash to shareholders. To be fair, the dividend tax credits meant that taxes on the first $33,000 of dividends were quiet low compared to regular income or interest, at about 3 1/2%.

Income producing investments have been very popular over the past few years. Generational lows in interest rates (4% for a 5 year GIC) have encouraged investors to look elsewhere for their income streams, and many have migrated to income trusts and dividend paying common shares. The higher payouts on trusts (say 5%-7%) have seemed more attractive than dividends in the 2% - 3% range.

The Department of Finance has been leery of income trusts, and done their best to discourage their spread. Their fear is that tax revenue will plummet, as businesses converting to trusts will not have to pay corporate taxes, and investors receiving trust payouts will be able to avoid or defer paying taxes as well. The problem at this time is small, about $300 million a year (about 0.2% of federal revenues) in direct loss of corporate taxes. The reality is more complicated, as many investors receiving payouts do in fact pay taxes. Investment industry sources suggest there is minimal net loss as the two balance each other out.

The first attempt to halt the march of income trusts was about a year ago with an attempted limit on how many trusts a fund could hold. It didn’t last long, as it turned out the limits would apply to all pension funds but Quebec’s version of CPP, the Caisse de Depot.

The second attempt came on September 16 with the announcement of a halt on advance tax rulings on conversions from corporations, and a study of the whole situation. Advance tax rulings are important in many conversions, though certainly not all. Many companies risk having to pay significant taxes on capital gains during the conversion process without the ruling. Companies considered likely candidates for conversion to trusts fell.

Another fear was that trusts’ earnings would become taxable within the trust, which would reduce payouts and decrease unit prices, which promptly lost 15% of their value. The halt and review announcement may have been triggered by comments from the Royal Bank to the effect they were considering converting parts of its business to the trust format.

There was also mention that the incentive to pay out large proportions of a trusts’ income might be at the expense of re-investing in the business, and so hurt the Canadian economy. The argument flies in the face of historical evidence, though no doubt some badly managed trusts, along with regular companies will choose to under-invest in the future.

The review process ended on November 24th as Ralph Goodale announced instead an increase in the dividend tax credit and resumption of advance tax rulings. The tax credit changes are complex and depend on the provinces making related changes to their taxes. The overall plan is to raise the dividend tax credit from 13% to 19%, and increase the dividend gross up from 25% to 45%, starting in 2006. Overall, most people receiving taxable dividend income (that is, not in RSPs, RIFs, etc.) will benefit.

But not all. Old Age Security, for example, can pay up to $828 per month but is “clawed back” if personal income levels get too high. The line on the tax return used to calculate that income includes the grossed up dividend amount. So some seniors will be better off switching their dividend investments for trusts unless the calculation method changes.

And the changes don’t address the income trust issues of a month earlier. Income trust payout will still be preferable to dividend payouts in many cases, and the hole in federal tax revenue created by the dividend credit is estimated to be at least as big as the current “leakage” from trusts. The Department of Finance will probably find the situation worse than before. We can thank, in part, the imminent election for the outcome.

What happened? It turns out that most income trusts are held by people. Investors didn’t appreciate the instant reduction in their personal net worth and cut in their incomes. A cynical person might think that feedback from the investment industry during the consultation process, and input by individuals to their MPs made it clear that this amounted to a tax increase going into an election. Joe Clark showed us that might not be a winning strategy, and in fact both major federal parties are now campaigning on the basis of more tax cuts.

What should have happened? If they truly wanted to level the playing field between trusts and corporations, the solution was to allow corporations to deduct dividends paid as a business expense, tax dividends as income in the hands of investors and get rid of the dividend gross up / credit system.

What happens next? We may see a third attempt to increase taxes on income trusts next year, as the Department of Finance bureaucrats’ concerns over trusts have not been resolved. Advice to investors is to enjoy the reprieve, and keep their portfolios diversified across asset classes, including common shares, bonds and foreign investments.