Canadian Trust Triage John Dobosz, 11.02.06, 5:15 PM ET

Investors in Canadian income trusts found out the hard way on Wednesday that there is nothing uniquely American about breaking campaign promises. Canada’s finance minister, Jim Flaherty, despite his party’s pledge less than a year ago not to impose additional taxes on the trusts, announced late Tuesday that the government proposes to tax trust distributions at regular corporate income tax rates--effectively eliminating the chief advantage of the trust structure as a flow-through entity.

The resulting bloodbath for trusts in Canada, including more than a dozen specializing in energy that also trade on exchanges in the United States, has left investors wondering what to do now. Most advisers who have recommended trusts in the past say it’s too late to sell--and at least one recommends fresh buying.

“I feel the market has overreacted to a situation that is not a done deal,” says Curtis Hesler, editor of Professional Timing Service, referring to the 12% to 15% haircuts many of the trusts took on Tuesday. Under the Flaherty proposal, existing trusts would be given an exemption from paying any modified tax until 2011.

Hesler holds eight Canadian trusts in his model portfolio and recommends waiting until the smoke clears before making any moves. “Panic causes mistakes, and selling does not seem prudent at this point, nor does additional buying until we see what we are up against. I will be very surprised if we don’t see some serious defense brought to bear by both Canadian industry and the electorate.”

For the past several years, Hesler and many other advisers had been big bulls on Canadian “royalty trusts,” which own or lease oil and gas rights and collect royalties from producers, which they pay out to shareholders. The payouts are considered qualified dividend income for U.S. investors and subject to only a 15% tax. The Canadian government withholds 15%, but U.S. investors can claim an offsetting tax credit on their Federal tax return. The dividends are not taxed at the corporate level, but only when they’re received as income by unit holders.

Richard Lehmann, editor of the Forbes/Lehmann Income Securities Investor, agrees that implementation of the Flaherty proposal is anything but assured, noting two abortive attempts since 2004 to change tax laws pertaining to trusts in Canada and the proposed grace period until 2011 for existing trusts. “Our thinking is that five years is a long way off, and political pressure will likely delay the tax further or kill it altogether," he says.

Lehmann, a big proponent of ‘Canroys’ since 2003, is busy adding more to his holdings as prices plummet and yields skyrocket. Harvest Energy Trust, for example, now yields 15.6% after losing 20% of its value in a day and a half of trading. Lehmann is also buying Canetic Resources Trust, which yields 13.5% after getting hammered 22% lower than its Oct. 31 close. Other Canadian trust casualties in which Lehmann finds yields too tempting to pass up include Provident Energy Trust at 13.7% and Penn West Energy Trust at 12.7%.

"You'd be hard-pressed to find these kinds of yields even on junk bonds," says Lehmann.

Jack Adamo, editor of Insiders Plus, was tempted to buy Fording Canadian Coal, but he’s holding off for now. What concerns him is not so much the Flaherty proposal--he doubts that it will pass--but the steel industry. “Fortunately, most of the developed world now understands that you can’t abuse business and expect it to thrive,” he says. “I want to talk with the company first, and I want to see a few more earnings reports from steel companies,” says Adamo. “So far, it looks like steel is going into a downturn at the same time the stock market is losing momentum. That could make Fording vulnerable to further weakness in the short term, since it sells its coking coal directly to the steel industry.”

The bombshell out of Ottawa, Canada also lit up the message boards at online investing community, where members feverishly discussed at what price royalty trusts would be a good buy. Ron Lane of St. Augustine, Fla., one member who’s heavily invested in a handful of trusts, says he’s avoiding selling his holdings into the current weakness. “The lemmings got out yesterday,” he says. “Fortunately, we’ve been in these for the past three and a half years, so we’re still sitting on gains. I’ll see what happens.”

Meanwhile, Lane says he's going to step up his buying of closed-end funds with yields around 8%, as well as check out some business development companies like American Capital Strategies.

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