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Busines of Law: Slaying the income trust Golden Goose

|Written By Jim Middlemiss

No doubt lawyers were crying in their beer following the ghoulish Halloween move by federal Finance Minister Jim Flaherty to tax income trusts.

The Golden Goose has been slain, a victim of overzealous bankers, lawyers, and greedy CEOs, who took a structure meant to work in certain circumstances and applied it to the overall economy without considering whether or not it was in the economy's best interest.

While investors, mostly senior citizens and pension funds, are left licking their stock portfolios wounds, lawyers who specialize in income trusts must figure out what to do next.

Income trusts have been a boon for big law firms the past five years, as Canada's corporate titans tripped over themselves to convert, led by teams of eager investment banks and lawyers willing to aid and abet conversions.

In the past five years, investment banks have raised more than $74 billion converting corporations into trusts and the market capitalization of income trusts trading on the Toronto Stock Exchange has soared from a few billion a decade ago to more than $200 billion today.

Who can blame CEOs for wanting to convert? Their companies get a pop in their stock price, which makes for happy shareholders and nicely impacts a bank account when you're holding lucrative options like most CEOs and upper management do. And investment banks and law firms reap big fees, so what do they care?

Under the trust model, the tax burden shifts to the trust unit holders. Many are U.S. investors, who paid a minimal 15-per-cent withholding tax, or Canadian investors, who hold units in registered pension plans, meaning the tax is deferred to some time down the road. It's still not clear whether or not the government will suffer a net gain or loss of tax dollars in the long haul.

Interestingly, the federal government (meaning mostly the Liberals since they were in power during the rise of the income trust economy), didn't seem overly concerned when dogs such as Atlas Cold Storage converted to a trust or FMF Capital Group Ltd., one of the worst examples of a trust bust, converted and shareholders instantly lost millions. Everyone looked the other way - simply carnage on the road to income trust Nirvana.

In the FMF instance, the ink on the cheques to law firms and investment banks for their fees was barely dry when the trust slashed distributions to unit holders and the stock price dropped like Jim Flaherty's approval rating at a senior citizen home. It fell from its $10 issue price to 18 cents today. Where were the legal and financial advisors then? Why wasn't government protecting the market then? Those are questions that Siskind Cromarty Ivey & Dowler LLP hopes to get answers to in a class action lawsuit it has brought against FMF and its underwriters.

It was only when bellwether Canadian companies started grumbling about moving to income trusts that the government stood up and took notice, reinforcing Canada's capital market image as a place where it's OK to fleece retail investors, but God forbid that companies do anything to hurt the tax man.

Telus kicked off the trust flap by announcing a conversion, forcing BCE Corp. to follow suit. Lurking in the trust background were grumblings that energy giants Encana and Suncor were set to follow suit and no doubt Canada's banks were eyeing a trust structure. It would have caused a domino effect. Surely, Bay Street bankers and lawyers were salivating at the prospect of huge fees should mainstream corporate Canada start trusting out.

While Flaherty has likely been struck from some lawyers' Christmas card lists, law firms should probably thank him. A lot of companies have been brought to market that have no business being an income trust, and many more companies are waiting in the wings. So in one sense Flaherty probably saved some law firms from being dragged into future messy class actions lawsuits à la FMF and having their reputations tarnished.

On the other hand, his actions have destroyed a structure that has served certain aspects of the economy well, such as energy and resources. CEOs in that sector are lobbying hard to be exempt from the proposed rules, arguing they have effectively used royalty trusts to build an efficient oil and gas economy unique to Canada.

Whether they will succeed in their efforts is not clear. What is clear from media commentary is that, despite the loss of income trust work, Canada's biggest law firms won't be suffering any time soon.

A number of lawyers from the top firms were quoted in the mainstream business press as saying that they will now simply bill their clients to undo all that has been done, as businesses look to convert back to corporations.

There's speculation private equity firms will snap up the underlying businesses comprising trusts. As well, expect to see increased M&A activity as corporate vultures circle trusts like wounded prey, creating even more work for law firms and investment banks. What Flaherty taketh with one hand, he giveth with another.

I don't begrudge law firms making a handsome buck. We should all aspire to earn well, and I certainly don't mean to suggest that law firms have been complicit in nefarious activities involving companies that have trusted out. But what they have been guilty of is milking the situation and helping build the road to income trust Nirvana that corporate Canada was racing down without taking a long-term view to what is best for the country and its economy.

What's sad is the lemming mentality that pervaded the income trust model and how everyone - from law firms to investment banks, CEOs, and shareholders - rushed to the exits in the shortsightedness of saving taxes. Those taxes pay for the roads we drive on, the sewers that keep our cities clean, the schools and teachers that educate our kids, and the hospitals that help our sick and infirm.

Taxes are used to fund and create the social fabric that we call Canada. They are not evil incarnate, and capitalism shouldn't be all about avoiding them. It should be about building a prosperous society that provides opportunity.

To build an economy based on a model where companies pay out rather than retain and invest their earnings is not healthy in the long run. It's why the U.S. and Australia took steps years ago to limit income trusts.

Don't get me wrong, I think Canadians carry a heavy tax burden and Ottawa, the provinces and municipalities don't always spend our money wisely or effectively. I am also disappointed that Conservatives viewed the answer as taxing the other guy (income trusts) more, rather than looking at a fundamental restructuring of the tax system itself and moving to a tax system that relies on flat taxes and consumption taxes rather than the current system, which is Byzantine and regressive.

But in this case slaying the Golden Goose was necessary in the short term. In the long run, it will make for a healthier economy, which can only help the profession. At least until law firms and investment banks figure out a work-around, which is probably being hatched now in the corridors of Bay Street.


Jim Middlemiss is editor of Canadian Lawyer and co-author of Your Guide to Canadian Law.

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