Canadian oil and gas royalty trusts took it on the chin in stock market trading Wednesday from a proposed Tax Fairness Plan announced Tuesday night that would ultimately (in 2011) subject them to corporate-level taxation.

For instance, Harvest Energy Trust shares fell nearly 14% to $25.29. Enerplus Resources lost nearly 15% to close at $46.25, and Pengrowth Energy Trust lost 12.01% to close at $19.27. Canadian companies dominated the list of biggest losers on the New York Stock Exchange Wednesday.

While it’s not a done deal, the tax changes are seen as likely to proceed. Among the provisions of the Tax Fairness Plan are plans to create a tax on distributions from publicly traded income trusts and limited partnerships and plans to reduce the general corporate tax rate by half a percent in 2011. These are aimed at leveling the playing field between trusts and corporations and reining in expansion of income trusts.

“The landscape has changed dramatically in the short time I have been minister of finance, and in fact, this year we have seen nearly $70 billion in new trust announcements,” said Jim Flaherty, Canada’s minster of finance. “The current situation is not right and is not fair. It is the responsibility of the Government of Canada to set our nation’s tax policy, not corporate tax planners.”

Widely seen as precipitating the taxing authority’s proposal are announcements by telecommunications companies Teles Corp. and BCE Inc. that they were planning to restructure as income trusts. Fears of deteriorating tax revenue brought about the proposed change, something the conservative government had promised not to do.

“In Wall Street terms, bad news like this proposal turns perception into reality,” John Olson, co-manager of Houston Energy Partners, told NGI. “In other words, the proposal here is to kill any new income trusts or royalty trusts up there basically now going forward with a tax holiday until the end of 2010, and at 2011 they start paying a 31.5% effective tax rate. What you will very likely see is many of these unit trusts sell down 20 to 30% depending on their tax positions.

“This may turn into a death by bureaucracy or by legislation up there, a slow death, though.”

“Certain funds face immediate consequences that could result in a stability ratings impact given unique circumstances affecting short-term potential risks to distributable cash flows and distributions to unitholders,” said Standard & Poor’s Ratings Services. “On an immediate basis, all funds will have reduced financial flexibility due to prohibitive access to the equity caused by lower unit prices.”

Citigroup analyst Richard Roy was a little more optimistic than Olson but equally alarmed in his Wednesday research note on the proposed tax change.

“In our view the recent decision will cause an extended period of turmoil for the income trust sector as investors decide which trusts will still be worth owning in 2011,” Roy wrote. “While our expectation is that trusts in the energy sector will lobby for a change, given the uncertainty involved we expect considerable volatility over the next few days (For U.S. investors, the change in tax law implies an increase in taxes withheld from the Canadian government from 15% to 41.5% starting in 2011).”

The note said Citigroup expects the oil and gas trusts in its universe to be around after 2011. “However, in the near term we believe absolute performance will be challenging and will be greatly affected by headlines related to this issue.” According to Roy, look for the following:

But investors in this space shouldn’t bother looking for a place to hide. “This is a very complex issue and we believe the entire sector will be down; no exceptions,” Roy wrote. “Potentially, trusts with large foreign ownership could be impacted more significantly because nonresident taxation changes dramatically (i.e. a 26.5% increase).”

The next step toward any taxation change in Canada is the drafting of the legislation. Following that will be three readings in the House of Commons and then a vote. With approval, the legislation would go to the Senate for final approval. “Given that the liberal government made a similar proposal last year, we believe at this point it is likely that the proposed changes are passed,” Roy wrote.

“The tax announcement raises questions on the strategic response from existing funds. Responses could include fund conversions to corporations, acquisitions of corporations with large tax losses, leveraging the funds to obtain a tax shield, or the acquisition of a fund by other entities,” said Standard & Poor’s stability analyst Ronald Charbon. “In any event, the future for the Canadian income trust market is once again in a state of uncertainty.”

What brought the trusts under scrutiny was their growing popularity, in energy and elsewhere. Master limited partnerships (MLPs) the income/royalty trusts’ south of the border cousin have seen similar growth in their popularity among energy companies, particularly the midstream. NGI asked Olson if a similar tax change might be proposed for MLPs in the United States.

“If Exxon or Chevron or Marathon decided to do a master limited partnership, then that would certainly raise a lot of hackles in Congress,” Olson said. “The [impact on] tax revenues would be huge.”

But a greater threat to MLPs is a changing of the guard in the House and Senate come Nov. 7. Olson said it’s “very plausible” that Democrats could win control of both houses on election day and the resulting committee chairmanships. Liberals “who have had a history of badgering the oil industry” could be in charge, Olson said. “Where this goes from there, Lord only knows.”

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