That initiative, the Tax Fairness Plan, is included in the package of legislation that makes up the Conservatives’ 2007 federal budget.

We’ve made some decent calls on the evolution of the tax proposal and its impact on the income trust universe since Oct. 31, 2006, and we’ve missed a few as well. But generally speaking, the one element we’ve emphasized as critical to whether the Tax Fairness Plan survives as currently conceived is the continuation of Conservative rule.

Obstinate, combative, imperious and self-assured, Finance Minister Jim Flaherty has shown no willingness to debate the substance of the Tax Fairness Plan. Flaherty and Prime Minister Stephen Harper have dug in, against objective fact, expert opinion and broad-based resistance from individual and institutional investors alike. If this minority government survives or wins another election, the Tax Fairness Plan will become law.

In the early stages of the tax-induced trust swoon, Harper seemed to be building toward a late winter/early spring election that would see the Conservatives capture a majority of seats in Parliament. That’s no longer the case.

A Decima Research poll of more than 1,000 Canadians conducted April 26-April 30 and released May 1 revealed that the Liberals (31 percent) have overtaken the Tories (30 percent). The Liberals have regained a lead over the Conservatives in Canada’s largest urban centers and have benefited from a mass exodus of 18- to 24-year-old voters from the Tory side.

Perhaps no other number reflects the abrupt weakening of the Conservatives’ and Harper’s standing than this: In Alberta—Harper’s home province and his party’s electoral base—support for the Tories has fallen by 11 percentage points since midwinter.

As noted below in a piece reproduced from MLM, Harper has probably maxed out in terms of national support; now his policies on the environment and with regard to Afghanistan have generated a negative backlash.

The Conservatives spent months trying to hammer out a policy on global warming and failed to satisfy Canadians (and Al Gore). And even last fall, Harper was vulnerable on Afghanistan, a thorn that dug into his side again recently in regard to Canada’s treatment of detainees.

The rookie Grit leader faces a difficult dilemma: Harper and the Conservatives are weak right now, but Canadians haven’t really bought in to his leadership yet. Does he strike now and topple the government, or wait until his party and the electorate embrace him? 

It’s been a long six months, and the climax is still well off in the future. But the numbers look good for Stephen Dion and the Liberals–and, therefore, income trust investors–at the moment.

Below, we’ve compiled the last several issues focusing on the political situation for those of you who don’t receive Maple Leaf Memo. And do sign up; it’s free, and we also provide updates on CE-covered trusts on a weekly basis.

Uneven Stephens

Stephen Harper is a skilled driver with a subpar car. Stephen Dion is at the wheel of a superior machine but can’t read the road the way the prime minister can. It’s a formula that will limit Harper’s majority ambition but could produce a surprising win for a guy who even some in his own party think should be manning the pit crew, at best.

Harper himself had to overcome a rocky beginning to his leadership tenure. He also faced resistance from his own ranks. And he’s climbed all the way to the top of a strong minority government (oxymoron aside), doing enough to satisfy a Canadian public leery of another political season and not yet ready—if it will ever be—to elect a Harper-led Conservative majority.

Short of Dion committing a huge gaffe (he’s already made some $400-haircut-level moves, such as being photographed eating a hot dog with a knife and fork), Harper will have to build support among voting groups where he’s weak–women and urban voters primarily–over time. His own people acknowledge that the 2006 election victory had more to do with Liberal corruption and other screwups than Conservative policy and overall appeal.

But the prime minister, once caricatured by political opponents as a far-right ideologue–the “grim reaper of Canadian politics,” according to one Toronto Globe & Mail columnist–cut some deals, spread some cash and even broke some promises on his way to the center. He called Quebec “a nation within Canada,” staving off a divisive parliamentary vote and lift.

The SES Research Best Prime Minister poll showed Harper with a huge lead over Dion, 42 percent to 16 percent. Only 40 percent of Liberals surveyed said Dion would make the best prime minister. Harper was second for Liberals with 26.4 percent. Harper was also the second choice for the New Democratic Party and the Bloc Quebecois.

But in trying to satisfy everyone, Harper may have maxed out short of the goal. The left is unhappy over perceived failures on climate change and child-care services. Those also happen to be critical issues in ridings (the Canadian equivalent of a US congressional district) Harper needs to win.

The right wasn’t pleased by the absence of broad tax cuts in the 2007 budget and also senses he used same-sex marriage simply as a political tool to keep a critical voting bloc in place. And there are the income trust voters, who are probably more right than left but plenty of both.

According to Faron Ellis, a political scientist at Lethbridge College in Alberta, Harper’s blind spot is on the right in western Canada. Ellis, a longtime researcher of Canada’s conservative parties, told the Canadian Press that Harper can’t take for granted his base of fiscal and social conservatives because many of them are “bitterly disappointed” in his performance.

Ellis said it would be perilous for Harper to think that fiscal and social conservatives will vote for his party because they have no alternative. “If the Conservatives believe all Westerners are a captive audience, they’re mistaken,” he noted.

The Liberals are now aggressively pushing their version of an income trust tax—no new trusts, a 10 percent tax on distributions refundable to Canadian investors—as part of an attack on Flaherty’s overall stewardship of the economy. Harper might have hoped to slice off left-leaning voters along his way to a majority, but Dion and Liberal finance critic John McCallum have turned those tables and are stoking conservatives’ ire in an effort to retake control of parliament.

“We’re going to fight this,” McCallum told a town hall gathering on Bay Street. “We’re going to fight it through an election.”

So It Goes

The Liberals have a chance to topple Prime Minister Stephen Harper before an election, though more by procedural curiosity than any matter of substance. The Canadian parliamentary system includes what’s called an “allotted day,” during which an opposition party–the Liberal Party–is able to call for a vote on any issue, such as no confidence in the government.

The Conservatives aren’t likely to go down that way, though. Recent polling data suggest a wide-open race, with a lot of jockeying. Harper dreams of running a majority government but has lost ground lately in the push to get support above the 40 percent threshold, considered a key marker for achieving majority control. Even after a 2007 budget proposal heavy on largesse, voters aren’t sold on handing over the whiskey and the keys just yet.

For their part, the Liberals have stopped their slide in Quebec, and a message seems to be falling into their laps. Not a few weeks ago, Stephen Dion was a mystery man, a blank slate upon whom local media stuck easy stories about his difficulty with English (he’s a native French speaker), his professorial bearing, and his eventual demise and replacement.

Lo and behold, the gift that keeps on giving…er, if you have to run a political campaign against his party, Jim Flaherty.

It’s not all him, and it’s not just the income trust tax issue. But the Finance Dept’s now-obvious mishandling of the matter and the similarly flawed interest expense revisions are fertile material for comics, e-zine editors and those otherwise interested in competent government.

“The change in the tax rules brought the whole income trust market to people’s attention, and a number of investors looked at them much more closely,” observed UE Waterheater Income Fund (UWH.UN) CEO Roger Rossi during a conference call discussing his company’s takeover by US-based Alinda Capital Partners. Alinda Capital took a look and decided to offer CD23 per unit for UE, a huge premium to the pre-deal closing price.

Earlier, UE had announced the acquisition of Edmonton, Alberta-based security monitoring company Voxcom Income Fund for about CD108.5 million (CD13.25 per unit) in cash. UE rents and services water-heating units and other home-comfort devices and recently expanded its operations to include home security systems. The Voxcom deal is yet another indication of this particular trust’s ability to grow its business and increase shareholder value.

Contrary to the impressions fostered by Cassandras such as Jack Mintz and Diane Urquhart, income trusts serve legitimate, productive purposes. We’ve said for years to focus investment decisions on strong, sustainable businesses, not the dodgy stuff converted to take advantage of the tax benefits of the trust structure or the chum hiding under a dazzling initial public offering circular rising along with an otherwise healthy tide.

As many US-based private capital shops are discovering, there are a lot of Canadian businesses generating significant cash flow. And right now there’s an entire sector full of them, a bargain bin at the Pick ’n Save.

The income trust tax issue, in and of itself, won’t win Canada’s Liberals an election.

Stephen Dion took a walk down Bay Street Monday and said the Liberals would change the income trust tax if elected by reducing it to 10 percent and making it refundable to Canadian investors. That’s a good start. Events continue to play out in his favor; it’s hard to imagine Canadians being pleased with the spate of foreign takeovers and what the deals say about a tax policy that’s now proven to be a big mistake.

They threw it together without contemplating its ramifications–a sign of haste, a lack of understanding, or both. They seem to have repeated the process for the interest expense revision. Though the Liberals will almost certainly hold their fire on the issue, there will be plenty of opportunities to catalyze an election campaign, perhaps over Harper’s handling of Canada’s involvement in Afghanistan or his stewardship of the environment.

“Many Canadians already know that the Conservatives fail to see the importance of investing in social programs and have failed to meet the challenge of the environment,” Dion said in a speech. “It is becoming clearer that the Conservatives’ incompetence includes the mismanagement of the Canadian economy.”

Harper played his best card with the budget, and Dion is still at the table. Is he a slow-playing shark?

The income trust tax proposal began as a broken campaign promise, evolved to a relatively isolated case of investor outrage and is maturing into a key count on an incompetence indictment for the minority government.

For Sale: Canada

Canadian Finance Minister Jim Flaherty bobbed, weaved and feinted his way from the Halloween trust tax announcement all the way through his testimony before a special hearing of the House of Commons Finance Committee. Aided and abetted by a pliant national press, the income trust tax story became one of “corporations paying their fair share” and “leveling the playing field” and other such amorphous, easily digestible memes.

The good thing is, as the great, mostly unknown conservative thinker Richard Weaver wrote, ideas have consequences. And consequences roll particularly hard off public-policy rubbish heaps.

The good news is the stench is wafting its way up to the elite media, and it could rouse an otherwise indifferent Canadian public to the incompetence, indifference and/or inside dealings of the present minority government.

Income trusts are being sold at an increasing rate to foreigners and private equity players. Including firms already up for sale as of Oct. 31, 2006, 22 trusts have been bought or are in the process of being bought, representing a total value of CD20 billion-plus. Foreign private equity accounts for about 45 percent of the deal value, with foreign corporations accounting for another 16 percent.

In the words of KCP founder and CEO David Cynamon: “The process was triggered by the Halloween announcement by the government, which forced us to look at an alternative strategic transaction of some kind knowing that there was a timeline in which not only our income trust structure would now be taxed, but for the most part the income trust playing field would be very different.” 

Before Halloween, income trusts allowed mid-cap businesses to stay Canadian-owned. But access to capital is now limited, and trust valuations are relatively low.

Given the amount of low-cost capital waiting on the sidelines, takeovers will continue. And don’t forget, income trusts generate strong cash flows–ideal businesses to service the debt used by private capital to finance transactions.

Flaherty, as is his way, ignored the facts.

“This is not something that has to do with a particular tax policy,” Flaherty said last week in a public appearance in support of the 2007 federal budget. “It has to do with large pools of capital that have been accumulated and are looking for purchases in various parts of the world.” On the last point, the finance minister is undeniably correct.

University of Toronto Professor of Business Economics Jack Mintz, sort of the intellectual godfather of the income trust tax, acknowledged that the proposed tax on distributions has made trusts vulnerable to takeovers but said it wasn’t necessarily a bad thing. He based this conclusion on the idea that ownership changes tend to usher in better management. Mintz noted that trusts were shielded, to some extent, from takeovers prior to the federal trust tax announcement because their relatively high market values made purchases more prohibitive.

“It allowed managers maybe to avoid the threat of takeover–and therefore encouraged inefficiency,” said Mintz told the Toronto Globe and Mail. “There’s a lot of Statistics Canada evidence now to show that even foreign companies have done a pretty good job of running Canadian companies and improving their productivity–that maybe this is all not such a negative thing after all.”

But we’re not talking about strategic players, professor, looking to maximize distribution channels or fill out a product line. These are financiers. They’re going to load up debt and use trusts’ strong cash flows to service it.

“When you are operating as an income trust and have the high valuations at that point–and the very high distributions–it made it difficult for someone to come in and do a takeover based on such a very high valuation,” Mintz said.

Let’s back up for a second: Flaherty pitched the trust tax—the Tax Fairness Plan—as a way to get back tax dollars these businesses were avoiding. But ownership by foreign capital will result in less tax revenue at the provincial and federal level. There will be no more tax revenue collected from Canadian investors paying dividend rates, private equity will load up debt on the strength of the Canadian asset base–making the operation basically nontaxable in Canada–and interest crossing the border will be free of withholding tax.

In an interview, Caxton-Iseman managing director Steven Lefkowitz said his company liked KCP’s management and its position in the marketplace. He said Caxton-Iseman doesn’t want to make any major changes at KCP.

Well, Mintz is basically acknowledging the underlying quality of the assets by suggesting “new management” rising from the private capital takeover is endemically good. But the whole reason private capital is after the business is the strong cash flow. Ergo, good assets plus strong cash flow equals solid cost management and predictability of revenue. Doesn’t that sound like a good dividend candidate?

Does Jack Mintz think we’re idiots?

Gutting The Farm System

PricewaterhouseCoopers’ regular report on Canadian initial pulbic offering (IPO) activity suggests another negative consequence of the income trust tax proposal: total IPO proceeds of CD298 million for the first quarter off 85 percent from the CD2 billion of the first quarter of 2006.

The Toronto Stock Exchange (TSX) and the TSX Venture market saw 20 new offerings in this period, down from 34 a year ago. Five new issues worth CD191 million were listed on the TSX in the first quarter, a tenth of the CD1.9 billion in IPO activity a year earlier, when income trusts dominated new issues.

It’s the second consecutive quarter of slow activity, indicating that small Canadian companies aren’t looking to enter public markets at present.

Before Oct. 31, 2006, income trusts were attracting foreign capital to Canada; Flaherty’s proposal and dogged refusal to alter it have reversed the trend. That Flaherty doesn’t see or won’t admit to the relationship between the Conservatives’ new tax policy and the spate of foreign takeovers demonstrates either that he doesn’t know how capital markets work (and calls into question his suitability for the office), that he doesn’t care (and that he’s indifferent to mid-cap Canadian-owned business) or that he had some idea it would play out this way (and sacrificed Canadians’ nest eggs and the distribution streams of otherwise healthy business on the altar of Big Global Capital).

So he’s incompetent, indifferent or sublimely calculating. In any case, Canada’s Liberal Party should be able to make some hay out of any of these concepts.

As stated above, if an election were held today, the poll indicates the Conservatives would win about 30 percent to the Liberals 31 percent.

Harper is not only short of 40 percent, the number Canadian political junkies considered the threshold to winning a majority government. He’s actually now running slightly behind.

We’re not counting on a tax law change in our strategy for investing in trusts. But for the first time since Halloween, change is starting to look like at least an even money bet.