The information below isn’t exhaustive of all possible US income tax considerations nor is it intended to provide legal or tax advice to any particular holder or potential holder of Canadian income or royalty trust units. Holders or potential holders of Canadian income or royalty trust units or common stock of Canada-based corporations should consult their own competent legal and tax advisors as to their particular tax consequences of holding Canadian income or royalty trust units or common stock issued by Canada-based corporations and the most beneficial way of reporting the distributions or dividends received and Canadian withholding tax paid to the appropriate taxation authorities located in the various jurisdictions.

In July 2008, the Finance Minister Jim Flaherty atoned at least a little for the Halloween Massacre by releasing draft legislative proposals that, among other things, introduced two different methods to enable a specified investment flow-through (SIFT) entity to convert into a publicly traded corporation, generally without material adverse tax consequences for the trust or its unitholders.

Conversion by a trust to corporate form could have been achieved under pre-existing tax rules, but such a process would have been too cumbersome because joint tax elections by the trust as well as its unitholders were required in order for the conversion to be tax-deferred. Nor did the pre-existing tax rules facilitate the winding-up of the underlying trust structure, which is of less obvious concern for individual unitholders.

At the most general level, the law on both sides of the US-Canada border recognizes that income trust conversions will be tax-free events for unitholders. The intent, colored by a reasonable bias in favor of the free flow of capital across borders, is to avoid tax consequences for investors.

In addition to tax deferral for investors and some carryover of tax accounts and attributes for successor corporations, Canada’s rules minimize the administrative burden to taxpayers by providing an essentially automatic rather than an elective rollover.

The Finance Ministry’s guidelines facilitate the conversion of SIFTs into corporations via one of two methods that are both tax-free for Canadian tax purposes and are most likely tax-free for US tax purposes as well.

Under the first method, SIFT unitholders would transfer their SIFT units to a taxable Canadian corporation in exchange for shares of the corporation on a one-for-one basis. Under the second alternative, the SIFT would restructure so that its only asset is a taxable corporate subsidiary (to which the SIFT has transferred any assets previously owned directly by the SIFT), and the SIFT would then liquidate and distribute to the SIFT’s shareholders the shares of the taxable corporation.

Most of the conversions announced and completed so far have been of the first variety. Because most SIFTs are corporations for US income tax purposes, a conversion structured as an exchange of trust units for shares of a new corporation should qualify as a tax-free transaction for US tax purposes.

The Exchange Method applies to conversions that are effected on or after July 14, 2008 and before January 1, 2013. The Distribution Method applies to distributions made after July 14, 2008 and before January 1, 2013. The 2012 deadline is designed to encourage conversions even if a trust might have tax pools available that would otherwise have allowed it to efficiently exist as a trust post-2012.

If the conditions of either the exchange method or the distribution method are satisfied, the conversion transaction is automatically tax deferred to the unitholders of the trust and the unitholders don’t have to file tax elections. To trigger a tax loss (if applicable) on the conversion, it appears that a unitholder will likely have to sell its units, or the resulting shares, on the open market.

However, in the information circular and proxy statement describing its conversion process to investors, Advantage Oil & Gas (TSX: AAV, NYSE: AAV) asserts, “The receipt of Common Shares pursuant to the Arrangement by a United States Holder will be a ‘taxable event’ for United States federal income tax purposes, and a United States Holder will recognize gain or loss equal to the difference between (i) the fair market value of the Common Shares received and (ii) such holder’s adjusted tax basis in its Trust Units surrendered therefor.” [sic]

Although this analysis is based on several elements of US federal tax law administration and enforcement, it concludes with an acknowledgement that the IRS could interpret the conversion transaction differently.

Advantage’s reading of the law would allow US investors to benefit from a likely tax loss, which usually only happens when you dispose of, or sell, your shares. Here’s the cool part of Advantage’s story for those of you who held on: You haven’t disposed of your shares, and you’re up 36 percent off your new initial cost basis of USD4.15.

Down the road you might have to book your capital gain and pay the taxes on it in a single year. Right now, though, you can offset whatever capital gains you’re going to book for 2009 with the tax loss from the Advantage conversion, under certain limitations. You can carry this loss forward until it’s totally depleted. (Tax losses and carry forwards are discussed in greater detail below.)

Please, any tax law experts–particularly anyone from the Paul, Weiss tax law team that handled the US end of the Advantage transaction–out there read this as a plea for enlightenment. I sat through a federal tax course about 15 years ago, though I imagine a certain Villanova Law professor would shudder at the thought of me projecting any kind of authority with respect to the US Internal Revenue Code (IRC).

But I’ve dug into it again this week–wondering why Advantage’s US tax interpretation of its “exchange method” conversion differs from other trusts’ readings of their own one-for-one reorganizations–and learned that all it really takes to get it is a lot of stamina, caffeine, and sufficient agility to bounce around from section to subsection to definition and back again.

Here’s what my reading of the IRC suggests to me.

The IRS is likely to view a trust conversion as a “statutory merger or consolidation.” Income trust conversions completed according to Canadian law are therefore likely to qualify for “non-recognition treatment” in terms of the IRC.

Before 2006 the term “statutory merger” was interpreted as a merger or consolidation effected under the corporate law of a “State or Territory or the District of Columbia.” But many foreign jurisdictions, including Canada, now have merger statutes that operate similarly to those of US state laws.

Reflecting the prevailing bias in favor of global capital flows, in 2006 the IRS and the US Treasury Dept established new rules for the treatment of “reorganizations” completed according to the laws of foreign jurisdictions. Specifically, Internal Revenue Code Section 386 definition of an “A Reorganization” to include transactions effected pursuant to foreign law and transactions involving entities organized under foreign law.

Section 368 reorganizations generally allow “target corporation” shareholders to exchange target stock for “buyer corporation” stock without gain recognition. An “A Reorganization” is defined in the IRC as a “statutory merger or consolidation,” a transaction in which a new corporate entity is created from the two merging companies, which cease to exist, or where one of the merging companies continues to exist as a legal entity, rather than being replaced by the new entity.

According to the Internal Revenue Code, a “corporate reorganization” is a trade of “corporate stock” that doesn’t result in a taxable gain or a deductible loss. It is, in the eyes of the IRS, a transaction entitled to non-recognition treatment.

The basis of your trust units, generally speaking, is your purchase price plus the costs of purchase, such as commissions. The basis of the shares you receive in a nontaxable exchange is generally the same as the adjusted basis of the trust units you gave up. If you have a nontaxable trade, you don’t recognize gain or loss until you dispose of the property you received in the trade.

Tax-Loss Carry Forward

The good news, again, about the taxable nature of the Advantage conversion–if this characterization withstands scrutiny–is that you can use your likely capital loss to offset any gains you’ll report for 2009. But if you still hold the common shares you’re still exposed to any potential upside.

Your losses and gains must be combined together to determine whether or not you’ll have a net loss for the year. If you have a capital loss of USD10,000, and a capital gain of USD11,000, then your net gain for the present tax year would be USD1,000. You can ignore the USD3,000 limit on losses per year because you have an overall net gain of USD1,000, in this example.

In other words, the USD3,000 limit only applies if your total net loss for the year exceeds USD3,000, after any capital gains have been added. If the net sum of gains and losses is no worse than -3,000, then you can claim all the losses in the current year.

In general capital losses are first used to offset capital gains and then used to offset other income up to USD3,000 per year. Unused losses are carried forward to the following year, when they can be used again to offset capital gains and up to USD3,000 of other income.  This continues year after year until the loss is used up or death occurs.

Losses that are carried forward retain their original short-term or long-term status. Therefore, if your original loss is long-term, the amount carried forward must be used to reduce the future years’ long-term capital gains (if any exist), before they can be used to reduce short-term capital gains.

Depending on your tax bracket, the carry-forward feature can be beneficial, or detrimental. If your tax bracket increases in the future, then the carry-over feature will save you more tax than you would have saved if the entire loss could be written off in the current year. If your tax bracket declines in the future, then you’ll save less tax.

Qualified v. Not Qualified

This issue is resolved–on a trust-by-trust basis–once the conversion to corporate status is complete. Dividends paid by Canadian corporations are, generally, qualified. Circumstances where this is not the case are rare, particularly in the CE coverage universe.

In the US, the 2003 Jobs Growth and Tax Relief Reconciliation Act (the 2003 Act) established that a dividend paid to an individual shareholder from either a domestic corporation or a “qualified foreign corporation” is subject to tax at the reduced rates applicable to certain capital gains, in most cases 15 percent.

A “qualified foreign corporation” includes certain foreign corporations that are eligible for benefits of a comprehensive income tax treaty with the US, which the Secretary determines is satisfactory for purposes of this provision and that includes an exchange of information program.

If the Canadian trust or corporation is listed on the New York Stock Exchange (NYSE), it’s dividend is probably qualified because of the Treasury Dept’s “readily tradable” test: “A foreign corporation not otherwise treated as a qualified foreign corporation is so treated with respect to any dividend it pays if the stock with respect to which it pays such dividend is readily tradable on an established securities market in the US.”

Not qualified according to the 2003 Act is any entity that can be classified as a passive foreign investment company (PFIC). This is a fact-sensitive determination that can only be made on a year-by-year basis after all the beans have been counted.

Within the meaning of the 2003 Act, a non-US entity treated as a corporation for US federal tax purposes is a PFIC if in any given taxable year if either: at least 75 percent of its gross income is “passive”; or at least 50 percent of the average value of its assets is attributable to assets that produce passive income or are held for the production of passive income. For the most part, however, the trusts and corporations recommended in the Portfolios and covered in How They Rate are operating businesses.

You can report distributions paid by a Canadian trust as qualified if: the trust has made a public statement to the effect that the units “will be, should be or more likely than not will be” treated as equity rather than debt for US federal income tax purpose; and, the security is considered “readily tradable on an established securities market in the US” or “the foreign corporation is organized in a country whose income tax treaty with the US is comprehensive….”

CE has provided links to statements issued by income trusts in its coverage universe in the Income Trust Tax Guide; these statements typically include language along the lines of the following:

In consultation with its US tax advisors, TrustCo believes that its trust units should be properly classified as equity in a corporation, rather than debt, and that dividends paid to individual US unitholders should be “qualified dividends” for US federal income tax purposes.

As such, the portion of the distributions made during 2008 that are considered dividends for US federal income tax purposes should qualify for the reduced rate of tax applicable to long-term capital gains. However, the individual taxpayer’s situation must be considered before making this determination.

Of course, any trust or corporation listed on the New York Stock Exchange is readily tradable. As for those issues traded on the US over-the-counter (OTC) market, the final piece of the “qualified” equation is provided by the United States-Canada Income Tax Convention.

• Review 1099s from your broker carefully. Check out individual trusts’ statements on the US tax status of their distributions. The best source of information–as indicated by the willingness of the IRS to rely on the tax status interpretation of the trusts–is the particular trust. We’ve heard many stories of CE subscribers successfully dealing with their brokerage firms on this issue.

• If there’s no statement published on a website, contact the investor relations (IR) representative of the particular income trust via e-mail or phone. If the Web statement or your contact with IR reveals the trust believes its distributions to be qualified–it’s best to get it in writing–give this information to your broker.

• Use the Qualified Dividends and Capital Gain Tax Worksheet of Form 1040 to determine the amount of tax that may be applicable.

• The bottom line is this: The IRS will waive penalties with respect to reporting of payments if individuals required to file Form 1099-DIV make a good faith effort to report payments consistent with the law.