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  Overreaction, panic greet income trust tax announcement

BENJ GALLANDER and BEN STADELMANN

Friday, November 9, 2007

It's been a year and a broomstick since Finance Minister Jim Flaherty's surprise Halloween announcement regarding new taxes on investment trusts provoked market mayhem, and the howling and bile sent his way hasn't dissipated yet.

"Lie. Conceal. Fabricate," shrieks the headline of the Canadian Association of Income Trust Investors website, as it berates Stephen Harper for breaking his promise and causing a $35 billion scandal that "destroyed" the trust industry.

Though the mendacity of politicians is legendary, this particular flip-flop maintained the capacity to shock and appall even the most hardboiled of business people.

The irony is that such 180-degree turns happen in the private sector all the time. There have been many occasions where we have seen a chief executive pour scorn on a takeover bid, characterizing it as insultingly low, yet a deal is made later at essentially the same price. Or the purchase of a company, announced with great fanfare as an essential complement to an enterprise's product line, gets cast off a couple of years later as a "non-core" loser.

We treasure honesty and candour as much as anyone, but we are realistic enough to know that leaders in both the public and private sectors frequently have to engage in a certain amount of posturing. Sometimes it is to help garner the support of a particular constituency; sometimes it's a shrewd negotiating tactic.

On the other hand, it can be as basic as the assessment of a scenario being found to be wrong, necessitating a sharp course correction. It would be nice if such changes of mind were presented to the public or shareholders with a little more humility, but that's a virtue, like frankness, that always seems to be in chronically short supply among the movers and shakers.

The way the media focused on trusts losing their tax-free status oversimplified the issue and contributed to public fury. The proposal for the specific tax was new, but this merely put trusts on a similar footing to regular corporations.

It's a choice between the business passing all of the tax burden on to the unit holders — or the trusts paying tax on income, and then unit holders paying a lesser amount at the advantageous dividend rate. Just exactly how that will work out for the individual investor varies, as it depends on such variables as marginal tax rates and province of residence, but for most people the after-tax net should only decrease modestly.

The other beef of the anti-Flaherty crowd is that the tax change has precipitated a wave of foreign takeovers. This one doesn't pass critical muster, either.

First, the actual number of takeovers has not been huge, and many of these were not by foreign entities, but by other Canadian trusts. Given the inherent difficulties associated with the business trust model, it's not surprising that consolidation is occurring.

Second, there has been no shortage of takeovers of plain vanilla corporations, especially in the resource area.

The reason for these takeovers has very little to do with taxation. The global commodity boom has created the motive, while restless surplus capital looking for good hard assets supplies the means. Canada's open-door policy to foreign investment provides the opportunity.

The real lesson of Flaherty's Halloween surprise is the susceptibility of the market to a panicky knee-jerk reaction. Usually, when the smell of crisis is in the air — as when the tech bubble was pricked, or during last summer's subprime meltdown — The Street rushes to reassure investors with bromides about the important thing being time in the market, not market timing.

But curiously, a year ago such platitudes were nowhere to be heard after the trust announcement. Instead, "voting with your feet" — i.e. dumping units wholesale in retaliation for what was viewed as government chicanery — was accepted as a reasonable and understandable reaction.

Making trading decisions in a fit of anger is rarely a good strategy, all the more so for holdings that are fairly illiquid. Under such circumstances, making "at the market" sales when demand is weak can be devastating.

Given that these tax changes were not to be implemented for five years, and the likelihood that they would be watered down by changing governments, it made a lot more sense to wait until tempers had cooled and the long-term implications could be better understood.

Halloween spooks may be scary, but it doesn't mean you have to run for cover just because a politician yells "Boo."


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