The Department of Finance announced rules for income trusts that allow existing entities to double in size by 2011 without giving up tax-free status. In addition, trusts will be able to convert back into a corporate structure without triggerin capital gains taxes or other tax consequences. There are limits, however, that will ensure taxes are most burdensome for the most profitable businesses.

The government continues with its rules, but now seems to be making efforts to reduce “impediments to conversion,” by trusts back into ordinary securities. Additional rules are described as being “designed to make it easier for these significant changes to happen in Canada and at the same time we get to the level playing field four years from now.”

The announcement of guidelines came on Friday following a federal-provincial meeting of finance ministers. Doubling in size now defines the upper limit of “normal growth” according to the government as it has previously announced new taxes and an interest in “restraining” income trusts.

Specifically, the notion of growth is related to market capitalization. New taxes will not be applied immediately, but will be applied to tax distributions as now planned, starting in 2011, if “growth” is less than either $50 million per year in market capitalization or no more than 40% in 2007 and 20% each year after that. Such growth in market value is considered cumulative so that growth later may be allowed if there is no growth now. However, the $50 million annual limit for small trusts will not be allowed to carry over from year to year.

Equity growth will not be considered growth if it involves replacing debt with equity as long as that debt either replaces debt outstanding as of Oct. 31 2006, or is issued subsequent to that date. On the other hand, if new debt is issued and then later converted into equity, the new equity value will be considered as part of the normal-growth limitations.

Any mergers or reorganizations of existing trusts will not be considered growth “to the extent that there is no net addition to equity.” This is a policy that would seemingly allow for mergers and acquisition activity in coming years, a trend that has become significant in the oil and gas sector.

To complicate matters and add a burden for policy administration, however, the Minister of Finance suggested that all pending trust deals will be allowed and measured against the rules.

But trusts will also have the right to ask for permission to grow more than the limits if managers see their company as having a special case. Managers will be seeking to explain transactions or situations to ensure their company is viewed as a special situation for purposes of meeting government guidelines.

The Department of Finance has just turned the trust market into an opportunity for “special interests” alone. All others will, in the normal course of business, be allowed to growth only within limits. This is despite the government statement that there is concern about lack of growth or productivity in the trust realm.

The net impact: Guidelines may be deemed unworkable by profitable and growing companies upon whom the burden of new tax is most likely before 2011 unless they spend additional money on debt refinancing or reorganization.