Montreal, Canada

Following an absolute massacre in October 2007 after Ottawa announced changes to the income trust tax regime, investors have returned en masse to Canadian income trusts. Lured by their fat payouts and preferential tax treatment investors have fallen in love with income trusts again. Energy trusts remain especially popular with rising payouts for those trusts over-weighted in the oil sector.

But ahead of tax changes in 2011, investors should be careful as a correction or severe sell-off grips the sector. For the most part, the market has probably discounted the tax conversions next year; still, it would only be prudent to reduce one's exposure as investors hold-out until the last minute before selling their trusts.

Effective January 1, 2011, income trusts classified as Specified Investment Flow-Through Trusts (SIFTs) will have to pay distribution taxes, or the SIFT tax. All sectors in the income trust space are subject to the SIFT tax but the level to which they will be affected depends on the type of income trust. Some investors might incorrectly interpret the SIFT tax and dump their trusts at the last minute.

Energy trusts appear to be in the best position for a successful conversion to dividend or income-producing companies. Several energy trusts, including Crescent Point Energy Corporation (Toronto-CPG) have already converted while maintaining their distributions.

Some trusts, like business trusts, are projected to have the most difficulty en route to conversion because most don't have any significant tax shelters to offset the rollover, according to a recent report from Canaccord Adams, a Canadian-based investment house.

The risk lies later in January next year when distributions will be less as a result of the higher corporate tax levied on the trusts. Most trusts won't maintain the same distributions. Although the Canadian sourced income will be taxed as a dividend and eligible for the dividend tax credit, some trusts will be forced to reduce their distributions nonetheless.

Better safe than sorry. The odds that all investors understand how the new SIFT tax regime is applied and what higher effective tax rates mean to earnings and distributions implies some sort of confusion or chaos before 2011. Energy trusts appear to be best positioned for the SIFT tax and for domestic and international investors alike, this sector should remain popular as energy enters its second decade in a secular bull market.

If you own Canadian income trusts contact your tax advisor for more information on how these securities will be taxed next year and how foreign withholding taxes on non-Canadian investors will impact your bottom line.