TORONTO (HedgeWorld.com)–A Canadian government proposal to cap pension fund holdings in income trusts could force the Ontario Teachers’ Pension Plan to scale back its roughly C$300 million (US$228 million) worth of investments in hedge funds.

The Canadian government is considering a proposal that would ban pension funds from investing more than 1% of total assets in income trusts and that also would ban them from holding more than 5% of any single income trust. Income trusts provide a return on capital and also distribute corporate cash flow to their investors. The trusts do not pay corporate tax, but investors are taxed on the payouts they receive from the trusts.

According to published reports, the government in Ottawa is concerned that growing holdings in income trusts by tax-exempt investors such as pension funds will further reduce tax revenue, since those funds would not pay tax on their payouts. Retirement plans’ growing interest in investment trusts has caused them to become one of Canada’s hottest investments, with C$75 billion invested.

The government’s proposal, contained in the proposed federal budget, would give pension funds between five and 10 years to comply with the caps, depending on whether the income trust holdings are direct or indirect. For indirect investments, such as those held through hedge funds, pension funds would have five years to comply. Direct investments get 10 years.

The Ontario Teachers’ fund has both direct and indirect income trust holdings, but direct investments constitute the bulk of the fund’s income trust holdings. The fund almost certainly is not in compliance with the caps, given that it has about 1.3% of its total portfolio invested in income trusts and that it holds more than 5% of two income trusts.

Robert Bertram, executive vice president of investments at the C$78 billion Ontario Teachers’ fund, said officials there have not yet begun looking into which hedge fund managers among the 130 in the fund’s portfolio have income trust holdings.

“Hedge funds are down the list of importance for us,” Mr. Bertram said. “We have a number of direct investments” that need to be sorted out first.

Among those direct investments are a 27% holding of Fording Canadian Coal Trust and a 10% holding in the Yellow Pages Income Fund.

Mr. Bertram said that because getting transparency from hedge fund managers can be difficult, it could take fund officials some time to get a handle on the effect the proposed caps would have on hedge fund investments.

“Hedge funds are not exactly the most open with respect to their own investments,” he said.

In a statement, Claude Lamoureaux, president and chief executive of the Ontario Teachers’ plan, ripped the proposed cap, saying it “discriminates against the 250,000 teachers and the millions of Canadian workers whose retirement income is managed by pension plans.

“This proposal would unfairly exclude them from benefiting from the growth and stable cash flows income trusts are expected to provide,” Mr. Lamoureaux said.

Ontario Teachers’ realized some C$800 million in investment income from its income trust holdings in 2003, according to the fund’s annual report. Overall, the fund earned an 18% return for the 12 months ended Dec. 31.

CClair@HedgeWorld.com