The surprise proclamation by the Canadian government that the income trust sector will lose its preferential tax status by 2011 sent shockwaves through the country’s fastest-growing sector and will almost certainly pour cold water on U.S. investors’ interest north of the border.

The timing of the last-minute press conference by Minister of Finance Jim Flaherty–on Halloween –did not go unnoticed by market watchers. The trick, however, was on trust investors, who saw the value of their investments plummet by 20% the next day with only a marginal recovery in the weeks that followed.

Josh Mendelsohn, chief economist at Mendelsohn Global Economics, a Toronto-based independent economic advisor, says U.S. investors were among those in the Canadian government’s cross-hairs. He says its revenues took a serious hit because in addition to the trusts not paying corporate tax, U.S. investors in trusts are only responsible for paying a 15% withholding tax in Canada.

He says the higher taxation will result in lower values for existing trusts. Their units could fall even further as 2011 draws closer and the tax treatment of trusts effectively becomes just like that of any other corporation.

Canada has about 250 income trusts in the real estate, oil/gas, telecom, industrial, food processing, and manufacturing sectors. Their market capitalization is about $200 billion CDN, roughly 10% of the total Canadian market.

Income trusts are equity investments that represent ownership in a company. At the same time, they produce a regular, usually monthly, stream of income to unitholders, based on the earnings of the underlying business.

The government’s motives were largely driven by fears that if too many Canadian companies made the income trust conversion, it would lose more than $1 billion in annual corporate tax revenues.

Mendelsohn says U.S. investors were attracted to Canada’s trust sector because of the high payouts but now they’ll have to reevaluate their positions. “If there’s a corporate tax on the trust distribution, (the trusts) will have less revenue to distribute,” he says.

He says that under the proposed tax changes, U.S. investors will still pay the withholding tax but the Canadian government will also collect the corporate tax rate–about 30%–on the front end.

David Kotok, chief investment officer of New Jersey-based money manager Cumberland Advisors, says the unexpected announcement has “dampened” its enthusiasm for the Canadian market in general.

“It makes it a gradation less likely that we would overweight Canada and a nuance more likely that we would underweight Canada,” he says. “All things being equal, Canada took a step backward in our eyes. When you surprise the market in a regulatory way that’s negative, you hurt yourself.”

Kotok is quick to note that the Canadian government could have exempted existing trusts from the tax hike, as would have happened in the U.S. where pre-existing use is protected.

“We started a game of checkers with the rule that you had to jump and then changed it that you don’t have to jump,” he says.