TORONTO (Bloomberg) — Canadian stocks had their biggest decline in almost five months after the government unexpectedly said it will begin taxing income trusts, whose securities make up about ten percent of the country’s main equity benchmark.Shares of Telus Corp. and BCE Inc. plunged on speculation the nation’s two biggest phone companies may not follow through on their plans to convert to the structure that avoids most taxes by distributing much of its cash flow to investors.

“You’d expect some correction, this is a bit extreme,” said Leslie Lundquist, who runs the Bissett Income Fund in Calgary with $1.2 billion in assets. “There will be a lot of volatility in the market in the coming days and weeks even.”

The Standard & Poor’s/TSX Composite Index slid 294.20, or 2.4 percent, to 12,050.39 in Toronto for its biggest decline since June 13. Gains for bullion producers such as Barrick Gold Corp. prevented bigger declines for the index.

Canada plans to tax income trusts for the first time and raise dividend tax rates for pension funds and foreign investors that own trusts, Finance Minister Jim Flaherty told reporters in Ottawa yesterday.

A measure of phone shares retreated 8.8 percent.

Telus dropped C$8.78, or 14 percent, to C$56.15 and was the biggest drag on the S&P/TSX. The stock erased more than half of its 25 percent gain before today following its Sept. 11 announcement of plans to convert to a trust.

“Any stock currently enjoying any premium due to the actual or potential tax advantage of the income trust structure can be expected to have that premium removed,” said David Wolf, chief strategist at Merrill Lynch Canada Inc. in a note to clients.

BCE fell C$3.60 to $28.10. Canada’s biggest phone company said September 11 it would become an income fund.

BCE also reported quarterly earnings today. Profit fell to C$302 million ($267.4 million), or 36 cents a share, from C$459 million, or 48 cents, a year earlier. Morgan Stanley’s Simon Flannery, top-ranked among fixed-line phone-company analysts by Institutional Investor, had estimated earnings would be 46 cents.

UBS AG analyst Jeffrey Fan downgraded BCE to “reduce” from “neutral,” and Telus to “neutral” from “buy”.

Merrill Lynch Canada analyst Joel Sutherland said in an e-mailed note that he expects trust valuations to “collapse,” and cut his recommendations on four trusts, including Yellow Pages Income Fund. Canada’s biggest directories publisher plunged C$2.86, or 19 percent, to C$12.26. Sutherland downgraded Yellow Pages to “sell” from “buy.”

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The income trust sub-index, which makes up about 10 percent of the country’s main equity benchmark, slid 12 percent. About C$19 billion in trust capitalisation was wiped out.

“We expected the market to be down and dirty on this — and it is,” said John Priestman, who helps manage about $5.3 billion in income trusts for Guardian Capital LP in Toronto. He estimated that “C$40 billion to C$60 billion of wealth may evaporate because the government is losing C$800 million in tax revenue.”

The government’s move would close a loophole in the C$200 billion ($178 billion) market for the high-yield securities favoured by many investors seeking regular cash distributions to boost retirement income.

The number of trusts in Canada has tripled to about 250, and their market value has soared 20-fold in six years as companies convert to avoid taxes and boost share prices. Foreign investors own more than a fifth of income trust units, said RBC Capital Markets analyst Sue Trinh in Sidney.

Existing trusts won’t be subject to the taxes until 2011, while new trusts will be taxed as of next year, Flaherty said. The advantage trusts enjoy over corporations is “not fair,” and the securities deprive the government of tax revenue, he said.