Canada: Taxation Of Trust Capital Securities: Is There A Pending Battle Between The Government And Canada´s Financial Institutions?

Last Updated: March 9 2007
Article by Guy David and Jonathan Gilhen

The recent announcement by the Government of Canada that it would begin taxing distributions of income trusts and other "specified investment flow-throughs" ("SIFT") has brought planned conversions of corporations such as Telus and BCE into income trusts to a grinding halt and, for some investors, has impeded an investment vehicle with considerable value. Another untold story in the income trust saga, with a plot that may begin to heat up, is the potential battle between Canada's financial institutions and the federal Department of Finance. Many of the large domestic chartered banks and other Canadian financial institutions use trusts to help raise capital because of the cost-effectiveness of this investment structure. As will be discussed below, these structures may be caught by the new tax on SIFTs, and the effect, intended or otherwise, may be the extinction of an innovative method for financial institutions to raise capital.

What are Trust Capital Securities?

Trust Capital Securities ("TruCS"), also commonly referred to as capital trust securities or a variety of similar names, are, simplistically, trust units. Consider a simple example. Bank X wishes to raise $100 million. Bank X sets up a trust called X Capital Trust which distributes non-voting units (TruCS) to the public. Bank X will itself retain control of the trust by holding special trust securities carrying all of the voting rights. X Capital Trust then uses the proceeds of the TruCS distribution to purchase a subordinated debenture from Bank X in the amount of $100 Million with a coupon rate of, say, 5%. X Capital Trust will receive interest payments on the subordinated debenture from Bank X and distribute this cash to TruCS holders. Distributions will essentially equal the coupon on the subordinated debenture. In this way, the interest income flows through X Capital Trust to the TruCS holders. With the exception of setting up the trust, all transactions take place simultaneously.

The structure noted above is a simplistic model. Trusts may also be capitalized with mortgage-based assets such as residential mortgages, or mortgage-backed securities that the bank may wish to remove from its balance sheet. TruCS will also typically contain a number of subordination provisions in order to meet the requirements of the Office of the Superintendent of Financial Institutions ("OSFI") for innovative instruments.

Why do Banks use TruCS?

Banks are required to maintain specified levels of capital under international accords (BASEL) and domestic legislation. Capital is divided into two distinct groupings for regulatory purposes: tier 1 capital and tier 2 capital. Tier 1 capital is the bank's core capital and generally consists of common shareholders' equity, qualifying non-cumulative perpetual preferred shares, and qualifying innovative capital instruments (such as TruCS described above). Tier 2 capital is the bank's supplementary capital, and generally consists of less permanent capital instruments, such as subordinated debt. Total capital is the sum of tier 1 capital and tier 2 capital. OSFI requires that banks maintain a minimum tier 1 capital ratio of 7%, and a total capital ratio of 10%. The ratios are determined by dividing the tier 1 capital or total capital, depending on the particular ratio to be calculated, by the risk-weighted assets of the bank. In addition, OSFI requires that the common shareholders' equity make up the majority of tier 1 capital by limiting innovative capital instruments to 15% of net tier 1 capital.

Should a bank wish to increase its risk-weighted assets such as loans and mortgages to its customers, it will have to set aside a corresponding amount of tier 1 capital and total capital to maintain its required ratio's and ensure they do not fall below the level required by OSFI. By issuing a subordinated debenture directly to investors, a bank would increase its total capital, but not its tier 1 capital, since such debentures are considered tier 2 capital. However, by issuing the debenture to a capital trust which then sells units, the units, with approval of OSFI, are considered tier 1 capital as innovative capital instruments. Where the mortgage-based assets of a bank are purchased by the capital trust with the proceeds from the distribution of TruCS, the effect will be to reduce the bank's risk-weighted assets and, as a result, its required capital ratio's will be improved. This improvement in the bank's capital ratios will allow the bank to create additional assets with the capital that has been freed up.

The debt instrument issued to the capital trust will have features similar to traditional tier 1 capital. For instance, the subordinated debenture will have greater permanence than a similar type debt instrument issued directly to the public (the term must be at least 30 years), failure to make payments cannot accelerate repayment of the debenture, and the debenture cannot be secured, guaranteed or given priority ahead of claims of depositors (or policyholders for insurance companies). In other words, the trust vehicle provides a bank with a means of boosting the value of subordinated debenture investments by sifting out their less permanent features and parking them in a capital trust, leaving the bank with tier 1 capital. The structure, however, plays another important role: it is a very cost effective way to increase tier 1 capital. Tier 1 capital is composed, with the exception of innovative capital instruments, mainly of equity. Issuing equity, however, would result in a bank paying dividends which are not deductible from income. With TruCS, the bank pays interest to the capital trust which is deductible as an interest expense under the Income Tax Act (Canada). Similarly, where the capital trust collects payments on the assets held (such as mortgages transferred to it by the bank), it can flow these payments through to TruCS holders on a tax-free basis. If the bank collected these payments itself, the income would be taxed at the bank level, and only the after-tax balance would be available for distribution. With mortgage-backed capital trusts, investors can obtain pure pre-tax exposure to a mortgage portfolio. Therefore, there are additional investment and tax-based benefits of using the capital trust over and above their attractiveness as a capital-raising instrument.

How Will the New Tax on SIFTs affect TruCS?

The new rules regarding the taxation of SIFTs may have a significant impact on TruCS financing. If the units of the capital trust are listed on a stock exchange or other public market, then the trust is a SIFT that will be caught by the new income trust rules. Some TruCS are traded publicly on the Toronto Stock Exchange, for example, RBC TruCS - Series 2010 (TSX: RYT.NT.M) and TD Capital Trust Securities (TSX: TDD.M).

If a capital trust is a SIFT, it will be subject to tax on the income it once flowed through on a tax-free basis. The tax benefit accruing to the bank from the interest expense will now (notionally) be offset by the tax liability to the capital trust. Similarly, there is no longer a benefit to having the trust collect on assets since the distributions will be reduced to account for the tax liability. A mortgage portfolio taxed in this way would no longer be an attractive investment because it would be taxed twice; first at the trust level and secondly as income to the TruCS investor. The cost of setting up and operating the capital trust will no longer be offset in any significant way by the benefits of using such a structure. Putting all of these together, the advantage to using a capital trust to raise tier 1 capital, or simply to securitize assets is essentially gone.

It remains to be seen how crucial capital trusts are to financial institutions, and whether the Government of Canada will carve out an exception for capital trusts set up by Canada's financial institutions. For TruCS that were publicly traded prior to November, 2006, the new rules will not apply until 2011, therefore there is enough time to change the framework for the tax treatment of these structures. Although the story is just beginning to unfold, given the importance of Canada's financial institutions, and the influence they wield, we probably haven't heard the end of it.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Events from this Firm
7 Nov 2019, Seminar, Birmingham, UK

Providing content specifically tailored to the needs of GCs and Heads of Legal working in government organisations and their affiliates.

14 Nov 2019, Seminar, London, UK

Providing content specifically tailored to the needs of GCs and Heads of Legal working in government organisations and their affiliates.

 
In association with
Related Topics
 
Related Articles
 
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions