Canada: Outlook For The Income Trust Sector

Originally published in Employee Benefit News Canada, Jan./Feb. 2007.

On Halloween night, Jim Flaherty, the federal minister of finance, stunned investors by announcing proposals to significantly change the income tax treatment of most publicly traded trusts and limited partnerships. The proposals will be effective for the 2007 taxation year for trusts that are listed after Oct. 31, 2006, but will be delayed until the 2011 taxation year for pre-existing trusts. Draft legislation to effect the proposals was released at the end of December 2006. For investment managers to assess the future of the sector, they need to understand which types of entities are affected and the options available to those entities.

In general, the new proposals will tax certain types of income earned by income trusts and limited partnerships in a manner similar to income earned by a corporation. In addition, distributions of such income made by these entities to investors will be taxed in a similar manner to dividends from taxable Canadian corporations, including availability of the new enhanced dividend gross-up and tax credit in respect of eligible dividends.

The proposals came in response to the trust conversion announcements by telecommunications giants Telus Corp. and BCE Inc. Specifically, the government was concerned over the loss of significant tax revenues and the impact of the trust structure on productivity and efficiency in the economy.

The move resulted in an immediate loss of approximately 15% to 20% of the sector’s value, representing a major shock to a promising sector that had grown to over 250 issuers with an aggregate market capitalization exceeding $215 billion. By halting the tide of income trust conversions and IPOs, the proposals have had their intended effect over the short term.

Designed to level the playing field between income trusts and corporations, the proposals expressly state that the new rules are targeted at nonresidents and tax-exempt entities (such as pension funds) that continue to obtain a sizable tax advantage if they invest in an income trust rather than a corporation. The proposals acknowledged that the previously announced enhanced dividend tax credit, which introduced tax neutrality between income trusts and corporations for Canadian taxable investors, had not had their intended effect, given the continuing advantages to tax-exempt and nonresident investors.

Using a simplified comparison of 2010 and 2011 investor tax rates, the chart below this article illustrates the effective tax rate differentials under the current system, based on a comparison of the combined entity and investor level tax. These figures clearly show the significant and targeted adverse impact of the proposals on pension funds and other tax-exempt and nonresident investors.

The proposals provide an exception for certain real estate investment trusts that invest primarily in real properties situated in Canada. However, the proposals will catch REITs that derive their income principally from other sources, including foreign properties and active management of real property (such as hotels or nursing homes). In addition, issuers of income deposits and similar securities that are not structured as income trusts or limited partnerships appear not to be caught by the proposals.

In general, affected income trusts that cannot significantly increase their distributable cash during the four-year transition period will likely be forced to cut their distributions thereafter, and many trusts will no longer be able to raise additional equity in the market. The proposals also limit "undue expansion" by income trusts during the transition period.

In mid-December it was announced that trusts will be permitted to issue new units worth as much as 100% of their Oct. 31, 2006 market value between now and 2011.

In addition, the new rules will allow trusts to merge with other trusts and convert to corporate status without adverse tax consequences to unit holders.

Trustees and management of affected trusts are currently assessing the changes and deciding whether the trust structure continues to make sense for them. A poll of trust executives and advisers conducted in December 2006 by Deloitte & Touche showed that the vast majority of respondents believe that by 2011 only 50 to 100 of the existing 250 trusts will continue to exist.

So what is likely to happen to these trusts? A range of possibilities is open.

Some of the affected trusts that have strong earnings growth potential (such as Yellow Pages, which recently increased its distribution level) have stated that they see no need to alter their organizational structure. Other trusts that need to raise capital and make acquisitions to support their growth plan are looking at the alternatives available to them.

One possibility is to go private, with the assistance of private equity financing, or to be acquired by a strategic industry player. Many U.S. and Canadian private equity firms have expressed their interest in participating in these transactions. Another possibility is to merge with another trust in the same industry in order to bulk up and realize synergies. As a result, M&A activity is likely to be vigorous in the sector, which in the case of otherwise healthy trusts holds out the potential of significant transaction premiums for investors.

Another option is to convert to a conventional corporate structure during or just after the four-year transition period. Yet another possibility that has been raised is to convert an existing trust to a new structure whereby investors would directly hold both an equity and a debt security in the underlying business rather than holding trust units. This structure could largely replicate the economic benefits of an income trust. However, it is unclear whether the government would seek to apply the antiavoidance rules announced as part of the proposals to eliminate the effectiveness of these structures.

Whatever path is chosen by an individual trust, it is clear that there will be significant activity and a major reduction in participants in the income trust sector in the next several years. As the sector declines, Canadian investors, including pension fund managers, will have to look elsewhere in their search for yield. This may result in increased demand for high dividend-paying common and preferred shares and lead to the development of new high-yield-based investment products, perhaps including a new high-yield debt market in Canada. —E. B. N. C.

The battle continues ...

The fight to change or repeal the new trust tax continues both on Bay Street and on Main Street. Lobby groups including the new Canadian Association of Income Trust Investors, the Canadian Association of Income Funds and the Coalition of Canadian Energy Trusts persuaded the House of Commons Finance Committee to hold hearings on the matter in late January. Because it is extremely unlikely that Finance Minister Jim Flaherty will back down, the best hope for investors may be if an election occurs before the trust legislation is passed in Parliament. But even then, the new government (whether Liberal or Conservative) could reintroduce the trust tax. —S. S.

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.