At their peak, income trusts in Canada were valued at over $200 billion. Yet with the future loss of its special tax status, the already diminished trust sector will shrink to a bare shadow of that. Over the next few years, the sector will present a number of interesting investment and acquisition opportunities for buyers on both sides of the border. In considering these opportunities, trustees and potential buyers will need to be aware of the legal and tax issues facing trusts.

A Sector with Diminishing Prospects

The announcement by Canada’s Finance Minister in October 2006 that income trusts would be placed on the same tax footing as corporations in 2011 came as a severe blow and caused an immediate reaction in financial markets. Trust valuations plunged, attracting the attention of buyers. In the subsequent months, acquirors with ready access to debt seized on opportunities to employ private debt in income trust acquisitions.

The initial burst of M&A activity has since subsided, and a major contributing factor has been the disruption of credit markets in North America. With tighter credit and growing economic uncertainty, fewer buyers are willing to undertake new acquisitions, and the remaining trusts are now looking more closely than ever at converting to corporate status.

A significant bellwether was the decision by TransForce Income Fund to become a corporation in May 2008. One of the largest trusts in the country, TransForce pursues growth aggressively by acquiring smaller companies, and its status as a trust hampered its ability to use securities as a financing method. It reverted to corporate status to enlarge its financial flexibility at a time when it saw considerable opportunity for acquisitions.

Another large conversion was that of Aeroplan Income Fund. Its motivation was quite different: there are limits on the proportion of foreign ownership of trusts, and Aeroplan had recently come close to reaching them. The tax consequences for a public income trust losing its mutual trust fund status is dire.

If and When to Convert

Conversion to corporate status is not without strategic issues for trusts. Their investor base largely comprises security holders who are looking for steady income. If they convert, many could be challenged to maintain dividends at the same level of distributions they delivered as trusts. If they fail to do so, they may see a significant exodus of investors, necessitating recruitment of fresh capital from other sources. Early converters have suffered market price drops (at least temporarily) and a significant degree of churn that may provide potential acquirers with an opportunity to obtain initial positions. For small business trusts with little market capitalization, a sale may be the more feasible outcome.

Whatever decision they ultimately make, many trusts will likely maintain their current structure until 2011. Absent other factors, there may not be compelling enough reasons to give up a significant tax advantage any earlier than necessary and current market conditions do not favor M&A activity. However, in early July 2008, the federal government released draft tax legislation that facilitates a tax deferred reconversion of income trusts to corporate form until the end of December 2012. This will certainly cause many trusts to reconsider corporate conversion and the timing thereof.

Legal Counsel and the Conversion Process 

The vast majority of business income trusts that are not sold prior to 2011 will likely revert to corporate status. With the new trust tax commencing at the end of 2010, there is only slightly over two years to complete such a conversion.

One important strategic question is the impact on valuation that a conversion entails. Once a conversion announcement has been made, the unit price may drop over the short term. It is counsel’s responsibility to ensure that the trustees have fortified their decision with sound financial, market and legal advice, and have adequately considered such questions as the dividend that will be declared upon conversion to a corporate structure. This in turn may impact the investor base, and the trustees need to consider a plan for shoring up investor interest in the newly-converted company.

Trusts must also consider a number of related issues: the use of the tax attributes of the entities in the trust structure, the effect of conversion on external indebtedness and the cost implications of conversion itself.

In some cases, a trust may decide to convert before 2011. This would necessitate an even more rigorous decision-making process by the trustees, since the trust would be foregoing a significant tax advantage that would be subject to careful scrutiny and examination. The trustees would need to undertake careful due diligence to consider all the options open to the trust to justify the decision to unitholders.

In light of the new conversion rules and in anticipation of improving credit markets and a concomitant increase in M&A activity, trusts would be well advised to consider their strategic alternatives – to start considering conversion plans or plans for selling. Whichever route the trustees of an income trust take, they must do so based on careful deliberation and with the assistance of experienced counsel.