The Canadian income trust market has always been defined by continual change. As of January 1, 2011, the Specified Investment Flow Through (SIFT) tax effectively levelled the playing field between trusts and corporations, leaving the income trust structure with little, if any, tax advantage. Announced on October 31, 2006, the SIFT rules forced trustees of income trusts to consider their strategic alternatives, considerations made all the more difficult by the unprecedented turmoil in the global banking system and a meltdown in the global capital markets over the last few years. But even as capital markets have stabilized there has been little uniformity of view regarding the best path for income trusts and whether unit holders are best served by conversion, sale or simply maintaining the status quo. And the debate continues now that the SIFT rules apply to all distributions of income from trusts, with a second critical deadline approaching for the 82 trusts remaining on the TSX. Trusts will only be allowed to convert into corporations on a “tax-deferred basis” until December 31, 2012. After that date, conversion will be taxable in the hands of the unit holders which means the economics of conversion for unit holders may be materially worse.
Let’s briefly consider what has transpired leading up to the application of the SIFT rules on January 1 of this year and reconsider the principal alternatives available to trusts.
Where Was the Torrent?
The SIFT rules knocked out any real advantage that trusts held over a conventional corporate structure. If anything, they put trusts at a material disadvantage to corporations because of their complex structuring and limited comparables. The disadvantages were initially perceived to be so compelling that the mere announcement of the pending SIFT rules in the autumn of 2006 set off a wave of activity in the trust sector as trustees weighed their alternatives and began to implement strategies to maximize unit holder value before the implementation of the SIFT rules. By the autumn of 2008, many trusts had been sold and a handful of larger trusts (such as TransForce Income Fund, CI Financial Income Fund and Aeroplan Income Fund) had converted back into corporations, in large part to gain greater financial flexibility and access to capital or, in some cases, to eliminate limits on foreign ownership or to get out from under the growth limits imposed under the SIFT rules. Those trusts not sold or not converted in the short term chose instead to continue receiving the tax benefit of the income trust structure as long as possible. Most commentators (including Osler) believed that “as long as possible” meant by the end of 2010 and we would see a torrent of conversions in the second half of 2010. But it did not happen. Like so many events related to trusts, the unexpected occurred and many trusts simply chose to remain as such, become subject to the SIFT tax and effectively be subject to corporate tax rates on the taxable income that they distributed to unit holders and to personal tax rates (which are generally higher) on taxable income that they do not distribute.
Status Quo Acceptable After All
Different trusts had different reasons for choosing not to convert. Many were able to shelter taxable income (through the application of tax pools) and elected to maintain the status quo, at least until the end of the tax-free conversion period in 2012. Others found that the advantages of conversion did not warrant the cost and chose simply to proceed as a fully taxable income trust. For some (and these may be in the majority) there was simply no demand by their unit holders to convert because unit holders would rather have the certainty of distributions that comes with a trust structure (even if subject to the SIFT tax) than a less certain dividend stream from a corporation. That realization seemed to play out in the market as a number of trusts that converted found that their share price suffered materially in the months following conversion.
For those trusts that have not converted there are still three primary strategies available:
Converting into a Corporation – This is still the best option for most trusts. Trusts that chose to convert gave the following reasons:
- a corporate structure was better suited to their growth strategy;
- the trust’s valuation was at a discount to growth-oriented corporate peers;
- easier access to capital, given the certainty of its structure and governance requirements;
- access to a broader universe of investors and analyst coverage (as trusts have been considered as a separate class of specialty investments); and
- a corporation is not subject to tax at higher personal tax rates on taxable income that is not distributed.
Selling, Merging or Privatizing - While a sale or merger may initially have been a very feasible option in 2006 in the days following the announcement of the SIFT rules, by 2008, market prices and the difficulty in obtaining acquisition financing made a sale or merger a difficult prospect for many trusts. However, the market for trusts may now be reviving. M&A activity is on the rise generally and is expected to accelerate through 2011. A sale or merger is quickly becoming a much more feasible alternative than it has been for the last few years.
Maintaining the Status Quo - Finally, as noted above, trusts that are able to shelter taxable income (through the application of tax pools) may choose to maintain the status quo, at least until the end of the tax-free conversion period in 2012 and perhaps indefinitely. Even if a trust may have to pay the SIFT tax, trustees may conclude that the advantages of conversion do not warrant the cost and so will simply proceed after 2012 as a fully taxable income trust. That is in fact what unit holders may prefer.
The strategy embraced by each of the remaining 82 trusts on the TSX is still up for debate. However, what is not up for debate is that the evolution of the Canadian income trust sector has been nothing less than a wild ride with undoubtedly a few twists and turns yet to come.