With the return of the “income fund” to the Canadian capital markets, you will find new opportunities to monetize, dispose of, or finance the acquisition of US oil, gas and energy assets. The resurrected income fund, referred to as a “foreign assets investment trust” or “FAIT,” offers potentially superior valuations to those available in private transactions and an opportunity to achieve better pricing on an IPO.
The income fund was the business vehicle of choice for many public issuers before the Canadian tax rules changed in 2006. Prior to the tax change, there were in excess of 240 publicly listed income trusts with an aggregate market capitalization in excess of C$200 billion.
Before the 2006 tax changes, an income fund could obtain a deduction from its taxable income to the extent that it made a distribution to its unitholders. Therefore, if the income fund distributed all of its income, it would pay no Canadian income tax. Additionally, to the extent that the income fund had available tax shelter from its operations (such as deductions for capital cost allowance, which is depreciation for Canadian tax purposes), it could effect a distribution as a “return of capital,” which would not be immediately taxable to the unitholder, and instead would reduce the tax cost of the unitholder’s trust units.
As a result of the 2006 tax changes, a public income fund in Canada is generally treated as a corporation with respect to its business income, and does not obtain a deduction for distributions. Distributions are instead treated as dividend income to the unitholders.
For reasons stated below, companies with US assets looking to utilize a FAIT offering have to have the right set of legal and tax advisors on both sides of the Canadian and United States border in order to assess and meet all the criteria of a proper FAIT offering. However, with the right team, the FAIT requirements can be successfully navigated and set your company in position to take advantage of the considerable tax benefits and access to capital.
The “FAIT” is Developed
The resurrected income fund is being referred to as a “foreign assets investment trust” or “FAIT,” as from a Canadian perspective, the operating assets are “foreign assets.” To avoid creating confusion with people outside of Canada, the structure is sometimes also referred to as a “cross-border income trust” or “CBIT.”
The key to the revival of Canadian income funds is that the 2006 tax changes do not apply where the income fund does not conduct business in Canada. Therefore, if the operating assets of the income fund are based in the United States (or another country other than Canada), then the income fund is taxed in Canada on the same basis as before the 2006 tax changes. This means that the income fund operate on a “pass-through” basis for Canadian income tax purposes, and distribute all of its income to unitholders without being subject to Canadian income tax.
The first FAIT financing was completed in November 2010. There have now been approximately seven FAITs which have effected initial public offerings (“IPOs”) in Canada, and are listed and trading on the Toronto Stock Exchange, the primary Canadian stock exchange. Three of these FAITs are engaged in upstream oil and gas development, three are engaged in real estate selected activities, and one is engaged in the energy retail business.
FAIT Disposition and Financing Opportunities
From the perspective of an owner of US assets, a FAIT can be used as a vehicle to effect a monetization or disposition of those assets. Canadian capital markets may well provide valuations that are superior to those that can be obtained in private transactions. A seller willing to complete an IPO process in Canada may be able to achieve better pricing on a sale. In a FAIT IPO, proceeds would then be used to purchase the US assets. The IPO proceeds could also be supplemented by debt financing secured by the target assets.
A FAIT can also be used by a seller to effect a partial monetization or disposition of US assets, with an interest (which may be significant) being retained by the seller. This would allow the seller to retain control of the assets, and effect further asset dispositions over time. The FAIT would become a co-owner of the assets with the seller in this structure.
From the perspective of a proposed buyer of US assets, a FAIT can be organized and used as the purchaser to finance the acquisition. Once again, IPO proceeds can be potentially augmented by debt financing proceeds.
Practical Requirements to Establish a FAIT
Canadian capital markets tend to have a lower offering threshold to effect an IPO than US capital markets. The optimal IPO size in Canada is currently an offering of C$150 million to C$400 million. For an offering at the bottom end of the IPO offering range, assuming a valuation based upon a 10 times “distributable cash” multiple, the distributable cash from the US assets should be at least C$15 million per year. This distributable cash needs to be sustainable, and ideally there would be growth opportunities related to the assets to grow the FAIT’s business.
There are no specific requirements related to the type of business activity of the FAIT. Upstream oil and gas development has been the most common business conducted by FAITs to date. This is likely a combination of a number of factors, including the popularity of oil and gas investments with the Canadian institutional and retail investors, the existence of experienced and knowledgeable management teams in this area, and the resurgence of the oil and gas industry in the United States.
A portfolio of power assets (whether gas, wind or solar, or a combination thereof) are also ideally suited for a FAIT, where there are long term agreements with suppliers and off-takers who are creditworthy.
The current FAIT model requires that there be a corporate “Administrator,” who assumes responsibility for operating the FAIT. The directors of the Administrator will be the “acting mind” of the FAIT, and will be elected by the FAIT unitholders. The Administrator employees are responsible for day to day operations of the FAIT, and FAIT reimburses the Administrator for employee costs.
In order to establish a FAIT, it is therefore necessary to have a “management team,” who will operate the FAIT through the Administrator. Typically, management members also have operational responsibilities within the US entity that directly owns the US assets. It is also necessary for the Administrator to have a number of “independent directors” (who are independent of the management team), and these individuals are typically chosen in consultation with the Canadian IPO underwriters.
As indicated, the FAIT would effect an IPO through a prospectus filed with Canadian securities regulators. It would realistically take three to four months to prepare and clear the prospectus for a FAIT offering. The FAIT’s trust units would be expected to be listed on the Toronto Stock Exchange, the main stock exchange in Canada.
The FAIT trust units could also be offered in the United States on a private placement basis. While a FAIT can be established such that there are no restrictions on non-Canadian ownership, Canadian withholding tax may be applicable to FAIT distributions to non-Canadians. This may affect the appetite for US investors in the FAIT.
Existing Upstream Oil and Gas FAITs
The following is a synopsis of the three upstream oil and gas FAITs that have been formed to date. They are listed in chronological order.
Eagle Energy Trust – Eagle completed its IPO in November 2010. The IPO offering size was C$150 million before the over-allotment option. Eagle acquired interests in the Salt Flat Field, a light oil property located in South Central Texas. The total proved plus probable reserves as reflected in the engineering report referred to in the IPO prospectus were net (i.e. after royalty interests) 5.1 million barrels of oil.
Parallel Energy Trust – Parallel completed its IPO in April 2011. The IPO offering size was C$342 million before the over-allotment option. Parallel acquired liquids rich natural gas interests in the West Panhandle Field, located in North Texas. The total proved plus probable reserves as reflected in the engineering report referred to in the IPO prospectus were net 23.8 million barrels of oil equivalent (“BOEs”), using an energy equivalency conversion ratio of 6 Mcf of natural gas to 1 barrel of oil.
Argent Energy Trust – Argent completed its IPO in August 2012. The IPO offering size was C$212 million before the over-allotment option. Argent acquired both oil and natural gas assets, the oil assets being mainly interests in the Austin Chalk and Eagle Ford Shale oil formations located in Central Texas and the natural gas assets being mainly interests in the South Escobas field in South Texas. The total proved plus probable reserves as reflected in the engineering report referred to in the IPO prospectus were net 12.2 million BOEs.
Canadian securities disclosure requirements permit reserves disclosure to include an issuer’s probable reserves. We understand this to be a more lenient situation than under US securities disclosure requirements, which permit disclosure of proved reserves only. Accordingly, an issuer in Canada can obtain valuation “credit” for probable reserves, although these reserves must be risked in accordance with Canadian securities disclosure requirements.
FAIT Tax Considerations
There should be no Canadian tax leakage in connection with a FAIT. There is expected to be some US tax leakage as a result of the FAIT carrying on business in the US. However, to the extent permitted by US tax laws, high yield debt is used to shield the operations of the FAIT from US income tax. Also, the FAIT will rely upon deductions otherwise available under US tax law, such as deductions for depreciation and depletion. US oil and gas activities are well-suited to a FAIT because drilling operations provide accelerated depreciation deductions, helping to defer US income taxes.
US tax issues can arise where the seller desires to retain an interest in the applicable US assets – either through ownership of trust units or a direct retained interest in the assets or co-ownership vehicle. The US anti-inversion rules can apply in these circumstances and cause the FAIT to be taxed in the US as a domestic US corporation. This result would adversely affect the tax efficiency of the FAIT structure. Therefore, it is necessary to consider the application of these rules. As a result, the retained interest of the seller in the FAIT or the applicable US assets may have to be modified so that the FAIT is not taxed as a US domestic corporation. A FAIT transaction can typically be structured in compliance with these rules.