income trust conversion - osler, hoskin & harcourteffective january 1, 2011, the specified...

Osler, Hoskin & Harcourt LLP

Osler Guide

Income TrustConversions

2 Osler, Hoskin & Harcourt llp | Income Trust Conversions

Table of Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4

A Change in the Landscape . . . . . . . . . . . . . . . . . . . . . . .5

What Options Does a Trust Have? . . . . . . . . . . . . . . . . . .6

Maintaining the Status Quo . . . . . . . . . . . . . . . . . . . . . .6

Selling, Merging or Privatization . . . . . . . . . . . . . . . . . .6

Converting into a Corporation . . . . . . . . . . . . . . . . . . . .7

Methods of Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8

1. Share Exchange Method . . . . . . . . . . . . . . . . . . . . . . .8

2. Share Distribution Method . . . . . . . . . . . . . . . . . . .10

3. Other Variations . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12

Timing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12

Nature of the Current Unitholder Base . . . . . . . . . . . .12

Effect on Existing Debt . . . . . . . . . . . . . . . . . . . . . . . . . .13

Effect on Existing Compensation Arrangements . . . .13

Effect on Existing Contracts and Licenses . . . . . . . . .14

Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14

The Logistics: How does it happen? . . . . . . . . . . . . . . .14

How We Can Help . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15

The Canadian income trust market has always

been defined by continual changes in Canadian

tax rules. Beginning on January 1, 2011, the

application of the Specified Investment Flow

Through (SIFT) tax will effectively level the

playing field between trusts and corporations,

leaving the income trust structure with little, if

any, tax advantage. Since being announced on

October 31, 2006, the SIFT rules have forced

trustees of income trusts to consider their

strategic alternatives, considerations made all

the more difficult by the recent unprecedented

turmoil in the global banking system and a

meltdown in the global capital markets.

Against this uncertainty, the SIFT rules have

forced trustees to consider:

• whether (or when) to convert into a

corporation;

• whether to pursue growth opportunities

(within or outside the “normal” growth

limitations under the SIFT rules as described

below); and

• whether to find a buyer and sell.

Introduction

Osler, Hoskin & Harcourt llp | Income Trust Conversions 3

The purpose of this Osler Guide is

to review the available alternatives

and to help set a framework for the

discussion that needs to happen

among all stakeholders when making

these decisions.

Income trusts enjoyed booming popularity in Canada before the announcement

of the SIFT tax. This popularity arose from the tax advantage that they

gained from being a mutual fund trust, which effectively permitted them to

distribute their available cash flow to unitholders with no (or a significantly

reduced) entity-level tax.

Background

The cash flow-through was accomplishedthrough a number of variations on a basicstructure by using vehicles that were (or couldbe made to be) flow-through for entity-level taxpurposes. The following illustrates a simplifiedsecond generation income trust structure:

The cash distribution provided an attractiveincome stream to retail investors, particularlythose who were past their prime capitalformation years, that was not otherwiseavailable from investments in traditionalequities issued by corporations. Trustssubsequently attracted an institutionalfollowing as mutual funds began includingthem in their portfolios.

Income trusts were originally used in theenergy and real estate industries. Starting in2000, more and more enterprises convertedfrom a corporation into a trust to shelterthemselves from corporate tax rates. At theirpeak in mid-2006, there were 245 incometrusts in Canada with a total market value of over $200 billion.


Fund

Trust

Public

LP

Effective January 1, 2011, the Specified Investment

Flow Through tax will apply to all distributions of

income from income trusts to unitholders.


A Change in the LandscapeIn 2006, the prospect of several largecompanies (including BCE) converting intoincome trusts set off alarm bells in Ottawa,and on October 31, 2006, federal FinanceMinister Jim Flaherty announced that he wasimplementing the SIFT tax to level theplaying field for trusts and corporations. TheSIFT tax applied immediately to new trusts,and this effectively ended overnight any newtrust conversion activity. Existing trustsreceived the benefit of a deferral through theend of 2010, but effective January 1, 2011, theSIFT tax will apply to all distributions ofincome from income trusts to unitholders.

This unexpected change set off a wave ofactivity in the trust sector as trustees weighedtheir strategic alternatives and began toimplement strategies to maximize unitholdervalue prior to the implementation of the SIFTtax. By the autumn of 2008, many trusts had

been sold and a handful of larger trusts(such as TransForce Income Fund, CIFinancial Income Fund and AeroplanIncome Fund) had converted back intocorporations, in large part to gain greaterfinancial flexibility and access to capital or, in some cases, to eliminate limits onforeign ownership or to get out from under the growth limits imposed under the SIFT rules. Those trusts not sold or not re-converted in the short term choseinstead to continue receiving the taxbenefit of the income trust structure aslong as possible.

However, the time to act is quicklyapproaching. The SIFT tax will apply to all distributions of income beginning in January 2011, and trusts will only beallowed to convert into corporations on atax-deferred basis until December 31, 2012.

There are three principal options available to existing trusts:

• maintain the status quo;

• sell, merge or privatize; or

• convert into a corporation.

What Options DoesA Trust Have?

Maintaining the Status QuoA trust can choose to maintain its truststatus. In doing so, it will become subject to the SIFT tax and effectively be subject tocorporate tax rates on the taxable income that it distributes to unitholders and topersonal tax rates (which are generallyhigher) on taxable income that it does notdistribute. Trusts that are able to sheltertaxable income (through the application oftax pools) may choose to maintain the statusquo, at least until the end of the tax-freeconversion period in 2012. Others may findthat the advantages of conversion do notwarrant the cost and so will simply proceedafter 2012 as a fully taxable income trust.

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.

Selling, Merging or Privatizing

While a sale or merger may initially havebeen a very feasible option in the daysfollowing the announcement of the SIFT tax, current market prices and the ongoingdifficulty in obtaining acquisition financingmake a sale or merger a difficult prospect for many trusts. In some cases, privatizing atrust by selling to institutional investors opento maintaining the trust structure may be aviable alternative because private trusts arenot subject to the SIFT tax on distributions.However, in most cases, opportunities toprivatize remain very limited, except to themost successful of income trusts.


Key reasons for choosing to revert to being a corporation.

Converting into a CorporationConverting into a corporation is an optionopen to all trusts. The number of announcedconversions is increasing, and a torrent ofconversions is expected in 2010. The mostsignificant business trust conversions thathave occurred to date provided the followingreasons for choosing to convert back to acorporation in advance of the application of the SIFT tax:

• a corporate structure was better suited to their growth strategy;

• a corporate structure allowed for greateraccess to financing; and

• the trust’s valuation was at a discount to growth-oriented corporate peers.


The most often cited potential benefits of converting into a corporation include the following:

• a corporation is likely to have easieraccess to capital, given the certainty of its structure and governancerequirements;

• a corporation may have access to abroader universe of investors and analyst coverage (as trusts have beenconsidered as a separate class ofspecialty investments); and

• a corporation is not subject to tax at higher personal tax rates on taxableincome that is not distributed.

Two basic methods are available to convert a trust into a corporation on

a tax-deferred basis under the SIFT conversion rules: the Share Exchange

Method and the Share Distribution Method

Methods of Conversion

1. SHARE EXCHANGE METHOD

Under this scenario, the units of the trust are exchanged for shares of a new corporation.The trust itself is wound up (together with any subsidiary trusts).

The following simplified charts illustrate the steps involved in a Share Exchange:


PRIOR TO SHARE EXCHANGE

Fund

Trust

Public

LP

Fund

Trust

LP

LP

Newco

Public

SHARE EXCHANGE AND WIND-UP DISTRIBUTION

FINAL

Public

NewcoNewco

• Under a Share Exchange, a new company (Newco)is incorporated.

• Public exchanges theunits of the Trust forshares of Newco on atax-deferred basis withno election required.

• The Trust is wound up and then the Fund is wound up within 60 days thereafter.

ConditionsCertain conditions must be met for theautomatic rollover to apply (and to eliminate the need for the parties to file tax elections):

• the exchange must occur during a specified60-day exchange period, at the end of whichthe new corporation owns 100% of the unitsof the trust;

• unitholders must dispose of all of their trust units during this exchange period;

• unitholders must only receive shares ofNewco in return for their trust units;

• all unitholders must be issued the same class of Newco shares; and

• the transaction must occur no later than December 31, 2012.

Unitholders are then deemed to havetransferred their units at a price equal to the tax cost of the units. To the extent that the fair market value of the Newco sharesreceived by a unitholder exceeds the fairmarket value of the units exchanged for suchshares, there will be an income inclusion to the unitholder (in the case of a non-resident,such excess will be subject to withholding tax).

To the extent that the fair market value of the units exchanged by a unitholderexceeds the fair market value of the sharesreceived by the unitholder and any part of the excess can be viewed as a benefitincurred by a person with whom theunitholder does not deal at arm’s length,the excess will be an income inclusion to the unitholder. (In the case of a non-resident, such excess will be subject towithholding tax.)

Note that these fair market value issuesreferred to above may, in turn, causevaluation issues that require a valuationopinion, particularly where the newcorporation holds assets other than thenewly acquired units of the trust.

One advantage of using a Share Exchangeover a Share Distribution transaction is that the new corporation becomes aunitholder of the former trust. As a result,the corporation can access certain taxattributes of the trust.

One advantage of using

a Share Exchange over

a Share Distribution

transaction is that

the new corporation

can access certain tax

attributes of the Trust.


2. SHARE DISTRIBUTION METHOD

Like the Share Exchange Method, the Share Distribution Method allows a trust to distributeto its unitholders on a tax-deferred basis the shares of a corporation owned by the trust. The trust (whose only asset can be shares of a taxable Canadian corporation) winds up anddistributes the shares of that corporation to its unitholders.

The following simplified charts illustrate the steps involved in a Share Distribution:


Fund

Trust

Public

PRIOR TO SHARE DISTRIBUTION

EXISTING TRUST

LP

Fund

Trust

Public

Fund

Trust

LP

LP

Public

SHARE DISTRIBUTION FINAL

Public

Newco

LP

Newco Newco• The Trust is wound upand then the Fund iswound up within 60 daysthereafter.

• The shares of Newco will be distributed to thePublic on a tax-free basis(no election is needed).

• A new company (Newco) isincorporated by the Trust.

• The Trust transfers itsinterest in LP to Newco on a tax-deferred basis(election has to be filed).

ConditionsCertain conditions must be met for theautomatic rollover to apply (and to eliminatethe need for the parties to file tax elections):

• the only property of the trust is sharesof a single class of a taxable Canadiancorporation;

• the distribution occurs no later than December 31, 2012;

• the distribution occurs within a 60-day period;

• all of the unitholders’ units of the trust are disposed of; and

• there is a distribution of all of the trust’s property.

To take advantage of the Share DistributionMethod, a trust that holds assets other thanshares of a Canadian corporation must firstrestructure its affairs so that its onlyproperty consists of such shares.

Unlike a Share Exchange, a ShareDistribution transaction does not result in the new corporation becoming a unitholder of the former trust. As a result, the corporation may not access the tax attributes of the trust.

To utilize the Share Distribution

method, a trust that holds assets

other than shares of a Canadian

corporation must first restructure

its affairs so that its only property

consists of such shares.

3. OTHER VARIATIONS

In addition to a Share Exchange and a Share Distribution, there are othermethods by which a trust may convertinto a corporation on a tax-deferred basisthat may be considered in specificcircumstances. However, the criticalfactor in considering any structure is that the conversion can be implementedon a tax-deferred basis.


Deciding whether, when and by which method to convert a trust into a

corporation involves a number of (often inter-connected) factors that should

be reviewed within the context of a trust’s structure, business, tax position

and distribution policy.

Considerations


TimingThe new SIFT tax does not come into playfor existing trusts until January 2011. Assuch, any trust considering a conversionbefore then needs to determine whetherthe benefits of becoming a corporationoutweigh the tax benefits available to atrust pre-2011. Such a determinationinvolves a consideration of the followingquestions:

• What are the actual tax savings thatwill be available to the trust and itsunitholders by postponing theconversion?

• Does the market price of the trust’sunits reflect the value of the tax savingsversus those of its non-trust peer group,and what is the market “punishment”likely to be for converting before thetrust is subject to the SIFT tax?

• Can the trust sustain its distributionsthrough 2011?

• What is the strategic vision for theentity and what distribution policyaligns with that vision?

• Are there benefits to implementing a new corporate strategy earlier?

Nature of the Current Unitholder BaseThe nature of the trust’s unitholder base needs tobe examined. Initial investors in trusts typicallysought a regular return on their investment.“Income” unitholders may choose to sell if therewill be a fundamental change in strategy andcorporate dividend policy post-conversion.

Consideration must also be given to the taxramifications to both Canadian and non-residentinvestors on conversion of a new businessstructure. For example, in many cases it may bepossible to structure a trust conversion under eitherthe Share Exchange or Share Distribution methodas a tax-free rollover for U.S. unitholders. In eachcase, however, all of the particular circumstances ofthe conversion will need to be examined, includingthe tax classification of the trust as a corporation,partnership or grantor trust for U.S. tax purposes as well as the possible application of the U.S.passive foreign investment company rules,before determining the actual consequences of a conversion to U.S. unitholders.

Income trusts are bound by certain foreignownership restrictions and many have alreadyrun up against their limit. However, no suchrestrictions apply to corporations (subject to anyindustry-specific ownership restrictions). As aresult, the corporation should receive the benefitof increased liquidity.

Bank and public debt must be

reviewed for restrictions on

change of control transactions.


Effect on Existing DebtThe specific terms of a trust’s debt will need to be examined as part of anydecision to convert. Generally speaking,bank and public debt contain restrictionson change of control transactions. Anumber of questions are relevant whenexamining the issue of existing debt:

• Will the transaction trigger arepayment of the debt under anychange of control provisions?

• Is any lender consent required for the transaction? Will the lender(s)require any amendments as a resultof the new structure?

• What will happen to the public debt?Will it be exchanged? Can the publicdebtholders force a “put” right?

• Does the new tax position of thecorporation have an impact on thecorporation’s cash position and doesit affect either its financial covenantsor its ability to service the debt?

Effect on Existing Compensation ArrangementsEmployment contracts signed by the trust mayalso have similar change of control provisionsthat would trigger severance or change ofcontrol payments to employees on conversioninto a corporation. Careful consideration shouldbe given to how to deal with these provisions.

In addition, the trust should examine its othercompensation arrangements (e.g., unit purchaseplans) and determine how they should berevised to reflect the new corporate structure.The trust should also reflect on the type ofsecurityholder approval required to implementsuch a new plan.

Most conversions to date have occurred

by way of a plan of arrangement.


Effect on Existing Contracts and LicensesWhat will the impact of conversion be on theexisting contracts and licenses to which thetrust is a party? Are there any change ofcontrol or assignment provisions in business-critical arrangements that will potentiallyhave a negative impact on the conversionitself or on the operation of the businessgoing forward?

CostFinally, the trust will have to assess whetherthe costs (financial advisors, lawyers, meetingcosts, management time, etc.) warrant theincremental benefits to be obtained byconverting.

The Logistics: How Does it Happen?Most conversions to date have occurred byway of a plan of arrangement. The creation ofNewco under each of the methods describedabove allows the trust to access the applicablecorporate statutes’ plan of arrangementprocedures. This process requires unitholderapproval, which requires a special meeting.

Most arrangements provide for dissent rights (and, to date, many conversions haveprovided such rights although, in practice,they have seldom been exercised). Yet, in anarrangement where the ultimate economicownership does not change, it is unclearwhether dissent rights should automaticallybe granted in a conversion.


How Can We Help?

TorontoMark A. TrachukPartner

Tel: (416) 862-4749Fax: (416) 862-6666Email: [email protected]

Christopher S. MurrayPartner


CalgaryFrank J. TurnerPartner


MontréalWard A. SellersPartner


Osler has extensive experience in providing advice on the strategic

alternatives available to trusts. We draw upon the proficiency of legal

practitioners in our Mergers and Acquisitions, Tax, Financial Services and

Corporate Finance groups to ensure that the required expertise is brought to

bear in executing strategic decisions. Our multi-jurisdictional capabilities in

our offices in Toronto, Calgary, Montréal and New York allow our specialty

groups to consistently provide outstanding client service.

Deciding whether or not to

convert into a corporation may

be the most challenging decision

the trust will have to make.

Toronto

Montréal

Calgary

Ottawa

New York

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