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Decisions, decisions
Income trusts might have been dealt a major blow last Halloween,
but there is a chance that the continuing uncertainty about their
future might actually come to an end shortly. On October 31, 2006,
the Minister of Finance announced that trusts, apart from REITs,
would be subject to corporate income tax within the trust (the “Halloween
provisions”). However, the tax would not be effective for
existing trusts until 2011, providing them with a tax holiday. Trust
unit prices fell precipitously after the announcement but subsequently
recovered some ground.1
On December 15, 2006, the Department of Finance provided some interpretation
surrounding the amount of permissible growth for existing trusts,
thus clarifying some of the statements in the announcement. As of
the date of publication of this article, there is still uncertainty
about whether the new provisions will be introduced and passed into
law. There are also questions about how the legislation and policy
announcements will be interpreted by the taxation authorities.
Regardless of the merits of the argument that led to the government’s
decision, trust company management will continue to operate trusts
to create needed cash flow. However, even with the tax holiday,
trust management must consider what corporate or financial structure
their company will take in the future. There are likely to be no
major moves in the near future, due to the tax holiday and the remaining
uncertainty associated with the timing and final wording of the
legislation and related policies.2
There is, however, some consolidation taking place in the sector
and several trusts have been or are rumoured to be takeover targets.
But planning is essential. Any restructuring must take into consideration
the major benefit of trusts—the continuing demand in the market
for yield-driven products and the positive impact of removing cash
from management who may invest it in non-productive ways.
Where to now?
This discussion, focused on business trusts exclusively, is intended
to identify some of the possible responses by trust management.
We recognize that there are unique elements to each trust that have
to be incorporated in the final decision about which structure is
ultimately chosen. Further, whether the market has over-or under-estimated
the impact of the tax holiday on trust values will have some influence
on the ultimate decision. We are not recommending any specific structure,
but only identify some of the underlying fundamentals requiring
consideration in any discussion about where to go from here. This
is by no means an exhaustive list.
To remind the reader, there are currently two forms of trust structure.
The original, or first generation trust, consists of a unit of internal
debt and equity on which distributions are paid. The internal debt
is structured so that at the time of its initial public offering
(IPO) or conversion, the interest component is large enough to eliminate
corporate tax. The components of the unit cannot be separated—a
major benefit of the structure since it eliminates potential problems
associated with financial distress.3
In the second generation trust, the underlying structure is a partnership
in which the trust holds securities. This means that all income
is taxed in the hands of the partners and not at the trust level.
The provisions of the October 31, 2006, announcement will apply
to Special Investment Flow Through (SIFT) entities, which include
both public trusts and public partnerships. We now turn to the possible
structures:
Option one: Find a new tax-efficient structure
During the period before the new tax treatment comes into effect,
tax lawyers and accountants will be thinking about new structures
to replicate the benefits of the previous SIFT structure. One approach
is to eliminate the trust and replace it with a corporation that
issues debt and equity, which are stapled together and trade as
a unit. These units can be broken into their debt and equity components,
each of which can trade in the market, although it is unlikely that
this would happen. The underwriters in the IPO would state that
they would make a market in these securities (or at least use their
best efforts to make a market). This is, however, unlikely to occur
given the small size of any such debt issues and the lack of liquidity
in Canada for such issues. An example of this stapled unit structure
is Timberwest Timber Trust, established in 1998. It is argued that
this structure does not rely on a trust and the proposed legislation
refers to trusts and not stapled units. There are also some U.S.-based
trusts that use this structure.
Another approach, a variation of the stapled unit, is to use the
structure that is prevalent for U.S.-based trusts, most of which
trade on the Toronto Stock Exchange. These structures are called
either income participating securities, or enhanced dividend securities
depending on the underwriter involved. There are approximately 10
of these structures currently trading on the TSX and are considered
by some to escape the Halloween provisions.4
They are structured to meet the demands of accounting firms, which
stated they would not sign trust company financial statements unless
the structure had characteristics that they believed would minimize
potential income taxrelated problems with the Internal Revenue Service
(IRS). These securities do not have a trust holding the debt and
equity but have paper-clipped debt and equity trading as a unit.
The unit can be easily undone with the underlying securities trading
separately. In addition, some of the debt is privately placed to
demonstrate that the yield on the debt is market-related. Also,
equity, separate from the unit, is listed for trading. This structure
most closely resembles the standard corporate form.
One problem with both structures, although more serious for the
IPS/EDS, is that the ability to split the unit into components eliminates
or at least reduces the benefits of the lowered costs of financial
distress. Once the units separate, the debt holders and equity holders
can have different views on outstanding payments on the debt in
the event of the company’s inability to pay interest. Further,
in the case of the IPS/EDS the outstanding debt brings into play
a third party for which cooperation with the unit holders may not
be in its best interests.5 Obtaining
consents from widely disbursed debt holders, whose interests are
not aligned with equity holders, is problematic and often very expensive.
Finally, and most important, the government signalled very clearly
in its October 31, 2006, announcement that it would look carefully
at all new structures to ensure they were not inappropriate tax-avoidance
techniques. Is the fact that these structures do not involve an
underlying trust sufficient to permit them to escape the tax ruling?
Will trustees encounter difficulty obtaining reliable, written tax
opinions on this thorny question?
Option two: Traditional to corporate structure
The Department of Finance in its December 21, 2006, announcement
was clear that there would be no tax on investors in the event of
a conversion from a trust to a traditional structure. However, there
remains uncertainty as to how trusts technically eliminate underlying
income trust entities to convert to a public corporate entity without
incurring significant tax penalties. Given our tax system where
interest payments are a tax-deductible expense, companies can create
value for shareholders by having a debt-intensive capital structure.6
The resulting debt will be of lower quality, thus generating a higher
yield. Also, the company can still pay out all (or most) of its
cash flows as dividends to investors, thereby satisfying the demand
for high distributions. In this corporate structure, as opposed
to trusts, there is no need to pay out cash flow or face punitive
tax consequences at the highest marginal personal tax rate. Also,
in the trust structure, third-party lenders restrict third-party
leverage to exceedingly modest levels as compared to the corporate
structure. The combination of high interest payments and high dividends
will provide the appropriate incentives to management in the corporate
structure to invest only in projects that are profitable. Thus,
in theory, the corporate governance benefits associated with the
trust structure can be available in the corporate form as well.
However, the benefits are not as strong as those of trusts. Unlike
the trust structure, there is no necessity to pay out all cash flows
as dividends. Missing or reducing a trust distribution is likely
to have a stronger impact on unit price than a comparable change
in dividend payments under the traditional form.
Notably, only companies whose cash flows are stable can use this
approach. Fluctuating cash flows would result in debt that is of
very poor quality and the increase in value to shareholders would
not be as great, given the possibility of default or bankruptcy.
Since investors not only want high distributions but also stable
ones, trusts with volatile cash flows will not generate high valuations
by converting to a normal structure, using limited amounts of debt
and paying substantially all of their cash flows as dividends. The
volatile cash flows will ultimately require the company to borrow
to maintain a steady dividend and this will expose the company to
risk of default.
Abandon public markets and go private
A trust structure is available if a company is private, thus making
a private placement to tax-deferred customers a possible approach.
However, to issue securities, the company will need to take advantage
of one of the exemptions permitting securities to be sold without
a prospectus. Further, to qualify for a mutual fund trust and thus
be eligible to tax-deferred investors, the trust must have in excess
of 150 unitholders. Also, as a trust, all profits need to be paid
out—there can be no retentions—or the trust pays tax
on the amount at the highest marginal personal tax rate. This can
be a problem for trusts for which cash flows are highly volatile
or where third-party debt principal repayments and/or additional
growth capital investment is required. This approach may be useful
for many stable business trusts that do not expect to need the public
markets or that might benefit from eliminating significant and evolving
regulatory burdens and investor relations costs associated with
public markets. Associated with this approach is the acquisition
of the trust by either a publicly traded company with a traditional
structure or a private equity transaction. In fact, since the October
31, 2007 announcement there have been seven takeovers launched,
including $1.9 billion in deals over the period January 2007 to
mid-February, 2007.7 The acquirers
were either traditional companies (the Labatt Breweries of Canada
takeover of Lakeport Brewing Income Fund) or private equity players
(British private equity fund Marwyn Investment Management in a $120
million deal to acquire Entertainment One Income Fund).
For the traditionaly structured acquirer, crucial variables will
be the issue of fit, current unit price, and the potential premium
that has to be paid. For private equity investors, the potential
use of leverage and price paid are crucial. Depending on the stability
of the underlying firm, private equity investors can use leverage
of six or more times EBITDA in their deals. In some cases, private
equity players will be able to offer premiums to current prices
in the 15% to 20% range. In other cases, they will be able to see
through current operating difficulties, purchase at low premiums
to current market and fix the companies without the glare of the
public markets.
In both situations where the private equity investor feels that
unit prices for trusts are too high, the premiums will have to be
much lower in order to have a profitable transaction. In these acquisitions,
the expectation is significant returns upon exit. However, due diligence
has a high fixed cost and it is more likely that larger private
equity players will focus on the larger trusts, with smaller private
equity players focusing on smaller business trusts. It is also possible
that a pool of institutional money could be generated to acquire
a diversified portfolio of trusts. Finally, unless the acquisition
is by a private trust or a current trust that doesn’t grow
above the limits set by the government, the tax holiday will be
lost.
Option three: Keep the trust structure
As a final option, the trust can keep its current structure. In
this case its distributions will be taxed at corporate rates and
the distribution will be deemed to be dividends and taxed at the
appropriate rates, including the dividend tax credit available to
non-tax-deferred accounts. The trust will still have to meet the
payout requirements of a trust. Thus, any taxable profits not paid
out will be taxed at the highest marginal personal tax rate. Unlike
a normal corporation, the return of capital element will still be
exempt from corporate tax and will be taxed in the hands of investors
as a capital gain upon sale of the security. However, this element
may be small to negligible for many business trusts, especially
those that are more mature and do not have a large growth in assets.
In addition, for trusts with stable cash flows, there can be a greater
utilization of third-party debt providing an additional benefit
through the tax deductibility of interest. To the extent a trust
would like to grow organically or by way of acquisition, it would
need to review the alternative of converting to a corporate form
early. In the corporate form, it would have access to normal leverage
levels and earnings retention policies to compete with private equity
players and other corporates for acquisitions. It is highly unlikely
that many companies will choose to remain a trust. The business
trust market is an important component of the capital market and,
eventually, there will be a large number of changes in business
trust structures over the next couple of years. In any event, it
is highly doubtful that more than a few trusts will retain their
current form beyond December 2010. The ultimate choice, and the
timing of any change, will be based on a number of variables including
the impact on the taxable status of investors and their after-tax
cash flow, the need or desire to make acquisitions, repay debt or
grow with capital expenditures, the impact on the investor’s
investment, and the need for the company to access public markets
to finance growth. Any decision will result in significant transaction
costs. The final choice must be the result of indepth analyses of
the alternatives and the need of trustees to maximize unitholder
values. Although the apparent and declining value of the tax holiday
will continue for four more years, business trusts should begin
to study their options now.
Acknowledgments
The author thanks Stephen Rotz and other industry
colleagues for valuable suggestions.
Endnotes
1. The price of the trusts should be the present
value of the untaxed cash flow until the tax is effective and the
present value of the after- tax cash flows from that time forward.
If you assume that corporate tax will occur at 30% in five years,
time, with a 10% discount rate the initial negative impact on price
upon the announcement should be about 20.5% with small reductions
thereafter until the tax is implemented.
2. Of course, in a rational market, this holiday is already included
in the current share price. However, the acquirer in any transaction
will have to be able to take advantage of the tax holiday. This
may be difficult if the acquirer is a public non-trust and even
if it is a trust, there are rules that limit the growth that a trust
can undertake during the tax holiday period.
3. In the event of distress where cash flows are insufficient to
make the interest payment on the internal debt, there is no chance
of default since the debt holders and the equity holders are the
same and there is no benefit of putting the company into default.
4. There are some companies that use this structure and trade both
on the TSX and AMEX. Also two companies with this structure trade
only on AMEX.
5. See P. Halpern and O. Norli, “Business Trusts: A New Organizational
Structure,” Journal of Applied Corporate Finance,
Summer 2006, pp. 66- 75 for a discussion of the IPS/EDS structures.
6. Company management will have to decide whether the company issues
straight or convertible debt or some combination.
7. Report on Business, February 15, 2007, p. B4
—Paul Halpern, professor of finance and TSX Chair in Capital
Markets, Rotman School of Management, University of Toronto
For a PDF version of this article, click
here.
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