Income Trust Market Update

Economic Outlook for Income Trusts

Decisions with respect to any particular income trust will depend in part on the economic outlook for the economy as a whole and the relevant sector in particular. While there are always uncertainties about any forecast, it is clear that Canadian economic growth will be negative in the order of minus-three percent in 2009 and weakly positive in the order of one-and-a-half to two percent in 2010. Inflation is likely to remain below the Bank of Canada target in 2009 and 2010 and hence the policy interest rate is likely to remain extremely low at least through this period. Growth in 2011 and 2012 is likely to be stronger but excess capacity is unlikely to be eliminated much before the latter part of 2012. The best planning assumption is for the Canadian economy to be operating at capacity in 2013 and for global demand for commodities to be strong once again.

David A. Dodge, O.C., Senior Advisor at Bennett Jones LLP, Former Governor of the Bank of Canada

At the height of the income trust boom, there were more than 250 publicly-traded income trusts in Canada with a total market capitalization in excess of $200 billion. Today, just under 200 trusts remain, with a total market capitalization of less than $100 billion.

The tax changes announced in October 2006, which will prevent income trusts (other than certain qualifying REITs) from continuing to deduct income distributions for tax purposes, become effective in 2011. Since the introduction of tax legislation in July 2008 to facilitate tax-deferred conversions, approximately 15 income trusts have converted or announced their intention to do so. Though management and trustees of income trusts will, by now, have given preliminary consideration to conversion, many have deferred making a final decision until closer to the end of 2010 in the face of current economic and market conditions.

Deadline for Conversion Decision

Publicly-traded income trusts in existence on October 31, 2006 can still continue to enjoy the tax-free holiday on income distributed to unitholders until the end of 2010 provided that the “normal growth” guidelines are not exceeded. After that time, the effective rate of tax for these trusts will approximate that applicable to corporations and income will, effectively, be distributed to unitholders as dividends.

The tax conversion rules permit these trusts to convert to corporations on a tax-deferred basis at any time up to the end of 2012 and, depending upon the conversion method selected, to transfer the tax attributes of the income trust to the new corporation. Depending upon a trust's particular tax situation, it may defer a conversion decision until the end of 2012 if the impact of the tax change during the preceding two-year period is not expected to be material.

Alternatives Available

There are many considerations to be taken into account in determining whether to convert now, the most important question being whether the non-tax benefits of immediate conversion outweigh the benefit to the income trust of the remaining 18 months of tax holiday. However, depending upon the income trust's business strategy, financial and market outlook and other considerations, there may be other more attractive alternatives to conversion, such as putting the income trust up for sale, merging with another income trust, being taken private by a significant unitholder or a management-led buy-out, converting to a U.S. master limited partnership if there are significant U.S. unitholders or assets, or “staying the course” and restructuring to achieve tax efficiency prior to 2011.

Convert Now

Key reasons for deciding to convert now include: ??

• If the income trust wants to grow through acquisitions: the trust's tax holiday on income distributions will immediately terminate if the trust exceeds the “normal growth” guidelines; as well, if the trust wants to fund acquisitions through the issue of its own securities, shares of a corporation may be more highly valued than trust units as financial performance of shares may be more easily valued relative to corporate industry peers and selling shareholders of the acquired entity could receive tax-deferred rollover treatment if paid in shares.
• ??If the income trust wants to grow organically: the “normal growth” guidelines restrict capital-raising efforts, which could be problematic for capital intensive industries. ??
• If the income trust will reduce or suspend distributions: if distributions have been or will be reduced or suspended because of liquidity problems or because the trust plans to reinvest income in acquisitions or other expenditures, the loss of the tax holiday may not be a concern; reducing or suspending distributions generally significantly impacts market price of the units since income fund investors are typically yield-focused and the certainty of conversion may be attractive to new financers or investors.
• ??If the income trust has an increasing number of foreign investors or needs access to foreign capital: the trust (other than certain trusts in the energy sector) will not be able to maintain its advantageous tax status as a “mutual fund trust” if it is considered to be established or maintained primarily for the benefit of non-residents; most trusts have provisions in their governing documents restricting non-residents from owning 50 percent or more of the outstanding units.
• ??If conversion will have a tax neutral effect until end of 2010: if the income trust has other bases on which to reduce its taxable income (such as tax depreciation, tax pools or tax losses), then early termination of the trust's tax holiday may not be adverse.

Wait and See

Reasons an income trust may defer a conversion decision until closer to the end of 2010, apart from losing the tax holiday, include:

• ??If the income trust does not want to be a take-over target: the potential for churn in an income trust's units on announcement of conversion, and the resulting market price drop, will make the trust a more attractive take-over target.
• ??If sale of the income trust or merger is a more desirable alternative: deferring a conversion decision to 2010 (or even 2012) may see the benefit of increased M&A activity; a merger transaction with another trust will not normally be considered growth terminating the tax holiday.

Stay the Course

And finally, if there are no significant benefits to conversion, an income trust might stay the course and not convert, but structure its affairs to remain as tax efficient as possible. However, in making such decision the trust must consider: ??

• The end of the transitional tax conversion rules on December 31, 2012: not converting to a corporation by 2012 may significantly impair the ability of the income trust to structure a future conversion on a tax neutral basis and will result in forfeiting the ability to transfer certain tax attributes to the new corporation. ??
• Complexity and cost: the cost of restructuring to improve tax efficiency, as well as the administrative cost and burden of maintaining the income trust structure.