Income Trust Tax Choices

Written By D. Bernard Morris

Key Elements of?? the Tax Changes:

• After December 31, 2010, publicly-traded income trusts (other than certain REITs) will no longer be able to deduct income distributions for tax purposes.
   
• Breach by an income trust of "normal growth" guidelines or foreign ownership restrictions will trigger immediate taxation. ?
   
• New tax conversion rules, applicable until the end of 2012, will allow income trusts to convert to a corporation on a tax-deferred basis:
   
  • ??No joint tax election will be required;
     
  • ??The tax attributes of the income trust (e.g., depreciation, tax pools, tax losses, Canadian exploration expenses and undeducted financing expenses) may be carried over to the new corporation; and ??
     
• Subsidiary entities may be wound up on a tax-free basis.

The new tax regime announced by the federal government in October 2006 for specified investment flow-through entities (SIFTs) is designed to achieve tax neutrality on Canadian source business profits earned by income trusts and corporations. Grandfathering rules permit SIFTs in existence at the time of announcement to defer application of this regime until 2011. Beginning January 1, 2011, distributions of most kinds of income to unitholders by a SIFT will be subject to the SIFT tax. A trust that qualifies as a REIT is excluded from these rules.

The government's transitional tax rules dealing with the conversion of a trust to corporation address two principal considerations on a conversion: the treatment of security holders of the income trust and the treatment of the income trust (and any subsidiary entities). The tax conversion rules generally permit the conversion to corporate form to occur on a tax-neutral basis for both security holders and the income trust (and any subsidiary entities) and, in some cases, also permit the tax attributes of the income trust to be carried over to the new corporation.

The conversion rules, when introduced, contained a number of uncertainties and deficiencies, many related to the treatment of debt, both internal to the structure and external. However, amendments to the rules introduced prior to their enactment in March 2009 substantially eliminated these issues. In the result there are relatively few interpretive issues and it is generally not necessary to apply for an advance tax ruling to do a conversion.

Tax Factors Impacting a Conversion Decision

Income trusts are faced with deciding whether and when to convert or to pursue other alternatives. There are numerous factors to be considered in deciding when and if to convert. Our previous update, Income Trusts – Decision- Making Checklist, listed many of the relevant factors. Certain key tax factors are elaborated upon here.

The value to a trust of postponing the application of the SIFT tax depends both on its unitholders and the nature of its distributions. Deferring the SIFT tax typically has greatest value to tax exempt, low income and non-resident unitholders. However, where a substantial portion of a trust's distributions consist of capital, all unitholders benefit from maintaining the trust structure. Capital cannot generally be returned tax-free in a corporate structure.

Trusts having only foreign business may currently be structured so that no SIFT tax would be payable, and therefore a conversion may not be beneficial for tax purposes. However, these cross-border trusts frequently relied upon the use of entities that are characterized differently for Canadian and U.S. tax purposes. Effective January 1, 2010, the terms of the recently enacted Fifth Protocol to the Canada-United States Tax Convention (1980) may alter the tax treatment of such structures.

A trust that exceeds "normal growth guidelines" will immediately become subject to the SIFT tax. The guidelines are administrative and in general terms permitted the trust to grow by the greater of $50 million annually (or, if the maximum annual growth took place, $250 million in aggregate from 2006 to 2010, inclusive) and a cumulative safe harbour amount of 100 percent of the trust's October 31, 2006, market capitalization (80 percent to December 2009 and 100 percent to December 2010). The guidelines were amended in late 2008 to accelerate the $50-million growth limit for 2009 and 2010 to permit an immediate issue of $100 million of new equity subject to the SIFT's cumulative safe harbour amount, which may permit more. Given the general drop in market capitalizations since 2006, this limitation on growth may not prove to be an issue.

An income fund that is established or maintained primarily for the benefit of non-resident persons loses its status as a fund. This will likely not be a concern unless the U.S. capital markets are becoming the main source of investor liquidity, in which case early conversion is advisable.

The New Tax Regime

The rate of tax on SIFT income is intended to mimic the combined Canadian federal and provincial corporate tax. Distributions of SIFT income are treated as eligible dividends which are taxed at preferred rates. The total tax on distributed SIFT income (SIFT level tax and individual tax) approximates the tax that would be paid by the individual on trust income received prior to the SIFT regime or on dividends received from a public corporation.

A number of early trust conversions have involved structuring intended to shelter trust income from tax for a number of years following the conversion. This serves to offset the entity level tax cost of converting prior to the 2011 deadline (i.e., the corporate tax payable), but does not address the loss of the ability to return capital. The main reason to defer conversion until at least 2011 and possibly beyond is to retain the ability to make distributions of capital to unitholders.

The transitional tax conversion rules are scheduled to expire at the end of 2012. It is possible for a trust to convert using "normal" tax rules, but the procedure would at best be cumbersome and may not be entirely tax-free. A trust seeking to preserve its ability to make tax-free capital distributions should nonetheless determine the impact of converting after 2012 without the benefit of the transitional tax conversion rules.