Income Funds
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Stephen N. Pincus had a swift and significant impact on the Notice of Ways and Means Motion. The
Jon Northup Canadian income fund sector. In the Conversion Rules provide income funds
Jarrett Freeman following two trading days, the S&P/TSX (and other publicly listed flow-through
Goodmans LLP Capped Income Trust Index dropped by entities) with tax-efficient mechanisms to
more than 16 per cent. Although most of convert to corporate form before they
Income Fund Update: Strategic this value was recovered by June 2007, the become subject to entity-level taxation.
and Structural Alternatives and government’s proposals effectively froze Since the release of the Conversion
the Conversion Rules further growth of the sector. Other than a Rules, 35 income funds have commenced
Canada’s income funds must review few REITs, no new income fund IPOs or and/or completed a corporate conversion.
their strategic and structural alternatives in conversions have been announced since the However, a number of income funds have
light of turbulent market conditions, as introduction of these proposals. The announced their intention to delay any
well as the looming SIFT tax, which growth of existing income funds has been fundamental structural reorganization until
generally will apply to them beginning in restricted by the limitations imposed by the shortly before the grandfathering period
2011. This article will discuss the current grandfathering rules. Furthermore, the expires, and it is expected that many others
challenges facing income funds, review impending change in income funds’ tax will follow suit. Moreover, certain income
certain of their key alternatives and explore status, combined with an active M&A funds may decide to retain their current
some of the factors that may influence market, led to a significant number of trust structure even after the new entity-
boards and management in reviewing these Canadian income funds being taken level tax becomes effective. Whether it is
alternatives. The article will also provide an private. Between October 31, 2006 and in the best interests of an existing income
overview of the new rules which facilitate February 6, 2009, the number of public fund to convert to corporate form, and the
the conversion of income funds to income funds in Canada decreased from appropriate timing of such conversion, is a
corporations. 254 to 178. complex analysis that will depend on
Canadian income funds also suffered various strategic factors, including the
Introduction during the recent market turmoil. From fund’s underlying business, its investor
The tremendous growth enjoyed by the June 17, 2008 to March 9, 2009, the base, management’s future growth plans
Canadian income fund sector came to an S&P/TSX Capped Income Trust Index and current market conditions.
abrupt halt on October 31, 2006 with the declined by approximately 56 per cent.
surprise announcement by the Department While the Index has since grown by Development of the Canadian
of Finance (Canada) (“Finance”) of approximately 55 per cent, the embedded Income Fund Sector
proposals to tax certain public trusts (other M&A/privatization premiums have Canadian income funds were first
than qualifying REITs) and limited generally disappeared. developed in the mid-1980s and initially
partnerships in the same general manner In response to current market focused on owning oil and gas properties
as corporations. Prior to these proposals, conditions and the impending end of the (royalty trusts) and real estate (REITs).
these entities were effectively treated as grandfathering period, many income funds Commencing in the late 1990s, a growing
flow-through entities for Canadian tax have initiated a review of their strategic and number of operating businesses in a wide
purposes and, as such, were not subject to structural alternatives, including the variety of industry sectors were also
entity-level taxation. The proposed rules possibility of converting back to corporate organized as income funds. The Canadian
were intended to eliminate the perceived form. However, effecting a corporate income fund sector grew from 52 income
“tax imbalance” created by income funds conversion using existing tax rules funds with an aggregate market
and thereby stem the swelling tide of presented a number of administrative and capitalization of C$20 billion in 2000 to
public corporations converting to income technical challenges, and the resulting 254 income funds with an aggregate
funds. For existing income funds that were corporate structure was often cumbersome. market capitalization exceeding C$218
publicly listed or traded prior to November Accordingly, on July 14, 2008, Finance billion in October 2006. Income fund
1, 2006, these taxation measures will not be addressed these deficiencies by releasing equity offerings represented approximately
effective until 2011 (the “grandfathering draft legislation to facilitate the conversion 40 per cent of the dollar value of all equity
period”), provided the entity does not of income funds into corporations on a tax- offerings on the Toronto Stock Exchange
exceed certain equity growth limitations deferred basis (the “Conversion Rules”). during 2005. The tremendous growth in
during this period (as discussed in more The Conversion Rules, with slight the income fund sector was fuelled by
detail below). revisions, were recently tabled in investor appetite for meaningful cash
The announcement of these proposals Parliament as part of the February 2, 2009 distributions, a low interest rate
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environment and volatile corporate equity The SIFT Tax market capitalization is defined as the
markets after the “dot-com bubble” burst. Enacted into law on June 22, 2007, the aggregate fair market value of the income
The proliferation of income funds in new tax measures apply to specified fund’s publicly traded units on October 31,
Canada was, in part, attributable to the tax investment flow-through trusts and 2006.
efficiency of the income fund structure. partnerships (“SIFTs”). In general, most
While several different generations of publicly listed or traded income funds that Strategic and Structural
income fund structures were used by hold significant investments in Canadian Alternatives
Canadian issuers, the principal objective of assets will constitute SIFTs. Historically, In response to current market
the structure – to maximize value by an income fund that distributed all of its conditions and the impending imposition
distributing pre-tax cash flow to income to unitholders would not be subject of entity-level tax, many income funds
unitholders – remained the same. to any entity-level tax because the have begun a review of their strategic and
Income fund structures generally distributions were deductible in computing structural alternatives. This analysis is often
involved a Canadian resident trust its taxable income. Once effective, the new complex, as there are a myriad of
completing a public offering and using the rules eliminate this deduction for SIFT commercial, capital market and tax related
proceeds of such offering to indirectly trusts in respect of distributions paid out of factors that may influence this review. The
acquire an interest in an underlying “non-portfolio earnings”. Instead, these following sections briefly explore certain
business. While the precise structure of distributions generally are subject to tax at alternatives available to Canadian income
Canadian income funds varied the combined federal and provincial funds and consider some of the factors that
significantly depending on a number of corporate tax rates. Unitholders who may influence the viability and
factors, income funds typically adopted one receive distributions that were subject to attractiveness of each of these alternatives.
of two general structures. the SIFT tax are deemed to have received
In “first-generation” corporate-trust a taxable dividend from a taxable Canadian 1. Corporate Conversion before
structures, the public trust held debt and corporation, such that Canadian 2011
equity of a subsidiary operating corporation. unitholders will be entitled to the As noted above, a number of income
To the extent possible, interest on this debt enhanced dividend tax credit in respect of funds have commenced and/or completed
would be structured to reduce or eliminate such distributions. the process of converting to a public
the corporation’s tax liability. This would For purposes of the SIFT tax rules, non- corporation. The decision to convert
permit the pre-tax cash flow of the portfolio earnings will include income from depends on, among other strategic factors,
operating corporation to be distributed to businesses carried on in Canada, income the particular income fund’s underlying
the income fund, and from the income fund from “non-portfolio properties” (other than business, its investor base, its tax
to investors, without the imposition of any certain dividends) and capital gains realized characteristics, current market conditions
corporate (or other entity-level tax). In on the disposition of non-portfolio and management’s future strategy in
“second generation” partnership-trust properties. Non-portfolio properties respect of capital expenditures, acquisitions
structures, the public trust would (indirectly generally will include significant and distributions. Certain principal
through a subsidiary trust) hold the investments in Canadian resident considerations that arise in connection
operating business in a subsidiary limited corporations, trusts and partnerships, with converting before the grandfathering
partnership. Because the limited partnership Canadian resource properties, timber period expires include:
was a flow-through entity for Canadian tax resource properties and real property Tax holiday: Existing income funds that
purposes, the operating income of the situated in Canada. convert to corporate form before their
business could flow out to investors, again As noted above, existing income funds 2011 taxation year will forfeit their
without the imposition of any entity-level that were publicly listed or traded prior to grandfathered flow-through status. A
tax. However, as noted above, many November 1, 2006 will not be subject to the decision to convert early, and the future
Canadian income funds adopted more SIFT tax until 2011, provided that the entity cash tax costs of doing so, must be weighed
complex structures to accommodate does not exceed certain equity growth against the perceived non-tax benefits of
complex business arrangements. limitations during the grandfathering period. converting (discussed below). The future
The Conversion Rules discussed below In general, an existing income fund is tax costs of converting will depend on the
are intended to facilitate the conversion of permitted to issue new equity during the income fund’s inherent shelter, including
all Canadian income funds, regardless of grandfathering period (October 31, 2006 to tax loss carryforwards and/or tax attributes
structure. December 31, 2010) at least equal to its of its underlying entities (e.g., tax
market capitalization. For these purposes, depreciation and other tax pools), which
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can be used to offset future taxable income. investors will typically have phantom process typically involves a meeting of
In addition, the relevance of an income income (i.e., taxable income without a unitholders to vote on the conversion. In
fund’s flow-through status will depend, in corresponding distribution of cash). Such order to achieve cost synergies, an income
part, on its investor base. As a result of the adverse tax consequences may restrict the fund may include the conversion approval
introduction of the eligible dividend rules, ability of an income fund to make as part of its 2010 annual meeting (and
taxable Canadian individuals investing discretionary adjustments to its payout then wait until the end of 2010 before
through an income trust or corporation are levels. By contrast, a public corporation implementing).
subject to approximately equal integrated may change its dividend policy without
tax rates. However, non-residents and tax- adverse tax consequences. This gives the 3. Maintain Trust Status Beyond
exempts (including RRSPs) generally boards of public corporations more 2011
continue to benefit significantly from an flexibility with respect to use of their cash Although existing income funds will be
income fund’s flow-through status. resources (for example, retaining cash to taxable in a manner similar to corporations
Foreign ownership restrictions: Income finance capital expenditures or acquisitions in their 2011 taxation year, there are certain
funds are subject to restrictions in respect rather than distributing such funds to differences between the new tax rules and
of permitted level of foreign ownership. In investors). Accordingly, income funds that the corporate tax regime, as further discussed
general, an income fund cannot be are re-evaluating how they use below. A decision to remain in trust form
considered to have been established or distributable cash generated by their must be made in light of the fact that the
maintained primarily for the benefit of business may consider converting before Conversion Rules will no longer be available
non-residents of Canada, and most income 2011. to income funds as of January 1, 2013.
funds restrict non-residents from holding, Non-tax considerations: There are a Qualifying REITs: The SIFT tax rules
in the aggregate, 50 per cent or more of number of non-tax considerations that may do not apply to REITs that satisfy certain
outstanding fund units. Income funds with lead an income fund to consider converting income and asset tests. Accordingly, it is
substantial non-resident holders may be to corporate form before 2011. For expected that many existing non-qualifying
willing to convert to corporate form, example, it may be easier to raise capital in REITs (which are currently grandfathered
thereby foregoing the benefits of the a corporate structure; corporate shares may until 2011) will restructure their affairs to
extended tax holiday, to attract additional be a more readily acceptable acquisition become qualifying REITs to sustain their
foreign capital. currency; and corporate shares may attract flow-through status beyond 2011.
Normal growth limitations: As higher valuations (particularly if the Foreign source income: An income
discussed above, the grandfathering from income fund sector becomes less liquid). fund may be able to structure
the SIFT tax until 2011 is contingent upon distributions of foreign-source income
existing income funds not exceeding 2. Corporate Conversion as of without any liability under the SIFT tax
certain equity growth limitations. Annual 2011 rules. The potential flow-through nature
limitations on permitted growth were It is expected that a number of existing of this income is particularly attractive to
recently removed allowing income funds to income funds will decide to optimize the non-resident and tax exempt
accelerate their remaining growth room. tax benefits of their current flow-through unitholders.
Income funds with active acquisition structure by waiting until shortly before Return of capital: The new taxation
strategies that are approaching their 2011 to convert to corporate form. In measures do not affect the ability of trusts
normal growth limitations will likely be addition to maximizing their tax holiday, to distribute “returns of capital”. In certain
more open to early conversion as, once other implications for existing income circumstances, this will continue to be a
these limits are exceeded, they will no funds of waiting to convert include: significant distinction between trusts and
longer be able to benefit from the Planning for SIFT tax: Existing income public corporations, which are generally
continued tax holiday. funds may consider implementing planning prohibited from making tax-deferred
Distributable cash flexibility: Income measures to maximize tax deductions and returns of capital.
funds are generally required to distribute to losses available once they become a taxable
their unitholders an amount equal to their corporate entity. For example, by not 4. Sale or “Going Private”
taxable income in order to preserve the tax deducting discretionary items (such as tax Transaction
efficiency of the flow-through structure. In depreciation) from taxable income, an As noted above, many income funds
circumstances in which the income fund income fund will preserve deductions for reacted to the new tax proposals by
does not have sufficient cash (or does not future taxation years. pursuing a sale or “going private”
wish to use its cash) to make distributions, Conversion Process: The conversion transaction (more than 30 such
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transactions have taken place since to structure a conversion in a manner that have cost in their new shares equal to the
October 31, 2006). However, adverse fully benefits from the Conversion Rules. cost amount of their exchanged units.
conditions in global credit markets The Conversion Rules permit two basic Where desired, the conversion may be
generally have significantly reduced the tax-efficient conversion strategies. In structured to permit a unitholder to
number of such transactions. general, income funds may convert by transfer other units on a taxable basis;
It should be noted that the Conversion either (i) having unitholders directly however, the Conversion Rules include a
Rules discussed below are not limited to exchange their income fund units for stop-loss provision that generally prevents
internal reorganizations; they may apply shares of a corporation (the “Exchange unitholders from realizing losses on the
where an existing Canadian corporation Method”), or (ii) redeeming the exchange. The Conversion Rules also
(whether public or private) completes an outstanding income fund units by contain an anti-avoidance provision which
acquisition of an income fund and the distributing to unitholders the shares of an generally applies where the fair market
acquiror wishes to rationalize the target underlying corporation that directly or value of the disposed units is not the same
corporate structure on a tax efficient basis indirectly owns the business (the as the common shares received pursuant to
following the acquisition. However, “Distribution Method”). The conversion the exchange. In these circumstances, the
structuring an income fund merger or strategy best suited for a particular income excess may be deemed to be a taxable
acquisition pursuant to the Conversion fund will depend on its current structure, shareholder benefit.
Rules will give rise to additional its tax attributes and other factors. Following the transfer of all income
considerations including: fund units to the corporation (whether or
Single class of share consideration: The Exchange Method not the transfer was tax-deferred in respect
Unitholders are only entitled to automatic The Conversion Rules include a new of some or all holders), the Conversion
tax-deferral if the acquiror corporation automatic rollover provision, whereby a Rules further permit the corporation to
issues one class of shares as consideration unitholder may exchange all or a portion rationalize its corporate structure by
for the income fund units (although it of its income fund units for shares of a dissolving the income fund and any
appears that the acquiror may have other corporation on a tax-deferred basis, subsidiary trusts on a tax-deferred basis.
classes outstanding). In addition, the provided that the following conditions are There are two separate provisions available
acquirer must be a taxable Canadian satisfied: to effect this rationalization. The first
corporation. provision (the continuity provision) ties
• the disposition takes place during a into the rules that permit the tax-deferred
Effective Date of Conversion period of no more than 60 days, at the dissolution of a corporate subsidiary into
Rules end of which all of the outstanding its parent, and will generally allow the tax
The Conversion Rules generally apply to equity of the income fund was owned attributes (e.g., losses and undeducted
conversions that occur after July 14, 2008 by the corporation; financing expenses) of the underlying
and before 2013. Finance intended that • the unitholder does not file a tax trust(s) to flow through to the corporation.
these rules would only be transitory and, election in connection with the transfer; In particular, this provision allows a trust
accordingly, the Conversion Rules will no and to dissolve and distribute all of its property
longer be available as of January 1, 2013. • the unitholder receives only shares of a to its sole beneficiary on a tax-deferred
single class of the corporation in basis if:
The Conversion Rules consideration for the income fund units
As noted above, the Conversion Rules that are transferred on a tax-deferred • the distribution of property by the trust
addressed many of the principal basis. occurs prior to 2013, and it results in a
substantive, technical and administrative disposition of all of the interests in the
issues that would typically arise on a For Canadian tax purposes, the particular trust;
corporate conversion and provide income exchange will be automatically tax-deferred • a Canadian corporation is the only
funds with a number of alternative in respect of those exchanges that satisfy beneficiary of the income fund. In
mechanisms to rationalize their resulting the foregoing conditions (i.e., there is no relation to a wind-up of a subsidiary
corporate structure on a tax-deferred basis. need to file a tax election). Unitholders will trust, the income fund must be the only
However, the Conversion Rules are be deemed to have disposed of these units beneficiary of the subsidiary trust. In
complex and an income fund must for proceeds of disposition equal to the cost these cases, the provisions require that
carefully consider its particular amount of their units (such that no taxable the subsidiary trust be wound up before
circumstances, and those of its unitholders, gain is realized), and will be deemed to the income fund;
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• where applicable, the income fund • the distribution occurs prior to 2013, the Distribution Method (to date, three
must be wound up within 60 days and it results in a disposition of all of income funds have done so), the
after the subsidiary trust is wound up; the interests in the particular trust; conversion may be implemented either
and • the property distributed to unitholders through a plan of arrangement or a special
• the trust must file a written election is shares of a Canadian corporation and meeting of the unitholders of the income
with the Minister where it disposes of the shares distributed are of a single fund. Under either approach,
property that is shares of a Canadian class; and implementation of the conversion
corporation. • where applicable, the subsidiary trust is transaction generally will require 662/3 per
wound up before the income fund and cent unitholder approval.
The second provision (the liquidation the reorganization is completed within Additional considerations in respect of
provision) permitting a tax-free 60 days after the subsidiary trust is the corporate conversion process include
dissolution of an income fund post- wound up. the following:
conversion applies where the property Fairness opinion: Approximately two-
distributed by the trust(s) consists only The Distribution Method is thirds of the conversions announced after
of shares of a single class of a Canadian effected, using the liquidation provision, the release of the Conversion Rules have
corporation, and the trust(s) does not on a tax-deferred basis for both the obtained an opinion from a financial
file the election mentioned above. income fund (and, where applicable, a advisor confirming that the conversion
Although the corporation is entitled to subsidiary trust) and its unitholders transaction is fair for unitholders.
wind-up the underlying trusts on a tax- without the need to file any tax Distribution policy: While certain
deferred basis pursuant to this second elections. For Canadian tax purposes, income funds have maintained
provision, the existing tax attributes of the income fund and unitholders are distribution levels (for example, because
the trust(s) will not be available to the deemed to have disposed of their of significant tax attributes available to the
corporation. property for proceeds of disposition corporation to minimize the effect of
equal to their cost amount; unitholders corporate-level taxation) others have
The Distribution Method will be deemed to have cost in the new reduced distributions in connection with
As noted above, the Distribution public corporation shares equal to the the conversion. Consideration should be
Method is effected by distributing to cost amount of their units. However, the given not only to the appropriate
unitholders the shares of an underlying Distribution Method does not allow the quantum of dividends post-conversion
corporation in redemption of their units. tax attributes of the income fund (or any but also to the timing of such dividend
In some circumstances, the Distribution subsidiary trusts) to flow through to the payments.
Method will be the simpler of the two public corporation. Internal reorganizations: In certain
corporate conversion strategies to circumstances, it may be desirable to
implement. Conversion Procedure implement certain transactions prior to
For example, under a typical “first The majority of corporate conversions completing a corporate conversion. For
generation” corporate-trust structure, the announced after the release of the example, where intercompany debt is
income fund would capitalize the Conversion Rules have used the underwater, consideration should be given
subordinated debt of the operating Exchange Method and have been to managing debt forgiveness implications.
subsidiary into shares and then distribute undertaken pursuant to a plan of In addition, the rationalization process
all of the shares of the corporation to its arrangement. We expect this to continue provides a good opportunity for the
unitholders in redemption of their trust to be the most popular procedure for corporation to consider whether the
units. The Distribution Method may be converting an income fund. However, efficiency of the structure may be improved
effected on a tax-deferred basis where: where a conversion is implemented using going forward. ■
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Stephen N. Pincus, Goodmans LLP
Tel: (416) 597-4104 • Fax: (416) 979-1234 • E-mail: spincus@goodmans.ca
P artner, Executive Committee member, head of one of the firm’s business law groups, and Chair of
REITs and income securities practice. Extensive practice in corporate, M&A, private equity, corpo-
rate and project finance, healthcare and cross-border transactions. Has led many major transactions, includ-
ing Canada’s largest equity offering in the past decade, first mutually initiated REIT merger, largest ever
income securities IPO, first healthcare REIT, first cross-border REIT, first cross-border income fund, first
offering of IPSs, and first high-dividend common share IPO of a US business. Recognized as a leading
lawyer by Lexpert®, Best Lawyers, Chambers & Partners, IFLR, Euromoney, PLC and Law Business
Research. Clients include Canadian, US and international corporate and investment banks, private equity
funds, and public/private companies. Advises boards on corporate governance and was retained by Indus-
try Canada to lead a study of income fund governance. MBA and LLB (Gold Medalist). Chair of Gov-
ernance Committee and a director of CAIF. Founding Chairman and a director of the Canada/South
Africa Chamber of Business. Author of The Canadian REIT Handbook.
Jon Northup, Goodmans LLP
Tel: (416) 597-4228 • Fax: (416) 979-1234 • E-mail: jnorthup@goodmans.ca
T ax Partner. Practice focuses on corporate/commercial transactions, including corporate finance, M&A,
corporate reorganizations, international planning and private equity. Has extensive experience advis-
ing issuers and investment dealers on structuring and taxation of income funds, REITs and similar offer-
ings, including advising on numerous initial public offerings. Advised Medical Facilities Corporation in
the first IPO of income securities offered solely in Canada, and advised each of Atlantic Power Corpora-
tion, Student Transportation of America and Keystone North America on its IPO of income securities.
Subsequently advised Keystone on its reorganization to a common share structure. Also advised GMP
Capital Trust on its conversion to a corporation. Frequent speaker in both Canada and the United States
on topics related to income securities and REITs. Recognized as a leading tax lawyer by The Best Lawyers
in Canada and Chambers Global and by Lexpert® for income funds. Named as one of Canada’s top 40
under 40 lawyers” in 2006 and one of “Canada’s 20 Corporate Lawyers to Watch” in 2007 by Lexpert® mag-
azine. Admitted to the Ontario Bar (2000).
Jarrett Freeman, Goodmans LLP
Tel: (416) 849-6023 • Fax: (416) 979-1234 • E-mail: jfreeman@goodmans.ca
T ax Associate. Practice focuses on various corporate and international tax matters. Has provided tax
advice on a number of mergers, acquisitions and income fund and REIT offerings, including Norilsk
Nickel’s C$6.8 billion acquisition of LionOre Mining, Keystone North America’s non-cash rights offer-
ing, Morneau Sobeco Income Fund’s acquisition of Shepell•fgi, the conversion of Charter Realty Hold-
ings Ltd. into a REIT and the conversion of GMP Capital Trust to a corporation. Obtained his LLB
from Osgoode Hall Law School in 2004 and was called to the Ontario Bar in 2005.
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