Feds issue rules for trust conversions

Income trust investors have been given a slightly clearer picture of what they can expect of trusts that decide to convert into corporations before legislation taxing trust distributions goes into effect in 2011.

The key announcement from the Department of Finance on the trust conversion rules is that there will be no tax incurred by either unitholders or the income trust to make the conversion to a corporation before the 2011 deadline.

For the most part, those who watch the trust sector say this announcement will have little to no impact on trust prices since the federal government had verbally committed to this when it announced it would tax income trusts in 2006. Nevertheless, it still provides peace of mind for income trusts since they will have flexibility to convert to a corporation if that is a better business model for them.

For many companies, there are little to no tax advantage to staying in an income trust structure after 2011. According to Warren Pashkowich, a transaction tax expert with Ernst & Young, the new guidelines provide a roadmap for how trusts can make the conversion.

“What this does is pave the road for the migration from the income fund structure to the corporate structure,” he says.

Pashkowich says this will also allow certain trusts to eliminate a dual format they are currently running, in which corporate structures exist under a larger income fund — in his opinion, an inefficient structure.

“Quite simply, it comes down to the fact that trusts are vehicles that cannot transact on a tax-deferred basis with a corporation. As a result, physically combining the operations under an income fund with other operations that are in corporate form is potentially problematic,” he says. “You end up running a dual structure, so from an administrative perspective, it becomes very difficult. It’s also difficult to consolidate the income of all of the operations if you have to carry them on with two different forms.”

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For investors in income trusts, today’s announcement has little to no impact, other than there is no longer any risk of their trust holdings having to incur additional tax charges if they convert to a corporation, says Leslie Lundquist, portfolio manager of the Bissett Income Fund.

“I think this was already expected in the markets. Broadly speaking, since the government indicated they didn’t want to tax investors when a trust converted, that was mostly discounted in the market. It should not come as really any kind of surprise,” she says.

At this juncture, the only concern for investors should be whether their holdings will continue to offer a distribution if they do convert to a corporation, Lundquist says.

“There will probably be some early conversions of income trusts that really weren’t about generating income but [about] avoiding paying taxes at a corporate level. Those trusts are the ones who are running into difficulty. They can’t really afford to pay their distribution. They need to convert in order to have an excuse to reduce their distribution,” she says. “If a company keeps their distribution, a rose by any other name will smell just as sweet. If we can continue to get the same distribution from Yellow Pages Income Fund, even though it calls itself Yellow Pages Corp., that’s fine by me.”

She adds, “To me that’s the real question over the trust market. It’s not so much the details of how to convert or what they convert to. The real question is strategically, does the board and management team believe they can continue to pay out a high level cash flow to investors? Do they want to? Would it be appropriate to do so?”

Gavin Graham, chief investment officer for Guardian Group of Funds, expresses similar sentiment about the announcement. He believes the structure of the income trust is virtually irrelevant after 2011 for income-oriented investors.

“Theoretically, if you are concerned with the distribution, you should not care if it’s a corporation or a trust,” he says. “If it was ordinary income that was being distributed previously, you were paying tax at a marginal rate. Now you’re paying tax; therefore, on a net basis as a taxable investor you’re no worse off than if you’re a non-taxed investor like a pension fund, RRSP or a fund investor.”

Graham points out the one difference investors might see after a conversion is a drop in valuation that will likely correspond to any cuts the company may make to a distribution.

“Keystone North America, which is a small funeral home operation, actually turned itself from an income participation security into a corporation and cut the distribution by 16%,” he says. “They pointed out if you were a taxable Canadian investor, you were no worse off because on a net basis, your income was the same. What happened was the share price went down 16%. Even though people are theoretically aware they are no worse off, if there is a cut announced with the distribution, the share price seems to fall in line with that.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(07/15/08)

Mark Noble