Minister spells out

Late Friday, hours after markets had closed and after many advisors had gone home for the weekend, the federal finance minister provided guidance on what he construes as “normal growth” for income trusts. The new guidelines are expected to result in a sizable increase in the number of new financings and mergers within this space.

The latest notice says the Ministry of Finance views “normal growth” as any capital increases as a result of new equity by an amount that does not exceed the greater of $50 million and an objective “safe harbour” amount.

The safe harbour amount will be measured against the income trust’s market capitalization as of October 31, 2006, in terms of the value of the trust’s issued and outstanding publicly traded units, excluding debt, options or other interests that were convertible into units of the trust.

According to the statement, for the period from November 1, 2006, to the end of 2007, the safe harbour for existing income trusts will be 40% of the October 31, 2006, benchmark. Each year afterward through to 2010, an income trust’s safe harbour will be 20% of that benchmark. Together, this will allow for growth of up to 100% over the four-year transition period.

Specifically, the notice says the merger of two or more publicly traded income trusts or a reorganization of such a trust “will not be considered growth to the extent that there is no net addition to equity as a result of the merger or reorganization.”

The notice also removed some of the anxiety from existing trusts that will likely convert back to a corporation at the end of their four-year tax holiday by removing any tax consequences to investors from the conversion.

The guidance reduced the ambiguity from Finance Minister Jim Flaherty’s October 31 announcement of his intention to slap a distribution tax on all new income trusts (existing trusts were granted a four-year transition period). The concern was over Flaherty’s comment in that announcement that while he would not interfere with the “normal growth” of income trusts, any “undue expansion” of an existing trust could result in the loss of grandfathering.

“What the guidelines have done is just given us a little more certainty that over the next four years, in large part, it is business as usual,” Les Stelmach, an income trust analyst based in Calgary who works closely with Leslie Lundquist on the Bissett Investment Management income trust funds.

Many trust experts had speculated that some trusts would forgo the tax holiday by converting back to a corporation if the constraints on growth were too restrictive. The notice on Friday eased some of those concerns. “I think this removed one potential lever that might have got a number of trusts to convert back to corporation quicker,” says Stelmach.

“We see value in that tax holiday,” he says. “Now that there are specific guidelines in place for trusts in terms of their growth of what they can issue in terms of equity, I think the convert to corp scenario has been potentially reduced.”

The guidelines will also be embraced companies that plan to growth through acquisitions, particularly those in the oil and gas sector. In absence of those guidelines, there was some concern as to how much equity they could issue. “This has certainly given them more flexibility than what they had imagined in a worst-case scenario.”

The news is expected to be well received by the market. “The guidelines are more generous and practical than many anticipated,” according to a taxation bulletin put out by the Toronto law offices of Blakes, Cassels & Graydon LLP. As a result of the changes, Blakes anticipates a “significant increase in new financings and mergers of [specified investment flow-throughs], many of which have been on hold since the October 31 announcement.”

Blakes found Flaherty’s confirmation that mergers between trusts may not result in a loss of grandfathering to be particularly welcoming, as this will “eliminate a major potential obstacle to currently contemplated mergers in the income trust and royalty trust sectors.”

Greg Boehmer, a tax partner with Ernst & Young agreed. “The proposed guidelines seem generous enough to allow for the execution of most existing business plans,” he says. The news should allow the trust sector to proceed with more confidence, he added.

Still, there are some gaps in the guidelines that require further clarification. “This is very much a good news, bad news scenario,” says Boehmer. While he welcomes the guidelines, he notes that they are in the form of draft legislation and lack specificity. With a minority government in place, and the possibility of a spring election being threatened by the opposition parties, it is possible that none of these proposals will become law under the current government.

Filed by Mark Brown, Advisor.ca, mark.brown@advisor.rogers.com

(12/18/06)