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The deadline for income trusts to convert to corporate form or face new taxes is fast approaching. Accordingly, large numbers of income trusts in Canada are seeking counsel from their financial and legal advisors regarding conversion. Although a few trusts have decided not to convert, the overwhelming majority are strongly considering a conversion, have already converted, or have initiated the conversion process.

Background

Beginning in 2003, income trusts became increasingly popular in Canada  as an alternative business structure. The income trust structure provides companies the advantage of shifting their tax burden on to the investor. On October 31, 2006, the Canadian federal government announced a new tax regime for specified investment flow-through trusts (SIFTs). Under the new regime, amounts distributed by SIFTs will be subject to taxation at corporate tax rates, as opposed to their previously favourable tax treatment.  Following several draft versions and despite significant opposition from the financial community and other lobbyists, the tax legislation for the conversion of an income fund into a taxable Canadian corporation received royal assent on March 12, 2009.

As of January 1, 2011, income trusts will be taxed at a corporate tax rate of 31.5% in respect of certain distributions made to unitholders. This change will go into effect immediately for new income trusts created.  For existing trusts as of October 31, 2006 , the new tax rules will take effect as of January 1, 2011 , provided that the trust does not undergo any significant expansion prior to the deadline.

At the time of the announcement in October 2006, there were 254 income trusts listed on the Toronto Stock Exchange (TSX). Since that time, the number has decreased to just under 200.  A large number of these "missing" trusts have either completed a sale of their assets, merged with an existing corporation or have themselves converted into a corporation.  There have been eleven conversions since 2007 and approximately thirty trusts have completed a merger or acquisition transaction. 

The federal government has incentivized trusts to complete the conversion. In July 2008, the Minister of Finance introduced two different methods to enable a trust to convert into a public corporation without suffering any significant adverse tax consequences for the trust itself or its unitholders: the Exchange Method and the Distribution Method.

Conversion Methods

The Exchange Method gives unitholders of a trust the chance to transfer their units to a corporation in exchange for shares of the corporation on a tax-deferred basis. In addition, this exchange can be affected without the need for a joint election to be filed by either the unitholder or the corporation. 

The Distribution Method is applicable in a scenario where a trust´s only asset is shares of a taxable corporation. With this approach, the trust can wind-up and distribute the shares of the corporation to its beneficiaries on a tax deferred basis. In other words, the trust transfers all of its assets to a company in return for shares of that company.

Unitholder Approval

Either form of conversion requires 66 2/3% unitholder approval. As such, RiskMetrics Group (RMG) has issued the following proxy voting guidelines. RMG will generally recommend voting against a conversion if:

• The conversion triggers change of control payments or accelerates vesting of options.
• The conversion resolution is bundled with an equity compensation plan resolution that does not require separate unitholder approval.
• The conversion authorizes the issue of preferred shares with undefined attributes by the new corporation, which may subordinate the rights and value of common shares and be used as a take-over defense.

In all other cases, RMG makes its voting recommendation on a case-by-case basis considering the following factors:

• The method of conversion, i.e., exchange or distribution.
• The rationale for early conversion ahead of the deadline.
• A comparison of one-year and three-year historic annual distribution yields with proposed annual dividend yields.
• The impact on equity-based compensation plans, features of new plans and whether or not the approval of these plans is bundled with approval of the conversion.
• Whether the conversion will trigger a change of control (regardless of whether a change of control payment will be triggered).
• The costs of implementing the conversion.
• Market reaction - Historical market performance dating back to October 30, 2006, the day before the announcement of changing tax rules; market response to the conversion announcement.
• The proposed corporate governance structure of the new corporation, including the new capital structure.
• Whether unitholders are granted dissent rights in connection with the conversion.

It is therefore very important for the income trust to clearly outline the rationale and benefits of the proposed conversion in its proxy circular including the specific terms and any other matters proposed for approval. In most cases in order for an existing trust to take advantage of conversion, they must complete the conversion by January 1, 2011.  Due to the benefits afforded by conversion, we expect the number of conversions to increase significantly in 2010.