Copyright 2011, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Income Trusts, September 2011
In December 2010, Eagle Energy Trust closed its initial public offering (IPO) of trust units in Canada, resulting in the first of a new generation of cross-border income trusts to access the Canadian capital markets. Since then, Parallel Energy Trust completed its IPO in April 2011 and Argent Energy Trust has recently filed a preliminary prospectus for a proposed IPO.
Each of these new trusts owns or will acquire an underlying energy business carried on in the U.S. However, and as discussed in further detail below, there is generally no restriction on other types of U.S. businesses being owned by these income trusts. The suitability of a particular business for these trusts will largely turn on the results of economic modelling based on anticipated deductions in computing U.S. income (i.e., deductions for interest, depreciation, depletion, etc.).
Owners of U.S.-domiciled energy or other businesses, including corporations and private-equity funds, as well as dealers and brokers, may find that the new generation of Canadian cross-border income trusts provides an attractive monetization opportunity for stable, long-lived income generating energy and other assets.
This Blakes Bulletin provides an overview of the new generation of cross-border income trusts, highlighting various tax, securities and commercial issues that must be evaluated when considering this structure.
Background on First Generation of Income Trusts
From the time the first Canadian royalty trust, which owned producing Canadian oil and gas assets, became a publicly traded entity in Canada in the late 1980s, the use of the trust model expanded to include publicly traded trusts owning a wide array of resource and other businesses that were generally carried on principally in Canada. In 2006, in the Canadian oil and gas subsector alone, there were 31 royalty trusts and income funds with a combined market capitalization of over C$83-billion.
In simple terms, the first generation of income trusts was structured to flow through all taxable income generated by an underlying business to holders of units in the trust, resulting in neither the trust nor any of its subsidiaries paying Canadian federal income tax. The holders of such units often received preferential tax treatment on distributions from the trust, and where such units were held by non-taxable entities or in tax-deferred plans, the net result was a complete tax deferral on the income distributed to such holders. These vehicles paid holders of units regular monthly cash distributions on a pre-tax basis thus providing yield-oriented investors with an attractive investment product, particularly over the past decade of relatively low interest rates. Their tax-efficient structures also allowed these trusts to acquire assets on a tax-advantaged basis resulting in a cost of capital that was often more competitive than could be achieved by corporate issuers.
On October 31, 2006, the Minister of Finance (Canada) announced the Canadian federal government's proposal to change the tax treatment of publicly traded income trusts through the enactment of the "SIFT rules". The SIFT rules were introduced to level the playing field between publicly traded income trusts and corporations and eliminated the tax advantages associated with the use of a trust. Essentially, under the SIFT rules, the Canadian-source income of certain publicly traded mutual fund trusts would be subject to an entity-level tax at a rate comparable to the combined Canadian federal and provincial corporate tax rate and the income distributed to holders of units in such trusts would be taxed as dividends.
The proposed SIFT rules, which were ultimately enacted through amendments to the Income Tax Act (Canada) (ITA), had a dramatic impact on Canadian capital markets and immediately curtailed the introduction of these vehicles. As a result of the adoption of the SIFT rules, many royalty trusts and income funds converted to corporations or were acquired by third parties. By way of illustration, by September 30, 2010, there remained only 12 oil- and gas-focused royalty trusts and income funds, with a combined market capitalization of C$51-billion and virtually all of these entities converted to corporations by December 31, 2010 or are expected to do so by December 31, 2012.
Overview of New Generation of Cross-Border Income Trusts
The successful IPO by Eagle Energy Trust in December 2010 re-introduced the income trust model to Canadian capital markets, resulting in what appears to be a rapidly developing sector involving this new generation of income trusts. This new generation of income trusts involves key structural refinements compared to the first generation of trusts in order to respond to the SIFT rules, but on balance, these new income trusts look familiar to investors in the Canadian capital markets relative to the large population of income trusts that existed in Canada before October 31, 2006.
As with the first generation of income trusts, the new generation of cross-border trusts are established and operated so as to qualify as "mutual fund trusts" under the ITA, which allows them to avoid payment of any federal income tax provided all income of the trust is distributed to holders of its units in the year. In general terms: (i) a mutual fund trust must be restricted to investing its funds in property (and it may not directly carry on business), (ii) the units of such a trust must be (a) qualified for distribution to the public and be distributed to the public with at least 150 holders of units holding not less than a minimum number of units and (b) redeemable on demand, and (iii) the trust cannot be established or maintained primarily for the benefit of non-residents of Canada. Interestingly, the restriction on non-resident ownership in a mutual fund trust does not apply if all or substantially all of the trust's property is not "taxable Canadian property" (TCP), which aligns with the requirements of the SIFT rules (discussed below) that also preclude the ownership of TCP by the trust. As a result, one of the sometimes vexing issues faced by the first generation of income trusts – how to regulate the level of non-Canadian ownership of a trust's units – is no longer an issue with the new cross-border income trusts, which would allow greater placement/ownership of the units of these trusts in the U.S. (subject to U.S. securities law considerations) and potentially U.S. listings.
Under the SIFT rules, a publicly traded trust or other flow-through entity (e.g., a partnership) cannot at any time in a taxation year carry on business in Canada or hold any "non-portfolio property", including the securities of Canadian or certain foreign entities unless such entities qualify as a "portfolio investment entity", which is an entity that does not itself carry on business in Canada and does not hold any "non-portfolio property". For the purpose of these rules, non-portfolio property generally includes:
- Securities of a corporation resident in Canada, a trust resident in Canada, a Canadian resident partnership (unless the entity qualifies as a "portfolio investment entity");
- Securities of a non-resident person or partnership if its principal source of income is one or any combination of sources in Canada (unless the entity qualifies as a "portfolio investment entity");
- Canadian real, immovable or resource property if at any time in the taxation year the total fair market value of all such properties is greater than 50% of the equity value of the trust; and
- Properties held by the trust that the trust (or a person or partnership that does not deal at arm's length with the trust) uses in the course of carrying on business in Canada.
As a result, a properly constituted trust that invests in a U.S.-domiciled energy or other business (which is itself not a non-portfolio property) through entities that qualify as portfolio investment entities is not subject to the SIFT rules, and income derived from such a business is eligible for the flow-through treatment that was available to the old generation of income trusts pre-SIFT rules. These trusts are also designed to allow income of the underlying business to be flowed back to the Canadian income trust through interest on notes issued by an underlying U.S. operating entity to the trust and dividends and other distributions in the most tax-efficient manner possible so as to minimize overall tax leakage within the trust structure for an extended period of time.
The income trust elects to be treated as a corporation for U.S. income tax purposes to provide certainty with respect to eligibility for the benefits of the Canada-United States Income Tax Convention and the applicable rate of U.S. withholding taxes. Additionally, certain U.S. business items (jurisdictional/state taxes and federal landholdings) may further affect structuring decisions in the U.S. It is also essential that inter-entity debt within the income trust structure that is used to shelter taxable income be respected as such for U.S. interest deductibility purposes.
The Canadian IPO Process
U.S. vendors who seek to monetize U.S.-domiciled assets by vending such into a Canadian income trust will need to understand the process by which an IPO can be completed in Canada, from a timing, diligence and securities law perspective. A number of the key considerations in this regard include:
- The IPO process in Canada can take three to four months, including time required to negotiate the definitive acquisition agreement relating to the assets or business to be indirectly acquired by the income trust, the drafting of structure and administration documents for the income trust and its subsidiaries, completion of due diligence, drafting and clearing a prospectus with Canadian provincial securities regulators and completion of marketing activities relating to the sale of the trust's units to public investors;
- Both the income trust and the underwriters will undertake detailed diligence investigations relating to the U.S. assets or business to be acquired, including commercial, title, environmental, and interest deductibility due diligence, and the trust and the underwriters will require substantial certainty on purchase price adjustments, rights-of-first-refusal and third-party/regulatory consents required prior to closing of the IPO;
- It will be necessary to consider whether the vendor of the U.S. assets or business will constitute a "promoter" under Canadian provincial securities laws, which analysis may turn on the role of the vendor in founding, organizing or substantially reorganizing the business of the income trust;
- Canadian provincial securities laws require that the prospectus for the IPO includes three years of audited (plus interim unaudited) financial statements relating to the underlying business to be acquired by the income trust or, in the context of an oil and gas business, operating statements and an engineering evaluation of oil and gas assets prepared in accordance with such securities laws, and historical operating information relating to the business to be acquired by the income trust; and
- Other key issues including corporate governance considerations, founder and executive compensation matters, stock exchange listing requirements and escrow/lock-up requirements for founders and insiders.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.