Canada: Guidance On Permitted Growth For Income Trusts

Last Updated: December 20 2006
Article by Corrado Cardarelli

The October 31, 2006 income trust taxation proposals indicated that "normal growth" of existing income trusts—but not undue expansion, such as the introduction of a disproportionately large amount of capital—would be permitted until the end of the transition period in 2011. On December 15, the Department of Finance announced the guidance that the markets have been anxiously awaiting on the meaning of "normal growth", "undue expansion" and related matters. This is a summary of, and some observations on, the December 15 announcement.

  1. Benchmark Capital as of October 31, 2006
  2. The key benchmark is the market capitalization of a Specified Investment Flow-Through (SIFT) on October 31, 2006. This will be measured by the value of a SIFT’s issued and outstanding publicly traded units, which does not include debt (even if the debt carried a conversion right or was itself publicly traded), options or other interests that are convertible into units. It appears that the value of exchangeable interests held by retained interest holders would also not be counted.1 It will be interesting to see how "value" will be determined (e.g., will the value be the trading price of a unit at the close of business on October 31, 2006?)

  3. Growth of 100% Permitted
  4. A SIFT may increase its capital by issuances of new equity over specified periods in specified amounts by reference to a safe harbour that is based on the benchmark. During the specified periods, a SIFT’s equity capital can grow by an amount that does not exceed the greater of $50 million and an objective safe harbour. For the period from November 1, 2006 to the end of 2007, the safe harbour will be 40% of the benchmark. A SIFT’s safe harbour for each calendar year from 2008 through 2010 will be 20% percent of the benchmark. Thus the announcement provides for growth of up to 100% over the four-year transition period. The fact that the test is expressed as the greater of $50 million and the safe harbour amount suggests that this is intended to assist smaller cap income funds to raise up to $50 million of new equity. Although it is not entirely clear from the announcement, it appears that the $50 million amount may be available in each specified period for a possible total of $200 million on the basis that the "greater of" test seems to be applied for each specified period.

  5. Safe Harbour Amounts Cumulative
  6. The safe harbour amounts are cumulative. The $50 million amounts described above are not cumulative. The example given is that a SIFT that issues no new equity in calendar 2007 will enjoy a greater safe harbour amount in 2008 (presumably, 60% of the benchmark).

    "New equity" will include units and debt that is convertible into units. The announcement notes that if attempts are made to develop other substitutes for equity, those may be included as well. The announcement does not specifically include as new equity, options or other interests (such as exchangeable interests) created after October 31 that are convertible into units of the SIFT (but the units issued on the exercise of these new options or other interests would presumably be counted as new equity). It will be interesting to see whether these post-October 31 options, etc., will be treated as substitutes for equity and thus be included as new equity.

  7. Replacement of Debt Outstanding as of October 31, 2006
  8. There is an exception to the meaning of "new equity": replacing debt that was outstanding on October 31, 2006 (whether through a debenture conversion or otherwise) will not be considered growth for this purpose. This should mean that units issued for this purpose will not count toward or otherwise affect the safe harbour. The exception seems to apply to any type of debt that was outstanding on October 31, 2006. We will watch with interest to see what parameters are ultimately placed on this exception.

  9. New Non-convertible Debt
  10. New non-convertible debt can be issued without affecting the safe harbour. However, the replacement of that new debt with equity will be counted as growth. For planning purposes, it may be possible for a SIFT to issue new equity in excess of the safe harbour amount (for an acquisition, for example) by issuing units having a value equal to the sum of (a) the amount permitted under the safe harbour and (b) the amount of debt that was outstanding on October 31, 2006. The SIFT would have to use the proceeds from the equity issuance described in (b) to repay the outstanding debt, but could borrow new non-convertible debt.

  11. New Equity Issued in Exchange for Exchangeable Interests
  12. The announcement also deals fairly generously with new equity issued to satisfy the exercise of rights that were in place on October 31, 2006 to exchange an interest in a partnership, or a share of a corporation, into that new equity. The new equity so issued will not be considered growth (and will presumably not affect the safe harbour). This matter was of concern to a number of income funds and holders of exchangeable interests. The announcement does not specifically provide for similar relief for new equity issued to satisfy the exercise of options that were in place on October 31, 2006.

  13. Merger of Two or More SIFTs Permitted
  14. The announcement also answered another widely asked question: Could existing income funds merge? It provides that the merger of two or more SIFTs, each of which was publicly traded on October 31, 2006, or a reorganization of such a SIFT, will not be considered growth if no net addition to equity results from the merger or reorganization. The most likely merger candidates will be income funds in the same business (most notably, income funds in the oil and gas sector), but merger candidates need not be so limited. It seems that a merger need not necessarily occur on the basis of the tax-free exchange mechanism provided in the Income Tax Act but could occur in other ways (such as a hostile takeover bid on a unit-for-unit exchange basis or other form of business combination). It is unclear what kinds of reorganizations are permitted, but perhaps this would include the transformation from a "fund-over-corporation" structure to a "fund-over-partnership" structure.

  15. Conversion of Trusts to Corporations
  16. The Department of Finance intends to allow conversions of SIFTs to corporations without any tax consequences to investors. The announcement states that the Department of Finance is considering the question and will make changes as required to facilitate tax-free conversions. It is possible for an income fund to incorporate its underlying entities on a tax-free basis (if they are not already in corporate form) and to wind itself up by redeeming its outstanding units in kind by distributing the shares of the underlying corporate vehicle to its unitholders. However, that transaction would normally be taxable to the unitholders. Similarly, it would be possible for a newly formed corporation to acquire all the units of the income fund in exchange for issuing its own shares to the unitholders on a tax-free basis (using the elective procedure for this purpose in the Income Tax Act) so that the unitholders would then be shareholders of the corporation; however, in that case, the corporation would continue to own the units of the income fund and it may not be possible to eliminate the income fund inside the corporation on a tax-free basis in the future.


1. However, as indicated in paragraphs 4, 5 and 6, new equity will not be considered to be "growth" for these purposes if it is issued to retire debt or on the conversion of convertible debt or on the exercise of rights under certain exchangeable interests.

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.

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