Originally published in Blakes Bulletin on Securities Law, February 2007
With approximately 250 income trusts in Canada, representing an aggregate market capitalization of almost C$200 billion, income trusts form a significant part of the Canadian capital markets. Until recently, however, there had been limited M&A activity involving Canadian income trusts as targets, outside of the more mature oil & gas and real estate investment trust (REIT) sectors. This may have been due in part to the relatively high valuations afforded income trusts in the Canadian public markets, and the fact that the "business" income trust sector (consisting generally of businesses outside of the resource and real estate sectors) has really only emerged in the past five years.
On October 31, 2006 the Canadian federal government announced proposed changes to Canadian tax laws that will significantly reduce or eliminate the tax advantages of Canadian income trusts. The new proposals, when implemented, will create a tax regime for most publicly-traded trusts and partnerships and their investors that will, in effect, be similar to that for public corporations and their shareholders. For income trusts with units listed on a stock exchange or other public market before November 1, 2006, the tax changes would commence beginning in the 2011 taxation year, providing a four-year "grandfathering" period. For more information about these proposed tax changes, see the following issues of Blakes Bulletin on Taxation: November 2006 – Canadian Minister of Finance Announces a Proposed New Tax Regime for Income Trusts and Public Limited Partnerships; December 2006 – Department of Finance Provides Guidance on "Normal Growth" for Income Trusts on December 15, 2006; and January 2007 – Taxation of Income Trusts and Other SIFT Trusts. The October 31 announcement caused an immediate negative impact on the trading prices of the units of most income trusts on the Toronto Stock Exchange. While there has since been some recovery, most observers foresee a permanent reduction in value and possibly further declines as 2011 approaches.
Even before the October 31 announcement, the Canadian market was beginning to experience an increase in M&A activity involving income trusts, including the first unsolicited take-over bids for business income trusts, a bid for PBB Global Logistics Income Fund by Livingston International Income Fund (October 2005), and a bid for Atlas Cold Storage Income Trust by an affiliate of Avion Group HF (August 2006). Many analysts and market participants in Canada predict this M&A activity will accelerate as a result of the proposed tax changes, and a number of M&A transactions have been announced or completed in late 2006 and the early part of 2007. Recent transactions include:
- a take-over bid for Calpine Power Income Fund by Harbinger Capital Partners (December 2006)
- the purchase of the operating subsidiary of Halterm Income Fund by an affiliate of Macquarie Infrastructure Partners (December 2006)
- the proposed purchase of Lakeport Brewing Income Fund by Labatt Brewing Company Limited (announced in February 2007)
- the privatization of Bell Nordiq Income Fund by its majority unitholder Bell Aliant Regional Communications Income Fund (January 2007) and the proposed privatization of Great Lakes Carbon Income Fund by Rain Commodities (USA) Inc. (announced in February 2007).
This Blakes Bulletin focuses on legal issues particular to M&A transactions involving income trusts and real estate investment trusts (REITs)1.
What Are The Terms Of The Income Trust’s Declaration Of Trust?
An income trust is created under a Declaration of Trust or similar agreement and is not governed by business corporations legislation. A Declaration of Trust is an agreement that establishes the trust, sets out the relationship between the trustees of the trust and the unitholders, and governs the activities of the trust. For an income trust, the Declaration of Trust is in essence the equivalent of a corporation’s governing statute, articles and by-laws. Among other things, the Declaration of Trust provides for:
- the attributes and entitlements of the income trust’s units
- the procedures for calling and holding unitholder meetings and voting of units
- unitholder approval of fundamental transactions, such as mergers or the sale of all or substantially all assets
- a mechanism for unitholders to approve amendments to the Declaration of Trust, often with the ability to do so by written resolution of the holders of a specified percentage of outstanding units
- a compulsory acquisition mechanism that may be utilized by an offeror following a successful take-over bid.
The Declaration of Trust is usually drafted to be similar to equivalent provisions in Canadian business corporation statutes in many (but not all) respects, and to conform to market standards. However, each Declaration of Trust is unique. The differences between a particular Declaration of Trust and equivalent provisions of corporations legislation can be highly significant in an M&A context.
Is There A Retained Interest And What Are Its Terms?
In many income trust initial public offerings, an equity ownership stake was retained by the vendor(s) or sponsor(s) of the income trust’s underlying business. This is commonly referred to as a "retained interest". A retained interest in an income trust is typically held in the form of units of a subsidiary limited partnership, or shares of a subsidiary corporation, that are exchangeable for units of the publicly-traded income trust at the option of the retained interest holder. In some cases, the rights of the retained interest holders to receive cash distributions are "subordinated" to those of the income trust’s unitholders for a period of time or until certain conditions are satisfied. In these cases, the retained interest generally cannot be exchanged for trust units until the subordination period has ended.
The terms and size of a retained interest can significantly impact a potential M&A transaction. Some considerations include:
- the retained interest holder will typically have the right to exchange its interest for units of the income trust, on a conditional basis, in order to tender the underlying units to a take-over bid made for units of the income trust (even where the retained interest is subordinated)
- retained interest holders are often entitled to vote at meetings of unitholders of the income trust together with holders of trust units (by virtue of "special voting units" of the income trust or a similar entitlement), and therefore would be entitled to vote on a proposed transaction requiring unitholder approval
- the size or terms of the retained interest may not allow an acquiror to implement a compulsory acquisition or non-consensual going-private transaction to obtain 100% ownership, necessitating a negotiated transaction
- the terms of the retained interest may include "coat-tail" provisions that could require a purchaser of the retained interest to make a take-over bid for all of the units of the income trust in certain circumstances.
The holder of a retained interest may also have governance rights in relation to the income trust or its subsidiary entities, such as special approval or veto rights over particular transactions, rights to board representation and pre-emptive rights. In some cases, particularly where the income trust’s operating business was formerly a division or subsidiary of another public company, there may be important commercial contracts (such as management or supply arrangements) between the income trust and the retained interest holder as well. Such rights may give the retained interest holder substantial leverage in any proposed M&A transaction.
Income Trust Distributions
Income trusts make regular (typically monthly) cash distributions to unitholders, and unitholders will expect to continue to receive distributions pending completion of an M&A transaction. Distributions are usually payable to holders of record on the last business day of each calendar month, and paid within 15 or 30 days of the end of the month. An M&A transaction involving an income trust should permit the income trust to continue making its regular cash distributions pending completion of the transaction. The applicable distribution record dates and payment dates should be taken into account when determining the pricing and timing of completion of an M&A transaction. Unitholders expect to receive cash distributions for the month in which they held units of the income trust, so completing a transaction late in a calendar month, but before the record date for distributions, will likely not be popular unless unitholders are compensated for the "lost" distribution. Once a distribution record date occurs, unitholders are entitled to the distribution declared for the applicable month. If an acquisition is completed after a distribution record date, but before payment of the distribution, the parties will need to make provision for payment of the distribution to persons who held units on the record date, even if all the units have subsequently been redeemed or acquired.
THE LEGAL FRAMEWORK FOR INCOME TRUST M&A
Canadian Provincial Securities Laws Apply
Income trusts are "reporting issuers" under Canadian provincial securities laws, and those laws will apply to a take-over bid or other M&A transaction involving an income trust as they would for any other public issuer. In particular:
- the take-over bid rules of Canadian provincial securities laws will apply to a take-over bid for an income trust
- the proxy solicitation and information circular rules of Canadian provincial securities laws will apply to any transaction that is to proceed with the approval of the income trust’s unitholders at a meeting of unitholders
- Ontario and Québec rules relating to "business combinations", "going-private transactions" and "related party transactions" will apply to M&A transactions involving income trusts. These rules impose formal valuation and minority securityholder approval requirements on, among other things, compulsory acquisitions and second step "squeeze-out" transactions. Exemptions from some of these requirements will often be available in an arm’s length acquisition, provided that specific procedures are followed and disclosures made.
A unitholder-approved acquisition of an income trust may proceed in a number of different ways, depending on the objectives of the parties and the structure of the target income trust. Examples of possible acquisition structures include:
- the acquiror may subscribe for units of the income trust in return for the acquisition consideration proposed to be paid to the public unitholders, with the target income trust then redeeming all of the publicly-held units in return for such acquisition consideration
- the acquiror may purchase equity and debt securities of one or more subsidiary entities of the income trust from the income trust in return for the acquisition consideration, with the income trust then redeeming all of its units in return for such acquisition consideration, with the trust ultimately being terminated
- the acquiror could purchase all of the assets of the operating subsidiary of the target income trust in return for the acquisition consideration, with the acquisition consideration being distributed through the income trust structure and ultimately to unitholders, with the trust ultimately being terminated.
In each case, approval by the income trust’s unitholders will be required for a number of elements of the transaction, including (i) the disposition of all or substantially all assets by the income trust or a subsidiary of the income trust, and (ii) amendment of the target income trust’s Declaration of Trust to provide for mandatory redemption of its units.
To implement such a transaction, the target income trust must hold a unitholder meeting to seek approval of the transaction by a special resolution of unitholders. In most cases, the threshold for approval will be an affirmative vote by at least twothirds of the votes cast by unitholders in attendance and voting on the resolution. If retained interest holders have been granted voting rights, as described above, those votes will typically be counted together with the votes of the income trust’s unitholders for the purposes of unitholder approval.
For a unitholder-approved transaction such as those described above, there will typically be an agreement between the acquiror and the target income trust, as in other friendly M&A transactions. Such an agreement would be expected to contain customary provisions relating to calling and holding of the unitholder meeting, conduct of business by the target, and deal protections such as a break fee, a non-solicitation covenant and/or a right for the acquiror to match other offers.
A cash transaction will be a taxable event for Canadian resident unitholders (other than tax-exempt unitholders). Generally speaking, unitholders would be expected to prefer a transaction in which they receive returns of capital and/or capital gains treatment rather than income from a Canadian taxation perspective. This can usually be achieved if the acquiror purchases units of the income trust directly from unitholders, and may also be possible where the income trust sells securities of a subsidiary to the acquiror and distributes the proceeds of sale to unitholders.
If the consideration consists of securities of the acquiror, it may be possible to structure a transaction that is tax-deferred for unitholders. For example, where both parties in an M&A transaction are income trusts, and the acquisition consideration consists of units of the acquiror, a transaction may be structured as a "qualifying exchange" transaction under the Income Tax Act (Canada) and achieve a tax deferral for the unitholders of the target income trust. This method was utilized in the acquisition of Calpine Natural Gas Trust by Viking Energy Royalty Trust in 2005 and the privatization of Bell Nordiq Income Fund by Bell Aliant Regional Communications Income Fund in January 2007.
As with shares of a public company, units of an income trust may be acquired by formal take-over bid. Take-over bids are subject to the requirements of applicable Canadian provincial securities laws, including:
- the prospective acquiror (referred to as the offeror) must prepare and send to the target’s securityholders a take-over bid circular in prescribed form
- a take-over bid must remain open for acceptance for a minimum of 35 days, and the offeror may not take up securities tendered to the bid until the minimum 35-day period has elapsed
- take-over bids may be made subject to conditions, other than a financing condition
- neither the offeror nor any person acting jointly and in concert with the offeror may enter into any collateral agreement, commitment or understanding with a holder of the target’s securities that has the effect of providing that holder with consideration of greater value than that offered to other securityholders (commonly known as the prohibition on collateral benefits).
A take-over bid can be made with the support of the trustees and management of the income trust. However, such support is not required and a take-over bid can be made on an unsolicited basis without any agreement from the target. It is often possible to complete a take-over bid more quickly than a unitholder-approved transaction.
A cash take-over bid will be a taxable event for Canadian resident unitholders (other than tax-exempt unitholders). As with unitholder-approved transactions, where securities are offered as consideration, it may be possible to structure a take-over bid in a manner that achieves some tax deferral under Canadian income tax laws for unitholders.
ACQUIRING 100% OF THE TARGET INCOME TRUST WHERE THERE ARE NON-TENDERING UNITHOLDERS
A take-over bid for a publicly-held issuer is unlikely to achieve 100% acceptance. As a result, in any take-over bid the offeror will be concerned with how to ultimately acquire 100% of the target issuer. If the target of the take-over bid is an income trust, the process for implementing a compulsory acquisition or other second step transaction can differ, sometimes significantly, from that employed for a corporate target.
Under most Canadian business corporations legislation, where an offeror makes a take-over bid for a class of shares and the offer is accepted by the holders of at least 90% of such shares (excluding those held by the offeror) within 120 days of the date of the bid, the offeror is entitled to acquire the remaining shares of the class through a compulsory acquisition procedure. Shareholders of the target corporation who did not tender to the bid are entitled to the same consideration as that offered in the take-over bid, or to demand "fair value" for their shares and apply to a court to fix such fair value if they do not accept an offer made by the offeror (typically referred to as an appraisal right).
Most income trusts have a compulsory acquisition provision in their Declarations of Trust, but there may be differences from the corresponding rights and procedures found in business corporations legislation. For example:
- a Declaration of Trust may require that a take-over bid for the income trust achieve 90% acceptance within a shorter period of time than the 120 days provided under corporate law (such as 90 or even 45 days) for a compulsory acquisition to be available to the offeror. Such a short period of time may pose difficulties for an offeror, particularly where the take-over bid is unsolicited. In some cases, offerors have sought to lengthen this period, or reduce the threshold to 66-2/3% acceptance, by having tenders to the bid also constitute approval of a written resolution consenting to desired amendments to the Declaration of Trust, as described below.
- a Declaration of Trust will often not include an appraisal right for non-tendering unitholders. Without an appraisal right, the second step transaction will at first instance constitute a "business combination" or "going-private transaction" subject to the formal valuation and minority approval requirements of Ontario and Québec related party transaction rules, although there is an exemption for a second step business combination that should be available if proper disclosure is made in the take-over bid circular.
Other Second Step Transactions
As an alternative to a compulsory acquisition, an offeror that acquires 66-2/3% of a Canadian target corporation will typically seek 100% ownership by implementing an amalgamation, share consolidation or other shareholder-approved "going-private" transaction. While there is no statutory procedure for an income trust to amalgamate with another entity, the same objective can be achieved by amending the target’s Declaration of Trust to provide for the mandatory redemption of all non-tendered units in return for the consideration offered in the take-over bid.
Any such transaction will likely be a "business combination" or "going-private transaction", subject to the formal valuation and minority securityholder approval requirements of Ontario and Québec related party transaction rules. In general, if prescribed disclosures are made in the take-over bid circular, a second step transaction will be exempt from the valuation requirements. While minority approval will still be required, if prescribed disclosures are made and certain other requirements are met, the offeror should be permitted to vote units acquired in a take-over bid as part of the "minority" in any required "majority of the minority" approval for a second step transaction.
Amending The Declaration Of Trust By Written Resolution
Second step transactions and, in some cases, compulsory acquisitions involving an income trust will usually require amendments to the target’s Declaration of Trust. Canadian corporate law requires 100% consent for a shareholder resolution in written form, but most income trusts permit amendment of the Declaration of Trust by written resolution of the requisite percentage of unitholders (typically 66-2/3%). This has proven useful to offerors who have, in a number of cases, sought to make desired amendments to facilitate second step transactions through a "consent solicitation" as part of a take-over bid. To make amendments in this way, the offeror’s take-over bid circular will state that tenders to the take-over bid will also constitute approval of a special resolution, in written form, approving desired amendments to the target’s Declaration of Trust. Under Ontario and Québec related party transaction rules, approval for such amendments is required to be obtained at a meeting of unitholders, and therefore exemptive relief from the applicable securities commissions will be required to permit the amendments to be made by written resolution. This exemptive relief has been granted on a number of occasions.
1. For simplicity, we will refer only to income trusts in this bulletin, but the issues discussed would generally be expected to apply equally to REITs, royalty trusts and other publicly-listed trusts.
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.