On July 14, 2008, the Minister of Finance released proposed amendments to the Income Tax Act (Canada) ("the ITA") which are intended to permit the "conversion" of income trusts into corporations (the "Proposals"). The following is a brief overview of the proposed new rules. For the most part, the new rules are to apply to transactions that take place after July 14, 2008 and before 2013.
On October 31, 2006, the Minister of Finance caught the investment community by surprise when he announced amendments to the ITA (the "SIFT Rules") directed at certain publicly traded income trusts and partnerships (referred to as "specified investment flow-through" entities, or "SIFTs"). Under the SIFT Rules, SIFTs are subject to tax at equivalent to corporate tax rates on certain types of income. The SIFT Rules generally do not apply to pre-existing income trusts before 2011, provided they do not exceed "normal growth" guidelines issued by the Department of Finance.
The SIFT Rules eliminate most of the tax benefits associated with income trust structures. As a result, many income trusts are likely to consider the possibility of converting to a corporate structure, especially as the 2011 deadline draws nearer. Reasons for converting might include avoiding the constraints imposed by the "normal growth" guidelines, avoiding foreign ownership restrictions under the mutual fund trust rules, eliminating the additional administrative and compliance costs associated with income trust structures, and greater flexibility in deciding whether to distribute or reinvest profits.
Until now, one of the key impediments to converting from an income trust structure to a corporate structure has been the lack of rules permitting a conversion to take place on a tax-deferred or "rollover" basis. Under current rules in the ITA, distributions of property by a publicly-traded income trust are generally deemed to occur at fair market value, which means that on a winding up of an income trust under current rules accrued gains on property held by the trust or on units held by unit holders would be realized. The Proposals attempt to address this problem by permitting for the wind-up of an income trust on a tax-deferred basis in certain circumstances.
The Proposals effectively provide for two alternative methods of winding up an income trust on a tax-deferred basis. The first wind-up method involves a distribution by the trust of shares of a subsidiary corporation to the unitholders. The second windup method involves the transfer by the unitholders of all of their units to a corporation in exchange for shares of the corporation, followed by a winding up of the trust into the corporation.
Each alternative method requires somewhat different conditions to be satisfied, and each produces somewhat different tax results. Consequently, an income trust that is considering converting to a corporate structure will need to carefully analyze both alternative methods in order to decide which of the two is the most appropriate in its particular circumstances.
It should be noted that both alternative methods also generally permit the winding up of a sub-trust on a tax-deferred basis, provided certain conditions relating to the ownership of the sub-trust and timing of the windings up are met. On the other hand, the Proposals do not specifically deal with the winding up of lower-tier partnerships, which will continue to be governed by the existing rules relating to the winding up of partnerships.
Distribution of Shares to Unitholders
The first conversion method involves the distribution by a trust of shares of a taxable Canadian corporation to unitholders of the trust. Provided certain conditions are satisfied, the shares can be distributed by the trust to its unitholders on a tax-deferred or rollover basis (i.e., no accrued gains are triggered in the trust). On the distribution, a unitholder in the trust will generally be considered to have disposed of his or her units in the trust, and to have acquired shares of the corporation, at an amount equal to the cost amount of the units to the unitholder (i.e., on a rollover basis).
From a commercial perspective, this method for winding up an income trust is likely the easiest to implement; however, the conditions for its application are relatively narrow. The rollover rule under this alternative only applies if the sole property owned by the trust at the time it is wound up consists of shares of a taxable Canadian corporation. This means that if the trust owns property other than shares of a taxable Canadian corporation, then in order to qualify under the first method the trust will need to either convert the non-share property into shares (for example, by transferring the property to the corporation in consideration for shares), distribute the non-share property to the unitholders on a taxable basis before winding up and distributing the shares or, if the shares are held by a sub-trust, wind up the sub-trust first (which can only own shares at the time of its winding up) and then wind up the trust and distribute the shares to unitholders. Alternatively, if the trust owns property other than shares of a taxable Canadian corporation, it may be able to distribute all of its property on a rollover basis under the second alternative described below.
A significant difference between the first and second alternative methods is that the first method does not provide for the preservation of various tax attributes of the trust, whereas the second method does. This means, for example, that if the trust has prior year tax losses or financing or unit issuance expenses that it would otherwise be entitled to deduct in future years, those undeducted amounts would effectively disappear if the trust is wound up under the first method, whereas such undeducted amounts could generally be carried forward in the new corporation under the second method.
Transfer of Trust Units to Corporation, Followed by Winding up of Trust
The second conversion method involves transferring all the units of the income trust to a corporation, following which the income trust is then wound up and its property distributed to the corporation. This alternative for winding up an income trust only applies where all of the units of the trust are held by a taxable Canadian corporation. As a result, it will first be necessary to provide for the transfer of all of the units of the trust to such a corporation before the trust can be wound up under the second method.
Under current rules, a unitholder of an income trust can transfer his or her units to a taxable Canadian corporation on a tax-deferred or rollover basis, provided the unitholder and corporation jointly file an election with the Canada Revenue Agency. In the case of a widely-held income trust, requiring each of the unitholders to file a separate election raises numerous administrative and compliance difficulties. The Proposals eliminate the need for unitholders to make separate rollover elections by providing for an automatic rollover where certain conditions are satisfied (including a requirement that all of the units of the trust must be transferred to the corporation within a 60-day period). If the automatic rollover applies, it applies to all unitholders and the elective rollover is not available. On the other hand, if the automatic rollover conditions are not met, unitholders should still be able to transfer their units to a new corporation on a rollover basis under the current rules as long as the appropriate election is filed.
Assuming all of the units of the income trust have been transferred to a taxable Canadian corporation, the trust can then be wound up into the corporation. Under the second method, the trust is effectively treated as if it were a taxable Canadian corporation, and the existing rules in the ITA applicable to the winding-up of a subsidiary corporation into its parent are made applicable to the winding up of the trust. These rules generally permit property of the subsidiary (in this case, the trust) to be transferred to the parent on a tax-deferred or rollover basis. The corporate wind-up rules also generally permit various tax attributes of the subsidiary – for example, prior year tax losses or undeducted financing or unit issuance costs – to flow up to the parent. This potential ability to move certain tax attributes from the trust up to the new corporation does not exist under the first wind-up rule described above.
Although the Proposals go a long way towards making it easier for income trusts to convert to a corporate structure, there are a number of technical aspects that will likely require further tweaking by the Department of Finance; for example, the calculation of the paid-up capital of shares issued to unitholders by a corporation under the automatic rollover rule described above, or the application of certain of the corporate wind-up rules to the trust under the second wind-up rule described above. In this regard, the Department of Finance has invited interested parties to provide comments on the Proposals by September 15, 2008.
Finally, it goes without saying that any proposal to wind up an income trust will not only give rise to potential tax issues, but will raise significant commercial issues. Among other things, trustees considering a conversion transaction will need to consider the powers accorded under the applicable trust deed to undertake a conversion transaction, the rights of unitholders under the trust deed, as well as other stakeholders such as debtholders of the trust or other persons with rights to acquire units of the trust (such as holders of exchangeable partnership units in trust structures with lower-tier partnerships).
Bennett Jones LLP is a leading Canadian law firm with offices in Toronto, Calgary and Edmonton and extensive experience in providing tax and other legal advice to income trust funds. Should you wish to learn more about the recent changes described in this article, please contact any one of our tax lawyers.
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.