Canada: The Rise And Fall Of Canadian Income Trusts

Canadian income trusts flourished in the earlier part of this decade and provided significant tax benefits to their investors, particularly to investors exempt from Canadian income tax and investors not resident in Canada. As a result of Canadian tax changes to impose entity level taxation on Canadian income trusts, these benefits have been eliminated, and it is expected that only a small number of income trusts will exist after the changes are fully effective on January 1, 2011. This article reviews the rise of income trusts in Canada, the Canadian tax changes that are leading to the fall of income trusts, what has happened in the income trust market since the announcement of the rules and alternative structures that may provide tax benefits similar to income trusts.

Canadian Income Trusts

General Description of Income Trusts

The term "income trust" is generally used to refer to a publicly traded trust that is resident in Canada and a "mutual fund trust" for the purposes of the Income Tax Act (Canada). Income trusts are generally classified as business income trusts, royalty trusts or real estate investments trusts ("REITs"). Royalty trusts are income trusts whose principal asset or assets are one or more royalty interests in resource property. REITs are income trusts whose principal activity is the renting, leasing or licensing of real property. The term business income trust is a catch-all term describing all income trusts that are not REITs or royalty trusts.

Typical Income Trust Structures

An important reason for the popularity of income trusts is the tax efficiency they provide. While trusts resident in Canada are generally taxable on their income at the highest marginal federal and provincial tax rates, a mutual fund trust can receive a deduction for income it distributes to its unitholders and so can avoid entity level taxation. Figure 1 depicts two typical business income trust structures.

The Trust-on-Partnership structure is generally more effective than the Trust-on- Corporation structure as it relies on the flow-through nature of partnerships and trusts to avoid entity level taxation. Substantially all of Operating LP's income from the Canadian business is allocated to Income Trust. Income Trust is entitled to deduct in computing its income amounts that are paid or made payable to its beneficiaries as income distributions. Typically, the trust deeds governing income trusts will specifically require the trusts to distribute sufficient income such that the trusts are not themselves subject to any Canadian income tax, although many trusts are revisiting automatic provisions in the face of implementing IFRS, under which such features may be problematic for equity characterization of trust units.

The Trust-on-Corporation structure is used where the business being acquired on creation of the income trust is owned by a corporation and there would be a material tax cost to eliminating the corporation. In these structures, entity level taxation is avoided through debt issued to Income Trust by Opco. Opco will deduct the related interest expense to offset its business income. Income Trust will be required to include the interest expense in income but will deduct distributions it makes to its unitholders. The Trust-on-Corporation structure works quite well where the business is expected to deliver fairly stable or predictable cash flows. Where cash flows fluctuate significantly (as will generally occur in the resource industry) or revenue growth occurs, the Trust-on-Corporation structure is not ideal as interest expense may not fully offset the income of Opco. As a result, royalty trusts generally use a structure such as the one described in Figure 2.

The Royalty Interest held by Income Trust is generally structured as a net profits interest ("NPI") in producing resource assets. The NPI would entitle Income Trust to 99% of Opco's profits from the Resource Property. Opco in computing its income would deduct the payments it makes to Income Trust under the NPI and, accordingly, Opco would only be subject to non-material amounts of Canadian income tax. Income Trust would include in its income the payments received under the NPI but would be entitled to deduct the distributions it makes to its unitholders. Accordingly, provided Income Trust distributes a sufficient amount of income to its unitholders, Income Trust would not be subject to Canadian income tax.

Tax Benefits to Unitholders The flow-through nature of Canadian income trusts provides significant tax benefits to taxexempt investors and non-resident investors. Historically, income trusts also provided significant tax benefits to Canadian taxable investors, as income that is earned through a public corporation has until recently been taxed at materially higher rates than income earned directly by individuals. In part as an initial response to the income trust phenomenon, in 2006 dividend tax rates on "eligible dividends" were lowered which effectively eliminated the tax benefit of income trusts for Canadian taxable investors.

Income trusts provide tax-exempt investors with a much higher net return relative to corporations by eliminating corporate level tax (generally at a rate of 32%). Similarly, nonresidents of Canada generally pay withholding tax at a rate of 15% on income trust distributions, instead of combined Canadian income and non-resident withholding tax of approximately 47% on income earned through dividend-paying corporations. As a result, for every $100 of income earned by an income trust, a tax-exempt investor would net $100 and a non-resident investor would generally net $85, compared to approximately $68 and $58, respectively, for every $100 earned by a public corporation taxable in Ontario.

This tax efficiency requires that the income trust distribute its income on an on-going basis, resulting in a different investment profile than a typical common share investment. As a result, the popularity of income trusts is likely at least partially attributable to the fact that Canada does not have a developed high-yield debt market.

The Rise of Income Trusts

The first income trusts were royalty trusts which date back to 1986. The REIT emerged in the early 1990s, enabling institutional and retail investors to invest in substantial pools of real estate assets on a tax-efficient basis. Business income trusts developed during this period but did not attract much attention until around 2001 when they began to gain momentum as tax-efficient yield investments in an environment of declining interest rates. The tax-efficient distributions of income trusts allowed unitholders to pay a premium to purchase income trust units when compared to shares of corporations, particularly in the low interest rate environment.

At the beginning of 2001 there were 70 income trusts with an aggregate market capitalization of approximately $14 billion. Although the stock market as a whole was going through tough times in 2001 and 2002, the income trust market was booming. In 2002 the initial public offerings of income trusts accounted for 94% (in terms of value) of all initial public offerings on the Toronto Stock Exchange. By the end of 2003 there were a total of 123 income trusts with an aggregate market capitalization of $74 billion. The momentum of income trusts continued to accelerate after 2003 and by October 31, 2006 there were a total of 245 income trusts with an aggregate market capitalization of $210 billion. From the initial focus on level yield income plays, the income trust market had expanded to virtually all types of businesses.

The Perceived Tax Leakage

As the number and scope of income trust conversions increased, the Canadian government became more and more concerned with the tax leakage it perceived from businesses adopting a flow-through trust structure. In September of 2005, the Minister of Finance estimated the federal tax leakage for 2004 at $300 million. In September of 2006, a University of Toronto Professor estimated that the combined federal and provincial tax leakage of businesses utilizing the income trust structure was $700 million annually and, after the completion of the publicly announced proposed trust conversions as of that date, the combined federal and provincial tax leakage would be $1.1 billion annually.

The Canadian Government's Response

For a number of years, the Department of Finance was unsure how to respond to the perceived revenue losses or how to curtail the growing trend of corporations converting to income trusts. In November 2005, they substantially reduced the tax rate on eligible dividends received by Canadian resident individuals from corporations. In the words of the Minister of Finance, this was intended "to make the total tax on dividends received from large Canadian corporations more comparable to the tax paid on distributions of income trusts, and to eliminate the "double taxation" of dividends at the federal level".

However, this legislative change did not address the tax benefits of investing in income trusts for tax-exempt and non-resident investors and, thus, did not stem the income trust conversion tide. From January 2006 to October 2006, corporations (including two large Canadian telecoms - Telus Corporation and BCE Inc.) with an aggregate market capitalization of $70 billion had either converted or announced their intention to convert into income trusts. In addition, there was market speculation that many other large Canadian corporations (including EnCana Corporation) would announce their intention to convert into income trusts. This led to the Department of Finance's announcement on October 31, 2006 (referred to by some as the "Halloween Massacre") of the specified flow-through entity legislation (the "SIFT Legislation") which imposes an entity-level tax on publicly-traded income trusts at a rate comparable to corporate tax rates and taxes investors on income trust distributions in a manner similar to shareholders of a Canadian corporation.

The SIFT Legislation provides existing income trusts and their unitholders with a grandfathering period ending December 31, 2010 under which the pre-SIFT regime applies, provided the income trusts comply with guidelines limiting their growth. While the SIFT Legislation recognized the significance of pooled real estate investment vehicles in Canada by providing an exemption for qualifying REITs (the "REIT Exemption"), the REIT Exemption is very narrow and generally only REITs that earn passive income qualify. REITs that undertake any sort of development activities or have operating components (e.g., hotels, seniors' housing, health care facilities, etc.) will not generally qualify for the REIT Exemption, and the industry continues to grapple with the looming application of these new rules.

At the time the SIFT Legislation was announced, the Department of Finance announced that rules (the "Conversion Rules") would be enacted to allow entities that were affected by the SIFT Legislation to convert into taxable Canadian corporations without any adverse tax consequences to them or their unitholders. The Conversion Rules were subsequently enacted into law on March 12, 2009 and contemplate the conversion of an income trust into a taxable Canadian corporation through either a unit-for-share exchange with a corporate successor (the "Exchange Method") or a distribution of shares of a corporate subsidiary by the income trust to its unitholders on redemption of the trust units (the "Distribution Method"). The Conversion Rules only apply where the transactions occur on or before December 31, 2012. The Exchange Method is described in Figure 3.

The Distribution Method is described in Figure 4.

The Conversion Rules also provide for a tax-deferred wind-up of an income trust after it is taken over by a taxable Canadian corporation, which can allow the purchaser to offer unitholders a rollover on an exchange of income trust units for shares of the purchaser. It also allows the preservation of tax basis where the assets of the income trust have a tax cost greater than their fair market value.

Income Trusts After the Halloween Massacre

In the week following the announcement of the SIFT Legislation, the aggregate market capitalization of the income trust market dropped $27 billion, or 13%. In this environment, many income trusts became prime targets for takeovers. In the one-year period following the announcement of the SIFT Legislation, there were 55 takeovers of income trusts either announced or completed. With the credit markets beginning to tighten at the end of 2007, the pace slowed substantially with only 5 takeovers in the following 18 months.

To date only 25 income trusts have converted to corporations. A few of these conversion transactions have been structured to include loss companies in an effort to allow the successor corporations to continue to distribute cash flows without the incurrence of entity level taxation for a period of time. It is expected that substantially all of the remaining income trusts (other than those that believe that they will qualify for the REIT Exemption) either will be taken over or will convert to corporations prior to January 1, 2011. Although it is possible for income trusts to remain as such past January 1, 2011 and be taxed in a similar manner to corporations, most income trusts will likely determine that their current structures are cumbersome (from both a commercial and tax perspective) and will convert to corporate form prior to such date.

There are currently 32 REITs that trade on the Toronto Stock Exchange. Of these REITs, only 10 have indicated that they believe they currently qualify for the REIT Exemption. Grappling with the narrowness of the REIT Exemption, their disclosure has been along these lines: "[w]hile there can be no assurance in this regard, due to uncertainty surrounding the interpretation of the relevant provisions of the REIT exemption, we expect that we will qualify for the REIT exemption..."

Of the balance of the REITs, 12 have stated that they will restructure their activities in an effort to qualify for the REIT Exemption by 2011, 9 have stated they do not and will not qualify for the REIT Exemption and 1 has stated that it does not currently qualify, and it is not determinable whether it can restructure its activities so that it can qualify, for the REIT Exemption.

Alternative Structures

Naturally other structures will be considered in light of the SIFT Legislation. At the time the SIFT Legislation was announced, the Department of Finance stated "if there should emerge structures or transactions that are clearly devised to frustrate ...[the policy objectives of the SIFT Legislation], any aspect of these measures may be changed accordingly and with immediate effect". While this has so far remained a vague threat, it has influenced thinking about alternatives.

Two principal alternative structures are discussed below. Other structures also are being considered more tentatively as successors to income trusts including, among others, crossborder high-yield common share structures, publicly traded royalty interests and structures utilizing a partnership formed, and with a mind and management, outside Canada to replace the trusts in some of the current income trust models.

REITS – Spinning off Bad Assets and Operations

At least two REITs have stated that they are considering spinning off their non-qualifying activities to a taxable corporation in order to satisfy the REIT Exemption. This would involve transferring non-qualifying operations and assets to a taxable corporation that would lease the real property necessary to operate the business from the REIT. Securities of the corporation and the REIT could trade together (often referred to as "stapled securities"). Assuming the REIT qualifies for the REIT Exemption, this structure would partially maintain the tax efficiencies of the income trust structure, with its benefits depending on the size of the real estate component in the business. Figure 5 provides an example of this structure.

Stapled Debt/Share Structure

As an alternative to the income trust structure, a number of offerings were completed by "stapling" common shares of a public Canadian corporation to high yield subordinated debt of that same issuer. The stapled securities, referred to as income participating securities or income deposit securities, have been generally used in the cross-border context – securities of Canadian corporations carrying on U.S. businesses. The stapled debt/share structure has only been used by one issuer that carries on a Canadian business. To date, these offerings have not generally been successful but with the fall of income trusts, these structures may gain momentum.

The stapled debt/share structure is designed to eliminate or minimize entity level taxation through deductible interest payments to holders of the stapled securities. These structures are essentially the Trust-on-Corporation structure described above, but without the trust. In the case of non-resident investors, Canadian withholding tax on interest has recently been eliminated (except in limited circumstances). Accordingly, in the stapled debt/share structure it is now possible to flow business income to non-resident investors free of any Canadian tax. Figure 6 provides an example of the stapled debt/share structure.

Whether these structures are offside the Department of Finance's warning about substitute structures remains to be seen.


The flow-through nature of income trusts will continue to provide tax exempt and nonresident investors with high-yield tax efficient distributions in the near term. With the SIFT Legislation coming into full effect on January 1, 2011, the search for alternative structures has begun in an effort to fill the hole that will be left in the Canadian capital markets by the disappearance of income trusts. At the same time, REITs are struggling to come to grips with the new regime that they face, and restructuring that may be required as a result.

In general, income trusts will be converting back to corporate form and their highdistribution model is likely to change. Whether or what other alternatives will develop and who they will suit remains to be seen. One of the fall-outs of the demise of the Canadian income trust market could possibly be the development of more of a high-yield debt market in Canada as yield investors look for alternatives. All of these questions will become clearer over the next few years as these changes work through, and as capital markets revive.

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.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

In association with
Related Topics
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of

To Use you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions