Canada: Taxation Of Trust Capital Securities: Is There A Pending Battle Between The Government And Canada´s Financial Institutions?

The recent announcement by the Government of Canada that it would begin taxing distributions of income trusts and other "specified investment flow-throughs" ("SIFT") has brought planned conversions of corporations such as Telus and BCE into income trusts to a grinding halt and, for some investors, has impeded an investment vehicle with considerable value. Another untold story in the income trust saga, with a plot that may begin to heat up, is the potential battle between Canada's financial institutions and the federal Department of Finance. Many of the large domestic chartered banks and other Canadian financial institutions use trusts to help raise capital because of the cost-effectiveness of this investment structure. As will be discussed below, these structures may be caught by the new tax on SIFTs, and the effect, intended or otherwise, may be the extinction of an innovative method for financial institutions to raise capital.

Trust Capital Securities ("TruCS"), also commonly referred to as capital trust securities or a variety of similar names, are, simplistically, trust units. Consider a simple example. Bank X wishes to raise $100 million. Bank X sets up a trust called X Capital Trust which distributes non-voting units (TruCS) to the public. Bank X will itself retain control of the trust by holding special trust securities carrying all of the voting rights. X Capital Trust then uses the proceeds of the TruCS distribution to purchase a subordinated debenture from Bank X in the amount of $100 Million with a coupon rate of, say, 5%. X Capital Trust will receive interest payments on the subordinated debenture from Bank X and distribute this cash to TruCS holders. Distributions will essentially equal the coupon on the subordinated debenture. In this way, the interest income flows through X Capital Trust to the TruCS holders. With the exception of setting up the trust, all transactions take place simultaneously.

The structure noted above is a simplistic model. Trusts may also be capitalized with mortgage-based assets such as residential mortgages, or mortgage-backed securities that the bank may wish to remove from its balance sheet. TruCS will also typically contain a number of subordination provisions in order to meet the requirements of the Office of the Superintendent of Financial Institutions ("OSFI") for innovative instruments.

Banks are required to maintain specified levels of capital under international accords (BASEL) and domestic legislation. Capital is divided into two distinct groupings for regulatory purposes: tier 1 capital and tier 2 capital. Tier 1 capital is the bank's core capital and generally consists of common shareholders' equity, qualifying non-cumulative perpetual preferred shares, and qualifying innovative capital instruments (such as TruCS described above). Tier 2 capital is the bank's supplementary capital, and generally consists of less permanent capital instruments, such as subordinated debt. Total capital is the sum of tier 1 capital and tier 2 capital. OSFI requires that banks maintain a minimum tier 1 capital ratio of 7%, and a total capital ratio of 10%. The ratios are determined by dividing the tier 1 capital or total capital, depending on the particular ratio to be calculated, by the risk-weighted assets of the bank. In addition, OSFI requires that the common shareholders' equity make up the majority of tier 1 capital by limiting innovative capital instruments to 15% of net tier 1 capital.

Should a bank wish to increase its risk-weighted assets such as loans and mortgages to its customers, it will have to set aside a corresponding amount of tier 1 capital and total capital to maintain its required ratio's and ensure they do not fall below the level required by OSFI. By issuing a subordinated debenture directly to investors, a bank would increase its total capital, but not its tier 1 capital, since such debentures are considered tier 2 capital. However, by issuing the debenture to a capital trust which then sells units, the units, with approval of OSFI, are considered tier 1 capital as innovative capital instruments. Where the mortgage-based assets of a bank are purchased by the capital trust with the proceeds from the distribution of TruCS, the effect will be to reduce the bank's risk-weighted assets and, as a result, its required capital ratio's will be improved. This improvement in the bank's capital ratios will allow the bank to create additional assets with the capital that has been freed up.

The debt instrument issued to the capital trust will have features similar to traditional tier 1 capital. For instance, the subordinated debenture will have greater permanence than a similar type debt instrument issued directly to the public (the term must be at least 30 years), failure to make payments cannot accelerate repayment of the debenture, and the debenture cannot be secured, guaranteed or given priority ahead of claims of depositors (or policyholders for insurance companies). In other words, the trust vehicle provides a bank with a means of boosting the value of subordinated debenture investments by sifting out their less permanent features and parking them in a capital trust, leaving the bank with tier 1 capital. The structure, however, plays another important role: it is a very cost effective way to increase tier 1 capital. Tier 1 capital is composed, with the exception of innovative capital instruments, mainly of equity. Issuing equity, however, would result in a bank paying dividends which are not deductible from income. With TruCS, the bank pays interest to the capital trust which is deductible as an interest expense under the Income Tax Act (Canada). Similarly, where the capital trust collects payments on the assets held (such as mortgages transferred to it by the bank), it can flow these payments through to TruCS holders on a tax-free basis. If the bank collected these payments itself, the income would be taxed at the bank level, and only the after-tax balance would be available for distribution. With mortgage-backed capital trusts, investors can obtain pure pre-tax exposure to a mortgage portfolio. Therefore, there are additional investment and tax-based benefits of using the capital trust over and above their attractiveness as a capital-raising instrument.

The new rules regarding the taxation of SIFTs may have a significant impact on TruCS financing. If the units of the capital trust are listed on a stock exchange or other public market, then the trust is a SIFT that will be caught by the new income trust rules. Some TruCS are traded publicly on the Toronto Stock Exchange, for example, RBC TruCS - Series 2010 (TSX: RYT.NT.M) and TD Capital Trust Securities (TSX: TDD.M).

If a capital trust is a SIFT, it will be subject to tax on the income it once flowed through on a tax-free basis. The tax benefit accruing to the bank from the interest expense will now (notionally) be offset by the tax liability to the capital trust. Similarly, there is no longer a benefit to having the trust collect on assets since the distributions will be reduced to account for the tax liability. A mortgage portfolio taxed in this way would no longer be an attractive investment because it would be taxed twice; first at the trust level and secondly as income to the TruCS investor. The cost of setting up and operating the capital trust will no longer be offset in any significant way by the benefits of using such a structure. Putting all of these together, the advantage to using a capital trust to raise tier 1 capital, or simply to securitize assets is essentially gone.

It remains to be seen how crucial capital trusts are to financial institutions, and whether the Government of Canada will carve out an exception for capital trusts set up by Canada's financial institutions. For TruCS that were publicly traded prior to November, 2006, the new rules will not apply until 2011, therefore there is enough time to change the framework for the tax treatment of these structures. Although the story is just beginning to unfold, given the importance of Canada's financial institutions, and the influence they wield, we probably haven't heard the end of it.

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.