Introduction. During 2002, a number of US businesses seeking liquidity for their shareholders or funding for other needs accessed the Canadian markets through offerings by "income trusts"–and found capital not available in the US markets. The Canadian public has a twenty-year history of investment in income trusts, a yield-oriented product offering steady returns to retail and institutional investors. In the current low interest rate environment, investor interest in these vehicles has grown. Companies and their advisors have developed structures offering a tax-efficient means to maximize yield to investors, thereby commanding a high valuation. Of course, not all businesses are appropriate for this type of offering, and the appetite for product is not endless; early 2003 will likely only offer an exit to the highest quality companies. Nonetheless, the income trust structure is an important tool in the array of liquidity alternatives, and US businesses and their advisors should develop an understanding of the structure and its key characteristics.
What is an Income Trust? An income trust (also called an income fund or a mutual fund trust) is a vehicle much like a real estate investment trust (or REIT). It is structured to raise capital through an offering of interests, or shares, and invest that capital in securities of a holding company for an operating business. The operating business in turn produces an income stream of interest and dividends, which are distributed to the shareholders of the income trust. The income trust itself is not subject to taxation, and a variety of structuring mechanisms are designed to maximize the distributable cash flow by lowering the overall tax burden of the operating company and its related entities. From the investors' perspective, the investment decision is predicated on the income trust's projected yield, or distributions to shareholders. While the potential for growth is a part of the analysis, the focus is on the anticipated cash flow. The investment therefore is designed as an alternative to bonds or bond funds, with the added benefit of possible appreciation through growth of the underlying business.
What Businesses are Good Candidates? Given the focus in valuation on yield, an income trust must invest in a business with a stable, steady level of cash flow and a stable, relatively low need for capital expenditure funding. Companies in many industries may be eligible. Examples of income trust asset classes include such diverse businesses as check printing, home cleaning products, shipping terminals, telecommunication services and wholesale food distribution. The key is steady, sustainable cash flow; the best candidates for an income trust offering have a proven track record and also offer an opportunity for cash flow growth. A useful factor might be the existence of long-term contracts providing predictable future income. As always, good management is critical. It is worth noting that income trusts may have a range of market capitalizations, such that companies of all sizes may access this market segment.
How are Income Trusts Valued? Valuation is based on a multiple of cash flow, and represents an inverse of the target yield. For example, if cash flow of $50 million is to produce a 13% yield on the offering price of the shares, pricing will imply a multiple of 7.7 times cash flow. The multiple of EBITDA may be lower, however, to the extent some portion of the EBITDA is required for capital expenditures or to pay US income tax. On the other hand, a company's free cash flow may be enhanced by leverage, and protected, to the extent possible, by shielding the tax burden of the operations. Therefore, cash available for distribution (as dividends or interest) to the income trust and then to shareholders is maximized through effective structuring.
How are Income Trusts Structured? The basic structure involves investment by the public at the "top tier" level in an income trust that qualifies as a "mutual fund trust" under Canadian law. This ensures the income trust is not taxable. The income trust invests the proceeds of the offering in equity and debt of a subsidiary holding company. The intercompany debt provides shelter to the taxable income of the holding company, for both US and Canadian income tax purposes. The level of shelter depends on the ratio of debt to equity investment in the holding company; in general, that ratio should be no greater than three to one. (Additional debt at the operating company level is possible, and may further shelter income.) The holding company in turn invests in the equity of an operating business. Offering proceeds may be retained by the operating business, or provide liquidity to shareholders seeking a full or partial exit.
There is substantial tax planning required to maximize the efficiency of the structure, especially for cross-border transactions. US tax issues to be addressed include characterization of the income trust investment in the holding company under "debt-equity" rules, classification of the income trust as a "fixed investment trust" and minimizing or eliminating US withholding taxes with respect to dividend and interest payments by the business to the income trust. Key Canadian tax considerations include ensuring an exception to the "foreign property" rules, issues relating to the operating business' status as a "foreign affiliate," as well as protecting the "mutual fund trust" status of the income trust and sheltering taxable income.
How Can Shareholders Gain Liquidity? Income trust offerings are not dependent on the sponsorship of financial investors; while management ownership is highly desirable, continued investment by other shareholders is not required for a successful offering. Proceeds of the offering may be used to give liquidity to shareholders. Equityholders may also remain invested in one of the lower "tiers" in the structure, and will have liquidity through exchange rights into income trust shares. While they continue their investment, existing stakeholders can retain governance rights at the operating company level, generally to the same extent as afforded to them pre-offering.
How Will Current Market Conditions Affect Offerings? Predictably, the interest rate environment and availability of other investment opportunities can affect the attractiveness, and therefore the pricing, of income trusts. Recent trends show continued focus on income trusts by both retail and institutional investors, together with increased interest on the part of companies with limited alternatives for liquidity. This resulted in a backlog of product during the last quarter of 2002. Liquidity opportunities for US businesses across the border will be determined largely by the quality of the companies seeking access to that market, as well as by the performance of those that have already effected offerings. Stay tuned.