The Popularity of the Income Trust Structure
An income trust allows stable, profitable businesses to operate under a tax efficient structure to regularly distribute cash flow generated by the business to holders of units of the income trust. The income trust structure has grown in popularity in Canada in the last few years for a number of reasons, including steady returns for investors at higher yields and attractive valuation multiples for vendors.
Income trusts, as a class, have been the best performer on the Toronto Stock Exchange for the last few years and there are now over 205 income trusts trading on the Toronto Stock Exchange having a combined market value of over $114 billion. Income trusts are tracked through their own indices, including the S&P/TSX Canadian Income Trust Index.
The popularity of income trusts is primarily driven by demand for steady returns at higher yields, particularly in the current environment of relatively low interest rates. Income trusts generally distribute to unitholders a fixed, substantial portion of the cash flow generated from the business on a monthly basis. Yields for income trust unitholders are typically much higher than for bonds or other fixed income investments, such as Canada Savings Bonds and Guaranteed Investment Certificates.
Part of the growth of the Canadian income trust market relates to one of the key benefits afforded to vendors, which is the attractive market valuation of the business achieved through the use of the income trust structure. In return for higher yields and other benefits associated with the income trust structure, public investors have been willing to pay higher valuations for businesses held by income trusts than would be available to a vendor by private sale.
While the income trust model has been applied to an increasingly diverse range of industries and business types, it is most successful when applied to businesses with a history of earnings and the expectation of stable, long-term cash flows with low or predictable future capital expenditures. Income trusts have been set up for companies in a wide range of industries, including telecommunications, transportation, food, retail, and entertainment.
The Tax Efficiency of the Income Trust Structure
Under Canadian income tax law, the profits of an income trust are not subject to taxation at the level of the trust provided that the trust distributes these profits to beneficiaries annually. While the beneficiaries may ultimately be taxed on the distributions based on their personal tax bracket, the income trust is merely a flow-through vehicle that is itself exempt from corporate tax.
In addition, income trust distributions often include, in part, a return of capital that the unitholder receives on a tax-deferred basis. Most of the income, including the monthly income, is taxed as a capital gain or loss when the units are ultimately sold at cost bases that have been adjusted downward by the amount of capital returned.
In contrast to corporations, income trusts are tax efficient entities. Dividends of a corporation are taxed twice, first at the corporate level on any profits, and, second, at the personal level by shareholders upon receipt of the already taxed dividends.
Recently, there has been much debate over the potential for tax revenue loss to Canada due to the increasing growth and popularity of income trusts. Some argue that a legislative response is needed to curtail the tax revenue loss and others argue that the income trust structure simply shifts the tax burden to unitholders.
The Income Trust Structure
Over the past few years, a wide variety of income trust structures have been implemented. Three examples of these structures are:
The Corporate Trust
The most basic income trust structure available to a company is that of a corporate trust. The income trust uses the proceeds of a public offering of units to acquire debt and equity of a newly created acquisition company, which then uses the proceeds to acquire the business. The newly created acquisition company and the operating business subsequently amalgamate and continue as one entity. On a monthly basis, distributable cash generated by the operating business is distributed to the income trust, which subsequently distributes the cash to unitholders.
Certain structuring issues are associated with the corporate trust. For example, the corporate trust structure is not tax-efficient for existing equity owners who wish to hold a retained interest in the income trust. In addition, because a corporation is not a flow-through entity, the corporate trust structure allows for the possibility of tax leakage and is subject to capital tax.
The Limited Partnership Trust
The limited partnership trust structure addresses many of the issues that apply to the corporate trust structure and has become the most commonly used structure. The income trust uses the proceeds of a public offering of units to subscribe for units and debt of a newly formed business trust, which in turn uses the proceeds to acquire a limited partnership interest in a newly formed limited partnership. The limited partnership then uses the proceeds to acquire the operating business. The limited partnership trust allows existing equity owners to receive limited partnership units on a tax-deferred basis which are exchangeable for units of the fund. On a monthly basis, distributable cash generated by the operating business is distributed to the operating trust and to the existing owners who hold limited partnership units and up the chain to the fund, which subsequently distributes the cash to unitholders.
The Revenue Royalty Trust
Unlike traditional income trust structures, investors in a revenue royalty trust receive distributions based upon a percentage of the gross sales of the operating business rather than net earnings. Similar to the limited partnership trust structure, the income trust uses the proceeds of a public offering of units to subscribe for units and debt of a newly formed business trust, which in turn uses the proceeds to acquire a limited partnership interest in a newly-formed limited partnership. Unlike the limited partnership trust structure, the limited partnership then uses the proceeds to purchase all of the intellectual property used by the operating business in connection with its business. The limited partnership then grants the operating business an exclusive long-term licence to use the intellectual property in consideration for a royalty equal to a specified percentage of gross sales of the operating business.
For revenue royalty trusts, compensation structures must be created to address additional gross sales from new businesses.
The Income Trust Process
The process of becoming a Canadian income trust resembles that of becoming a public company, with additional requirements unique to income trusts.
Selection of a Board of Trustees
Creating the Board of Trustees of an income trust is an important aspect of the income trust process. The market will require a certain balance within the Board of Trustees to properly market the income trust. A number of criteria are reviewed when considering Board composition, including independence and specialized expertise of potential trustees, understanding of financial statements, industry-specific expertise, and public market experience.
Preparation of a Prospectus
A prospectus is required for the initial public offering of units of an income trust and constitutes the disclosure document whereby investors acquire units. The prospectus also plays a critical role in marketing the offering and; therefore, a number of parties have a significant amount of input into the disclosure contained in the prospectus. Among other things, the prospectus must include the following elements:
- Description of the income trust and its business - Significant attention is often placed on historical operating results and growth of the operating business.
- Financial statements and discussion of operating results - The prospectus must contain three years of audited financial statements and, in certain cases, reviewed quarterly financial statements. Financial statements are accompanied by related management's discussion and analysis of financial condition and results of operations.
- Distributable cash analysis - The distributable cash analysis is critical to the determination of yield. Estimated distributions for the first year following the public offering primarily drive pricing for the income trust. The yield for the income trust must be competitive with the yields for other income trusts and in particular with income trusts with similar business profiles. The perceived growth prospects for the income trust will also be a factor in pricing. If the market perceives that the income trust has very good growth prospects, a premium may be placed on the income trust and a better valuation obtained for the public offering.
- Compensation Matters - The prospectus must disclose compensation paid to executive officers and any incentive plan to be implemented. In connection with the public offering process, certain members of management will be required to enter into non-competition agreements to protect the income trust from future competition in the event of the departure of such individuals.
- Retained Interest and Subordination - In many instances, existing shareholders maintain a retained interest in the income trust. The level of retained interest varies for each income trust; however, the average retained interest generally falls between 10% and 30%. Requests may be made for the retained interest holders to subordinate their ability to receive distributions until distributions have been paid to all other unitholders in circumstances where the distributable cash is based on an estimate prepared by management rather than historical financial results.
- Risk factors - The prospectus must offer investors a clear understanding of the risk factors and speculative nature of the business or the securities being offered.
Rights of Unitholders
Similar to the rights a shareholder has by owning common shares of a corporation, upon the purchase of units, unitholders acquire the right to vote at unitholder meetings, to elect trustees, to appoint auditors, and to approve fundamental changes.
Income trusts are typically governed by their declarations of trust. Many of the terms of the income trust instrument parallel the attributes of corporate legislation; however, other elements of corporate law are not generally replicated in income trust transactions, which are usually negotiated based on prior transactions and current market standards.
On December 3, 2004, the Canadian Securities Administrators (CSA) adopted National Policy 41-201 - Income Trusts and Other Indirect Offerings. As the first securities regulatory policy to focus directly on income trusts, the policy addresses vendor liability and prospectus disclosure, and clarifies the general application of the existing securities framework to income trusts in both an initial public offering context and on a continuing basis.
Securities regulators view income trust offerings as a form of indirect offering involving non-arm's-length parties, and where the vendors "initiate or are involved in" the initial public offering process, the Securities Regulators view them as non-arm's-length vendors who are "effectively accessing the capital markets themselves".
The CSA broadly classifies "promoter" for the purposes of Canadian securities regulations as including vendors who receive a significant portion of the offering proceeds as consideration for services or property in connection with the founding or organizing of the business of an income trust. Promoters are consequently required to sign the prospectus in that capacity and assume liability for misrepresentations in the prospectus.
Influential vendors who are active in the operating business but who are not otherwise promoters must take "appropriate responsibility" for the information in the prospectus. The prospectus must disclose the measures taken to provide investors with rights and remedies against such vendors in lieu of those afforded by securities legislation. The prospectus must include clear descriptions of acquisition agreements (describing each vendor's representations, warranties, and indemnities), and must identify the acquisition agreement as a material document that is available for review by investors.
Risks
Despite the many attractive aspects of income trusts, there are also significant risks that should be taken into account when considering carrying on business as an income trust.
Income trusts are a form of business, and as such, rely on and respond to overall market conditions, in addition to the underlying business on which the income trust is based. Because the performance of an income trust is directly related to these two variables, they are inherently risky. This risk to the income trust is accentuated by the fact that income trusts distribute substantially all of their profits on a continuous basis and therefore there is no surplus capital on which to rely during a downturn of the market or the underlying business. This can lead to a potential reduction in distributions. Income trust distributions are not assured, and part of a "return" may in fact be repayment of the capital initially invested in the income fund. The yields of an income trust are not based on a legal commitment but on management projections for the underlying assets.
Income trusts are vulnerable to changes in Canadian income tax laws, which could potentially eliminate the favourable tax position of income trusts in the market and reduce their popularity and viability as investment vehicles.
Income trusts are generally considered to be less attractive in a high interest rate environment, and fluctuations in interest rates may pose risk to the business underlying the income trusts and affect the amount of cash that can be distributed to unitholders.
While there are no doubt benefits to becoming an income trust, those benefits must be carefully and conscientiously weighed against the potential risks.
The Current Income Trust Market
Despite the various risks, income trusts are an increasingly popular investment vehicle in Canada, possessing attributes attractive to both investors and vendors. There are several significant positive aspects of income trusts, not the least of which is the possibility of reduced or deferred amounts of corporate tax payable, both in the short and long term. In addition, many small companies who were previously unable to enter the Canadian equity markets are now able to access the financial markets by means of income trusts. Vendors are also able to raise significant amounts of capital and sell off assets or companies at more attractive valuations due to current high valuations of income trust units, leading many to employ income trusts as an attractive exit strategy. Vendors also benefit from the ability to use equity to complete mergers and acquisitions by using trust units instead of cash to purchase another business.
It is anticipated that the number of businesses constituted or reorganized as income trusts will increase significantly in the near future. While no one can know where this growth will ultimately lead, the Canadian income trust market is currently thriving and promises exciting future expansion.
1. The authors wish to thank Jennifer Reed, student-at-law, for her assistance on this article.