A matter of trusts

Key players in many sectors of the economy, income trusts have become important acquisition and consolidation tools. But will they grow to become fearsome predators?

By Claude Désy

The number of listed income trusts on the Toronto Stock Exchange (TSX) is at a record high. During the past five years, their number has tripled. The market capitalization of income trusts accounts for 10% of the TSX’s total market capitalization and 16% of listed issuers, reaching 247 at the end of the second quarter of 2006. During the first six months of 2006, public offerings by income trusts accounted for 38% of the initial public offerings (IPO) for the TSX. They are also a popular investment for institutional investors who currently hold a substantial part of the units issued by income trusts. This type of investment is now an integral part of the S&P/TSX composite index.

During the past three years, they have outperformed the S&P/TSX composite index, which has created a strong demand for this type of security.

Income trusts have become an alternative to traditional listings by corporate entity issuers. Under what circumstances might an IPO take the form of an income trust, either to finance a business or sell it in whole or in part? Which company should consider converting to an income trust?

Units of income trusts are held by investors wishing to own the rights to a stable monthly cash distribution with modest price growth potential. It is an alternative to the ownership of shares in a corporate entity that retains and reinvests all or the greater part of its cash flow. Its promoter gains access to the capital market and to investors willing to acquire an equity interest for the right to participate in these distributions.

The investor’s risk level relates mainly to the type of business generating the cash flow and to some degree the financial, legal and tax characteristics of this structure. Different income trusts have many similarities, but also have significant differences. Distribution stability ratings are produced by credit rating agencies for some of the trusts. Financial analysts’ reports published by brokerage firms also estimate the risks and potential of income trusts. The investment vehicle’s financial structure (a conduit) may increase the probability of stable cash distributions over time. For instance, subordination of distributions favouring the income trust over the vendor of assets to the income trust or by its promoter decreases the risk of the public investors’ distributions not reaching the expected levels.

A mutual fund trust is the legal entity that floats an issue. It is the first link in a chain of entities and financial instruments between the investor and the source of stable cash flows that bears little or no income tax at the conduit level.

As discussed above, some structures prioritize distributions in favour of the trust, thus public investors take precedence over the vendor of assets to the trust. In the example below (“Simplified structure”), the vendor has kept a residual participation in the limited partnership. The B units won’t receive any distributions until the A units have reached a set distribution level. This subordination feature is not common to all income trust structures.

New economy and old economy
The sources of cash flow from income trusts are usually found in the traditional economy. During the last market cycle, technology stocks were snapped up by investors hoping for a quick return from the increase in the price of the security. On the other hand, the message given by income trust investors boils down to this: if the business is doing well, we want the distributions of the liquidity generated by its operations; if it needs new capital, float a new issue. The growth of an income trust is closely related to the goodwill of the investors, which is conditioned by the regularity and growth of the distributions. It is a financial model where management’s leeway is directly linked to the investment’s return measured by the distribution.

Income trust promoters typically control long-term assets generating stable cash flows that need limited reinvestment. This stability reflects the intrinsic nature of the kind of business that, in some cases, dominates its market.

The vendor of a mature asset or business to an income trust receives immediately the future value of its stable cash flows. Afterward, he or she may use the proceeds of sale for purposes he or she considers more advantageous, based on his or her expertise. For instance, a promoter who has developed a source of stable cash flow will take his or her developer’s profit and reinvest it in another project. In other cases, a business is simply sold to the public investor.

Conversion
During the past two years, a significant number of companies have changed their legal and tax structure to one of an income trust. From 2002 to June 2006, 52 such conversions have taken place, 34 during the past two years. It is a business that follows the steady cash flow generated model for income distribution puposes. On average, the generated market capitalization increase is about 20%.

Income trusts are becoming key players in many sectors. With their access on a repeated basis to the public capital markets, they have become powerful acquisition and consolidation tools. It is to be expected that the first ones to reach a critical mass in an industry will become dominant players and fearsome predators. Once established in an industry that generates stable cash flows, this method of holding and distributing stable cash flows simply cannot be ignored by the marketplace.

There are specialized income trusts. The mission of others is to acquire medium-size businesses generating stable cash flows, some of which would have no other means of accessing the capital markets. For the vendor this is an alternative to selling to a private buyer or to an IPO. Also, such a sale could be an integral part of a management buyout.

Types of income trusts
Income trusts are generally classified based on the type of cash flow. They can be classified as follows:

• royalty trust commodity business (e.g., restaurants)
• business trust
• power trust
• acquisition trust
• fund of funds

Royalty trusts yield cash flows from a royalty on gross sales. Since the cash flow of natural resources royalty trusts are linked to the sale of commodities, it can be subjected to significant price shifts. In the case of a business trust its cash flow is generated from business operations.

Real estate investment trust uses the same vehicle. In this category, financial analysts include businesses that operate hotels, seniors’ residences or resorts. In these cases, the generated cash flows come from running a business, not from a real estate portfolio. Nonetheless, the market classifies these trusts in the real estate portfolios category, which are grouped as follows:

• residential
• commercial
• offices
• retail
• hotels and leisure
• seniors’ residences
• diversified

The objective of the vehicle’s financial and tax modelling is the distribution of generated cash flow. To achieve this, the trust will strive to minimize cash outflows, particularly its tax burden, mainly income tax or from other cash outflows. Under this model, taxable income is not taxed in the hands of the entities composing the instrument (trust, limited partnership, etc.) but in the hands of investors. This is especially attractive for deferred income plans and pension funds, which are nontaxable entities for which only the amount received, taxable or nontaxable, matters. A tax expense can significantly influence the market price of units or the proceeds of a public offering and indirectly the acquisition price paid by the trust for an asset or a business generating a steady cash flow. For example, if the annual distribution over the market price of an income trust unit required by the market is 10%, a dollar of recurring income tax will reduce the amount of a public offering by $10. Debt restructuring, in certain cases, can also increase the distributions. For instance, distributions can be increased by replacing a debt carrying an interest expense and principal repayment with a debt not requiring principal repayment before its term. This is only possible where the debt level of the income trust is appropriate.

The financial market prioritizes cash distributions over accounting profit. In other words, the market looks at the amount of monthly or quarterly distributions, whether taxable in whole or in part. One of the reasons for this is that, now many income trust investors are indifferent to income tax since they are non-taxable entities. The relative weight in the capital markets of these investors makes the market less sensitive to the tax factor. However, income trusts have significant tax advantages for taxable investors.

Currently, their annual distributions range from 3.63% to 23.08% of the market price. The table on page 35 briefly summarizes the distribution levels of income trusts and real estate investment trusts.

Proceeds
In the calculation of the value of a stable cash flow sold in whole or in part to an income trust, the perpetuity of the cash flows is assumed. It is a security with no maturity date with distributions beginning on a determined date and continuing indefinitely. The mathematical formula for calculating the value of these cash flows is:

where V is the value of the annual predictable cash flow from an income trust, F is the predictable annual distribution to unitholders, taking into account the public offering issue expenses, the annual costs of a public entity, reserves for contingencies and a reserve for long-term cash flow stabilization. In the case of the computation of the value for an IPO an IPO discount will be deducted. Certain trust will retain some of the generated liquidities for growth. On average, business income trusts distribute in the range of 80% to 85% of their cash flow generated from operations.

K is the percentage of annual distributions over market price required by the market which varies by business sector and the size of the income trust. After an IPO, the amount of distribution by unit required by the market should decrease over time with the stability of the distributions.

For example, a predictable annual stable cash flow of $12 million, at a required distribution rate of 10%, generates a market value of $120 million.

Cash-flow stability is primarily a function of the type of business owned by the trust. However, steps can be taken to increase stability over time, but this will not change the intrinsic nature of the cash-flow source. One method is not to distribute all the generated cash flow but to set up a reserve for the months in which it will be more difficult to make distributions. In the course of an IPO, or later in the course of the sale of an asset or business to an income trust, the vendor could retain an equity interest in the operations. These vendors may participate in cash-flow distributions on the same basis as the public. Alternatively, their distributions could be subordinated to the investors’ distributions, reducing the risk that the public investor will not receive the anticipated distribution.

The regularity of the distributions is the Achilles heel of an income trust. Some are conservative and have based their calculations on realistic distribution assumptions; others, less cautious, will be unable to distribute the anticipated cash flows. The latter will no longer have ready access to the capital market. During the period January 2001 to February 17, 2005, 52% of a group of 107 business trusts maintained their distributions, 36% increased it on average by 9.7%, 7% had an average decrease of 17.6% and 5% totally suspended their distributions.

The basic measure for calculating income trust yield is its distributions. This is a non-GAAP measure of earnings. Unlike a corporation, an income trust does not distribute its net after-tax earnings; it makes distributions, part of which are taxable in the year.

The table on page 36 shows the value of different components of a cash flow of a taxable corporate entity that sells all its stable cash flow in the course of an IPO. Alternatively, it is the value of a corporation already listed on the TSX that converts the income trust financial model. In such a case, there is no IPO discount, or just a limited one. The table shows the market value of each element of calculation of distributable cash with an assumed distribution rate of 10% over the market price of a unit

In the course of an IPO only a portion of the total cash flow could be sold since the selling price of subsequent tranches should not be subject to an IPO discount.

Implementation
An income trust distributes the maximum amount of its available cash flows generated from operations. Distributions received from a trust are taxable only in the hands of the unitholder, up to that holder’s share of the trust’s taxable income for the year. Distributions over this amount are not included in the unitholder’s income. This excess amount is a capital distribution and for income tax purposes, reduces the adjusted cost base of the holder’s units. Income tax on these amounts is deferred and is generally taxable as a capital gain when the holder sells or the units are redeemed, or when their adjusted cost base becomes negative. Among other things, this may be due to the fact that the allowed tax depreciation is higher than the maintenance capital expenditures and debt service.

Trusts take all necessary steps so that taxable income generated by operations will be transferted to the unitholders. The trust is only taxable on its share of income that was not transfered to the unitholders. To achieve this, all of the trust’s taxable income is transferred so that the trust has no income tax to pay. This is achieved by the fact that the taxable income of the limited partnership is transferred to the trusts which, in turn, will transfer it to its unit holders. For the nontaxable unitholders, no income tax is payable upon these distributions. However, income tax might become payable when the nontaxable entity, for example a RRSP plan, transfers it to its beneficiary, most likely a taxable individual.

A large number of income tax provisions apply to the implementation of an income trust conduit. It should be noted that the taxable investor’s after-tax return is influenced by the tax treatment of the transfer to the trust of the asset or of the business generating the cash flow, particularly if the party selling the assets transfers them using a tax rollover provision. In such a case, the seller defers the income tax applicable on the value of the asset appreciation. However, the tax cost of the assets for the conduit will be lower than if the transfer was done using a different method. For tax purposes, the seller’s transfer price is equal to the tax cost of the asset for the conduit. Thus, the deductions that can be claimed by the conduit, indirectly the holder of taxable units, will be lower.

The vendor of assets to a limited partnership receives units of the said limited partnership and, in many cases, also receives a right to exchange, with or without condition, limited partnership units against units of the income trust. Thus, the vendor’s capital gain is deferred until the units of the received limited partnership are exchanged for units of the trust. In the course of the exchange, the seller will receive securities listed on a recognized stock exchange where they can be freely traded. He or she can then sell the trust units on the open market and generate the funds required to pay the income taxes triggered by this sale.

Assets cannot be directly transferred to a trust by way of a tax rollover. If the transaction must be done on a partially or wholly tax-free basis by way of rollover, the assets are indirectly transferred to the trust. It is transferred to a corporation or more often to a limited partnership held by the income trust. An indirect transfer is made to these entities because they can take advantage of rollover rules.

The Income Tax Act provides that a mutual fund trust cannot run a business, but it can hold an investment in the capital or a debt issued of a corporation or a limited partnership. This is why income trusts don’t directly hold businesses.

The importance of income trusts in the Canadian economy makes them an indispensable tool in many situations. In the strategic planning of any business or in the case of the estate planning of an entrepreneur, its possibilities, advantages and inconveniences have to be seriously considered.

Claude Désy, FCA, is a lawyer, a corporate finance and tax specialist and partner in the Montréal law firm of De Grandpré Chait