Canadian Income Funds
US power companies are looking at Canadian income trusts as a source of financing for acquiring distressed assets and cashing out existing projects in the United States.
The trusts have seen phenomenal growth in Canada. At last count, there were more than 114 trusts with a market capitalization of C$57 billion, or roughly 7% of the aggregate capitalization of the Toronto Stock Exchange. Last year, 86% of new capital raised through initial public offerings in the Canadian market was through income trusts. The figure for the first half of 2003 was 80%.
The transactions are structured to produce higher returns for investors than from investing directly in operating companies. This means the trusts can afford to pay more than competing bidders for operating businesses.
Most trusts invest in assets in Canada. The first trust based on assets in the United States was formed in 2002. By August 2003, there were nine trusts centered on US businesses.
The trust structure has hit occasional turbulence. A decision by Pricewaterhouse Coopers in September not to take an assignment as auditor for Specialty Foods — the manufacturer of such products as Nathan’s franks and Fischer’s bacon — led other accounting firms to announce that they were reviewing the US tax risks in the Canadian income trusts in which they have been involved. US-based Specialty Foods sold 45% of the company to a Canadian income trust in March 2003. Lee Sheppard, a writer on tax subjects whose columns are read by policymakers in Washington, wrote in March that, “So troubled are some practitioners by these deals that your correspondent has received an unprecedented two separate packages of prospectuses for these deals.”
However, the deal structures are continuously evolving. The first issue of “income depositary securities,” or IDSs — a new structure not involving a trust for use with US businesses where a large share of the investors will also be in the US — started to trade on the American Stock Exchange the first week in December. Another purchase of interests by an existing Canadian income trust in two US power plants is scheduled to close in mid-December. The accounting firms appear to have been comfortable with these transactions.
A Canadian income trust is a trust formed in Canada that raises money in the capital markets and pools it for investment.
Most trust units are placed with retail investors. There has been less interest in them among institutional investors because of fears about potential liability. Persons with claims against a corporation cannot ordinarily sue the shareholders to recover on the company’s debts. The fear is that the trustee might be sued as the manager of the business and, in turn, have a right of indemnification from the unitholders under Canadian case law or that the unitholders might be sued directly under the theory that the trustee is merely acting as their agent. Most Canadian counsel believe the risk of liability passing through to unitholders under either of these theories is remote. Nevertheless, fear of liability has acted as a deterrent to institutional investment. The Ontario finance minister said in her budget message in late March that the government would limit liability imposed on unitholders in trusts formed under Ontario law, but the measure to do this failed to pass before the legislature adjourned in June. Passage of such a law in Ontario is expected to lead to enactment of a similar law in Alberta. Most trusts are formed in one of the two provinces.
The typical trust has 20 to 30% Canadian institutional investors, 55 to 70% Canadian retail investors, and 10 to 20% foreign investors — mainly US.
The main attraction of the trusts as a source of financing is that the trust investors receive pre-tax dollars from businesses in which the trust invests. The trust is not subject to income tax in Canada. Rather, its earnings are taxed to the investors directly. About 40% of existing units are held through tax-deferred retirement funds with the result that the earnings are often not taxed immediately at the investor level either.
The investors focus on the cash return. The return may be expressed like a dividend yield. It is the cash distributed to unitholders in the latest period divided by the current price of one income trust unit.
Because of the tax advantage, the typical trust returns at least 27% more cash to Canadian investors than would a similar investment directly in corporate shares. The trust structures its investments in such a way that its share of cash flow from a power project or company in which it invests will have been largely untaxed in either the United States or Canada, and the trust itself is not subject to income tax.
Private equity firms have used this math to turn large profits. For example, Kohlberg Kravis Roberts & Co. and the Ontario Teachers Pension Plan Board together acquired 90% of the Yellow Pages business in Canada from Bell Canada in November 2002 for C$900 million, and then resold a 25% interest in the business in the summer 2003 through an income trust for C$935 million. American Industrial Partners achieved similar alchemy by acquiring Great Lakes Carbon — a US-based producer of calcined petroleum coke for making aluminum — in 1998 and then selling down the investment to a Canadian trust in 2003.
Canadian companies are moving to convert into income trusts from corporations. There were seven such conversions in 2002. Some US companies with appropriate business models have also converted. One US company that converted last spring had reduced its tax rate to 4% in the first quarter after converting.
Some market analysts in Canada have warned that the Canadian government may be forced eventually to respond to the erosion in the corporate tax base. Estimates of the current erosion range from C$500 million to $C1 billion a year. However, many countries have eliminated taxes at the shareholder level on earnings that were already taxed to a corporation (so it is not clear how much the erosion bothers the Canadian government apart from the need to make up tax revenue). The Bush administration pushed the United States in the same direction last spring with the reduction in the tax rate on dividends received by individuals to 15%.
A company wanting to sell part of its business should usually receive a higher valuation from a Canadian income trust than from another purchaser. The discounted cash flows that are projected from the business will have a higher value because the calculations are done using pre-tax dollars. Investment bankers have been peddling the structures as an exit strategy for private equity funds for their US portfolio companies.
The most suitable investments for income trusts are in companies or projects with a history of stable and predictable cash flow. The capital expenditures required to maintain the business should also be predictable and reasonable. Ideally, there should a moderate prospect for growth. Utilities and transmission lines with regulated rates of return and power projects with long-term offtake contracts fit this profile.
Standard & Poor’s and Dominion Bond Rating Service both rate income trusts based on the sustainability of cash distributions. The Standard & Poor’s rankings are from 1 to 7 from most stable to least stable. S&P has tended to give power funds its highest ranking. However, as of December 2002, only 25 income funds had asked for ratings.
The amount of cash that can be raised through a Canadian trust is a function of the certainty of the cash projections. The riskier the business model, the higher the yield required by the investors. Most operating companies have significant debt. The cash the trust investors will receive is what remains after payment of this debt. More debt adds to uncertainty about cash-flow projections. Short-term debt that must be refinanced introduces risk that the interest rate will change.
Power plant and pipeline trusts might offer cash returns of 9 to 11%, according to a recent study by the Bank of Canada. The bank said returns for oil and gas trusts might exceed 20% reflecting the greater risk in a business that is based on depleting reserves and volatile commodity prices. There were eight trusts focused on the power industry by December 2002 with a value equal to 11% of total market capitalization of all income trusts.
The structures for income trusts are varied and evolving.
However, the basic idea is a trust is formed in Canada and units are sold to the public and listed on a Canadian stock exchange.
It is important that the trust qualify as a “mutual fund trust” for Canadian tax purposes and distribute all of its earnings currently to avoid being taxed. This means that it cannot be “established or maintained primarily for the benefit of non-residents” of Canada. Thus, foreign ownership of the trust units must stop at 49%. However, there is an exception to the foreign ownership restriction for trusts that have never held more than 10% of their assets in “taxable Canadian property.” Thus, a trust with all US assets would be free to raise capital in both the US and Canadian markets without worrying about breaching the limit on foreign ownership.
In cross-border deals, the trust forms a Canadian corporation as a subsidiary. A sizeable fraction of trust units are held in Canadian retirement savings plan accounts that are subject to a 30% limit on the amount of foreign content. The units in a trust whose only asset is a US business would be considered foreign property. Formation of a Canadian subsidiary ensures that the trust is considered invested in Canadian property, even if the ultimate assets are American. The Canadian subsidiary must have a “substantial Canadian presence.”
The trust capitalizes the Canadian subsidiary with one-fourth equity and three-fourths debt. Thus, for example, if $100 million were to be invested in the Canadian subsidiary for it to use, in turn, to acquire US assets, $25 million would be contributed to the Canadian subsidiary in exchange for shares and the other $75 million would be lent.
The Canadian subsidiary then uses the money to acquire equity interests in a US partnership or limited liability company that owns a project or is an operating business.
Canadian income trusts take the position that their earnings from US projects or businesses are largely free from US income taxes. The US partnership or LLC is not itself subject to tax. Tax is collected from the partners. Under US tax rules, the Canadian subsidiary that is a partner must file a US tax return and pay income taxes — just like any American partner — on its income that is “effectively connected” with a US business. However, the Canadian subsidiary takes the position that the income it earned as a partner is largely offset by the interest it pays on its debt to the trust. Interest payments are deductible by the Canadian corporation in computing its US income taxes.
The United States has “earnings stripping” rules that prevent foreign parent companies from capitalizing their US subsidiaries largely with debt and then “stripping” the earnings from the company by withdrawing them as interest payments to the parent. When the rules apply, interest deductions are disallowed. At least two things must be true for the rules to apply. The Canadian subsidiary must have a high debt-to-equity ratio — it does — and the interest must be paid to a related party. It is not in this case as long as the trust is ignored for US tax purposes so that the interest is considered paid to each unitholder individually.
The US normally also collects a withholding tax at the border on payments by a US taxpayer to someone outside the country. The payments by the Canadian subsidiary to the income trust would normally attract a US withholding tax. However, the trusts take the position that there is none in this case because the payments cross the border as interest and there is an exception in the US tax rules from withholding tax for “portfolio interest.” The key to qualifying as “portfolio interest” is that the Canadian corporation cannot pay the interest to one of its shareholders that owns 10% or more of the shares. If the trust is ignored, then the interest is treated as if paid to the thousands of unitholders individually.
With US taxes offset, the trusts argue there is little tax below the investor level in Canada, either. The Canadian subsidiary is subject to income taxes in Canada in theory on its earnings. However, its earnings are largely offset by the same interest deductions that offset its income for American taxes. The trust is not taxed as long as it distributes all its earnings. The main Canadian tax is collected at the investor level.
There is a different structure for situations where an income trust is used to raise capital in Canada to acquire a US target company. The structure makes use of a Nova Scotia unlimited liability company that is a “hybrid” for tax purposes — it is taxed in Canada but ignored in the US — and there are more steps in how the capital moves from the trust to where it is used to make the US acquisition.
The trusts have hit occasional turbulence.
Some critics charge that the debt on which earnings are paid out as interest is not really debt. The interest rates are high. The debt is subordinated — because of the tiered structure — to other creditors of the operating business. It is held by the same persons who hold the equity.
Specialty Foods — a US company that converted to a trust structure — said Pricewaterhouse Coopers declined to act as its auditor because of doubts about the interest deductions the company was taking. The announcement in September this year sent a chill through the income trust market. Deloitte, KPMG and BDO Dunwoody announced that they, too, were reviewing the trusts in which they were involved. In October, another PwC client, Heating Oil Partners — a US-based distributor of home heating oil that is owned 86% by a Canadian income trust — said it would continue to file US tax returns that claim interest deductions, but would take the “conservative” approach of excluding the interest from its tax calculations in financial reports to investors. PwC has remained its auditor.
Policy concerns make some Canadian fund managers nervous. One told Forbes in October that she refuses to buy income trusts based on US companies because she cannot understand why the US government would allow US business profits to be shifted to Canada and taxed there rather than in the US.
Securities regulators in Ontario are wrestling with reporting requirements. An income trust is an indirect offering of interests in an operating company, but the reporting entity for securities law purposes is the trust. The issue is whether investors are getting the disclosures they need to make informed investment decisions. This and other issues are expected to be addressed in an upcoming draft policy statement on income trusts. In June, Canadian securities regulators also proposed the equivalent of the Sarbanes-Oxley rules in the US that will require the chief executive officer and chief financial officer of companies to certify the financial statements and require annual disclosures about audit committees and services provided by outside auditors. Details about how the new rules apply to income trusts remain to be worked out.
Two of the most recent cross-border deals have used a newer structure called “income depositary securities” that raises fewer tax issues. The first registration statements for IDS offerings were filed with US and Canadian securities regulators earlier this year. The first set of IDSs began trading on the American Stock Exchange in December.
The idea behind the new structure is to replicate the economics of the Canadian income trust structure but broaden the market for the securities. The structure does not use a Canadian trust. Rather, a US corporation is formed to raise capital by issuing IDSs. Each IDS is a common share in the corporation and a fractional interest in a subordinated note. The IDS is traded on a US stock exchange and the shares — but not the note — are also listed on a Canadian exchange. The investor can separate the two pieces or combine them again as a single unit. The US corporation has the same high debt-to-equity ratio as in the basic trust structure.
With IDSs, there is again little tax except at the investor level. The US corporation that issues the IDSs is in theory subject to income taxes in the United States, but its income is offset by the high interest payments on the note portion of the IDS. Since the interest is paid directly to the investors, there is a stronger case for avoiding US earnings stripping rules that would disallow the interest deductions and for avoiding US withholding taxes on interest paid to Canadian investors on grounds that the interest is “portfolio interest.” Because the debt and equity are separable, there is arguably a lower risk that the debt will be recharacterized as equity.
A drawback with the IDS structure is the IDSs are foreign property. They will attract less Canadian pension money. However, since the investor will be a shareholder in a corporation rather than a unitholder in a trust, the liability concerns disappear with the result that there may be more interest in them in the institutional market. There are also no limits on the percentage of the deal that can be sold to US investors.
Canadian counsels continue to tinker with the IDS model in the hope of achieving non-foreign property status to bring back the Canadian retirement savings plan investors. At the end of the day, the IDS structure is an attempt to do directly in the US market what the Canadian income trust permitted in Canada: allow US businesses to be both publicly-traded and have their earnings taxed only at the shareholder level.
The US project finance community has tried using US real estate investment trusts, or REITs, and master limited partnerships to get to the same place, but these entities — which the US tax laws expressly permit to operate as publicly-traded businesses with only one level of tax — are really only suited for investors in real estate and oil, gas and other natural resources businesses. Efforts to persuade Congress to allow master limited partnerships to be used in other energy businesses have failed to date.
by Keith Martin and Heléna Klumpp, in Washington