The federal government’s intention to impose taxes on Canadian income trusts will have long- and short- term implications with respect to Standard & Poor’s Ratings Services’ stability ratings universe, the ratings agency says.

S&P says the “Tax Fairness Plan” has a high probability of being enacted into legislation. As proposed, the revised tax structure would subject all new income funds (after Oct. 31, 2006) to the federal corporate tax rate (currently expected to be 18.5% in 2011), while existing funds will be exempt only until 2011, allowing essentially for a four-year tax holiday at the trust level. Most REITs appear to be exempt from this change in tax policy.

“The tax announcement raises questions on the strategic response from existing funds. Responses could include fund conversions to corporations, acquisitions of corporations with large tax losses, leveraging the funds to obtain a tax shield, or the acquisition of a fund by other entities,” said Standard & Poor’s stability analyst Ronald Charbon, in a news release.

From a broad stability rating perspective, there are a number of things to consider. First, stability rating criteria do not–and cannot–incorporate the impact of unknown and a priori immeasurable systemic shocks, such as a profound change in tax policy. The tax announcement is considered a systemic event as it has widespread but consistent effect on all trusts. Second, stability ratings are relative ratings and, ultimately, the taxation of income funds will create a downward “level-shift” in the amount of cash available for distribution among all non-REIT income funds.

“The fundamental cash generation characteristics of our rated income funds are generally unchanged following the tax announcement. Nevertheless, after 2011, there will clearly be a negative impact on cash available for distributions, but it will be a consistent reduction on a relative basis across the spectrum of income funds,” noted Charbon. “Because the businesses, their assets, and cash flows before taxation are largely unaffected by a tax policy change, we do not expect to make widespread stability rating changes,” he said.


Notwithstanding this broad relative impact, there are a number of selective implications. Certain funds face immediate consequences that could result in a stability ratings impact given unique circumstances affecting short-term potential risks to distributable cash flows and distributions to unitholders. On an immediate basis, all funds will have reduced financial flexibility due to prohibitive access to the equity caused by lower unit prices. Funds with proposed equity issuances in the near term are at risk to complete their equity deals and might need to find alternative sources of financing. In addition, funds that have used dividend reinvestment programs as a source of capital might see those cash sources dry up due to the lower intrinsic value of the shares and the likely move back to “cash distribution” preference by unitholders. Finally, with depressed unit prices, convertible debentures are farther out of the money and look more like permanent debt instruments, as has always been the analytic approach taken in Standard & Poor’s stability ratings.


In the medium term, the strategic growth (that is, nonorganic growth) initiatives of all income funds may be limited and asset portfolios are likely to remain at best static. Although income funds are conceptually based on mature stable assets, asset growth was a mechanism through which funds were able to revitalize and regenerate their asset base. Without a strong outlook for asset growth, the focus on income funds internally funding sustaining capital expenditures is heightened as a sustainability issue. Another possible consideration is that debt covenant patterns, if based on after-tax metrics, could be in danger of being triggered.