Two years after federal Finance Minister Jim Flaherty shocked the stock market with his plan to slap a sector-killing tax on income trusts, the decision has resurfaced as an election issue. In the meantime, companies are facing up to the reality of having to convert to being corporations.

Flaherty’s infamous Halloween trick from 2006 is still controversial. The finance minister effectively put an end to the income trust phenomenon — the widespread conversion of traditional corporations to an income trust structure to take advantage of favourable tax treatment — by imposing a large levy on income trust distributions, designed to nullify the tax advantage of such trusts.

In the current election campaign, that 2006 decision has once again become a hot button. In Flaherty’s own riding, a former investment banker and head of a taxpayer lobby group that was formed to oppose the decision is challenging Flaherty for his seat. (For more on the challenger, go to www.investmentexecutive.com and click on “Canada Votes 2008.”) Moreover, the Liberals have pledged that, if elected, they will roll back the Tories’ October 2006 surprise and replace the planned 31.5% tax on income trusts with a 10% tax that will be refundable to Canadian residents.

As Investment Executive went to press, the polls seemed to indicate that the Liberals had little chance of forming the government. Nevertheless, the income trust decision is back on the political agenda.

Until now, companies have been operating under the assumption that the income trust party would soon be over, and are grappling with the fallout from that decision. Such trusts have until 2011 before they face the new tax regime. Assuming that the current policy against these trusts prevails, the sector is expected to disappear over the next few years. Many income trusts effectively disappeared in the wake of the 2006 announcement of the new tax treatment. The creation of new trusts immediately stopped and many existing trusts were quickly snapped up by private-equity interests and other strategic buyers.

Ahead of that 2011 date, most income trusts are expected to convert to a corporate structure. Some may prefer to do it sooner rather than later. They may find that a couple of years of superior tax treatment is outweighed by corporate objectives such as undertaking major growth plans. (The new trust tax regime limits the amount by which existing trusts can grow.) These trusts may want to develop corporate strategies that do not fit well within the trust structure, which works best for firms that don’t make heavy capital investments and can flow a healthy income stream through to unitholders.

Already, a handful of firms have made the decision to convert to corporate status. Among the early movers are TransForce Income Fund, which became TransForce Inc. in May, and Aeroplan Income Fund, which became Groupe Aeroplan Inc. in June. In making the move to corporate status, both firms cited the increased flexibility of the corporate structure compared with the trust structure, and Aeroplan noted that the foreign investor limits faced by trusts were becoming a constraint.

Following these two high-profile conversions, several other firms have signalled their intention to make the leap. On Sept. 25, unitholders in BFI Canada Income Fund approved its planned conversion into a corporation. Earlier in the month, Eveready Income Fund said that it would convert early, too. Similar conversion conversations are doubtlessly going on within all the income trusts as they contemplate their future.

But that conversation is complicated by the fact that the trust structure is back as an election issue. CI Financial Income Fund of Toronto has been in the thick of the income trust debate over the past few years. It struggled with its original decision to convert to an income trust amid uncertainty about the government’s policy toward trusts. When CI was finally confident that trusts would be allowed, it went ahead and converted. But it enjoyed only a few months as a trust before the infamous Halloween 2006 decision.

Although CI CEO Bill Holland says that the firm has discussed the prospect of reverting to a corporation, it probably won’t do so for the foreseeable future. The problem, Holland told an investor conference hosted by CIBC World Markets Inc. in late September, is that the tax treatment of the income trust structure has now been put back on the table by the Liberals.

@page_break@In this environment, there’s no way CI can revert to being a corporation, Holland explained, because of the renewed uncertainty surrounding the trust structure’s status. Operating as a trust has a significant value to CI shareholders, he noted. So, if there’s any chance that the government will revive the structure, CI has to stay as a trust on the chance that it may be able to preserve that value.

In the meantime, companies such as CI are a bit at sea because this uncertainty affects corporate planning. Holland reports that CI has been unable to get straight answers from the government on questions about what it can and can’t do as a trust. In turn, this has hampered CI’s ability to carry out corporate deal-making (such as mergers and acquisitions).

One area in which the government has provided some greater clarity is the rules governing firms that do decide to convert to a corporation from a trust. Those rules were released for comment in mid-July, and the comment period closed in mid-September.

The proposed rules effectively offer trusts two ways to convert tax-efficiently, which was what the government promised firms when the new tax regime was announced in 2006. Under the proposals, unitholders will be able to swap their income trust units for shares in a taxable Canadian corporation on a tax-deferred basis in one of two ways: they can either exchange their trust units for shares in the new corporation, or the trust can distribute shares in a subsidiary corporation to unitholders. Both methods are subject to a variety of conditions, and these two special conversion options will be available only until the end of 2012.

Using the straight exchange approach, unitholders must receive shares as their only payment for their units, the shares must have equal value to the units and there can only be a single class of shares. After the exchange takes place, the income trust and any subsidiary trusts can then be wound up.

The distribution variation doesn’t have the same limitations as the exchange method, in terms of limiting the conversion to a single class of shares and ensuring that the new shares have the same value as the old units. But the distribution method only makes sense for those trusts that have a Canadian corporation as their only asset. If the trust owns other property, it will probably have to convert that property into shares first if it chooses the distribution method.

Another key difference between the two approaches, as Toronto-based law firm Stikeman Elliott LLP points out in its comment paper, is that the distribution method typically doesn’t allow the tax attributes of the income trust to carry over to the new corporation. For example, if the trust has past tax losses that it wants to claim in future years, it would probably lose the ability to claim these losses if it undergoes conversion to a corporation as a distribution. The converted company could retain the losses, however, if it uses the exchange method.

The method an individual income trust should use to convert to a corporation is a very complex decision. As the Stikeman Elliott paper explains: “[The decision] will be influenced by the unique characteristics of the trust, such as the trust’s size, business, performance, distribution policy and underlying tax situation.”

The proposed conversion rules are being fairly well received. Prior to the release of the Liberal platform and the potential reopening of the income trust can of worms, CI’s Holland indicated that he was “pretty happy” with the proposed rules governing conversions.

Indeed, Toronto-based accounting firm Deloitte & Touche LLP indicates in its comment that the two primary conversion methods being proposed should work for the majority of trust structures, albeit not all of them: “For example, the legislation may not allow troubled trusts with ‘underwater debt’ owing from corporate subsidiaries to convert without adverse tax consequences.”

Moreover, the Stikeman Elliott comment notes that under proposed conversion rules: “It appears that only two layers of trusts will be permitted to be wound up on a tax-free basis, which, unless amended, may cause difficulties for more complex income trusts that include more than two layers of trusts in their structure.”

These conversion rules are very complex, and are almost certain to face technical amendments in response to the comments generated during the consultation period this past summer. And, in the midst of an election, it’s impossible to tell when the final version of these rules will be enacted into law. But then, uncertainty has been the one constant in the income trust sector over the past few years. IE