Despite ottawa’s attempt to throw cold water on the red hot income trust business, fund companies and investment dealers are hopping on the trust conversion bandwagon. Even banks are wondering if it’s possible to make the switch. And the more companies that make the leap to a new life as an income trust, the greater the pressure on their competitors to follow suit.

Canadian capital markets’ relentless race toward widespread income trust conversion began earlier this year, after it was decided that trusts would be added to the market’s flagship index, the S&P/TSX composite. On the heels of provincial governments enacting legislation that solved the structure’s liability issues and the federal government backing down from a plan to restrict pension plans’ ownership of business trusts, the barriers to increased corporate conversions have vanished, too.

Several large, high-profile companies then announced trust conversions, many others mused aloud about it and, as promised, the process of adding trusts to the index began.

This wave of new developments changes the type of company for which conversions would be attractive. The classic trust was a slow-growth business that generated heaps of cash to fund hefty distributions. But now just about every company that’s conscious of maximizing shareholder value is contemplating conversion.

The list of firms making the leap in recent weeks includes CI Fund Management Inc. and Precision Drilling Corp. CanWest Global Communications Corp. says it will spin most of its newspaper assets into a trust and, earlier this year, investment dealer GMP Capital Corp. declared it will also convert.

But in mid-September, conversions took a breather, as Ottawa released its long-awaited discussion paper on the income trust issue and stepped up to curb conversions by putting a moratorium advance tax rulings. This may stall CI’s proposed conversion, as it was planning to seek such a ruling.

Prior to that, CI had planned to have its board consider the proposed conversion in early October and, if approved, the plan would be put before its shareholders at the annual meeting before the end of November. The firm, which considered and rejected a conversion in 2003, notes that it has since seen “many favourable changes to the long-term environment for income trusts,” including addition to the index, elimination of liability issues and the government backtracking on plans to restrict trust ownership by pension funds.

The addition of trusts to the index began after the market closed on Sept. 16. Earlier in the week, Standard & Poor’s Ratings Services published the S&P/TSX provisional income trust index, which includes 68 names. In December, 50% of the float of the PITI will be included in the composite index. The other 50% will be added in March 2006.

Following the trust discussions by CI and GMP, analysts began speculating about the other financial services firms that could benefit from a trust conversion. Large asset managers are thought to be particularly attractive candidates, as they tend to generate big and stable cash flows that are just what a company needs to succeed in a trust structure. By converting to a trust, they minimize taxes at the corporate level and flow the returns directly to unitholders.

The possibility of more trust conversions was the topic of the day at a financial services conference hosted by Toronto-based Scotia Capital Inc. in mid-September. AGF Management Ltd. is thought to be ripe for trust conversion, and its stock popped sharply in response to CI’s announcement.

At the conference, AGF CEO Blake Goldring suggested the firm would seriously consider converting to a trust, but only after it finishes selling its Unisen division and implements changes designed to turn around the company’s retail fund sales. In a research report, Genuity Capital Markets analysts estimate the probability of AGF converting to a trust in the next 12 months to be 50%.

Other possible trust candidates in the financial services industry appear more reluctant to embrace the structure. Speaking at the same conference, TSX Group Inc. CEO Richard
Nesbitt said the TSX is comfortable with its current structure, although he didn’t rule out an eventual move to a trust configuration. Likewise, Murray Taylor and Charlie Sims, co-presidents and co-CEOs of Winnipeg-based money manager IGM Financial Inc. , said they have no immediate plans to take IGM along that route.

@page_break@Vancouver-based brokerage Canaccord Capital Inc. is another obvious trust conversion candidate. After evaluating the possibility and concluding that a conversion is possible in the next 12 to 18 months, CIBC World Markets Inc. raised its target price for Canaccord to $17 a share from $12. CIBC World Markets noted that Canaccord has said it has looked at the trust option but hasn’t yet made a decision.

Analysts and investors appear to be looking at every decent-sized financial firm as a possible trust and, at the Scotia conference, the mother of all trust conversions — that of a Schedule 1 Canadian bank — was pondered, as well. As with other financial firms, banks appear to be prime candidates for the income trust structure.

But could a bank really convert into a trust? Toronto-based BMO Nesbitt Burns Inc. analyst Ian de Verteuil thinks not. In a report examining the idea, he says such a transaction would be very tricky to pull off. De Verteuil points out that the banks’ regulator, the Office of the Superintendent of Financial Institutions, would probably never allow it because the banks’ regulatory regime imposes capital requirements and requires banks to be widely held. In a typical trust structure, the trust owns the underlying company and loads up on debt to maximize its tax efficiency. So the conflict between the banks’ regulatory regime and the demands of an effective trust structure make it unlikely an entire bank could convert.

A more viable option would be for a bank to spin off specific subsidiaries, such as a wealth-management division, into trusts. At the conference, Royal Bank of Canada CEO
Gord Nixon said it might make sense to do that, depending on what happens with trust rules.

The federal government has been pondering just what to do about the explosion in income trust issuance and conversion ever since its 2004 budget and its ill-conceived proposal to restrict pension funds from owning income trusts. Ottawa’s primary concern with the growing popularity of the income trust structure is the fact that increased corporate tax efficiency means lower tax revenue for federal coffers. Its paper, released
Sept. 8, estimates that federal revenue was $300 million lower than it otherwise would have been if trusts were structured as corporations. Defenders of income trusts point out that the revenue isn’t necessarily lost but is just taxed in the hands of unitholders or deferred, as in the case of tax-exempt investors.

Apart from the revenue impact, the government also worries that the popularity of the trust structure is distorting the composition of corporate Canada. By favouring mature, low-growth companies with lower costs of capital, the tax advantage for trusts may, at a macro level, draw capital away from younger, growing companies that don’t fit the structure as neatly.

The paper proposes three possible policy responses to the issues: limiting the deduction of interest expenses by operating entities; taxing income trusts in a manner similar to corporations; or better integrating the personal and corporate income tax systems to neutralize the tax advantages of income trusts vs traditional corporations.

The range of policy responses offered, and the content of the paper, has comforted analysts that Finance hasn’t prejudged the issue and decided definitively to kill the goose that has been laying the golden egg for the Canadian capital markets in the past few years.

“The consultation document and the process suggest that this is not a file that is going to go very far or very fast,” writes TD Bank Financial Group chief economist Don
Drummond in a research note. “On key issues of the economic impact of income trusts, the revenue loss and what, if any, policy changes should be made, the document is largely agnostic. Both positive and negative influences on economic efficiency are identified without a clear view offered on what Finance thinks is the net impact.”

Given the lack of a definitive policy response, the timing of federal budgets (typically late winter) and the probability of an election in early 2006, Drummond says, it’s unlikely policy changes are imminent. The consultation period runs until the end of the year, and further public input will be sought at symposiums organized by the Canadian Tax Foundation.

When the government does decide to deal with the trust issue, the hope of most market players is that it will do so as painlessly as possible — eliminating the tax arbitrage opportunity by cutting the taxes on corporate dividends to avoid the capital market distortion that trusts invite. Once companies are more or less indifferent to the tax treatment, they would then be free to choose the corporate structure that is appropriate to the firm. The likely candidates for trusts are mature, cash-generating businesses whose managers could benefit from the discipline imposed by a structure that requires the operation to pay out most of its cash.

In the meantime, the list of trust conversion candidates will grow. The question facing many other contenders in the financial sector is when, not if, they expect to make the switch as well. IE