The planned trans-
formation of telecom giants BCE Inc. and Telus Corp. into income trust structures may be the most significant conversions so far for income trust evangelists. The moves spread the trust gospel even further into the mainstream, and may inspire even more followers.

With the announced conversions of the two big telecom firms, the market quickly turned its imagination to who would be next to make the leap. The big banks are popular targets of such speculation, in part because Royal Bank of Canada CEO Gord Nixon mused about the idea at an investor conference last year.

Although the banks have indicated they aren’t planning to convert anytime soon, that’s unlikely to put an end to the debate over whether they should. As the income trust structure has gained acceptance, just about every CEO and board is obliged to consider conversion.

The income trust structure has been around for years, but it’s only in the past couple of years that it has gone mainstream. Originally used as a clever way to finance large-scale resources extraction projects, use of the trust structure steadily crept into other sectors with similar characteristics (mature, stable cash generation). But it has morphed even further into a full-blown alternative structure for almost any company.

The primary appeal of the structure is that it enables companies to minimize their tax bills by flowing most, if not all, of their income through to shareholders, so it is taxed in the shareholders’ hands. This advantage has been a cause for concern for the federal government (see story below). For investors, trusts are also appealing because they deliver a stable income flow and they impose a discipline on corporate management, preventing it from building up cash and squandering it on follies such as value-destroying acquisitions.

As the virtues of the trust structure have won favour with investors, some of their disadvantages have been eliminated. Early concerns about unlimited legal liability have been legislated away and the threat of an added tax on trusts was turned back by a public outcry. Trusts have also been legitimized by their inclusion in stock indices. The decision of whether to organize as a trust or a traditional company is no longer just one for prospective new issuers to ponder; any existing public company has to consider the merits of converting to a trust.

The Telus and BCE announcements set off a flurry of speculation about other possible conversion candidates for a couple of reasons: it raises the bar on the size of company converting, and it highlights the competitive pressure that may push companies in that direction.

A report from UBS Securities Canada Inc. indicates that BCE made its conversion decision in part to keep up with Telus, which decided to convert first. “Management indicated that Telus’s trust conversion was ‘certainly a factor’ behind its decision to convert,” the report says, adding that BCE management expects this arrangement to help it to restore “greater parity in cost of capital.”

If the trust structure can provide a capital cost advantage, it is incumbent on every CEO to consider conversion.

Theoretically, financial services companies make ideal candidates for the trust structure because they tend to be stable, cash-generating machines. The concept has already been proven in the asset management business by CI Financial Income Fund (formerly CI Financial), and even in the more volatile dealer business, courtesy of GMP Capital Trust (previously GMP Capital Corp.). In mid-October, Dundee Wealth Management Inc. announced it would join the party by spinning off 15% of its management subsidiary, Goodman & Co. Investment Counsel Ltd. , into an income trust of its own.

As for the other publicly traded fund companies, there doesn’t appear to be a great deal of interest in converting at this point. Executives at IGM Financial Inc. have indicated that they have no plans to go the trust route — citing several reasons for their reluctance, including that the trust structure is still fairly young and untested through different markets, and there is still uncertainty about whether the tax advantage trusts currently enjoy will persist.

AGF Management Ltd. has been the subject of speculation that it may convert, but one analyst expresses doubt. “AGF is unlikely to convert into a trust due to its low overall tax rate, and the fact that AGF Trust and AGF’s foreign operations are not ideal trust candidates,” Genuity Capital Markets analyst Karin Huo says in a recent report. “As well, the company is still implementing the initiatives needed to revitalize its investment-management business and thus, conversion to an income trust is not a priority at this time.”

@page_break@The prospects for the big banks and insurers to convert are seemingly dim, too, although they arguably improved when firms as big as Telus and BCE announced that they would make the move. “Before the announced conversions of Telus and BCE, we would have thought that the likelihood of banks or lifecos converting into income trusts is so remote that it is not even worth consideration,” says a research report from Desjardins Securities Inc. “In our view, it is still remote. But we estimate that potential increases in value, if it were to happen, are significant, especially for those companies generating most of their earnings in Canada.”

Before the banks could attempt to unlock that value, there would be some significant obstacles to overcome. For one, anything a large financial institution tries to do in Canada — particularly one of the Big Five banks — carries political implications. These considerations aren’t entirely foreign to the telecom sector, either.

Indeed, UBS indicates that BCE’s planned conversion, for example, is subject to approval from shareholders, the court (because it is using the plan of arrangement method) and the Canadian Radio-television and Telecommunications Commission.

For a large financial institution to convert, the Finance Department and the federal banking regulators would have to be onside. Rod Giles, manager of communications and public affairs at the Office of the Superintendent of Financial Institutions, indicates there is nothing in the Bank Act or Insurance Companies Act that would necessarily prevent a large bank or insurer from converting.

“While such a scenario would certainly present both policy and prudential issues and challenges, OSFI’s role would be to closely examine any such proposed transaction from a prudential perspective,” says Julie Corbett, communications officer at OSFI. “Generally speaking, the kinds of prudential issues we would look at would be sources of funding and capital levels, given that most of the income is paid out as earnings. These are not trivial issues.”

But they aren’t necessarily deal killers, either. And from a strictly business perspective, conversion might make a great deal of sense.

Desjardins’ report argues that there is no fundamental reason why large financial institutions couldn’t be structured as trusts. “We are not convinced that their need for capital, soundness and confidence is incompatible with an income trust structure,” it says. “We can well imagine that the gut reaction of managements to the idea of converting would be negative because they would abhor the idea of losing absolute control over the retention or distribution of earnings by their businesses. But we also believe that the risk is overdone.”

One of the questions that a large financial institution contemplating a trust conversion would have to ponder is whether to trust the whole company, or just to spin off a division, such as wealth management, that may work particularly well as a trust, as Royal Bank’s Nixon has suggested. The Desjardins report notes that while a spinoff might be easier to stickhandle past regulators, it’s not clear whether the holding company discount that would be created by such a move would negate the benefit of organizing as a trust.

The Desjardins report finds that, assuming the banks were to contemplate converting the whole business and were able to pay out most of their tax bills to unitholders, the benefits would be substantial. After all, it reports, a couple of the banks paid as much as $1.2 billion in taxes in fiscal 2005. Assuming a 6% yield, estimated valuation increases for banks in trust form, rather than corporate form, range from a low of 20% for Bank of Nova Scotia to a high of 66% for CIBC. Assuming a 7% yield, Scotiabank’s boost is estimated at 17%, with CIBC potentially in line for a 56% gain.

Valuation increases of this magnitude are not unheard of for firms that undergo the transformation from corporation to trust. For example, BCE gained about 35% in the wake of the recent conversion announcements (most of it after Telus indicated its plan to go first).

The report doesn’t produce the same analysis for the insurers. But it does note that, similar to the banks, the firms with a greater proportion of earnings generated and taxes paid in Canada would benefit most from conversion. “As with banks, regulatory obstacles would be high. But if the value proposition is strong, it is an alternative that would have to be examined,” it concludes.

While the large banks and insurers might be the most interesting firms to muse about making the move to the trust structure, there are plenty of other prospects, including a number of retailers, that have been tapped as potential converts.

As long as the tax advantages persist, companies can’t help but consider the idea. IE