Once an income trust has made the decision to convert to a corporation, there are two structural options available under the tax rules providing for tax-deferred conversions: the exchange method and the distribution (or redemption) method. The exchange method, implemented by plan of arrangement, has become the more common technique.

Income trust structures typically involve the operating business being held in a limited partnership or corporation, with the trust owning the equity in the operating entity either directly, or indirectly, through one or more flow-through entities. The objective of the conversion is to substitute shares in a listed corporation for outstanding units of the income trust on a tax-deferred basis and, typically, to also collapse the former income trust structure to simplify operations from a commercial and tax point of view.

Exchange Method

Under the exchange method, all income trust unitholders transfer their units to a Canadian corporation in exchange for a single class of shares of the corporation. As a result, the unitholders become shareholders of the corporation and the corporation becomes the sole unitholder of the income trust. The income trust is then wound up into the acquiring corporation. The following are the basic conversion steps:

• A corporation issues a single class of shares to unitholders in exchange for their outstanding units on a tax-deferred basis without the need for unitholders to fi le an election (accrued losses on trust units cannot be realized).
• The income trust and subsidiary entities may be wound up into the corporation on a tax-deferred basis (provided that the wind-up is completed by no later than December 31, 2012).
• Where there is subordinated debt in a subsidiary entity owing to the income trust, this internal debt may remain in place and be addressed in a post-conversion reorganization.
• Any debentures (including convertible debentures) of the income trust may be assumed by the corporation (unless not permitted by the governing trust indenture, in which case the debentures will need to be exchanged for debentures of the corporation or the governing trust indenture amended).
• Any options held by trustees and employees of the income trust may be exchanged for options of the corporation under a new incentive plan focused on equity growth.

Typically, a court-approved plan of arrangement will be used, particularly to effect the exchange of the units for shares.

The key advantages of the exchange method are:

• The tax attributes of the income trust and any subsidiary entities generally flow through to the corporation. Any property transferred on wind-up of the income trust or subsidiary entities should transfer at its tax cost.
• The unitholders obtain a tax deferred exchange without the need for fi ling a tax election.
• This structure can be used to achieve a take-over or merger with an income trust, and has been used in a number of cases where an income trust has effectively merged with a loss company.
• In theory, the structure has the flexibility to permit unitholders to opt out of the “conversion” rule and do a taxable sale to the corporation or, with the corporation's participation, a partially taxable sale to limit the amount of the gain, possibly to the amount of capital losses realized elsewhere. However, accrued gains on trust units are uncommon and this option has not been offered in a conversion since a loss denial rule was added to the tax conversion rules.
• In theory, the exchange method may permit other consideration to be issued, such as debt securities by issuing different consideration for different property, though this structure has not yet been tested.
• Collapsing subsidiary entities can be deferred until after the conversion in order to allow time to address other structural issues, such as internal debt.

A disadvantage of the exchange method (as well as the distribution method) is the requirement that, in order to qualify, only one class of shares can be issued on exchange, which could result in significant dilution to existing unitholders if there are holders of retained interests. However, exchangeable interests may be collapsed into a single class with the unitholders to eliminate retained interests.

Distribution Method

Under the distribution method, the income trust reorganizes so that its only asset is shares of a Canadian corporation (which may be an existing corporate subsidiary of the trust). The income trust then distributes those shares to unitholders in consideration for the redemption of their units. The following are the basic conversion steps:

• The corporation acquires all of the assets of the income trust with payment to the income trust being shares of the corporation.
• As appropriate, the corporation implements a restructuring of the assets it has acquired, generally liquidating any subsidiary entities and consolidating all assets in the corporation.
• The income trust is wound up and its assets (being only the shares of the corporation) are distributed to unitholders on a tax-deferred basis in payment of the redemption price.
• Where there is subordinated debt in a subsidiary entity owing to the income trust, the subordinated debt is exchanged for shares of the corporation and these additional shares are distributed to unitholders in payment of the redemption price.
• Any debentures (including convertible debentures) of the income trust may be assumed by the corporation (unless not permitted by the governing trust indenture, in which case a plan of arrangement using the exchange method or an amendment to the governing trust indenture will be required). The assumption by the corporation of any existing debt should generally result in automatic rollover treatment and not result in any debt forgiveness to the income trust.
• Any options held by trustees and employees of the income trust may need to be cancelled and replaced by options issued by the corporation under a new incentive plan.

The key advantage of the distribution method is simplicity. It can be effected without a plan of arrangement, though frequently an arrangement is used. Either way, unitholder approval is required. A material disadvantage is that the tax attributes of the income trust and any subsidiary trusts do not flow through to the corporation or to the former unitholders, with the result that the benefit of those tax attributes may be lost.

The distribution method is most often used where commercial considerations prevent the use of an exchange transaction, such as where a “change of control” provision in debentures may be triggered, yet an internal reorganization leading to the distribution to unitholders may be permitted.

The results of an internal due diligence review, together with expert legal advice regarding tax considerations, internal reorganization structures, contractual terms, securityholder rights and compensation arrangements, are critical to determining the best conversion structure.

Our next Income Trust Update, Implementing a Conversion.