Income trusts need to consider their alternatives, including conversion into a corporation, before the specified investment flow-through (SIFT) tax becomes effective on Jan. 1, 2011.
The SIFT tax, announced on Oct. 31, 2006, is intended to put income trusts and corporations on a level tax playing field. At the time, the trust market was booming and a number of large corporations – such as BCE and Telus – were looking at converting into an income trust. The federal government decided it needed to stem the loss in tax revenue, and introduced the SIFT tax.
Both energy trusts and business trusts will need to consider their options; some real estate investment trusts (REITs), other than those that operate hotels or retirement and nursing homes will be exempt from the SIFT tax.
Beginning in 2011, income trusts will be subject to a SIFT distribution tax of 16.5% (15% beginning in 2012) along with a provincial tax component (10% for income earned in Alberta). These tax rates mirror corporate income tax rates, but apply to income trust distributions of certain types of income, rather than the income itself.
Income trusts that need equity infusions in the coming months are constrained by the “normal growth” limitations that were introduced along with the SIFT tax. Those limitations would make the SIFT tax effective earlier if an income trust increases its equity by an amount exceeding 100% of its market capitalization on Oct. 31, 2006.
“It is difficult for an income trust to grow with these limitations,” says Johnson Tai, a corporate tax partner and leader of PwC’s Mergers and Acquisitions tax practice in Calgary. “Raising equity is already difficult enough in the current economy.”
Some Alberta-based income trusts, including Crescent Point Energy, Advantage Energy and Eveready, have already converted into corporations. The vast majority of Alberta-based income trusts have not yet converted into corporations, but many are considering their alternatives and timing.
Converting before 2011 could result in a loss of income trust benefits. However, converting early may make sense if there is a need to cut or eliminate distributions, a need to access capital beyond the “normal growth” limitations, or a concern that non-resident ownership of the income trust will exceed 50%.
Converting to a corporate structure after Jan. 1, 2011 would maximize the income trust benefits, but could result in being subject to the SIFT tax, even if only for a short period of time. Another thing to keep in mind is that the Income Tax Act has provisions which allow income trusts to convert into corporation in a tax-deferred manner. “These conversion rules are available only until the end of 2012,” Tai explains. “So if you decide to convert after 2012, your conversion may not be free of tax.”
The process of converting from an income trust into a corporation can take anywhere from three and six months. The cost of a conversion also needs to be taken into consideration. “Costs will vary based on the size of the income trust and the industry it which it operates,” Tai says. “If you have to quantify the cost, it is likely the same as converting from a corporation into an income trust, updated to current dollars.”
For some income trusts, especially smaller ones, another option is to look for a buyer. Potential acquirers include foreign state-owned companies (who would have particular interest in resource-based income trusts) and tax-exempt pension funds. Private equity players or larger competitors may also be interested buyers.