Income trust conversions: dealing with retained interests
Income trusts have played a relatively unique role in Canadian capital markets over the last few years and, with the recent changes to their tax treatment and the proposed "conversion" rules, they promise to do so for at least another few years. The following excerpt from our Income Trust Conversion Guide discusses the issue of retained interests.
Update: A revised 2010 version of the Guide has now been published. Download a copy here.
Dealing with a Retained Interest
Many income trusts feature “retained interests”; i.e., individual equity interests held by the pre-IPO owners of the underlying business of the trust. These retained interests are, for tax (and other) reasons, often held at a different structural level than the public (i.e., often directly in the underlying operating business), are usually exchangeable for units of the trust, and often carry voting rights at the trust level on an “as exchanged” basis. The retained interests also frequently have substantial governance rights and protections, including veto rights over certain kinds of transactions by the trust.
Many retained interests are “subordinated” in priority of distributions to the public, and generally cannot be exchanged for trust units during the period of subordination. The subordination typically continues for a specified period of time, and may in certain cases also require that certain cash distribution and/or other performance measures be met by the trust before subordination can be lifted. Note that the specific subordination provisions of each particular trust, if any, need to be carefully considered, as they vary from trust to trust.
Given the foregoing, a trust with a retained interest raises a number of issues that would need to be addressed by any conversion to corporate form, including:
- Whether the retained interest is also to be “converted”, and if so, at what ratio?
- If the retained interest is subordinated, and the tests for lifting the subordination have not yet been satisfied, then a conversion of the retained interest may disadvantage either the unitholders, who would presumably be diluted by a full conversion of the retained interest, or the retained interest holder, who could potentially lose the ability to meet the test for lifting the subordination.
- If the retained interest is not converted, then in addition to the structural complications, the tax impact of the conversion of the trust to a corporate form could, if it reduced the future cash available for distribution by the (post-conversion) corporation, negatively impact the retained interest holder by reducing the distributions payable to the former unitholders and potentially making it more difficult for the retained interest holder to meet the applicable performance targets for lifting the subordination. This might have “value” effects that would preclude the Exchange Method and require the Distribution Method.
- The impact of the conversion transaction on the retained interest holder could potentially give rise to “minority approval” requirements if the retained interest holder, in effect, gains a benefit under the conversion relative to its pre-conversion position.
- If the retained interest is subordinated, and the tests for lifting the subordination have not yet been satisfied, then a conversion of the retained interest may disadvantage either the unitholders, who would presumably be diluted by a full conversion of the retained interest, or the retained interest holder, who could potentially lose the ability to meet the test for lifting the subordination.
- What, if any, governance rights the retained interest holder will continue to enjoy following the conversion.
- A retained interest holder frequently enjoys trustee nomination rights, as well as veto rights over significant transactions. Any conversion transaction would need to consider if these rights would continue post-conversion.
- In the Exchange Method, given the “equal value” and one share class limits, query whether security holder agreements could be kept in place, or if not then put in place contemporaneously with a conversion into corporate form.
- A retained interest holder frequently enjoys trustee nomination rights, as well as veto rights over significant transactions. Any conversion transaction would need to consider if these rights would continue post-conversion.
