The bombshell dropped by Minister of Finance Jim Flaherty on October 31, 2006, raised a storm of protest from the income trust sector, erased $35 to $40 billion in market capitalization and shut down the IPO market for income trusts. These effects were no doubt in line with the Minister’s expectations. What he may not have expected, however, was the level of anxiety he raised in the market over the concept of “undue expansion.”

In that announcement, the Minister said existing specified investment flow-through (SIFT) entities would not be subject to the new Distribution Tax until 2011. However, he warned that if a SIFT did not respect the policy objectives of the Tax Fairness Plan, for example, by undue expansion, it could see its four-year deferral taken away.

Immediately, financing plans and mergers and acquisitions went on hold while the sector tried to determine what would qualify as undue expansion, as opposed to the “normal growth” that was permitted. There are a number of areas of uncertainty in the Tax Fairness Plan proposals, but this one, with its threat of immediate taxation on distributions, was of most immediate concern. (For a discussion of other key areas of uncertainty, please see the Deloitte publication, Facing the new realities for publicly traded trusts and partnerships.) On December 15, 2006, in response to calls for clarification, the Department of Finance released guidance on what constitutes normal growth for SIFTs.

The guidance allows for equity capital growth of $50 million a year or 100% over four years, broken into “safe harbour” percentages of 40% for the first year and 20% each for the remaining years. These safe harbour percentages are cumulative and based on a SIFT’s market capitalization at end of trading on October 31, 2006. Included in equity capital growth are units, debt convertible into units, and any substitutes for equity that may be developed.

The guidance indicates that mergers or reorganizations of existing SIFTs will not be considered growth for the purpose of calculating the above limits if there is no net addition of capital. Also left out of the growth calculation are conversions into equity of debt outstanding on October 31, 2006, issuance of new non-convertible debt, and new equity issued under a contract that was in place on October 31, 2006.

The prescribed normal growth for SIFTs is much better than many had feared, though certainly not sufficient for all. In the long run, this guidance on normal growth will not have an impact on the fate of SIFTs in four year’s time. Deloitte’s informal surveys of income trust management show that a majority believe there will be fewer than 50 trusts remaining in Canada in 2011, compared to the 256 that exist now. Download the full survey results from Calgary and Toronto. We don’t believe that Friday’s announcements would change these results.

The near-term outlook, however, has improved. Many income trusts were feeling that without adequate access to new equity capital, they would be forced into converting to a corporate structure almost immediately. This means that whatever happens in 2011, at least there will be more SIFT survivors in 2008. However, the writing is on the wall for income trusts in the longer term and we believe there will be many bids for income trusts over the coming months.

Andrew Dunn

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