At the most general level, the law on both sides of the US-Canada border recognizes that income trust conversions will be tax-free events for unitholders. The intent, colored by a reasonable bias in favor of the free flow of capital across borders, is to avoid tax consequences for investors. In addition to tax deferral for investors and some carryover of tax accounts and attributes for successor corporations, Canada’s rules minimize the administrative burden to taxpayers by providing an essentially automatic rather than an elective rollover.

In the wake of its Oct. 31, 2006 announcement that income trusts would be subject to entity-level taxation beginning in 2011, the Canadian government has issued several proposals and subsequent revisions related to the processes by which trusts would convert to corporations.

There are two ways of converting an income trust into a corporation:

• Direct Exchange of Trust Units for Shares: All income trust unitholders transfer their units to a Canadian corporation in exchange for 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.
  
  
• Distribution of Shares on the Redemption of Trust Units: The income trust reorganizes so that its only asset is shares of a Canadian corporation. The trust then distributes those shares to its unitholders on the redemption of the unitholders’ units. As a result, the unitholders become shareholders of the corporation, and the income trust is wound up.

The current form of the conversion rules provides for a rollover on an exchange of units for shares of a taxable Canadian corporation, subject to certain conditions. The exchange must take place during a defined period; a unitholder can receive no consideration other than shares of the corporation; the shares must have the same fair market value as the units; and the shares must be of the same class as the units.

If these conditions are met, a unitholder is deemed to have disposed of his trust units at his cost amount and to have acquired the shares at a cost equal to that amount. Canada-based individuals can elect out of the rollover and trigger a capital loss or gain on the conversion, where the adjusted cost base of the unitholder’s trust units is less than or greater than the fair market value of the shares acquired on the conversion. As currently written the rules seem to indicate that the rollover will be automatic for US-based investors. Should you choose to book a loss or gain, simply sell your units on the open market ahead of the completion date of the conversion transaction.

Following the exchange of shares, the corporation succeeds the trust as the publicly traded entity.

Once the new corporation succeeds the trust, the income trust can generally be eliminated from the final structure on a tax-free basis on satisfaction of certain conditions. Existing rules for the amalgamation and wind-up of corporations will apply to trusts if: the sole beneficiary of the trust is a taxable Canadian corporation; the trust is wound-up before 2013; and where the property of the trust is shares of a taxable Canadian corporation, the property wasn’t acquired by the trust on a distribution under the conversion method discussed below.

The second conversion method would allow a trust to convert into a corporation by distributing all of its property, which must consist solely of shares of a taxable Canadian corporation, to its unitholders on a tax-deferred basis. There will be no gain or loss to an income trust or its unitholders if the trust transfers shares of a taxable Canadian corporation to its unitholders.

Many income trust structures will have to be reorganized in order to convert under this alternative. For example, if the trust owns operating assets as well as shares of a corporation, the assets will need to be transferred to the corporation prior to the wind-up. And this “distribution” alternative doesn’t preserve the tax attributes of the income trust.

In plain terms, the IRS is likely to view a trust conversion as a “statutory merger or consolidation.” Income trust conversions completed according to Canadian law are therefore likely to qualify for “non recognition treatment” in terms of the US Internal Revenue Code (IRC).

Before 2006 the term “statutory merger” was interpreted as a merger or consolidation effected under the corporate law of a “State or Territory or the District of Columbia.” But many foreign jurisdictions, including Canada, now have merger statutes that operate similarly to those of US state laws.Reflecting the prevailing bias in favor of global capital flows, in 2006 the IRS and the US Treasury Dept established new rules for the treatment of “reorganizations” completed according to the laws of foreign jurisdictions. Specifically, Internal Revenue Code Section 386 definition of an “A Reorganization” to include transactions effected pursuant to foreign law and transactions involving entities organized under foreign law.

Section 368 reorganizations generally allow “target corporation” shareholders to exchange target stock for “buyer corporation” stock without gain recognition. An “A Reorganization” is defined in the IRC as a “statutory merger or consolidation,” a transaction in which a new corporate entity is created from the two merging companies, which cease to exist, or where one of the merging companies continues to exist as a legal entity, rather than being replaced by the new entity.

According to the Internal Revenue Code, a “corporate reorganization” is a trade of “corporate stock” that doesn’t result in a taxable gain or a deductible loss. It is, in the eyes of the IRS, a transaction entitled to nonrecognition treatment.

The basis of your trust units, generally speaking, is your purchase price plus the costs of purchase, such as commissions. The basis of the shares you receive in a nontaxable exchange is generally the same as the adjusted basis of the trust units you gave up. If you have a nontaxable trade, you don’t recognize gain or loss until you dispose of the property you received in the trade.

When or whether and why or why not a particular trust will convert to a corporation are complex issues. Many trusts will likely choose to convert to a corporate structure before the new tax takes effect in 2011, some as part of a going-private, merger or acquisition transaction.

A trust generally will prefer to defer conversion as long as possible to avoid paying entity-level tax, if it has sufficient tax attributes to shelter otherwise taxable income. The 2012 deadline is, however, designed to encourage conversions; trusts with tax pools that would otherwise allow it to efficiently exist as a trust post-2012 will have to weigh this against the potential future costs of reorganizing.

Funds with significant income from foreign subsidiaries, or which make substantial non taxable returns of capital to unitholders, will likely also retain their existing structure as long as possible. However, an earlier conversion may be beneficial where a trust is unable to comply with the government’s normal growth guidelines or where restrictions on foreign ownership are a consideration.

Early conversion may also be influenced by considerations such as gaining broader access to debt and equity capital markets, more certainty in regard to governance issues and more flexibility in management of cash flows to assure future growth.