Editor: Mr. Smith, please tell us something about your professional background.
Smith: I am Canadian by birth but a U.S. securities lawyer by training. I am a partner at Winston & Strawn and practice in New York, but I am also qualified in Ontario and England, having practiced in both Toronto and London. My area of specialization is international corporate finance, in addition to cross border M&A, and within that specialty my particular focus is the coordination and integration of U.S. securities rules with those of Canada and England.
Currently, I have been very busy talking to our clients and my partners about Canadian cross border income trust offerings as an exit vehicle for our private equity clients and as a source of capital for a number of our other clients.
Editor: What is a cross border income trust and what are cross border income securities?
Smith: The concept of an income trust has been with us for some time. It is a flow-through vehicle - that is, there is no corporate-level tax - that ensures that the net income of a business flows through to its investors, where it is taxed in the hands of the investor. The Canadian income trust (much like its American cousin, the "Master Limited Partnership") developed out of the Canadian oil and gas industry and was designed to ensure that oil and gas royalties and revenue would be transferred in a tax-efficient way to investors. It cut out an entire layer of taxation, which, of course, was of enormous benefit to the investor. That vehicle - the Canadian income trust - evolved in Canada over the last few years into a corporate structure that has been utilized by other businesses and in many other industries to great effect.
In fact, so many Canadian companies have turned themselves into income trusts that Standard & Poors has now included income trusts into its Toronto Stock Exchange composite index. Because it has been so well received, however, the Canadians have literally run out of companies to turn into income trusts. That's when Canadian investment bankers took the idea to the States a few years ago.
Given the lack of a vibrant IPO market in the States, there was a ready audience among U.S. businesses to consider the concept. They saw an opportunity to go public, albeit in Canada, through this trust structure. The initial vehicle appeared very similar to a Canadian income trust, except that the assets were located in the U.S. Key to the structure was the deductibility of internal corporate interest payments being made at the U.S. level up to the parent Canadian trust. Only by being able to deduct the cost of these interest payments from taxes otherwise payable to the IRS could the parent Canadian trust pay out a significant, trust-like yield to its Canadian investors. It was not long before the U.S. tax authorities were quick to see the tax leakage, however, and began to question the tax treatment of the payments out of the U.S. and into Canada. The IRS contested the tax deductibility of that internal debt as a tax avoidance scheme. Consequently, a number of auditors began to pull their opinions on the viability of the structure.
There was a moment when people thought that that was the end of the cross border income trust. However, Canadian investment bankers came up with a way around the IRS uncertainty by changing the corporate structure, yet still ensuring a trust-like, high yielding product for investors. This is what is known as an income security, although each of the Canadian banks in this area has a different name for its own product. The yield on this product is like that of an income trust, but for tax and corporate purposes it is not an income trust.
Although this new corporate model can appear complicated at first, with exotic things like "spinster stock" and "bachelor bonds" thrown into the mix, the fundamental structure is not that hard to figure out. Essentially, the U.S. business generates revenue which is paid up its corporate chain by way of regular dividends on preferred stock owned by a Canadian parent company, or in some models a Canadian unlimited liability company, which Canadian company in turn pays that dividend out to its stock and high yield bond holders as dividend and interest payments. Unlike the IRS, Canadian tax authorities are much clearer as to what constitutes debt verses equity, removing any ambiguity that the high yield debt might be characterized as equity and thereby ensuring that the interest payments on the debt are tax deductible. Again, key to the high yield payments is the tax deductibility of the interest paid on the high-yield debt. At the end of the day, Canadian investors buy common stock and high yield debt from a Canadian public company whose revenue generating assets are almost solely based in the States. Together, the common stock and high yield debt are what is known as an "income security" and, although the stock and debt are separable, they generally trade as a unit in the after-market.
Editor: Ok, but I am curious. What are "spinster stock" and "bachelor bonds"?
Smith: A little while ago the Big Four accounting firms got together and issued their list of "ten commandments" setting forth their acceptance of the income security structure but only if certain rules were adhered to. Two of those rules were that a small portion of equity, at least 10%, had to be left on the table by the selling owner of the U.S. business. This is the "spinster stock." Also, a small tranche of bonds, the "bachelor bonds," has to be issued by the Canadian parent - typically it is privately placed - that is separate, yet similar, to the bonds being issued with the common stock as part of the income security. Each of these structural tweaks helps the auditors value the debt and equity of the business with greater certainty.
Editor: Essentially this is a U.S. company going public in Canada by issuing these "income securities." What types of companies are doing this?
Smith: Any company that generates a steady stream of revenue and certainly not just oil and gas companies. It is this stream of revenue that constitutes the yield Canadian investors want. In the U.S, the idea has really caught the attention of private equity bankers with investments in private companies that they can't sell or exit via a traditional IPO in the States. Until the U.S. IPO market comes back, the only way to exit some of these investments is to go public in Canada by way of one of these cross border income security offerings. One other nice thing about going public in Canada is that the securities law regime, disclosure issues and corporate law in Canada are pretty similar to those in the U.S.
Editor: Who are the major Canadian underwriters for these cross border offerings?
Smith: Almost all of the large Canadian investment banks are involved in this. The leading three for cross border offerings are BMO Nesbitt Burns, RBC Dominion Securities, and CIBC World Markets - in what order, I'm not sure. Other banks getting involved include TD Securities and National Bank. It is important for U.S. businesses considering this option to hook up with a Canadian bank that has got great reach into the Canadian institutional and retail markets.
Editor: Would Sarbanes-Oxley be applicable to the Canadian company?
Smith: No. That is one of the selling features for going public in Canada as opposed to the U.S. In light of Sarbanes-Oxley, the Canadian securities regulators have adopted additional corporate governance measures, but they take a different approach from their U.S. counterparts. Canadian regulators state what the best practices for corporate governance are, but there are no predetermined penalties for violations of best practice. In effect, Canada has a "principles-based" approach to corporate governance rather than a "rules-based" approach like Sarbanes-Oxley. This has profound implications for the cost of maintaining a public company in Canada verses the States. For example, the Canadians currently have not mandated anything like §404 of Sarbanes-Oxley. Consequently, Canadian public companies have significantly reduced accounting costs and auditors' fees.
Editor: Why is the structure so popular?
Smith: Most would say that it is the valuation that companies receive when they turn themselves into income trusts or issue cross border income securities, which are valued like an income trust. There is a huge demand at the institutional and retail level in Canada for this type of product because of the yield it pays. Nothing else is currently comparable. Canadians, over the years, have put a lot of their money into Canadian income trusts and are quite used to the product. Cross border income securities, that are valued and traded like trust units, feed the demand. Additionally, for private equity investors, the structure provides an exit for their investments and a realization of gains that can be invested elsewhere. Lastly, and this is a somewhat new development, what we are seeing now, is the use of cross border income security offerings into Canada as a tool of acquisition financing where the target assets are located in the States.
Editor: What are some of the risks associated with the structure?
Smith: As I have indicated, the tax treatment of these structures represents something of a risk and, indeed, an earlier iteration of the structure - the cross border income trust - broke down as a consequence of that risk. The IRS questioned the deductibility of the interest payments being made by a U.S. company to a Canadian parent on debt it owed the parent, prompting auditors to walk. The new structure is supposed to have resolved this issue in that it provides for deductibility to occur in Canada, where the rules governing what is debt and what is equity are clearer.
I think that the biggest risk is that the Canadian government slows down the conversion of Canadian businesses into income trusts, thereby impacting the valuations of trust products generally, including cross border securities. In fact, very recently the Canadian government has stated that it will cease providing advance tax rulings to Canadian businesses considering converting into a trust - an advance tax ruling is one of the first steps in converting to a trust. The Canadian government has seen a real erosion in corporate tax revenue because of all the businesses that have turned themselves into trusts and it is trying to stop that. Whether this turn of events in the domestic market has an impact on cross border securities offerings remains to be seen.
Editor: What has been your personal experience with these structures?
Smith: I had the benefit of working on the very first cross border income security offering for Volume Services of America, an American company that went public in the U.S. and Canada at the same time by issuing income securities. We had to clear an S-1 with the SEC as well as a long form Canadian prospectus with Canadian securities regulators, and I helped integrate and coordinate the applicable U.S. and Canadian securities laws. It is interesting to note that the income security structure has evolved since VSA, and the U.S. IPO piece has generally been dropped. Now, nearly all of these offerings are public in Canada only. I think that is a reflection of the greater demand for high yield products north of the border, given the fact that the Canadian market has no deep high yield debt market. Since VSA, I have worked with my partners and a number of Canadian investment bankers and leading Canadian lawyers in explaining the structure to several U.S. businesses at various stages of contemplating one of these offerings.
Editor: What about Winston & Strawn's experience?
Smith: It is impossible to advise on these structures in the absence of a sophisticated tax practice. Winston & Strawn possesses that resource in nearly all of its offices, and we have a number of tax partners that have actively worked on these transactions. In fact, our tax lawyers regularly advise Duff & Phelps, which acts as financial advisors with respect to these transactions. In addition, our tax attorneys have terrific working relationships with Canadian tax lawyers who are leaders in this field north of the border. Now that a number of these companies are up and running, they are thinking of acquisitions in the U.S. or Canada, using their income securities as tender offer consideration or as part of an acquisition financing plan, and our tax attorneys are helping advise businesses and bankers in this regard as well.
Published October 1, 2005.
