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Income Participating Security: the next generation of income trust

by Wayne Cheveldayoff, 2004-05-20

Bay Street lawyers and investment bankers have coined the phrase “Income Participating Security” for a new version of income trust.

The Income Participating Security (IPS) definitely fills a need and, depending on how things play out, it may end up dominating the sector sometime down the road.

The IPS pays out a high cash yield, just like an income trust. The difference, which is a big one, is in the structure.

Investors are generally familiar with the units of an income trust. The units represent an ownership interest that entitles the holder to a stream of cash flow, which commonly is made up of business income, dividends, and return of capital.

In contrast, an IPS consists of a common share and a high-yield bond fused together. The cash flow is made up of the dividend from the common share and the interest paid by the bond. The two are initially linked but later can be separated and traded individually.

The new IPS structure had its premiere this spring as part of the initial public offering of Medical Facilities Corporation, which operates three of the largest specialty hospitals in South Dakota.

The hospitals, which specialize in surgical, imaging and diagnostic services in the orthopaedic, neurosurgical, and ear, nose and throat fields, generated $85 million in revenues and $24 million in distributable cash in 2003, according to the final prospectus filed at

The prospectus indicated a cash yield to investors of 11 per cent – an annual payment of $1.10 per IPS unit. Each unit was issued at $10 in a deal that closed March 29.

The Medical Facilities IPS was comprised of one common share (initially valued at $4.10) and $5.90 worth of subordinated notes with an interest coupon of 12.5 per cent.

The notes have a maturity of 10 years, but can be extended by the issuer for two five-year periods after that. At the same time, Medical Facilities can call the notes back beginning after five years by paying a declining premium to face value (a 5 per cent premium in the sixth year, a 4 per cent premium in the seventh, and so on).

The Medical Facilities IPS trades like an income trust (symbol DR.UN on the TSX). The prospectus provides that after 90 days from closing, the common share and 12.5-per-cent notes can be separated and traded separately. If this happens, they can also be joined again later and trade again as an IPS.

On April 27, Medical Facilities announced that for the March 29 to April 30 period, it would be paying a total 10.05 cents per IPS, made up of a dividend of 3.31 cents per common share and an interest payment of 6.74 cents per $5.90-face-value of notes.

Those familiar with income trusts can see how dramatically different the IPS is structured, with only interest and dividends being paid out.

In contrast, income trust units, which cannot be divided, pay out a combination of fully taxable business income, dividends and a tax-deferred return of capital.

Take, for example, the income trust units of Superior Plus Income Fund (SPF.UN on the TSX). The fund paid $2.28 per unit of cash in 2003, made up of $1.50 in business income, 68 cents in dividends and 10 cents in return of capital.

Why was the IPS structure used for Medical Facilities instead of the usual income trust structure?

The answer can be found in the minutia of law and taxes.

One key difference between the IPS and income trust structures relates to legal liability. Some (not all) lawyers believe that investors in income trusts do not have the benefit of corporate limited liability. Since they own a direct interest in the business, it is thought they could end up on the hook for losses if the trust went bankrupt or was sued for far more than its net assets.

The perceived unlimited legal liability is a key reason why many institutional pension funds have stayed away from trusts. (Both Ontario and Alberta have stated they will pass legislation to confer limited liability on trust units but this has not yet happened.)

By structuring the Medical Facilities deal with common shares and subordinated notes (both of which have limited liability), the Bay Street financial engineers made the deal more attractive to major pension funds.

The IPS’s attractiveness was proven in the recent downturn in the income trust market. While the value of many trust units dropped by 10 to 20 per cent on interest rate fears in April and May, the Medical Facilities IPS stayed close to $11 per unit, which was its high since the deal closed in late March.

While limited liability was a key benefit, it is likely that the tax issues drove the new structure. Most of the other U.S. businesses (involved in yellow pages, meat processing, cheque distribution, etc.) that had gone ahead with income trusts in the Canadian market were severely rocked when their auditors raised questions about whether the U.S. Internal Revenue Service would clamp down on the deals because of the tax revenues it is losing.

Essentially, the deals were set up so that cash would be sucked out of the business without paying income taxes. To do this, the U.S. businesses issued high-interest-rate debt to the trust and then deducted the interest, leaving the business with little or no taxable income.

When the auditors balked at endorsing these structures, the deals came to a halt. Bay Street then started to look for a new structure that had more certainty of being regarded as legitimate by the IRS.

It is thought that by using common securities like notes and common shares that can trade separately, deals like the one done for Medical Facilities will not be challenged by the IRS. However, just in case, the prospectus allows for a reduction in distributions in the event the deductibility of interest payments is not allowed.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2004 Wayne Cheveldayoff