Pizza Pizza Royalty Income Fund
TSX : PZA.UN

Pizza Pizza Royalty Income Fund

November 18, 2011 16:54 ET

Pizza Pizza Royalty Income Fund Announces Amendment to Vend-In Mechanism

TORONTO, ONTARIO--(Marketwire - Nov. 18, 2011) -

Attention Business Editors:

The Trustees of the Pizza Pizza Royalty Income Fund (TSX:PZA.UN) (the "Fund") and Pizza Pizza Limited ("PPL") announced today that they have approved an agreement (the "Amending Agreement") to amend the terms of the Amended and Restated Limited Partnership Agreement dated July 24, 2007 (the "Partnership Agreement") governing Pizza Pizza Royalty Limited Partnership (the "Partnership").

Subsequent to January 1, 2011, the federal tax imposed on specified investment flow-through entities such as the Fund ("SIFT Tax") has resulted in an unintended, negative impact for unitholders on the economics associated with the vend-in adjustment by which new Pizza Pizza and Pizza 73 restaurants are added to the pool of restaurants on which a royalty is paid by PPL (the "Royalty Pool") to the Partnership. This vend-in adjustment is designed to compensate PPL for the additional royalty income accruing to the Partnership from PPL's development of new Pizza Pizza and Pizza 73 restaurants, and to be accretive to current unitholders. The Amending Agreement will, for unitholders, eliminate this negative impact on the vend-in adjustment resulting from payment of the SIFT Tax and restore the original intent of the adjustment.

Background to the Amendment

In 2007, the Federal Government of Canada amended the Income Tax Act (Canada) to impose the SIFT Tax, an entity level tax on Canadian publicly listed income trusts. The Fund became a taxable entity effective January 1, 2011. As a result of the SIFT Tax, the Fund will pay tax approximately equal to or less than the rate applicable to income earned by a Canadian public corporation. The SIFT Tax reduces the amount of cash available for distribution to the unitholders by the Fund.

On December 15, 2010, the Trustees of the Fund determined, having considered a number of alternatives to maximize unitholder value in the face of the imposition of the SIFT Tax, that the Fund should, initially, retain its current structure following January 1, 2011. Having made that determination, the Trustees of the Fund and management of PPL began an analysis of the structure of the Fund, its subsidiary entities and material agreements to determine whether any adjustments or amendments were needed as a result of the imposition of the SIFT Tax.

Details of the Amendment

PPL, Pizza Pizza Holdings Trust, Pizza Pizza GP Inc. and the Partnership propose to enter into the Amending Agreement, dated December 15, 2011 and effective January 2, 2011, to amend the terms of the Partnership Agreement. As is detailed below, the net effect of the Amending Agreement will be to reduce PPL's entitlement to receive additional Fund units (through changes to the Class B Exchange Multiplier and the Class D Exchange Multiplier) when new Pizza Pizza and Pizza 73 restaurants are added to the Royalty Pool.

Under the Amending Agreement, the definitions of the Pizza Pizza and Pizza 73 Estimated and Actual Determined Amounts, which are the basis for determining changes to the Class B and Class D Exchange Multipliers and PPL's additional unit entitlements, would be amended to include SIFT Tax as part of the formula to calculate the Determined Amounts. The Determined Amounts would be calculated in the same manner as under the current formula, except that the resulting figures would be multiplied by a number equal to (1-Tax%). "Tax%" will be an estimate of the Fund's effective tax rate for the year (determined using the total income taxes paid by the Fund during the fiscal year divided by the total cash received by the Fund during that fiscal year) (i.e., for the Adjustment Date of January 1, 2012, it will be the effective Fund tax rate for the year ended December 31, 2011). This estimate of the effective tax rate will be subject to an adjustment when the actual effective entity level tax rate of the Fund for the year is known.

The Fund's Trustees have reviewed the calculations under the Partnership Agreement and the Amending Agreement and have concluded that the Amending Agreement will eliminate the dilutive effect of the SIFT Tax to unitholders at the Adjustment Date. The Amending Agreement would be effective as of January 2, 2011 and would govern the vend-in of new Pizza Pizza and Pizza 73 restaurants to the Royalty Pool on January 1, 2012 and each January 1 thereafter. PPL is under no contractual or other legal obligation to enter into the Amending Agreement. However, PPL management has advised the Fund that it believes that an adjustment to the vend-in formula is in the best interest of all parties. If no change is made to the vend-in adjustment, future additions to the Royalty Pool will be dilutive to current unitholders. The Amending Agreement has no impact on PPL's existing entitlements to distributions from the Partnership or its additional unit entitlements.

The following compares the vend-in formula prior to and after the Amending Agreement:

ROYALTY POOL ADJUSTMENTS prior to the Amendment

PPL holds Class B Partnership Units and Class D Partnership Units, which are exchangeable for Fund units based on specific rates, referred to as the Class B Exchange Multiplier and the Class D Exchange Multiplier. PPL also receives distributions on the Class B Partnership Units and Class D Partnership Units based on the number of Fund units that it would hold if the exchange right was exercised in full.

Annually, on January 1 (the "Adjustment Date"), an adjustment is made to the Royalty Pool to include the forecasted system sales from new Pizza Pizza restaurants opened on or before December 31 of the prior year, less system sales from any Pizza Pizza restaurants that have been permanently closed during the year. The change in the amount of the Royalty due to the Partnership as a result of changes in the system sales of the Royalty Pool will affect PPL's retained interest through an adjustment to the Class B Exchange Multiplier. On the Adjustment Date, the adjustment to the Class B Exchange Multiplier involves first calculating the "Estimated Determined Amount", which is defined as 92.5% of the royalty revenue added to the Royalty Pool, divided by the prevailing yield of the Fund units. The Estimated Determined Amount is multiplied by 80%, then divided by the current market price of the Fund units, and then further divided by the number of Class B Partnership Units outstanding. This fraction is added to the Class B Exchange Multiplier from the preceding year, which was "one" on the closing of the Fund's initial public offering. On the following Adjustment Date, a second adjustment to the Class B Exchange Multiplier will be made in the same manner, based on the Actual Determined Amount, once the system sales for new restaurants are known with certainty.

If, during a year, a Pizza Pizza restaurant is closed, the sales of the restaurant from the closing date would no longer be included in the calculation of the royalty payable to the Partnership by Pizza Pizza. To compensate for this, in certain circumstances, the Pizza Pizza Licence and Royalty Agreement and the Partnership Agreement provide that an amount (the "Make-Whole Payment") reflecting the reduction in the royalty resulting from the restaurant closure will be paid by PPL to the Partnership for the balance of the year in which the restaurant was closed, commencing from the closing date. The Make-Whole Payment will be the sales of the closed restaurant for the first 52-week period in which it was included in the Royalty Pool multiplied by the royalty rate, payable as to one-twelfth per month.

Similarly, on each Adjustment Date, a separate adjustment is made to the Royalty Pool for the Pizza 73 restaurants. The Royalty Pool is increased to include the forecasted system sales from new Pizza 73 restaurants opened on or before September 1 of the prior year, less system sales from any Pizza 73 restaurants that have been permanently closed during the year. On the Adjustment Date, the adjustment to the Class D Exchange Multiplier is calculated in a similar manner as the Class B Exchange Multiplier described above. At the time of acquisition of the Pizza 73 Rights, the Class D Exchange Multiplier was zero.

The following is an example of how the Actual Determined Amounts that impact the Class B Exchange Multiplier are calculated under the current Partnership Agreement formula. The same calculation would apply to the Class D Exchange Multiplier, except that the royalty percentage would be 9%:

Example of Current Vend-in Calculation:

3 restaurants opened during 2010 – each with $900,000 in System Sales
1 restaurant permanently closed during the year – with $750,000 in System Sales (the System Sales of that restaurant when originally vended into the Royalty Pool)
Previous 12 month distributions on Units = $0.93
Current Market Price = $9.00
Net Additional Royalties = 0.06 x ($2,700,000 – $750,000)
= $117,000
Annual Yield ($0.93/$9.00) = 0.1033
Determined Amount = 92.5% x $117,000
0.1033
= $1,047,677

ROYALTY POOL ADJUSTMENTS after the Amendment

Under the Amending Agreement, the vend-in calculation would change by taking into account the effect of the SIFT Tax. The calculation of the Determined Amounts would change as follows. The Determined Amounts would be multiplied by a number equal to (1-Tax%), where the term "Tax%" will be an estimate of the Fund's effective tax rate for the year. This estimate of the effective tax rate will be subject to an adjustment when the actual effective entity level tax rate of the Fund for the year is known. PPL's additional entitlements to Fund units through changes to the Class B and Class D Exchange Multipliers will be trued up on January 1 of the following year once the actual performance of the new restaurants is determined and the actual effective tax rate is confirmed.

To illustrate the effect of the Amending Agreement, the following are two examples of the current version of the vend-in calculation following a reduction in the Fund's cash distribution to unitholders, roughly equivalent to the SIFT tax percentage, to $0.70 and a second example showing the effects of the Amending Agreement. Note that all of the numbers used below are for illustration purposes only and, in particular, the distribution amount may not be reflective of actual distribution levels following January 1, 2011.

Example of the SIFT Tax effect prior to the Amending Agreement:

Same assumptions as previous example except distributions/Unit/year = $0.70
Assume Tax% = 28.5%
2011 estimated unitholder distribution = $0.70
Net Additional Royalties = $117,000
Annual Yield ($0.70/$9.00) = 0.0778
Determined Amount = 92.5% x $117,000
0.0778
= $1,391,067

Example of the SIFT Tax effect following the Amending Agreement:

Same assumptions as previous example -
assume Tax% = 28.5%
Net Additional Revenues = $117,000
Annual Yield = 0.0778
New Determined Amount = (1 - 0.285) x 92.5% x $117,000
0.0778
= $994,613

As can be seen with these examples, the net effect of the Amending Agreement will be to reduce the Determined Amount, which will in turn reduce the Class B and Class D Exchange Multipliers and the additional unit entitlements that PPL will receive when restaurants are added to the Royalty Pool on an Adjustment Date, by an amount roughly equivalent to the effective tax rate of the Fund.

Related Party Disclosure

The Amending Agreement will be a "related party transaction" for purposes of Multilateral Instrument 61-101 ("MI 61-101") because it involves an amendment to the terms of the Partnership's securities that are owned by a related party. PPL is a "related party" of the Partnership because, as a general partner of the Partnership, it is actively engaged in the business of the Partnership, is responsible for, and has authority in, assisting Pizza Pizza GP Inc. in the management of the business and affairs of the Partnership and performs additional specific duties in connection with the business of the Partnership as are delegated to it by Pizza Pizza GP Inc. from time to time pursuant to the Partnership Agreement. PPL also provides consultation and management services to the Partnership as to the operation and management of the Partnership's business, in addition to the assistance provided to Pizza Pizza GP Inc.

The Fund's Trustees, each of whom is independent of PPL, are also the trustees of Pizza Pizza Holdings Trust and constitute a majority of the directors of Pizza Pizza GP Inc. As such, the Trustees have independently assessed the Amending Agreement and whether it is fair to the unitholders. The Trustees have also determined that the Amending Agreement is not prejudicial to unitholders; as such, the Amending Agreement does not need to be submitted to the Fund's unitholders for approval pursuant to the constating documents of any of the Partnership, Pizza Pizza GP Inc., Pizza Pizza Holdings Trust or the Filer. The Trustees believe that the Amending Agreement is advantageous to the Partnership, the Fund and its unitholders and does not confer any benefit or transfer of value to PPL or any other related party of PPL.

The Fund applied to the Ontario Securities Commission ("OSC") for an exemption from the minority approval requirement for related party transactions in section 5.6 of MI 61-101. The exemption was approved by the OSC on November 7, 2011. The Amending Agreement is not subject to the valuation requirement for related party transactions pursuant to section 5.4(1) of MI 61-101.

Forward Looking Statements

Certain statements in this report may constitute "forward-looking" statements which involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward looking statements. When used in this report, such statements include such words as "may", "will", "expect", "believe", "plan", and other similar terminology. These statements reflect management's current expectations regarding future events and operating performance and speak only as of the date of this report. These forward-looking statements involve a number of risks and uncertainties. The following are some factors that could cause actual results to differ materially from those expressed in or underlying such forward-looking statements: competition; changes in demographic trends; changing consumer preferences and discretionary spending patterns; changes in national and local business and economic conditions; legislation and governmental regulation; risk of technology failures; accounting policies and practices; and the results of operations and financial condition of PPL. The foregoing list of factors is not exhaustive and should be considered in conjunction with the other risks and uncertainties described in the Fund's Annual Information Form. The Fund assumes no obligation to update these forward looking statements, except as required by applicable securities laws.

About the Fund, a publicly-traded entity

The Fund is a limited purpose, open-ended trust established under the laws of Ontario. The Fund, indirectly through the Partnership, has acquired the trademarks and trade names used by PPL in its Pizza Pizza and Pizza 73 restaurants. The Pizza Pizza trademarks were licensed to PPL in 2005 for 99 years, for which PPL pays the Fund a royalty equal to 6% of the system sales of its Pizza Pizza restaurants in the Royalty Pool. There are 607 Pizza Pizza restaurants in the Royalty Pool for 2011. On July 24, 2007, the Partnership acquired the trademarks and other intellectual property of Pizza 73 and licensed them to PPL for 99 years, for which PPL pays the Fund a royalty equal to 9% of the 88 Pizza 73 restaurants in the Royalty Pool for 2011.

A key attribute of the Fund is that revenues are based on top-line, system sales of the Royalty Pool restaurants and not on the profitability of either PPL or the restaurants in the Royalty Pool. Moreover, the Fund is not subject to the variability of earnings or expenses of the operating companies. The Fund's only expenses are current income tax, administration expenses and the interest on debt. Thus, the success of the Fund depends primarily on the ability of PPL to maintain and increase system sales of the Royalty Pool restaurants and to meet its royalty obligations.

The Fund's trust units are listed on the Toronto Stock Exchange under the symbol PZA.UN.

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