The Department of Finance announced this morning that it will
amend the Income Tax Act (Canada) (the "Tax
Act") in response to certain transactions involving
"stapled securities" that it considers to be end runs
around its efforts to tax income trusts. On October 31, 2006 (often
referred to as the "Halloween massacre"), the Minister of
Finance announced legislation (the "SIFT Legislation")
taxing Canadian income trusts, essentially putting an end to tax
advantages they had enjoyed as flow-through entities for tax
purposes. The rules allowed for a transition period for existing
income trusts and introduced a carve-out for qualifying real estate
investment trusts ("REITs"). While much focus since the
Halloween massacre has been on transitioning to the new regime,
some have looked to "stapled" structures as alternatives.
Two income trusts recently converted into structures involving
publicly traded units consisting of stapled debt and equity
components (similar to a number of offerings several years ago of
Canadian corporations carrying on U.S. businesses). In addition,
earlier this year two REITs adopted a structure involving REIT
units stapled with units of a taxable entity in order to qualify a
portion of their operations for the exception from entity-level
taxation for qualifying REITs. Today's announcement puts an end
to both of these structures.
A stapled debt/equity structure generally involves a public
corporation issuing a unit comprised of a common share and a
subordinated high-yield debt instrument. The corporation's
taxes are reduced or eliminated through deductible interest
payments on the subordinated debt to holders of the stapled units.
This result is similar to the flowing-out of income that occurred
under the income trust structure. Today's announcement denies
the corporation a deduction for interest paid on the stapled
subordinated debt. As a result, stapled debt/equity structures will
be less efficient than pure equity capitalization for taxable
Canadian investors, who are generally taxed at a higher rate on
interest than on dividends from Canadian corporations.
The stapled structure adopted by some REITs serves a different
purpose. The conditions for REITs to be exempt from the SIFT
Legislation are very restrictive, essentially limiting REITs to
earning passive income and precluding them from undertaking
development activities or holding operating real estate assets
(e.g., hotels, seniors housing, health care facilities, etc.). The
REIT stapled structure involves a REIT spinning off its
non-qualifying assets and operations to a separate taxable entity,
with the securities of the REIT and the sister entity trading
together as stapled units. The REIT rents its real property to the
sister entity and the sister entity operates the facilities. The
new legislation provides that any payments (including rent) made by
the sister entity to the REIT will not be deductible. Thus, while
the status of the REIT itself is not affected by these changes, the
earnings represented by the non-deductible payments from the sister
entity will now be taxed twice - once in the sister entity and once
in the hands of the REIT unitholders.
The new legislation provides a transition period before the rules
become effective for existing stapled structures. For those that
were in existence on October 31, 2006, the legislation will not
apply until January 1, 2016 and for those that came into existence
after October 31, 2006 but before July 20, 2011, the legislation
will not apply until July 21, 2012.
Today's announcement also contains minor technical changes to
the SIFT Legislation, and moves SIFTs onto a corporate instalment
regime (i.e., monthly rather than quarterly tax instalments).
For a more detailed discussion of income trusts, the SIFT
Legislation and the two stapled unit structures described above see
our article titled "The Rise and Fall of Income Trusts"
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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