Shifting Sands For Investment Funds - After Budget 2012, It's Not Business As Usual
There are many times when a seemingly small shift in the earth can give rise to significant ripple effects. The likelihood of such effects can be magnified when one small shift is combined with another. We may well see this result from the combined impact of a proposed change to subsection 100(1) of the Income Tax Act (Canada) (the "ITA") included in the recent federal budget ("Budget 2012") and the recent Supreme Court of Canada decision in the Copthorne case. Although this would impact many different taxpayers, particular concern arises for investment funds in which tax-exempts are investors.
The Budget Proposal
First the Budget proposal. Buried amongst the many tax proposals in Budget 2012 is an at first seemingly innocuous change to the preamble to section 100 of the ITA. In general terms, subsection 100(1) is a very specific anti-avoidance rule aimed at transactions that effectively result in the avoidance of the recapture of depreciation by a taxable person. More specifically, currently this subsection will apply upon a disposition by a person of an interest in a partnership to a person exempt from tax under section 149 of the ITA. In such a case, in general terms, the gain realized by the person on the disposition will be increased by an amount that reflects unrealized gains on partnership property other than non-depreciable capital property. In many cases this results in unrealized recapture of depreciation on assets held in the partnership being added to the gain realized by the person on the disposition of the partnership interest.
The Budget proposal, as presented in the Supplementary Information in the Budget Papers, focuses on the proposal to extend the application of this subsection to dispositions of partnership interests to non-residents of Canada (other than when the partnership carries on business exclusively in Canada through a permanent establishment in Canada). More innocuous is the single sentence in the Supplementary Information that states that the proposal will also "clarify" that section 100 applies "to dispositions made directly, or indirectly as part of a series of transactions, to a tax-exempt or non-resident person". It is this, combined with the recent jurisprudence on the meaning of "series" in respect of the Copthorne case, that is the cause for concern (as an aside, we note briefly that the use of the word "clarify" in the Supplementary Information is interesting as it suggests that the existing provision is intended to apply in the circumstances covered by the proposal, and that the proposal does not represent a change of policy, something that we would suggest is hard to support in these circumstances as the existing wording seems to cover neither dispositions to non-residents nor dispositions that are indirect or part of a series).
Copthorne attracted a significant amount of attention in the Canadian tax community because it represented only the third time that the Supreme Court has addressed the application of the general anti-avoidance rule or "GAAR". We commented on this aspect of the decision in Canadian Tax @ Gowlings, Volume 9, Number 1 (January 25, 2012). However, perhaps as important as the comments of the courts (both the Supreme Court and the lower courts) on GAAR were their comments on the concept of "series". In particular, the Copthorne case involved the "linking" of two sets of arguably separate transactions. The first set involved planning variously described as "preserving" or "multiplying" (depending on one's perspective) corporate paid-up capital that could be of benefit at some time in the future. The particular circumstances in which that paid-up capital might be useful in the future was not certain at the time the first set of transactions was undertaken. These transactions have been described as an exercise in "setting the table". Nevertheless, Canada Revenue Agency ("CRA") contended that the first set of transactions and the second set formed one series under the extended definition of series in subsection 248(10) of the ITA, which includes within a series any "related transactions or events completed in contemplation of the series". The courts supported the CRA position. Specifically, the Supreme Court of Canada stated that:
The Federal Court of Appeal rightly noted that a strong nexus is not necessary to meet the series test...The court is only required to consider whether the series was taken into account when the decision was made to undertake the related transaction in the sense that it was done "in relation to" or "because of" the series...Although the "because of" or "in relation to" test does not require a "strong nexus", it does require more than a "mere possibility" or a connection with "an extreme degree of remoteness".
The courts did state that each case would have to be considered based upon its particular facts. However, it seems fairly clear that a transaction or set of transactions undertaken today with the possibility or expectation of another transaction or set of transactions that might be undertaken in the future, whether or not specifically contemplated or determined at the time of the first set, can be linked with the second. As well, there is no certainty that the passage of time or occurrence of intervening events will "de-link" the transactions (although the Supreme Court did state that "the length of time between the series and the related transaction may be a relevant consideration in some cases; as would intervening events taking place between the series and the completion of the related transaction").
So what does this mean?
Clearly it is not "business as usual". In the past one could usually get fairly comfortable that subsection 100(1) would not apply in the case of the acquisition of an interest in a partnership by an investment fund some or all of the investors in which included tax-exempt parties. This will have to be reconsidered. Examples of where new subsection 100(1) could have an impact on investment funds that take the form of a partnership include:
- a fund offering with multiple closings, where investors coming in at a later closing do so by acquiring some of the pre-existing units held by investors that invested through an earlier closing (particularly if the later investors include tax-exempt entities);
- a multi-fund structure that requires rebalancing (again, this could involve subsequent closings where investors coming in later include tax-exempt entities – the point here is the risk that new subsection 100(1) might even impact the parallel fund in which the investing tax-exempt entities do not hold units); and
- forced sales of units by defaulting investors where units owned by the defaulting partners are acquired by non-defaulting partners that are tax exempt.
These are but a few examples of situations that will require rethinking of old approaches. We note, however, that the proposed legislation may leave open solutions to these potential problems in many circumstances. We also note that although the description of the proposal in the Supplementary Information refers to "indirect" dispositions, that word does not appear in the related Ways and Means Motion, and it is the wording of the Ways and Means Motion that will make its way into the ITA. Accordingly, the impact of the Budget proposal may not be as significant as the description in the Supplementary Information might lead one to believe. Nevertheless, this proposal will require careful consideration.
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