Canada: Private Equity @ Gowlings: October 10, 2012 - Volume 3, Number 3

Edited by Alan James and Rob Blackstein

Recently released Budget Legislation impacts fund structuring

Partnerships are a form of business organization often used in business, whether to bring together small groups of joint venturers or larger groups such as investors in private equity funds.  Partnerships are attractive as a form of business organization because of their general flow-through status for Canadian tax purposes.  Partnerships are particularly attractive business organizations when tax-exempt participants, such as pension funds, are investors.  However, a proposed tax change announced in the federal budget of last March is proving to be problematic for partnerships in which pension funds invest, particularly given the expansion of the original proposal that was made public in the form of draft amendments to the Income Tax Act  (Canada) (the "ITA") released on August 14, 2012 (the “Draft Legislation”).

The proposal in question related to subsection 100(1) of the ITA.  In general terms, subsection 100(1) is a targeted anti-avoidance rule aimed at transactions that effectively result in the avoidance of the recapture of depreciation by a taxable person.  More specifically, as it has read since its introduction as part of the significant Canadian tax reform of 1972, this subsection can apply upon a disposition by a taxpayer of an interest in a partnership to a person exempt from tax under section 149 of the ITA (a "tax exempt").  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.  The typical situation that can give rise to the application of subsection 100(1) is one in which a partnership holds a direct interest in depreciable real property.  In such a situation, if a taxpayer realizes a capital gain on a disposition of an interest in the partnership to a tax exempt, unrealized recapture of depreciation on assets held in the partnership will be added to the capital gain realized by the taxpayer.

The announcement in the Budget focused on the proposed extension of the application of this subsection to certain dispositions of partnership interests to non-residents of Canada.  More innocuous was the single sentence in the Budget papers that stated 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”.  This caused some concern in Canadian investment fund circles, but many were hopeful that the proposals would prove to be practical and workable when the amending legislation was finally released.  However, the opposite proved to be the case when the Draft Legislation was released.  As proposed in the Draft Legislation, amended subsection 100(1) (in very general terms) could apply:

  • on a direct transfer of a partnership interest by a taxpayer to a tax exempt;

  • on a disposition of a partnership interest by a taxpayer if, as part of a series of transactions that includes the disposition, a tax exempt acquires an interest in the partnership;

  • on a disposition of a partnership interest by a taxpayer to an acquirer that is itself a partnership if tax exempts hold more than 10% of the interests in the acquirer partnership, or to a trust if tax exempts hold more than 10% of the interests in the trust;

  • on a “dilution, reduction or alteration” of an interest in a partnership of a taxpayer if, as part of the same series of transactions, there is an acquisition of, increase in or alteration in an interest in the partnership by or of a tax exempt and it can reasonably be concluded that one of the purposes of the series was to avoid the application of subsection 100(1).

It should be noted that one of the favourable changes to the original proposal included in the Draft Legislation is a “de minimis” exception to the rules.  However, this rule is extremely limited in its application and does not go nearly far enough to be of practical advantage.  In particular, the de minimis exception applies only on the purchaser side of the transaction (in other words, if the participation of tax exempts or non-residents in the purchasing partnership or trust is 10% or less).  There is no de minimis exception for small holdings in a partnership, with the result that a disposition of even a small interest in a partnership can be subject to the new rules.

These new rules are proving to be of concern in structuring both closely held partnerships in which a tax exempt is a member and more widely held private equity funds in which tax exempts participate.  Although it seems that tax exempts can participate in such partnerships from the establishment of the partnership without impacting the other members of the partnership, or upon subsequent issuances of partnership interests as part of a new equity raise, this is not the case for transfers of interests in partnerships.  In particular, consideration has to be given to rights of first refusal and “shot-gun” rights which are typically built into closely held partnerships.  Other examples of where new subsection 100(1) can be a concern 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.

The government generally aims to have all of the legislation emanating from a federal budget enacted before the end of the calendar year of the budget.  To this end, the usual practice for the Department of Finance is to release in early to mid-August draft legislation for comment, with a view to having a bill ready for introduction into the House of Commons upon its return from its summer recess, which will be September 17 this year.  Accordingly, notwithstanding the significant issues still surrounding this legislation, it seems that it may well be introduced into the House within the next several weeks.

New Canadian Investment Fund Manager Registration Requirements Explained

Since 2009, the manager of an investment fund that has its head office located in Canada has been required to register as an “investment fund manager”.  A manager for these purposes includes any person or other entity who (i) directs the business, operations or affairs of an investment fund, (ii) organizes the investment fund and (iii) is responsible for the management and administration of an investment fund.  As of September 28, 2012, the investment fund manager registration requirement will also apply, in certain circumstances, to international investment fund managers who do not have their head offices in Canada.

First it is important to note that the investment fund manager registration requirement only applies to managers of “investment funds”. Investment funds include only “mutual funds” and “non-redeemable investment funds”.  A mutual fund is defined as a fund (i) whose primary purpose is to invest money provided by its security holders, and (ii) whose interests entitle the holder to receive on demand, or within a specified period after demand, an amount computed with reference to the value of a proportionate interest in the whole or part of the net assets of the fund (i.e., the interests are redeemable for a pro rata share of the fund's net asset value).  A non-redeemable investment fund is a fund (i) whose primary purpose is to invest money provided by its security holders, (ii) that does not invest for the purpose of exercising or seeking to exercise control of an issuer, or for the purpose of being actively involved in the management of any issuer in which it invests (other than an issuer that is a mutual fund or a non-redeemable investment fund), and (iii) that is not a mutual fund. Thus, a fund that (i) does not permit redemption on demand at net asset value, and (ii) invests for the purpose of exercising control over and actively managing the issuers in which it invests (other than another investment fund), generally will not be considered to be an investment fund and its manager would therefore not be required to register as an investment fund manager in Canada.

The Canadian securities regulators have provided guidance which indicates that funds that generally engage in private equity or venture capital (“PE/VC”) investing will not be considered  to be investment funds and that the managers of PE/VC funds will not be required to register as investment fund managers. In this regard, the Canadian securities regulators have identified certain characteristics typical of PE/VC investment: (i) PE/VC funds typically raise money under one of the prospectus exemptions inNational Instrument 45-106 (Prospectus and Registration Exemptions), including for trades to “accredited investors”; (ii) investors in PE/VC funds typically agree that their money will remain invested for a period of time; (iii) PE/VC funds typically use the money raised from investors to invest in the securities of portfolio companies that are not publicly traded; (iv) PE/VC funds usually become actively involved in the management of their portfolio companies, often over several years, and in this respect examples of active management of a portfolio company include circumstances when a PE/VC fund has (a) representation on the board of directors, (b) direct involvement in the appointment of managers, and/or (c) a say in material management decisions; (v) a PE/VC fund looks to realise on its investment either through a public offering or a sale of business, at which point the investors’ money will generally be returned to them, along with any profit; (vi) investors rely on the expertise of the PE/VC fund and its manager to select and manage the portfolio companies it invests in; and (vii) a PE/VC fund manager typically receives a management fee and carried interest in the profits generated from its investments and does not receive compensation for raising capital or trading in securities. 

For non-Canadian managers of mutual funds and non-redeemable investment funds that qualify as investment funds, registration as an investment fund manager will depend on what activities the investment fund and its manager carry on in Canada and where in Canada such activities take place.  In Ontario, Quebec and Newfoundland and Labrador, registration would not be required if an investment fund manager does not have a place of business in Ontario, Quebec or Newfoundland and there are no security holders of the investment fund, or there has been no active solicitation of residents by the investment fund manager (or any of the investment funds it manages), in Ontario, Quebec or Newfoundland after September 27, 2012.  Active solicitation involves intentional actions taken to encourage a purchase of the securities of the mutual fund or non-redeemable investment fund.  If there are fund security holders resident in Ontario, Quebec or Newfoundland or if there is active solicitation in these provinces after September 27, 2012, registration of the investment fund manager is required. 

There is, however, a registration exemption for international investment fund managers without a place of business in Canada where all of the securities of the investment funds managed by the investment fund manager are distributed under a prospectus exemption to permitted clients only (the “Permitted Client Exemption”).  “Permitted clients” are a subset of “accredited investors” which includes institutional investors and ultra high net worth individuals (who beneficially own financial assets, before taxes and liabilities, in excess of CDN$5 million).

In order to rely on the Permitted Client Exemption, certain notice requirements must be satisfied:

  • notice of reliance on the exemption must be sent to the applicable securities regulatory authority, which includes disclosure of assets under management attributable to investors in the local jurisdiction, a submission to jurisdiction and the appointment of an agent for service;

  • notice of reliance on the exemption must be sent to the applicable securities regulatory authority regarding disciplinary history, settlement agreements and ongoing investigations of the investment fund manager; and

  • notice must be sent to permitted clients that the investment fund manager is not registered in the local jurisdiction together with certain other prescribed disclosure.

In all of the other Canadian jurisdictions, regulators have indicated that the need to register as an investment fund manager in those provinces will depend on what activities are taking place in the jurisdiction. The presence or solicitation of security holders in or by  an investment fund does not automatically trigger the requirement to register.  Registration will be only required in a jurisdiction if investment fund management activities take place within the jurisdiction.  Multilateral Policy 31-202 describes some of the activities that would trigger the registration requirement including, among others, overseeing the day-to-day administration of the investment fund and establishing a distribution channel for the investment fund.

If required, a manager of a non-Canadian investment fund has until December 31, 2012 to file the investment fund manager registration application and/or the documentation allowing it to rely on the Permitted Client Exemption.

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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