In our M&A Outlook for 2012, we discussed the emergence, in 2011, of foreign asset income trusts and noted that we expected the trend to continue in 2012 with offerings providing Canadian yield-seeking investors with exposure to foreign-based real estate assets. In fact, in 2012, a number of offerings were brought to market providing Canadian investors with exposure to various classes of real estate assets from multi-unit residential to industrial. With the search for yield still very prominent, look for more of such offerings in 2013.
Structures used by non-residents of Canada for acquiring shares of Canadian corporations and Canadian assets will likely see some revisions in 2013. Currently, the Canadian tax system provides a competitive advantage to non-resident bidders for shares of Canadian corporations and other Canadian based assets over their Canadian resident counterparts. Generally, non-residents are able to use internal leverage to reduce the future taxes payable by the Canadian target corporation or in respect of income from the Canadian based assets. The interest deductions created through the internal leverage reduce Canadian corporate income taxes at rates approximating 25% in exchange for Canadian withholding tax at a rate that in many cases is reduced to 10% under an applicable tax treaty. For U.S. investors, the advantage is even greater as the Canada-U.S. Income Tax Convention provides for a nil withholding rate on all interest paid by a Canadian resident to a non-resident, including related party interest. In addition, it is generally possible to structure instruments that are treated as debt for Canadian purposes but equity for U.S. purposes. As a result, while the Canadian payor receives a deduction for the interest paid, the U.S. recipient does not have a corresponding income inclusion.
Two tax changes enacted in 2012 will lessen this advantage. The first is the reduction in the acceptable thin capitalization ratio from 2:1 to 1:5:1. As a result, foreign acquirers will be allowed to use less internal leverage to fund their Canadian acquisitions thereby reducing the amount of interest deductions that will be available to shelter future income.
The other important tax change is the introduction of the "foreign affiliate dumping rules". These rules generally apply to an investment in a foreign subsidiary made by a Canadian corporation that is controlled by a non-resident corporation. Under these rules, the investment may result in the Canadian corporation being deemed to have paid a dividend to its non-resident parent in the amount of the investment made in the foreign subsidiary. The deemed dividend is subject to Canadian dividend withholding tax. Alternatively, the rules may apply to reduce the paid-up capital of the shares of the Canadian corporation which reduces the amount of internal debt that may be used to fund the Canadian corporation under the Canadian thin capitalization rules.
The rules also apply to a Canadian corporation controlled by a non-resident corporation that acquires, or makes an investment in, the shares of another Canadian corporation that derives more than 75% of its value from foreign subsidiaries. Accordingly, in the case of the acquisition of such Canadian corporations, it may no longer be advantageous to use a Canadian acquisition corporation. Typically, Canadian acquisition corporations have been used by non-residents to make acquisitions of Canadian corporations in order to maximize paid-up capital (which acts as a pipeline to distribute profits to the foreign shareholder without Canadian withholding tax) and internal leverage.
Finally, a growing trend for structuring Canadian acquisitions is the use of the hybrid asset/share purchase. While not necessarily a new structure, current Canadian corporate tax rates and individual tax rates on dividends and capital gains often make it advantageous for both sellers and buyers to use a hybrid purchase structure. In very general terms, the hybrid structure involves the purchase of the assets of a Canadian corporation followed by the distribution of some of the after-tax proceeds from the asset sale and then the sale of the shares of the corporation. This structure provides the purchaser with a step-up in the cost base of the assets for Canadian tax purposes while still providing sellers with the favourable tax treatment they would receive from a straight share sale. The hybrid structure adds complexity to the transaction but the tax savings for sellers and purchasers can be significant so look for this trend to continue.
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.
