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.
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