For a number of reasons, income trusts have featured prominently in the business media in the last few months. One issue that has garnered its share of headlines concerns the restrictions on ownership of income trusts by non-residents that often apply under Canadian income tax law. One of the more high-profile stories in this regard was the announcement on June 16, 2003 by Provident Energy Trust, a Canadian income trust listed on both the TSX and AMEX, that non-resident ownership of Provident’s units had increased significantly over the last three months, to the point where Provident was in danger of exceeding the maximum threshold for investment by non-residents provided for in its declaration of trust. As a result, Provident indicated that it might have to restrict transfers to non-residents, halt trading of Provident’s units on AMEX or potentially even force non-residents to redeem units, if necessary, in order to ensure continued compliance with its declaration of trust. Provident’s units fell sharply in heavy trading on the day of the announcement. Fortunately, however, Provident subsequently determined that, under applicable tax laws, its structure did not, in fact, prevent it from exceeding the 49% limit on non-resident ownership. As a result, Provident was able to deal with its difficulties by, among other things, proposing to amend its declaration of trust to remove the outright restriction on non-resident ownership, and thereafter the issue receded somewhat from the front pages of the newspapers. This has left income trusts and their advisors with an opportunity to concentrate on finding solutions to the non-resident ownership issue that, to the greatest extent possible, avoid undue restrictions on non-resident ownership while retaining maximum investment and operational flexibility.
The non-resident ownership issue arises out of the fact that income trusts are commonly structured as "mutual fund trusts", as defined for tax purposes. As such, many income trusts are subject to the requirement, which applies with some exceptions to all mutual fund trusts, that the trust must not be "established or maintained primarily for the benefit of non-residents" of Canada. The principal exception to this rule applies to mutual fund trusts that, essentially, have never held more than 10% of their assets in "taxable Canadian property". For these purposes, "taxable Canadian property" includes, in particular, shares of Canadian corporations, units of certain Canadian trusts, Canadian real property and certain Canadian resource properties. Trusts that are and always have been under this 10% threshold on taxable Canadian property are not subject to the foreign ownership restrictions.
Some additional background may help to explain the reasons for the existence of the non-resident ownership restriction and the significance of the 10% taxable Canadian property test. Canadian tax law does not generally impose income tax on capital gains realized by non-residents of Canada unless the gains are considered to arise in Canada. The relevant tax rules make this concept precise by providing that non-residents are only subject to Canadian income tax on capital gains realized on the disposition of taxable Canadian property which, as suggested by the partial list above, is property (such as Canadian real estate) which has a fairly clear nexus with Canada. However, in most circumstances units of a mutual fund trust are expressly excluded from the definition of taxable Canadian property, and it might therefore be possible for non-residents to avoid Canadian capital gains tax in respect of the disposition of taxable Canadian property by investing in a mutual fund trust that is heavily weighted in that area. To mitigate this possibility, Canadian tax rules provide that mutual fund trusts that invest more than 10% of their assets in taxable Canadian property and are established or maintained primarily for non-residents will lose their mutual fund trust status, thus ensuring that capital gains realized by non-residents on a disposition of trust units will be subject to Canadian tax.
Historically, most income trusts have held primarily Canadian-based assets, and it was generally expected (without too much analysis) that the 10% threshold on taxable Canadian property would, or at least could at some point, be exceeded. As a result, trusts tended to focus on complying with the non-resident ownership restrictions to ensure qualification as a mutual fund trust. Unfortunately, there was (and is) some uncertainty as to what criteria are to be applied in determining whether a trust has been "established or maintained primarily for the benefit of non-residents" and, indeed, the Canada Customs and Revenue Agency (the "CCRA") takes the view that no hard-and-fast criteria can be given. Nevertheless, mutual fund advisors have felt the need for more concrete guidelines, and in the absence of guidance from the CCRA, mutual fund trusts have generally interpreted the "primarily for the benefit" requirement to mean that no more than 49% of the units of a trust may be held by non-residents of Canada. Indeed, it has been typical for income trust declarations of trust to include this 49% restriction, as well as a provision to the effect that if at any time the trustee becomes aware that more than 49% of the units are held by non-residents, or that such situation is imminent, the trustee may refuse to accept transfers of units to non-residents and indeed may require non-residents to redeem or sell their units. Although these provisions in some ways constitute an unnecessarily heavy-handed approach to dealing with the non-resident ownership issue (and indeed a similar restriction was partially responsible for Provident’s difficulties), it has until recently been seen as a simple and not too onerous way of dealing with the problem, particularly since non-residents historically did not comprise a very large part of the investor base for most income trusts.
More recently, however, the returns generated by income trusts have made them increasingly popular among U.S. investors, and indeed some income trusts have been listed on U.S. stock exchanges such as the New York Stock Exchange or AMEX. Also, when an income trust acquires a U.S. business, a portion of the consideration often consists of units of the trust, or at least of securities which are exchangeable for units of the trust, and these units may form a relatively significant block of non-resident-held units. As a result, non-resident holdings of units may in some cases be significant.
For these reasons, it is likely that income trusts will increasingly be structured so as not to be subject to non-resident ownership restrictions, by ensuring that not more than 10% of the assets of a trust are held in taxable Canadian property. In the case of trusts which acquire predominantly or exclusively U.S. or other foreign-based assets, this structuring may be relatively straightforward. However, with proper planning, even some Canadian-based trusts may be able to stay onside the 10% test. In addition to such planning, it can be expected that the declarations of trust for funds that comply with the 10% test will no longer automatically include an outright bar on non-resident ownership in excess of 49%, and may replace this restriction with a more flexible requirement that would give the trustees (or the trust manager) authority to monitor non-resident ownership and to take such steps as may be necessary with regard to non-resident ownership where necessary to preserve mutual fund trust status. These and other planning techniques should ensure that non-resident ownership restrictions do not unduly impede investment in income trust units by non-residents of Canada.
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.