While the Canadian market is increasingly seen as an attractive one for U.S. private equity investors, real success depends on identifying the substantive differences between the two regimes and structuring the investment accordingly.
American private equity funds have become major players in the Canadian marketplace and have figured prominently in a number of recent large transactions north of the border.
To name a few examples: Bain Capital, LLC, along with the Beaudoin family and the Caisse de dépôt et placement du Québec, formed a consortium which, in December 2003, acquired the recreational products division of Bombardier Inc. for C$960 million. This summer, another investor group led by Hicks, Muse, Tate & Furst acquired Persona Inc., Canada’s sixth largest cable television operator, for C$400 million.
And, in a transaction that represented 2003’s largest Canadian IPO, a group of investors led by Kohlberg Kravis Roberts & Co. formed an income fund to monetize their interest in the Yellow Pages telephone directories business, which they had acquired from Bell Canada less than a year earlier. The Yellow Pages Income Fund completed two offerings in a span of less than four months for total proceeds of C$2.5 billion.
The Income Fund Phenomenon
The Yellow Pages transaction illustrates the importance of income funds (also known as "income trusts") in the Canadian corporate landscape. Income funds (which until very recently were unique to Canada) are typically formed to acquire income-producing businesses with a history of stable earnings and low ongoing capital needs. Their primary focus is on maintaining the earnings flow necessary to protect unit distributions. Typically, management is constrained from making significant acquisitions or otherwise fundamentally altering the fund’s core business.
When structured properly, an income fund acts as a flow-through vehicle for tax purposes; income taxes are paid at the unit holder level rather than at the level of the fund itself. In part because of this tax efficiency, converting a business into an income fund frequently results in higher multiples than a plain-vanilla IPO.
The rise in popularity of income funds has implications for U.S. private equity investors looking at the Canadian market. When a company is seeking to raise capital and is facing a choice between the public markets and sources of private equity, the income fund structure can represent formidable competition to the private equity alternative. There is a corollary however: in evaluating a potential acquisition, a private equity investor should give thought to whether conversion to an income fund would be a viable option for achieving liquidity. As the KKR/Yellow Pages transaction vividly demonstrates, in appropriate circumstances the income fund structure can present an attractive exit vehicle.
Investment Structure Issues
Apart from the ubiquity of income funds, there are other significant differences between the U.S. and Canada which private equity investors need to be familiar with when participating in Canadian transactions.
In particular, limited liability companies (LLCs), which are commonly used as private equity investment vehicles in the U.S., are not the vehicle of choice for cross-border investments into Canada. This is because LLCs are not considered "residents of the U.S." by the Canadian taxation authorities for purposes of the Canada-U.S. tax treaty. As a result, they are not entitled to relief under the treaty from the taxation in Canada of capital gains received on liquidation of a Canadian investment, nor are they eligible for the reduced rate of withholding tax that would otherwise apply to interest and dividend payments from a Canadian entity.
Another feature of Canadian tax law is its preferential treatment of "Canadian controlled private corporations," commonly referred to as CCPCs. Corporations that qualify as CCPCs are entitled to lower corporate tax rates, greater access to investment tax credits and more favorable tax treatment for employee stock options.
Acquisition by a U.S. private equity investor of a controlling equity interest in a corporation will disqualify the corporation from CCPC status. Even a minority investment can have the same result if, for example, the U.S. investor has contractual rights which give it de facto control of the corporation or has a right to acquire a controlling equity position at a future date. The rules in this area are complex and there is often a tension between the desire on the part of a U.S. equity investor for effective control and the desire to preserve the tax benefits of CCPC status where possible.
Canadian Sellers and Market Receptive
None of the differences between the U.S. and Canadian regimes is insurmountable. The key to success is to recognize the differences up front and structure the investment accordingly. With this in mind, the Canadian market can be an attractive one for U.S. private equity investors: Canadian deal documentation looks quite similar to its U.S. counterpart, Canadian sellers are generally receptive to private equity purchasers and the Canadian capital markets provide readily accessible paths to liquidity.
Stephen Sigurdson is managing partner in Osler’s New York office and specializes in cross-border transactions. Geoff Taber is based in Toronto, where he practises corporate finance with an emphasis on technology and life sciences companies and the venture capital funds that finance them.
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