Reprinted from Tax Notes Int’l, October 24, 2005, p. 375 Volume 40, Number 4 October 24, 2005
(C) Tax Analysts 2005. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
The author wishes to thank his partners Duncan Osborne and Alan Shragie with Davies Ward Phillips & Vineberg LLP for reviewing and commenting on drafts of this article.
I. Overview, Background, and Context
This piece could be considered an unplanned sequel to the relatively recent article in Tax Notes International1 that focused strategic structuring considerations for foreign acquirers of publicly owned Canadian businesses carried on through flow-through entities, and more particularly through trusts2 (whether real estate investment trusts (REITs), royalty funds or trusts, or business funds or trusts (all terms of business not statutory terminology3)). The occasion (for this sequel) are two recent announcements by the Canadian government, 4 reported on in two September issues of TNI, 5 which may harbor adverse changes to the manner in which this recent phenomenon in Canadian businesses and capital markets6 may be taxed. Although any such adverse change would, by and large, be aimed at the domestic scene (that is, in respect of Canadian investors in Canadian publicly traded trusts), it inevitably could have direct or indirect material effects, in and for theinternational dimension, which has two distinct aspects.
The first is a question of how the two recent Canadian government announcements7 may affect foreign investors in Canadian-based businesses carried on through publicly traded flow-through entities, or on the overall Canadian tax considerations respecting foreign takeovers of such businesses. The other comprises the rather fascinating dynamic by which the Canadian investment community has brought together Canadian investor appetite for flow-through entity investments and target businesses being carried on in other countries (largely, if not exclusively, in the United States). This sees a marriage of the Canadian technology respecting flow-through entity tax treatment for Canadian investors and U.S. tax strategies focused on minimizing corporate level tax on U.S.-source business profit, through internal financing (earnings stripping) arrangements.8 Because these situations do not entail the earning of Canadian-based profit that would, in the case of a conventional publicly traded corporate arrangement, attract corporate level tax in Canada (but instead are aimed at minimizing overall tax with respect to U.S.-source profit), they are not the reason, target, or object of the Canadian government’s September 8 consultation process. As a result, such targeted U.S. business arrangements are not dealt with further in this article; however, it would not be at all surprising should changes (if any) ultimately adopted in the consultation process affect, even if only inadvertently, the overall tax position of Canadian investors with respect to such arrangements, particularly (or perhaps only) where they entail the use of publicly traded trusts and not the IDS or IPS format.
As indicated9 the double (that is, corporate level and shareholder level) tax faced by Canadian taxable investors in conventional publicly traded Canadian business corporations, and the single (corporate level) tax in the case of Canadian tax-exempts, has fueled a virtual explosion10 of trust-based arrangements. These seek (in cases where a lower-tier operating corporation is not required in the structure11) to flow through — for Canadian tax purposes — all income being earned to investors in publicly traded trusts and, in certain cases, (where a corporation cannot be avoided12) as great a portion as possible. The targeted tax result of such trust approach is simple enough, as illustrated in the August 8 M&A Forum installment for Ontario-based taxable individuals, with respect to Ontario-based businesses. In such case, the overall tax rate on distributed profits can be reduced from a level of some 56 percent (where a corporation is used) to 46 percent (and lower to the extent that such investors have in place their own tax shelters) where a trust is used and, in the case of tax-exempts, from 36 percent13 down to zero percent. As noted above, this transition from corporate to trust-based entities has reached the point where nearly 10 percent, by market cap, of the Toronto Stock Exchange (TSX) is made up of publicly traded trusts, which are now being accorded full public markets status by becoming eligible for inclusion in the Standard and Poor-Toronto Stock Exchange Composite Index. 14
The ostensible fly in the ointment, however — from the standpoint of the Canadian Fisc — is the erosion or reduction of the tax revenue base. 15 That concern undoubtedly underlaid both a March 2004 federal budget announcement that pensions funds would be limited in the amount of investments they could make in publicly traded trusts — an initiative that was then deferred for further consultation and study16 — and the September 8 Finance consultation paper. But it is also true that voices in the investment community have harbored deep concerns that the trust model is distorting business and investment activity and decisions, because the allure of tax benefits, by maximizing profit distribution, often clashes with and is overriding the need to retain profits for R&D, expansion, and so forth — which retention generally arises from operations structured through publicly traded taxable corporations. And, notwithstanding some (cynical?) skepticism respecting its motives, the government’s consultation paper does point to that aspect of the publicly traded trust phenomenon as a cause for review. 17
Although the government’s paper is framed in a general domestic context, the focus below is whether any of the foreseeable changes that might follow from this consultative process will adversely affect foreign investors in Canadian publicly traded Canadian-asset or business focused trusts, or takeovers thereof by foreign parties. The gruel is rather thin in that, as examined in the September 19 article (note 5), the consultation paper contains but a brief reference as to what the government may have in mind. The initial responses being considered are as follows:
The focus of this paper is to assess the tax and economic efficiency implications of FTEs to determine if the current tax system is appropriate or should be modified. If it is determined that the tax system needs to be modified, the question arises as to the potential policy approaches. This section lists some policy approaches that are relevant to the issues identified in this paper. . . .
Although not an exhaustive list, policy approaches that derive from the discussion of issues in this paper include: limiting the deduction of interest expenses by operating entities, taxing FTEs in a manner similar to corporation, or better integrating the personal and corporate income tax system. 18
The second development (the September 19 announcement putting rulings on ice) is, on the one hand, more specific, substantive, and immediate — suspending, as it does, rulings applications relevant to certain current deals or reorganizations of existing trusts — but on the other hand, it is of relatively narrow application. It is relevant only to a relatively small number of situations described briefly below. Where it does apply, it would not directly affect the position of foreign investors or acquirers. But as noted below, it has spawned a torrent of controversial debate as being politically motivated.
In the international context (as referred to in note 8), the consultation paper reached out, in developing its initial commentary, to the experience with flowthrough vehicles in other countries, and discusses Australia, the United Kingdom, and the United States. The comments are mainly consistent with those in the August 8 M&AForum installment (note 1) in that the government paper concluded that in the countries it examined, either no publicly traded flow-through entities are being utilized to conduct domestic business or, where they appear, they are restricted to investment in real estate, or in certain other passive or niche situations (for example, in Australia, in venture capital). The August 8 M&A Forum installment also noted flow-through entities in the real estate and/or portfolio investmentmutual fund context in Belgium, France, Germany, and the Netherlands, with Italy having a hybrid situation in which real estate income of some entities may be exempt from tax unless and until distributed to investors. 19
Finally, as referred to earlier, although the consultation paper extends to flow-through entities in partnership format, that approach has usually been avoided because, prior to changes earlier this year, Canadian tax-exempts were effectively prohibited from investing in partnerships.20 The recent amendments do open up the format, but in light of usage to date, the thrust and focus of the consultation paper and the comments below are on the trust arena.
II. Implications for Foreign Investors In Canadian Publicly Traded Trusts
The difficulties faced by the government in thinking through a rational policy respecting the taxation of publicly traded flow-through entities — both in concept (for example, in a vacuum) and in comparison to publicly traded taxable corporations — may be gleamed to some extent by examining the current comparative tax position of foreign investors in Canadian publicly traded trusts21 and in Canadian corporations. Whereas a nonresident investor in a Canadian taxable corporation will incur combined corporate level and shareholder withholding taxes of roughly $50 per $100 of distributed pre-tax corporate profit (made up of, say, 35 percent at the corporate level22 with a 25 percent withholding tax on the residual dividend of $65 derived therefrom23 subject to treaty reduction), a nonresident unit holder in a mutual fund trust will, in general, pay no more than 25 percent on such holder’s share of income flowed-through a trust, a rate that may be reduced to 15 percent under some treaties. 24 Such taxation can apply to the entire interest of the nonresident investor in the profit of the trust where it operates without a lower-tier captive corporation or, in the latter case, on that portion of corporate profit that can be extracted by the trust through internal debt leverage. 25
But is this (comparative) result totally inappropriate? If a foreign investor participates in a publicly traded Canadian corporation by way of debt capital (that is, by being a lender), there may be total exemption from Canadian tax on the share of profit extracted by (noncontingent) interest payments or where the latter exemption does not apply, the standard domestic withholding rate of 25 percent on interest payment may well be reduced by treaty down to 10 percent. 26 It is true that such loans made by foreign investors who are also shareholders may trigger application of Canada’s thin capitalization rules, which would limit the amount of deductible interestbearing debt to twice the calculated equity base of the corporation attributable to such foreign lenders. However, this rule (under section 18(4) et al. of the Act) can only arise when the foreign lender, alone or together with affiliated persons, owns 25 percent or more of the stock of the corporation. Although there are no comparable limitations with respect to trust arrangements, there is a separate rule that could be seen as providing a proxy for the protection afforded the Fisc in respect of Canadian corporations by the latter thin capitalization rules. In particular, a basic requirement to qualify as a mutual fund trust is that it has not been established and/or maintained principally for the benefit of nonresidents. 27 As discussed in the August 8M&AForum installment (note 1), the government has proposed to replace that test with a mechanical rule that no more than 50 percent of the stock of a mutual fund trust can be owned by nonresidents; however, those proposals have been postponed for further study. 28
It could be argued that there is a gap, from the Fisc’s standpoint, when nonresident ownership is in the second quartile (that is, between a 25 percent interest and 50 percent stock interest) and that in this case there is an earnings stripping potential that arises with respect to a trust format that is not available in the case of corporate format. But that is probably illusionary in that, as noted above, it takes more than simply a 25 percent or greater nonresident shareholders’ interest for the corporate thin cap rules to apply. There must be an affiliation between stockholders who together hold more than 25 percent of the stock of a Canadian corporation. Therefore, to say that there is anything particularly inappropriate from the standpoint of the foreign investor as to the manner in which Canadian business profit is being earned through publicly traded trusts is treated, in comparison to that which arises in the case of business conducted through publicly traded corporations, is either simplistic or simply generally not valid.
Furthermore, the landscape is complicated where one takes into account the above-noted derivative29 of the publicly traded trust approach, where that approach entails business being conducted through a lower-tier corporation and funded, to the maximum extent possible, by interest-bearing loans made to that corporation by the trust. In the IDS or IPS derivative arrangement, investors can effectively achieve the same partial flow-through treatment (as where a trust and lower-tier corporation is utilized). Although, as noted, the derivative approach apparently has not been used to this point (but see note 8 respecting the plans of one Canadian company, Cinram International Inc.) to structure Canadian-based businesses (but only Canadian investment in U.S. businesses), if it were (and subject to the thin cap factors noted earlier, and any adverse changes that may be made to counter this situation30), the results for foreign investors would be no different than if they were dealing with a regularly structured Canadian taxable corporation — that is, when they would separately seek to purchase debt of such corporation and, to the extent they wish equity participation, the stock of such corporation.
What changes could arise for foreign investors as a result of the consultation process? As noted above, the consultation paper refers to (‘‘not an exhaustive list’’): ‘‘limiting the deduction of interest expenses by operating entities, taxing FTEs (flow-through entities) in a manner similar to corporations, or better integrating the personal and corporate income tax systems.’’
The first approach (‘‘limiting the deduction of interest expenses with operating entities’’) would not, per se, affect those trusts that operate without lower-tier corporations. For that format, any such change of law would not affect the present structure and results of the trust or any of its beneficiaries, resident or nonresident. In the case of trusts operating through lower-tier corporations, the effect for all investors would be (in relevant factual situations) taxation at the corporate level of more profit than at present; for foreign investors, the portion of corporate level profit that cannot be extracted by interest paid to the upper-tier publicly traded trust would (once distributed effectively by way of dividend from the corporation to the trust and then distributed to the beneficiary) attract overall Canadian taxes in the area of some 50 percent (see above), subject to reduction of the withholding tax component when the beneficiary is in a treaty country. Obviously, such change would, inter alia, be adverse to foreign investors.
If the change took the form of taxing the trust in a manner similar to a corporation, presumably the results described above for foreign investors in taxable Canadian corporations would arise, which obviously is far inferior to the present status. But would that simply lead to more corporate debt investment than equity investment, or to approaches to combine the two through bifurcated instruments (for example, IPS or IDS arrangements)? It is true that the latter could then run up against existing thin cap rules with respect to foreign investors (as described, but qualified above in this context), or — as indicated above — beefed-up restrictions on corporate level interest deductions. But such a dynamic and cycle of action and reaction precludes any type of precise prognostication at this time.
What about the third approach (‘‘better integrating the personal and corporate income tax systems’’)? 31 Does this mean that trust arrangements would be left intact but changes made to improve overall taxation of those who invest in businesses of publicly traded corporations? To that extent, would it not simply open up additional possible alternatives for effective foreign investment in Canada? Does ‘‘better integrate’’ mean looking at countries (such as Australia, Chile, Mexico, and the United Kingdom) that have eliminated foreign shareholder withholding on dividend distributions, 32 or countries (such as Argentina and Brazil) that have even eliminated the shareholder tax on dividends for both domestic and foreign investors? Or does it mean reducing significantly corporate level tax on distributed profit with the view of then taxing the shareholder more than at the corporate level? The latter would tend to circle back to the effects of the current trust regime. Or would it see significantly greater credit given to shareholders for corporate level taxes? How that would play out for foreign shareholders is difficult to fathom, given the lack of any evident existing precedent33 in other countries for refunding, to foreign shareholders, corporate level tax on distributed profit, where a normal treatyassisted withholding on dividend can reduce the rate down to 5 percent or 15 percent.
All in all, it can be seen that at this juncture there simply is no basis to clearly forecast the nature of changes, if any, to come and their effect on foreign investors in Canadian capital markets, whether in regular taxable Canadian corporations or in flowthrough trusts.
Finally, what is the effect for foreign investors of the September 19 moratorium on trust rulings? 34 By and large, if not exclusively, the rulings that have been sought (and therefore are now suspended) relate to the relatively narrow situation when an existing trust (or perhaps one that is being formed) is seeking to utilize certain specific rules in the Act to emerge with a trust arrangement that does not have a subsidiary operating corporation, to achieve maximum flow-through of underlying business profits. 35,36 This matter does not, per se, directly involve foreign investors in Canadian trusts. But the obvious indirect effect is that when the object transaction is not carried out (because the parties believe that it should be accompanied by a ruling), there will be diminished or eliminated investment opportunity otherwise available to a foreign investor to achieve maximum benefit of flow-through treatment. If, for example, the absence of a ruling means that in the case of an existing publicly traded trust operating through a lower-tier corporation when interest payments made to the trust are substantially less than the corporate level operating profit (so that excess is taxed at the corporate level), any decision to not proceed with the reorganization, in the absence of a ruling, will simply suboptimize after-tax results for a foreign investor. It is not known at this time how the government intends to fully correlate the September 8 consultative process and the September 19 moratorium on such rulings, nor is it known to what extent the reference in the September 19 press release for transitional relief for specific deals in progress will play out.
However, this development will, per se, have no effect on the following: those existing trusts that are in place and not seeking to reorganize; businesses being brought to market through IPOs that either involve arrangements that do not require lower-tier corporations, or, where the parties decide to proceed with lower-tier corporations, the limitations on flowthrough effects inherent in the amount of investment that can be structured as loans by the trust to the operating corporation does not — as a matter of the particular facts — result in material corporate level profit, net of the internal financing expenses; or conversions from public corporation to public trust that do not seek to eliminate the former from the resultant structure.
III. Implications for Foreign Acquirers of Canadian Trusts
The August 8 M&A Forum installment (note 1) used a three-pronged framework to examine the question of structuring foreign total acquisitions of Canadian publicly traded trusts. First, it was noted that the buildup of Canadian businesses in a broad cross-section of business sectors being conducted through publicly traded trusts is of relatively recent vintage and, as a result, the cycle of business dealing is such that there apparently has been only one prior such deal37 with the result that there was not much precedent for such a transaction. But, on the other hand, given that nearly 10 percent of the TSX now is represented by trusts carrying on all manner of business, it was reasonable to expect that the next wave in the trust phenomenon might well be an increasing number of takeovers by foreign or domestic parties. Third, the matter was examined in comparison to strategies in which foreign parties take over conventionally structured Canadian business, which is conducted through publicly traded corporations. For acquirers it was noted that there are at least four key tax objectives: (1) tax-free recovery of the investment, (2) basis step-up for various purposes, (3) merger of external or internal acquisition debt with the target’s profits going forward, and (4) establishment of basis for a future exit strategy.
The focus was on the interrelated effects for acquirer and seller, with a view to determining to what extent the acquirer’s objectives (above) could be achieved without duly compromising the interests of the unit holders of a target trust. The analysis showed that in the case of a takeover of a trust carrying on business through one or more lower-tier corporations, there could be as effective (and in some cases, perhaps more effective) results for the acquirer than in comparison to acquiring a conventionally structured publicly traded corporation— and without compromising the position of the selling unit holders. And, in such case, this could be achieved by either a unit level or entity level deal. In fact, where the focus is on the objectives of a basis step-up of underlying assets, in the case of a takeover of a trust with a number of directly held lower-tier operating corporations, step-up could be achieved (in the stock of such subsidiaries) even when the currency for the acquisition is stock of the foreign acquirer, a result that would not be available where the entity being acquired is a publicly traded corporation (with such second-tier subsidiaries) and not a trust. 38 Furthermore, equal efficiencies could be available for selling shareholders whether the transaction takes the form of acquiring the interests in the trust or having the trust sell its lower-tier corporations and then liquidating. But when the target trust operates directly or through lower-tier trusts and/or partnerships, there could be conflict between the interests of the parties as between the two forms of transactions. 39
In the latter context, what effects may be foreseen for foreign acquirers of Canadian publicly traded trusts in light of the possible changes suggested in the consultation paper? In principle neither the first nor the third suggestions (either limiting the deduction of interest expenses by operating entities or better integrating the personal and corporate income tax systems) would have any conceptual or mechanical relevance to factors that would arise at the point of taking over a publicly traded trust. In practice, of course, this might change the dynamics of the market and affect, either upwards or downwards depending upon the changes, the price asked for a target trust. That is pure speculation at this juncture.
It is the second prospect (that the trust will be taxed in a manner similar to corporations) that could well affect, at least in concept, the structuring strategies of acquiring publicly traded trusts. First, if the trust were taxed in the manner of a corporation, it is doubtful the current strategies that could be effective for all parties where lower-tier operating corporations of a trust are acquired (as the mode of the takeover) would be as effective as under current law. In particular, the prospect of integrating the overall tax results for the selling unit holders may well be eliminated and render such an acquisition no more feasible than seeking to acquire a publicly traded Canadian corporation by an asset deal rather than a share deal.40 Second, if the acquisition takes the form of acquiring the interests in the trust, it is premature to speculate whether the trust could be unwound, after its acquisition by the foreign acquirer, on the same tax-efficient basis as could be available under current law. Third, where the currency for the deal is foreign acquirer stock, it is premature to speculate the extent, if any, to which ‘‘exchangeable shares’’ could be used to achieve deferral (rollover) treatment for target’s unit holders.41 Fourth, it is premature to speculate as to the effects if an attempt were made to continue the trust that, under current law, assuming a complete acquisition, would not be tax-efficient. All in all, it would appear that a change that would tax a trust as a corporation would, particularly in certain circumstances, provide inferior results for the parties and, in other circumstances, the results would only be known once the overall rules related to taxing a trust as a corporation are known.
Finally, there is no direct mechanical or functional relationship between the question of structuring an acquisition of a Canadian publicly traded trust and the current moratorium on rulings respecting either reorganizations of currently traded trusts or formations of new ones.
IV. Summary
The foregoing and the August 8 M&A Forum installment reflect the manner in which the Canadian business and investment community have been able to work, within the framework of certain tax rules of general application and certain specific modifications thereto, to develop an approach to publicly owned and traded businesses, through trusts, that reduces or eliminates problems of double taxation (in the case of taxable investors) and single taxation (in the case of tax-exempts) that arise in conventionally structured corporate approaches (an issue certainly not unique to Canada). This has evolved in a fashion that raises important implications and consequences, inter alia, for: (1) Canadian investors, foreign investors, and potential foreign acquirers of Canadian businesses; (2) the very way in which business and investment decisions are made; and (3) the Canadian government, in terms of tax revenues. With nearly 10 percent of the TSX, by market cap, now represented by Canadian businesses, in a broad cross-section of sectors, carried on in flow-through trust format, there has been a significant opportunity for, inter alia, foreign investors to participate in the Canadian business scene with very favorable tax results, both during the holding period and at the point of a divestiture. And for foreign parties, in light of the proliferation of the trust approach to carrying on Canadian business, there is the prospect that abundant opportunities for takeovers and acquisitions will arise that will raise unique challenges and, in some cases, opportunities respecting the manner in which such deals would be structured from the tax standpoint. In some cases, detailed in the August 8 M&A Forum installment, the results in such takeovers and acquisitions may be comparable to those applicable to takeovers of Canadian publicly traded businesses carried on in conventional corporate format, in other cases more favorable and in some cases perhaps less favorable.
However, whatever the opportunities or challenges or pitfalls faced by foreign investors and potential foreign acquirers under current law, the spectacular success of the trust approach to carrying on publicly owned business in Canada now has drawn a reaction from the Canadian government — as explored above and in prior TNI coverage (note 5) —a reaction that the government has made clear, in its two September announcements (note 4), stems from both tax revenue base concerns and those respecting issues of economic efficiency, and so forth. In the latter context, there is divided opinion in the business community as to whether the trust format approach to carrying on business should be encouraged or discouraged, and in relation to the tax revenue base factor, the government faces a major challenge in deciding whether to maintain the status quo, legislate to discourage the use of trusts, or (as many advocate) level the playing field between that format and corporate format by improving the tax results for corporations and/or their shareholders. The long-term prognostication has been clouded, at least in part, by the second government announcement — the rulings moratorium of September 19 — which could be seen as a red herring, but one that clearly has affected both the markets and current deals in progress (whether formation of new trusts or reorganizations of existing ones). Indeed, it is interesting to note comments attributed to Len Farber, the general director of the Tax Policy Branch of the Department of Finance, at hearings on September 28 of the Senate Standing Committee on Banking Trade and Commerce, which could be viewed as suggesting that the objective of the moratorium was of an in terrorem nature.
Ralph Goodale, the Finance Minister, was invited to the last minute meeting, but didn’t attend. Len Farber, general director, tax policy branch, was one of the three bureaucrats who represented Finance at yesterday’s hearing.
Mr. Farber said the September 8 consultation paper was ‘‘almost dismissed’’ by the market as the heady pace of conversion announcement continued. ‘‘It would be inappropriate for the government to give advance tax rulings on any transaction during’’ the consultation period, Mr. Farber said. 42
There are at least two different ways to consider the current imbroglio in relation to foreign investors and potential foreign acquirers of Canadian businesses. First, with respect to straight foreign investment in Canadian trusts—in a nontakeover or total acquisition context — the foregoing indicates that the manner in which the government decides to deal with the tax policy issues going forward may or may not affect, as a matter of straight tax effects, foreign investors. If the approach is to change the tax regime for corporations and their shareholders, then there of course would be no direct change at all in the very favorable overall tax treatment that foreign investors now enjoy in acquiring units of Canadian publicly traded trusts carrying on Canadian businesses. If the approach is to tinker with interest deduction rules (as between a trust and a wholly owned corporation carrying on a business that is debt-funded by the trust), foreign investors in trusts in that (trust-subsidiary corporation) format may well experience indirect but clearly adverse results. But in those cases in which the trust does not employ a lower-tier corporation in its operations, that specter of tax inefficiency should not arise. It is the third approach suggested in the September 8 consultation paper — namely, an adverse change to the rules governing trust arrangements that would affect all investors, including nonresidents.
The second factor is the effect on future acquisitions and takeovers by foreign parties of Canadian businesses conducted in trust format, and that effect itself has two dimensions — one a matter of tax technology, and the other a matter of markets—and in particular the extent to which reasonably priced trust takeover targets will be available. That will be influenced by the tax policy decisions taken. For example, if there are changes to the trust rules but those trusts now in place are grandfathered (that is exempted from such changes), the latter presumably would gain greater value in the markets and become more expensive as takeover targets. If instead all trusts — both existing and newly formed — were made subject to harsher tax rules, then presumably that would have the opposite effect. If the changes focus on taxation of corporations and their shareholders, it is more difficult to predict the effect on valuations and takeover prices of trust arrangements. The other dimension, the tax technology involved in takeovers, may or may not be affected by any tax rule changes going forward. There should be no effect, in concept, should the government adopt an approach that does not, per se, change the taxation of trusts, but if the latter becomes the tax policy choice, it is premature to speculate on the manner in which acquisition structures and strategies would be affected upon total acquisitions by foreign parties of Canadian businesses carried on in trust format.
Postscript
On October 14, 2005, the province of Alberta — where the first energy trusts appeared some 20 ago —entered the fray by announcing it was considering a special tax on nonresident unit holder’s share of trust income. Athough the direct negative effect for foreign parties would be clear, how that would address the fundamental tax revenue-loss concerns that arise from the overall effects in respect of the preponderent investors in trusts — domestic investors — is not at all clear. Separately, there could be federal-provincial constitutional constraints on the manner in which a province can impose tax on a nonresident. 43
1 See Nathan Boidman, ‘‘Cross-Border Investment in and Acquisitions of Public Flow-Through Entities: Canada,’’ Tax Notes Int’l, Aug. 8, 2005, p. 499, which was the 10th installment in the TNI Forum on International Mergers and Acquisitions (herein the ‘‘August 8 M&A Forum installment’’ or ‘‘Boidman (note 1)’’). For an overview of the Forum (and its 20 other participants), see Nathan Boidman, ‘‘M&A Forum — International Mergers and Acquisitions: A Forum for Discussion — Introductory Note,’’ Tax Notes Int’l, Aug. 8, 2005, at p. 497.
2 As explained in the August 8 M&A Forum installment (note 1), partnership format can also provide flow-through treatment under Canadian tax law, but, as noted therein and below, has not generally been utilized in publicly traded business arrangements.
3 As noted in the August 8 M&A installment (note 1), at p. 502, certain draft legislation does refer to ‘‘business income trusts.’’
4 Department of Finance News Release, Sept. 8, 2005, No. 2005-055, ‘‘Department of Finance Launches Consultations on Issues Related to Publicly Listed Flow-Through Entities (Income Trusts and Limited Partnerships)’’; accompanying consultation paper, ‘‘Tax and Other Issues Related to Publicly Listed Flow-Through Entities (Income Trusts and Limited Partnerships)’’; and Department of Finance News Release, Sept. 19, 2005, No. 2005-059, ‘‘Government Postpones Advance Rulings on Income Trusts and Other Flow-Through Entities: Emphasizes Importance of Consultations.’’
5 See Donald H. Watkins and Sasha N. Nowicki, ‘‘Canada Issues Paper on Flow-Through Entities,’’Tax Notes Int’l, Sept. 19, 2005, p. 1059; and Sirena J. Scales, ‘‘Advance Rulings for Trusts Put on Hold,’’ Tax Notes Int’l, Sept. 26, 2005, p. 1148.
6 As explained in both the August 8 M&A Forum installment (note 1), and by Watkins and Nowicki (note 5), from just a few isolated instances of the use of publicly traded trusts in the real estate or resource sectors in the 1980s, the use of such format to carry on publicly traded business in just about any industrial sector has virtually exploded over the last 5 to 10 years with the result that by mid-2005 (as detailed in note 23 of that installment), 8 percent of the TSX, by market cap (reaching over C $150 billion) and 13 percent by number of issuers (over 200), was represented by businesses in a number of sectors carrying their activities through publicly traded trusts. An article by Paul Vieira (‘‘Tax regime under scrutiny in wake of trust explosion,’’ National Post, Sept. 9, 2005, at FP-1, together with an accompanying table at FP-3) puts the market cap as high as C $169 billion as of August 26. As well, a recent report puts the number of listed trusts (including IDS and IPS arrangements noted elsewhere) at 227. See Carrie Tait, ‘‘Beware of Americans dressed up as trusts,’’ National Post, Sept. 26, 2005, at SR-9. The tax reason for the phenomenon, explained in the prior TNI articles and considered further below, is simple enough. The total or partial flow-through effects for tax purposes of such arrangements reduce overall tax on distributed profits earned through this format, for taxable investors, and, in some cases, eliminate it entirely for tax-exempts. On the nontax side, one reason was the advent of low interest rates in the early 1990s. See John A. Brussa, ‘‘Royalty Trusts, Income Trusts, and Search for Yield: A Phenomenon of a Low-Interest-Rate Environment?’’ Report of Proceedings of the Forty-Eighth Tax Conference, 1996 Tax Conference (Toronto: Canadian Tax Foundation, 1997), 19:1-27).
7 See notes 4 and 5. The first, on September 8, entails a consultative process intended to result in a specific tax policy, respecting flow-through entities (FTE) going forward that may or may not change the current applicable framework. The second, on September 19, announced a moratorium on issuance of rulings being sought for certain new or revised deals.
8 As noted in the August 8 M&A Forum installment, at pp. 502, 503, and 516, such publicly traded structures, for U.S. targeted businesses, typically take one of two forms. One sees, at the top, a Canadian formed publicly traded trust that, through a number of intervening entities, owns an operating U.S. C corporation that, inter alia, pays interest on internally provided financing by the trust (and its lower-tier entities), all with the view — from the overall tax standpoint — of moving U.S.-source business profit through to the investors in the Canadian trust with the minimum, if not nil, Canadian and/or U.S. tax. Unlike the situation for Canadian-based business activities, these arrangements have evolved to sometimes take a second format, which does not involve a trust. This involves a listed U.S. or Canadian corporation that is owned and funded by investors through debt and equity investment — units. If a U.S. corporation is involved, the arrangement generally is referred to as ‘‘income deposit securities’’ (IDS) arrangements, and when they involve a Canadian corporation, ‘‘income participating securities’’ (IPS) arrangements. To date, it appears that the latter, not involving a trust, has not been used in Canada for Canadian-based business situations. (But a very recent report indicates this may change. See Wojtek Dabrowski, ‘‘CI fund CEO mulls choices,’’ National Post, Oct. 11, 2005, at FP1, who wrote, ‘‘[A] notable exception is the duallisted Cinram International Inc., which on Friday said it could convert its stock into so-called income-deposit securities, a high-yield structure used by some U.S. companies.’’) The government consultation paper refers to IDS arrangements in relation to a survey of other countries and (under the heading, in the United States) notes:
The concept of the IDS is similar to that of the business income trust in Canada — the use of a debt instrument allows the operating corporation to reduce its taxable income by the amount of the interest deduction. One of the key differences between the IDS and the business income trust structure is that the IDS does not involve the creation of a trust — the investor holds the underlying securities directly — and so the U.S. tax issues are simplified.
IDSs are essentially securities issued by U.S. corporations that consist of both dividend-paying common shares and high-yields subordinated notes, which are ‘‘clipped’’ (paper-clipped) together. The IDS can be separated by the holder and is generally automatically separated under certain events. This feature is used to provide comfort that U.S. tax rules that cause certain debt to be treated as equity would not apply to U.S. corporations issuing IDSs. There are currently 10 corporations issuing IDSs in the U.S, which are listed on either the American Stock Exchange, the Toronto Stock Exchange, or both, having an estimated market capitalization of Canadian $3.5 billion. [Source — CIBC World Markets, Income Trust Weekly, June 30, 2005] One reason that has been put forward for the relatively small number of IDSs to date is the uncertainty over whether the subordinated notes would be treated as equity for tax purposes, which would nullify the desired tax effect.
It is interesting that this commentary does not note that these structures have been created basically for Canadian investors in U.S. businesses (although there have been some — apparently not too successful — attempts to market IDSs to U.S. investors) and, moreover, the consultation paper does not refer to the Canadian corporate (IPS) approach to the such U.S. business target arrangements.
9 See above, and examined and explained in detail in the August 8 M&A Forum installment (note 1), and in the September 19 article (note 5).
10 See note 6.
11 See Boidman (note 1).
12 See Boidman (note 1).
13 The 36 percent rate is the combined federal and provincial corporate rate tax on profits allocable to a permanent establishment in the province of Ontario. The combined rate may be higher or lower when other provinces are involved. For details, see p. 501 of the August 8 M&A Forum installment (note 1).
14 For details, see Watkins and Nowicki (note 5), and Wojtek Dabrowski, ‘‘S & P Unveils Income Trusts Index — 68 Names to Start,’’ National Post, Sept. 14, 2005, FP12, who notes that: ‘‘[T]he list rolled out yesterday is only a first step toward full inclusion of trusts into the composite index. In December, the qualifying trusts will be introduced to the composite at 50 percent weighting. Then, in March, the process will be complete with full weighting and the elimination of the provisional list. A version of the composite without the trusts will still exist.’’At FP-14 of the same issue, there is a listing of the 68 trusts of the provisional index. However, as discussed further below, the September 19 moratorium on trust rulings spooked the market so much that there were then reports of possible delays in the foregoing index plans. See, for example, Carrie Tait, ‘‘Trusts Lose $9 B After Ottawa Stops Tax Rulings,’’ National Post, Sept. 27, 2005, FP-1; and Andrew Willis, Eric Reguly, Sinclair Stewart, and Grant Robertson, ‘‘Ottawa’s move on income trusts throws sector into disarray,’’ The Globe & Mail, Sept. 28, 2005, B-1. But the latest reports are more positive. See ‘‘S&P sticks to plan — Income trust — Will list them despite possible policy shift’’ (Canadian Press), Montreal Gazette, Oct. 12, 2005, at B4; and Grant Robertson, ‘‘S&P to stick with trust plans,’’ Globe and Mail, Oct. 12, 2005, at B6.
15 The consultation paper refers to C $300 million of lost revenue for 2004.Watkins and Nowicki (note 5) point out at p. 1061 that the government’s paper itself puts into question this C $300 million estimate, citing sources that indicate it may be higher or lower. In particular, see notes 2 and 3 or their article (which reproduce notes 25 and 26 in the government’s paper). Such estimates may not reflect offsetting tax revenue that may be generated by taxes on gains derived by investors from selling interests in trusts at market valuations that are driven up by the trust format.
16 See Boidman (note 1), note 58 and the text thereat.
17 The consultation paper, at p. 17 (section 6), discusses ‘‘Economic Efficiency Issues Related To FTEs’’ and notes that in assessing the effect on the economy of the turn to carrying on business as publicly traded trusts, ‘‘arguments have been made on both sides of this issue’’: that is, ‘‘some have argued that the tax treatment of FTEs leads to greater economic efficiency — at least for certain type of businesses — while others have argued that this tax treatment distorts investments and decisions which relate to reduced economic efficiency.’’ In that respect, the consultation process, initiated by the September 8 consultation paper, will be seeking input from the public as set out at p. 18: ‘‘[W]hat impacts are FTEs having on investment decisions and the allocation of capital in Canada? Is the overall impact on the economy positive or negative?’’ For a further discussion, see Watkins and Nowicki (note 5). For an interesting perspective on the economic benefits of income trusts, see Keith Kalawsky, ‘‘Goodale panics on trusts,’’ National Post, Sept. 21, 2005, at FP1; Andrew Willis, ‘‘The trust is fading in Bay Street’s marriage to finance,’’ Globe & Mail — Report on Business, Sept. 21, 2005, at B15, who writes, ‘‘[F]ears that the structure stifles economic growth are even more misplaced . . . . The discipline of trust translates into focused companies, some of which are becoming continental leaders, and these companies hand their extra cash to income-hungry-older voters’’; and Philip Brown, ‘‘The Truth About Income Trusts,’’ National Post, Sept. 28, 2005, at FP-8. But see Terrence Corcoran, ‘‘Goodale wakes up to economic risks of trusts,’’ National Post, Sept. 20, 2005, at FP19.
18 At p. 3 of the consultation paper. Then at p. 19 of the paper, the foregoing is repeated and elaborated with the following statement: ‘‘Improving the integration of the personal and corporate income tax systems would make the tax system more neutral between all forms of business organizations. These approaches may be complex, as they would have to take into account a variety of factors, such as different types of FTEs and the tax status of investors in these entities. They may also be costly in terms of foregone federal tax revenues or have a significant impact on the FTE market.’’
19 See discussion, Boidman (note 1), at p. 500 (including notes 4, 5, and 6), as well as the discussion in note 2 respecting the United States and its REIT legislation.
20 For discussion, see Boidman (note 1), at note 57 and the text thereat.
21 As explained in the August 8 M&A Forum installment (note 1), such trust arrangements are always structured to qualify for ‘‘mutual fund trust’’ (MFT) status — under section 132 of the Income Tax Act (Canada), R.S.C. 1985, Chap. 1 (5th supp.), as amended (herein, the Act or ITA) — to, inter alia, avoid a special trust level tax (under Part XII.2 of the Act) of 36 percent where certain types of income are distributed to nonresident unit holders and, as well, to provide for such foreign investors the basis for exemption from Canadian tax upon a sale of an interest in the trust. Under that rule (see section 115 and 248 of the Act), provided that a nonresident, alone or together with certain affiliated persons, does not own at the point of a disposition, or within five years prior thereto, 25 percent or more of the units of the trust, there is no Canadian tax in respect of gain derived therefrom.
22 Depending upon the province, that rate may be higher or lower.
23 See Part XIII of the Act.
24 See Boidman (note 1) at pp. 506-508 for details respecting the general effects for, and implications of, foreign investors in Canadian income trusts. Beyond the scope of this piece are the various exceptional rules that can apply to a foreign investor in a Canadian publicly traded trust. First, a trust need not restrict its foreign ownership (as discussed below) where, in principle, its business sector does not involve real estate or resource property. See Boidman (note 1) at notes 26, 28, and 29, and the text thereat reflecting both the current and the proposed (but deferred) rules limiting nonresident investors and the circumstances when there is an exception to such limitation. For a detailed discussion, see Michael Kandev and Fred Purkey, ‘‘Practical Applications of Trusts,’’ Canadian Tax Foundation — Report of Proceedings of the Fifty-Sixth Tax Conference, Sept. 26-28, 2004, Toronto, p. 40:1; and Stephen S. Ruby, ‘‘Recent Transactions of Interest,’’ Canadian Tax Foundation — Report of Proceedings of the Fifty-Sixth Tax Conference, Sept. 26-28, 2004, Toronto, p. 4.1. Second, if such trust realizes capital gains with respect to certain Canadian property in the course of its activities the effective tax applicable (generally but not necessarily always) is the same rate as applicable to ordinary income. Third, if the trust is primarily involved in real estate or resource property, there may be a tax (under Part XIII.2) on distributions that do not reflect the underlying taxable income or profits. See Boidman (note 1), at note 38 and the text thereat respecting Part XIII.2. This new tax will apply if the value of the trust is primarily attributable to real property in Canada or Canadian resource property or timber property in Canada. But, as indicated above, in certain cases capital gains, distributed, would bear no tax. This is where not more than 5 percent of the units of the trust are held by nonresidents. (Technically, this exception requires reference to whether or not more than 5 percent of the total of all amounts that are distributed as capital gains (entailing a designation under 104(21) of the Act) are for nonresident persons.)
25 For explanations of these two different formats, see Boidman (note 1).
26 Exemption from Canadian withholding tax on interest payments to nonresident lenders arises when the lender, alone or together with certain affiliated persons, deals at arm’s length with the Canadian corporate borrower (generally meaning ownership of less than control of the corporation), no more than 25 percent of the loan is required to be repaid during the first five years thereof, absent default, and the interest due is not contingent. See section 212(1)(b)(vii) of the Act.
27 There is an exception. See note 24.
28 See note 24 respecting this proposal (and the proposed mechanical exception to the limitation).
29 As noted above (note 8), the derivative arrangement (seen so far only for Canadians investing in U.S.-based businesses — although note 8 referred to plans by Cinram International Inc. to adopt an IDS approach) sees either a Canadian corporation issue ‘‘income participating securities’’ (IPS) or a U.S. corporation issue ‘‘income deposit securities’’ (IDS) when investors directly own debt and equity units in a publicly traded Canadian or U.S. corporation.
30 The open-ended nature of the current government study is such that it is possible that Finance will attempt to deal with these types of structures even though not used at present for Canadian businesses.
31 For think-tank and media financial writers who apparently favor dealing with the matter this way, see, inter alia, ‘‘The 2005 Tax Competitiveness Report; Unleashing the Canadian Tiger,’’ by Jack M. Mintz, with Duanjie Chen, Yvan Guillemette, and Finn Poschmann, 2005, C.D. Howe Institute; Corcoran, infra note 36 (October 4); and Carrie Tait, ‘‘Assessing the Goodale effect,’’ National Post, Sept. 26, 2005, at SR-1. But some observers caution against rushing to judgment. This is reflected in a report respecting a meeting earlier this month of securities industry and professional firm representatives. Carrie Tait, ‘‘A taxing issue for income trusts,’’ National Post, Oct. 12, 2005, at FP14, wrote, ‘‘[B]ut after different tax scenarios for income trusts and corporations were discussed, one of the last men to hold the floor — John Ulmer, a tax lawyer at Davies Ward Phillips & Vineberg — pointed out that overhauling Canada’s tax structure could open up a Pandora’s Box of possibilities that could create further headaches. ‘You don’t get tax reform of that magnitude that quickly,’ the tax lawyer told the group. ‘Fundamental tax reforms will take years.’ Take, for example, the option of taxing trusts. That would ‘level the playing field’ between trusts and corporations, but it would also create another tax loophole companies could exploit, he explained in an interview after the round table. Income deposit securities or IDS units would suddenly become in vogue on the TSX. These securities are capable of skirting corporate taxes and trust taxes, and that would make them as popular as income trusts are now, he said. So Ottawa would then have to deal with that disparity. Fixing the IDS loophole, however, means addressing interest deductibility. And touching those rules would send ripples through the industry. ‘Interest deductibility is an issue that affects everybody — it affects corporations, it affects trusts, it affects individuals,’ he said. This domino effect is not lost on the Finance Department, Mr. Ulmer reminded the audience ‘the reason that things don’t change overnight is that first [the government] has to decide what they want to do and then they have to figure out all the potential ramifications,’ Mr. Ulmer said. ‘It is very difficult to make changes that don’t impact other areas.’ ’’ (With respect to IDSs, see elsewhere herein.) For similar themes, see Simon Romano, ‘‘Bursting Income Trust Ballons,’’ National Post, Oct. 17, 2005, at FP1. See also Jack M. Mintz, ‘‘Goodale’s choice: Shareholder tax reform and corporate income tax relief are avenues the Finance Minister can choose to avoid a battle over income trusts,’’ National Post, Oct. 12, 2005, at FP23.
32 In some cases (e.g., Australia), this requires that the distributed profit has been fully taxed (i.e., in Australia, at 30 percent) at the corporate level (i.e., ‘‘fully franked’’).
33 Certain European imputation system countries used to, but no longer, provide refunds for domestic corporate tax to foreign shareholders of resident corporations under a treaty: e.g., Finland, France, Ireland, Italy, and the United Kingdom. In this respect, note 18 to the consultation paper states, ‘‘Before 1999 (and applicable to dividends paid up to April 2004), the U.K. corporate tax system was fully integrated for tax-exempt investors through a refundable tax credit attached to dividends.’’ See ‘‘Trends & Company/Shareholder Taxation: Single or Double Taxation?,’’ Cahiers de droit fiscal international, International Fiscal Association, Volume LXXXVLLLa, 2003, Sydney Congress.
34 The scope of the moratorium is wider according to recent public statements by the government, then initially announced on September 19. The ruling moratorium apparently is to apply to conversions, publicly traded partnerships, and tax shelters (a broader list than the September 19 press release suggested). See 2005 Canada Revenue Agency (CRA) round table at the 57th Annual Conference of the Canadian Tax Foundation, Vancouver, Sept. 25-27, 2005 (not yet published).
35 In the August 8 M&A Forum installment, reference was made to what may have been the first of such situations in which the matter involved a reorganization of an existing publicly traded trust. See Boidman (note 1), at note 31 respecting Davis + Henderson Income Fund. For a detailed discussion, see Ruby (note 24).
36 An understanding of the narrow scope of the issue is not shared by all — although it has become clear that the government intended, by its announcement, to put a damper on all new deals, not just those few that actually required rulings — because of uncertainty of the nature and effect of future tax changes. Media reports on this relatively highly technical matter range from those that accurately reflect the relatively narrow area where rulings are being sought and those that suggest (in whole or in part) the contrary. For a glimpse of that range and reports of the effect on specific high-profile deals, see, inter alia, Grant Robertson, ‘‘Income Trust — Trust seekers defiant as stocks take a hit,’’ Globe & Mail — Report on Business, Sept. 21, at B1; Carrie Tait, ‘‘Ottawa rattles conversion candidates,’’ National Post, Sept. 21, 2005, at FP-13; Paul Vieira, ‘‘Ottawa puts trust tax rulings on hold,’’ National Post, Sept. 20, 2005, at FP-1; Steven Chase and Keith Damsell, ‘‘Ottawa slows down trust conversions,’’ Globe & Mail — Report on Business, Sept. 20, 2005, at B-1; David Ebner, ‘‘Precision drilling’s trust conversion still on hold — CI says conversion vote on hold,’’ Globe & Mail, Sept. 29, 2005, at B-6; Terence Corcoran, ‘‘Rescue dividends, not income trusts,’’ National Post, Oct. 4, 2005, at FP-2; and Carrie Tait, ‘‘Jazz spinoff into trust put on hold — Parent ACE cites uncertainties with sector,’’ National Post, Oct. 1, 2005, at FP-2, who notes the effective in terrorem objectives of the government’s rulings moratorium as follows: ‘‘[W]hile these rulings aren’t necessary to become a trust, the market is interpreting the announcement as a signal that Ottawa could make changes that will effect the income trust sector.’’ Indeed the latter observation is consistent with various comments from the Department of Finance (see, for example, note 42 below and related text) that have made it relatively clear that the moratorium was announced as a means of shocking the trust sector to slow down the pace of income trust activity — in other words, a political statement — and not really to put a stop to the conversion reorganizations. It seems it was reports in the press of the high-profile announcements in the days leading up to the announcement that spooked Finance.
37 For a discussion of the cash takeover of FACS Records Storage Income Fund by a U.S. acquirer in 2000, see Boidman (note 1) at pp. 509 and 510. Separately, there have been several takeover-mergers of one REIT by another over the past several years that rest upon specialized rules that would have no application to an all-cash or foreign stock (as currency) takeover of a trust. For detailed discussions of such REIT merger-takeovers, see Neal Armstrong, ‘‘Real Estate Investment Trust Mergers Rely on Section 132.2,’’ Corporate Finance, Federated Press, Vol. X, no. 2, 2002 at p. 942, and Ruby (note 24). See also Boidman (note 1), at note 47 and related text.
38 For a discussion, see Boidman (note 1), at pp. 514-515.
39 In this respect, it was noted in the August 8 M&AForum installment that in the still-incomplete all-cash offer for the O&Y REIT Trust, the form of transaction proposed, which is an acquisition of real estate properties of the REIT rather than the units of the REIT, led to potential additional tax for unit holders (upon liquidation of the REIT following its cash sale of its properties). That transaction, in fact, was originally rejected by the REIT unit holders, who were then (on August 26, 2005, pursuant to a news release, ‘‘Brookfield Consortium Announces New Agreement to Acquire O&Y REIT and a Revised Agreement to Acquire O&Y Properties,’’ and related agreements) offered a unit-level deal, requiring a tender of 50 percent of outstanding units of the REIT held by persons other than O&Y Properties Corporation, an affiliated party. Reports earlier this month indicated that that requirement would be met. See, for example, Bloomberg News, ‘‘Reichmann family cleared to make $1.25-billion sale,’’ Montreal Gazette, Oct. 12, 2005, at B4. For a discussion, see Boidman (note 1), at pp. 511 and 512. For a discussion of the manner in which a foreign acquirer can, on a tax-effective basis, unwind a trust after acquiring its units provided its underlying property is nondepreciable capital property such as stock of lower-tier operating corporations, or interests in lower-tier trusts or partnerships, see Boidman (note 1), at pp. 510, 511, 513, and 514.
40 In the rare circumstances of the takeover by Vodafone (U.K.) of Telesystems International Wireless (Canada), the deal was an asset acquisition. For details, see Boidman (note 1), at note 42.
41 The August 8 M&A Forum installment noted, in this context, that under current law an offer of exchangeable (by a special purpose Canadian acquisition corporation established by the foreign acquirer) would be effective where the deal involves an acquisition of the investors unit in the trust, but not where it involves an acquisition of assets or property from the trust. See discussion at Boidman (note 1). In this respect, the public is still awaiting release by the Department of Finance of proposals, promised in October 2000, that would permit a direct exchange of stock of a Canadian corporation for stock of a foreign acquirer. Whether such would apply to the exchange of units of a trust for such foreign stock is an open question. See Boidman (note 1), at note 41.
42 See Carrie Tait, ‘‘Senator blasts Finance over trust issue,’’ National Post, Sept. 29, 2005, at FP1. The in terrorem effect aspect is also noted in note 36, excerpting Carrie Tait, National Post, Oct. 1, 2005.
43 See Patrick Brethour and Steven Chase, ‘‘Alberta minister pushes a trust tax,’’ The Globe & Mail, Oct. 15, 2005, at B5.
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