Canada: Ontario Budget 2015: Building Up LDCs

The ongoing LDC merger and consolidation discussion, sparked by the publication of the Ontario Distribution Sector Review Panel Report in December 2012, took a significant step forward earlier this month with the release of the report of the Premier's Advisory Council on Government Assets (the Clark Report). Click here to read our previous analysis of the report. That report recommended changes to the tax regime applicable to local distribution companies (LDCs) to encourage LDC consolidation and private sector participation. On April 23, 2015, Ontario's Minister of Finance tabled the 2015 Ontario Budget which provided more detail on the proposed tax changes.


Until the late 1990s, local electricity distribution was structured as a department within a municipality rather than a stand-alone entity. The electricity sector underwent significant restructuring in the late 1990s, including the passage of the Electricity Act, 1998 (EA). Under that statute, municipalities were obliged to transform these utilities into stand-alone corporate entities by November 2000. Companion changes were required to provide a revenue stream to the Province to pay down the "stranded" debt of Ontario Hydro, to promote economic efficiency and to create a level playing field for the taxation of these new municipal electricity utilities (MEUs) with private sector taxable corporations that were anticipated to enter into the electricity sector. Thus, the EA introduced a "payment in lieu of taxes" (PILs) regime, along with components of that regime dealing with transfers of assets and departures from the PILs regime.

In summary, PILs are imposed under the EA as a mirror-image tax regime to the Income Tax Act (Canada) (ITA) and Taxation Act, 2007 (Ontario) (TA) applicable to private corporations. To the extent that an MEU is exempt from ordinary income tax payable to both the federal and the Ontario governments under the ITA and the TA, respectively, the MEU pays to the Ontario Electricity Financial Corporation an equivalent amount under the PILs regime. To preserve the tax base for this revenue stream, the regime imposes a tax of 33% on the fair market value of electricity assets (or interests therein) at the time those assets are transferred to a person outside the PILs regime, with the amount of transfer tax reduced by PILs paid by the transferor up to the time of the transfer.  Along similar lines, the departure tax is imposed when an MEU itself exits the PILs regime and becomes taxable under the ITA and TA.

It is generally acknowledged that the transfer tax and departure tax rules have inhibited consolidation in the LDC sector and have limited the ability to access private sector capital needed to expand and upgrade infrastructure. The Clark Report recommended that the Province alleviate some of the tax barriers to achieving these goals by adopting the following measures:

  • a temporary three-year reduction, starting in 2016, in the rate of transfer tax from the current 33% to an unspecified level;
  • a time-limited exemption from transfer tax for small MEUs (where "small" is defined as an MEU with less than 30,000 customers, which include half or more of Ontario's LDC sector), to provide them with an incentive to consolidate with larger entities without resulting in material loss of on-going revenue to the Province;
  • a time-limited exemption from the capital gains component under the departure tax rules (with the exception of goodwill); and
  • that these time-limited tax incentives to promote consolidation should be offered from January 1, 2016 for a period of three years..

The Budget

In the Budget tabled on April 23rd the government confirmed that it is acting on the recommendations of the Clark Report to spur consolidation and encourage efficiencies in the LDC sector, including transfers of electricity assets to the private sector. The Budget proposes the following measures, which mirror the Clark Report recommendations:

  • reducing the rate of transfer tax from 33% to 22%;
  • exempting from transfer tax entirely any MEU with fewer than 30,000 customers;
  • exempting capital gains arising under the departure tax;
  • applying such measures for the period beginning January 1, 2016 and ending December 31, 2018.

The Budget also proposes to amend the regulations under the EA to add a rule to prevent the avoidance of PILs through dispositions of partnership interests made directly, or indirectly as part of a series of transactions, to a person who is not subject to PILs or a partnership whose members are not all subject to PILs.


From the Province's perspective, changing the tax rules is a double-edged sword.  Modifying the rules to incent departure from the PILS regime might accelerate tax revenue in the near term.  However, the trade-off is the loss of the future revenue stream represented by the federal portion of ordinary income tax that might become payable by an MEU that leaves the PILs regime. The Budget provides no estimate of the expected revenue generation or loss expected from the measures proposed.

From the perspective of MEUs and their (mostly municipal) shareholders, the temporary reductions and exemptions in the Budget are welcome steps forward and should reduce the tax cost of consolidation and partnering with the private sector. However, certain transactions may continue to result in significant tax exposure, such that the decision to embark on these  transactions will likely continue to be motivated by commercial reasons rather than the tax relief contained in the Budget.

The departure tax applies when an MEU leaves the PILs regime because it ceases to be tax exempt under the ITA and the TA. An MEU can lose that tax exempt status if a private sector entity acquires a mere 10.1% of the MEU.  Despite that minor private-sector investment, the departure tax would be triggered on 100% of the MEU's assets. The Budget does not propose to address this mis-match.  Accordingly, there appears to be an incentive for an MEU to sell a larger stake to the private sector in the short term rather than a phasing-in of private sector capital over several years.

Further, while the proposed three year exemption in departure tax exempts capital gains, it would not exempt income triggered by the recapture of previously-claimed depreciation on the MEU's depreciable assets.  From discussions with Ministry of Finance officials, we understand that this was a deliberate policy decision. For many MEUs, the capital gain resulting from a deemed disposition at fair market value may be minimal. However, it is a safe bet that such a disposition will produce significant recapture of depreciation, 100% of which is included in income and would be subject to departure tax. Accordingly, each MEU will have to closely examine its financial and tax records to determine its exposure to recapture.

The Budget contained one proposal that did not form part of the Clark  report recommendations, namely the introduction of an anti-avoidance rule targeting attempts to convert what would otherwise be recaptured depreciation (100% of which would be subject to PILs) into capital gains (only 50% of which would be subject to PILs). The rule is to be designed along the lines of section 100 of the ITA. In general terms, that rule applies to transform a capital gain arising on the sale of a partnership interest to a non-resident person or tax exempt person into an income gain, as if the vendor had sold depreciable property rather than a partnership interest.  The proposed PILs rule would apply where a PILs-paying entity directly or indirectly disposes of an interest in a partnership to a non-PILs paying person. The Budget materials provide no guidance as to how such a rule would operate, including the extent to which the "look-through" and related rules in s. 100 of the ITA would be adopted. However, the proposal suggests that the government is concerned about the use of partnerships to reduce PILs that would otherwise be triggered on a sale of electricity assets.

It is also interesting to note that the Budget did not mention the potential for additional relieving measures to spur consolidation, such as relief from land transfer tax in particular circumstances. Nor does the Budget discuss the potential for changes to the EA and the Municipal Act, 2001 to clarify existing rules and perhaps introduce new rules, to facilitate the formation of appropriate structures for purposes of LDC consolidation. Ministry of Finance officials acknowledged that these issues may need to be addressed going forward.

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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