Canada: Considerations In Income Trusts, Royalty Trusts And Reits Acquisitions

This article was originally published in Blakes Bulletin on Mergers & Acquisitions Tax - June 2006

REITs, royalty trusts and income trusts (collectively, Trusts) have proliferated in the past several years and represent a significant portion of Canadian public equity markets. As the concentration of ownership of business assets in Trusts has increased so, too, has interest in mergers and acquisitions (M&A) involving Trusts.

The Canadian tax considerations applicable to corporate M&A is well understood and based on an established body of relevant statutory rules and administrative practices. In contrast, the Canadian tax considerations in respect of M&A involving Trusts is somewhat nascent.

The fundamental Canadian federal income tax objectives applicable to a purchaser of all the units of a Trust and its unitholders will broadly be the same as in a conventional corporate takeover. There are, however, many regimes in the Canadian Income Tax Act (the ITA) that apply only to Trusts that present unique opportunities and pitfalls in structuring transactions. By way of background, Trusts are structured to qualify as "mutual fund trusts" for purposes of the ITA which provides many benefits under the ITA including (i) being qualified investment for RRSPs, (ii) non-residents holding less than 25% of the units are not subject to tax on capital gains on a disposition, (iii) the section 116 tax clearance certificate process does not apply to non-residents, (iv) special taxes (e.g., alternative minimum tax and Part XII.2 tax) applicable to other types of trusts under the ITA do not apply, (v) a special capital gains refund mechanism, and (vi) the ability to merge mutual fund trusts on a tax-deferred basis (as discussed below). As in any other trust, all income and capital gains of a Trust paid or payable to unitholders in the year will be deducted by the Trust and included in the income of unitholders.

As in corporate M&A, the possibility of structuring the transaction on a partial or fully tax deferred basis is one of the most important preliminary business and tax considerations. This will be particularly relevant where the purchaser has a compatible business that the purchaser wants to merge with the business of the target Trust.

There have been numerous tax free "mergers" of Trusts. A qualifying merger of mutual fund trusts under section 132.2 is not taxable to the mutual fund trust or its unitholders. The following steps have to be taken to qualify:

ONE. A "mutual fund corporation" (as defined by the ITA) or mutual fund trust (the discontinuing entity) transfers all or substantially all of its property to a mutual fund trust (the continuing trust) (which would normally assume the liabilities of the discontinuing entity).

TWO. All or substantially all of the units or shares of the discontinuing entity that are outstanding immediately before the property is transferred to the continuing trust (the transfer time) are, within 60 days after the transfer time, disposed of to the discontinuing entity.

THREE. No unitholder or shareholder of the discontinuing entity that disposes of units or shares to the discontinuing entity within that 60-day period (otherwise than pursuant to the exercise of a statutory right of dissent) receives any consideration for the units or shares other than units of the continuing trust.

FOUR. The continuing trust and the discontinuing entity jointly elect to have section 132.2 apply to the merger.

The discontinuing entity may trigger gains to absorb tax losses as there is no carryforward of unused losses.

Land transfer tax, provincial sales tax, and GST considerations may apply depending on the type of assets.

Examples of tax free mergers pursuant to this provision are ResREIT and CAP REIT, Ultima Energy Trust and Petrofund Energy Trust, Livingstone International Income Fund and PBB Global Logistics Income Fund. A tax-free merger pursuant to this provision can be combined with an alternative of an all cash offer.

It may also be possible to structure a tax deferred transaction for unitholders where section 132.2 will not be applicable. For example, a corporate purchaser of Trust units (or assets of the Trust) may not be a "mutual fund corporation" but rather a standard taxable corporation that wishes to offer its shares as consideration either for Trust units or property of the Trust. The purchaser and vendor(s) could file joint elections under subsection 85(1) of the ITA so the transfer(s) will occur on a taxdeferred basis. If the parent of the purchaser was a nonresident public corporation, an exchangeable share transaction could be considered. Where an election under subsection 85(1) is being considered, the purchaser would also have to canvass all the implications of acquiring Trust units or Trust property on a tax-deferred basis including any adverse implications in respect of subsequent transactions involving the acquired property. Similarly, the Trust would have to consider the implications of receiving shares on a tax-deferred basis especially where they would be distributed to unitholders.

In many situations, a tax deferred transaction may neither be desired nor possible. This would certainly occur where all the consideration is cash. In this transaction, the purchaser will either purchase Trust units directly from the public unitholders or acquire units directly from the Trust which then uses the subscription proceeds to redeem units held by the public.

As in a conventional corporate M&A, the purchaser may focus on the amount of the tax shield of the assets of the Trust, the ability to obtain a step-up in the tax cost of certain property of the Trust on a tax-free basis, deductibility of interest on any acquisition financing against the income generated from the Trust’s assets, and non-resident withholding tax on distributions if the purchaser or its parent is a nonresident. Also, the Purchaser will have to consider that the Trust will generally lose its status as a "mutual fund trust" after the year of acquisition. This will result in the application of a number of rules in the ITA which will make it desirable to distribute all its assets and terminate the Trust after closing and certainly before the end of the year.

For the foregoing reasons, the purchaser would prefer to purchase assets, and consequently not have to concern itself with having to terminate the Trust and underlying entities (if any). A sale of assets of the Trust will generally encounter resistance, particularly if it triggers ordinary income.

In a corporate acquisition, it is often very important for the corporate purchaser to obtain a step-up in the tax cost of nondepreciable capital property (e.g., shares) of the target corporation. To effect the bump in a corporate transaction under paragraph 88(1)(d) requires compliance with many technical rules and an amalgamation of the purchaser and target or winding up the target. This transaction can be achieved on a tax-free basis. In the case of a Trust, a step-up in tax cost of its assets will not be possible unless the Trust is terminated. It will, however, be very important to achieve this without incurring a tax liability.

A termination of the Trust will give rise to a disposition of its underlying assets at fair market value which, depending on the assets, may result in capital gains (or losses) or income (e.g., recapture) which will flow through to the purchaser (as sole unitholder). As the gain will generally be paid or payable to the unitholder, the Trust will not itself be taxable on the gain.

Where the Trust only owns non-depreciable capital property (e.g., shares, debt, interests in trusts), there is an ability to terminate the Trust on a tax-free basis for the purchaser and bump the tax cost of its assets distributed to the purchaser to fair market value. This is because in computing the proceeds of disposition for the units of the Trust held by the purchaser, the gain realized by the Trust will be deducted. This will result in the purchaser realizing a capital loss as its tax cost will be fair market value at the time of acquisition. Provided the capital gain, which flows through the Trust to the purchaser, and the capital loss realized by the purchaser are the same amount, there will be no net tax payable. It is important that the termination of the Trust occurs before there has been an increase in value from the time of acquisition, otherwise a gain will result. Consideration may be given to the Trust transferring any nondepreciable property to a Canadian partnership on a taxdeferred basis pursuant to subsection 97(2) of the ITA before the termination of the Trust in order to avoid the realization of ordinary income which will not be offset.

Interest expense on acquisition financing should be generally deductible by the purchaser provided it is a resident of Canada. The interest would be deducted against income from the Trust if it is not terminated, or against the income producing assets if the Trust is terminated and the assets distributed to the purchaser.

Unlike corporations, there are no rules that apply to an acquisition of control of a trust. The replacement of the trustees of the Trust can result in an acquisition of control of any corporation controlled by the trust.

Resident unitholders of the Trust will generally want capital gains treatment rather than ordinary income which may result from the sale of non-depreciable capital property. A sale of units will also avoid the inequitable tax consequences to certain unitholders that would result from an asset sale by the Trust. For instance, a unitholder who did not get the benefit of capital cost allowance (CCA) claimed in prior years by the Trust will be allocated a portion of recapture.

The computation of the tax cost of the units to each unitholder will be very important. The tax cost will be reduced by distributions received by the particular unitholder of amounts other than income and the tax free portion of capital gains. These reductions will affect the computation of the gain realized.

It will be very important to address at the outset the distribution and allocation of income of the Trust to existing public unitholders or to the purchaser in the year of sale. An agreement regarding the allocation could be reflected in the acquisition agreement. The income for the year of sale will also be affected by CCA, and transaction costs. In some transactions, CCA may not be available to be claimed for the current year where the post closing plans of the purchaser entail a disposition of depreciable property prior to the year end.

Generally, non-residents will prefer to sell Trust units as no tax will generally be payable under the ITA compared to Canadian withholding tax otherwise applicable to a distribution of income and capital gains from a Trust. A non-resident unitholder is not subject to tax on the gain under the ITA unless it (together with non-arm’s length persons) hold 25% or more of the units of a mutual fund trust. Even if this ownership test was met and the gain was taxable under the ITA, a tax treaty might provide protection in certain cases. Recent amendments to the ITA impose withholding tax specifically where a mutual fund trust realizes a capital gain from the sale of taxable Canada property which it distributes to non-residents and where there is a distribution of tax sheltered cash flow by certain trusts such as REITs.

In conclusion, we expect to see increased M&A activity involving Trusts. There will undoubtedly be opportunities for creativity.

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.