ANNOUNCEMENT AND BACKGROUND INFORMATION
On October 31, 2006, the Minister of Finance (Canada) announced a sweeping reform of the tax treatment of income trusts and publicly-traded partnerships (FTEs).
The changes announced by the Minister of Finance are aimed at taxing FTEs in a similar fashion as corporations and generally deeming distributions to unitholders of such entities to be taxable dividends. However, there will be a 4-year transition period during which existing FTEs will preserve their existing beneficial tax status. After the end of the transition period, existing FTEs will become subject to a "corporate-type" income tax at the FTE level on what would otherwise be the taxable income of these entities if they were subject to tax. The taxable income so computed will exclude taxable dividends which, if received by a taxable corporation, would be subject to the dividend-received deduction. The so-called "distribution" tax will be imposed at a rate of approximately 31.5%. The rate factors in both a federal corporate income tax at a rate of 18.5% and an additional 13% rate in lieu of provincial tax. The deemed provincial tax rate exceeds the current corporate income tax rates charged in many provinces, including, among others, Quebec, Alberta and British Columbia. Unitholders receiving trust distributions will be considered to receive taxable dividends subject, for a Canadian taxable individual, to the dividend gross-up and dividend tax credit and, for a foreign unitholder, to any withholding tax reduction or exemption for dividends provided for under the income tax treaty, if any, between Canada and its country of residence. A notable difference between corporations and FTEs subject to the new rules is that any distribution to unitholders in excess of the FTE’s taxable income subject to the new "distribution" tax will be treated as a tax-deferred return of capital. By contrast, public corporations are generally prevented from effecting tax-deferred returns of capital, except in very limited circumstances.
ENTITIES SUBJECT TO THE NEW RULES
Generally, the new rules are targeted at FTEs: (i) resident in Canada, (ii) the units of which are listed on a stock exchange or other public market and (iii) holding one or more "non-portfolio property", a term of art which is designed to cover, very generally, greater than 10% economic interests in a subsidiary entity and investments the value of which exceeds 50% of the equity value of the FTE.
Exempted from the application of the new "distribution" tax and the dividend treatment on distributions are Real Estate Investment Trusts (or REITs) that meet the following criteria:
- They do not hold, at any time in the year, non-portfolio property other than real property situated in Canada (whether held directly or through intermediate entities);
- At least 95% of their income for the year is from property (passive income such as dividends, royalties, interest, taxable capital gains from the disposition of real property, etc.);
- At least 75% of their income for the year is attributable, directly or indirectly, to rents from, mortgages on, or gains from the disposition of real property situated in Canada; and
- They hold throughout the year real property situated in Canada, cash and debt or other obligations of Governments of Canada with a total fair market value equal to at least 75% of their equity.
FTEs, the assets of which are, to the extent of at least 50% of the equity value of the entity, Canadian resource property, timber resource property and real property situated in Canada (other than a REIT meeting the abovementioned criteria) will be subject to the new rules.
While the announcement does not refer to Income Depositary Securities (or IDS) structures (i.e., publicly-traded stapled units comprising a share and a subordinated note) and the new rules are, on their face, ill-adapted to an IDS setting, the Minister of Finance has left the door open to challenge new structures that may be used to avoid the application of the new rules.
CONCERNS RAISED BY THE NEW RULES
The announcement made by the Minister of Finance raises a number of legitimate questions, including the following:
- Will FTEs operating retirement residences or hotels qualify for the exemption for REITs considering that, arguably, part of their income is derived from services, as opposed to from rent?
- Will provinces seek to impose capital taxes on FTEs subject to the new rules, considering that these entities will, for all intent and purposes, be treated as corporations?
- Why are FTEs operating in the oil and gas business subject to the new rules when the United States allow the ownership by REITs (and certain publicly-traded partnerships) of such assets? Will that affect the level playing field between oil and gas players in Canada and the United States?
- Will the CRA and provincial tax authorities allow conversions of FTEs subject to the new rules into public corporations on a tax-free rollover basis?
Retained Interest In Income Trusts By Founding Partners
In addition to the above questions, one issue that is raised by the new "distribution" tax involves income trusts which will become subject to the new rules and in which founding entities hold a retained interest (typically at the level of an operating or holding partnership).
Most agreements whereby an interest is retained by a founding partner provide for an "economic equivalent" concept whereby distributions on the units held by the founding partner cannot exceed the distributions, on a per unit basis, received by holders of units of the income trust. Other agreements define "Distributable Cash" in such a way as to take into account expenses and costs of the income trust structure. In either instances, it may be argued that distributions to the founding partner should be reduced to take into account the new "distribution" tax. However, the distributions received by the founding partner will likely not be considered to be taxable dividends subject to the dividend-received deduction. Therefore, there exists a potential for double taxation of the distributions of the founding partner. In some instances, capitalizing the subordinated debt of the operating corporate entity, when applicable, could reduce the potential for double taxation.
We expect that amendments sought to existing agreements to resolve potential double taxation of the founding partner may face opposition from unitholders of income trusts. We question whether the tax authorities will allow a retained interest to be converted into units of the FTE on a rollover basis.
Incentive Not To Claim Discretionary Reserves And Deductions
During the transition period, existing FTEs may, depending on their specific circumstances, have an incentive not to claim discretionary reserves and deductions for tax purposes so as to preserve such tax attributes for use once the new regime becomes applicable to them. In the interim period, this would result in a greater portion of the distributions to unitholders being considered to constitute taxable income. However, it may permit higher future distributions after the end of the transition period.
De-Capitalization And Vulnerability To Take-Over Bids From Private Equity Investors
Finally, since the market capitalization of FTEs has dropped significantly and is expected to remain at depressed levels in the near-term, FTEs will now face a higher cost of equity capital and may prefer to use debt capital instead. This new preference may lead existing FTEs to consider de-capitalizing themselves by borrowing from third party lenders and returning equity capital to their unitholders. Their investors may demand this action to counter the value erosion created by the new regime that will become applicable to them. However, considering the depth of the U.S. high-yield debt market compared to the same market in Canada, U.S. private equity investors, for instance, may have a competitive advantage over FTEs in securing such debt capital, using leveraged equity structure to secure further tax benefits, and may launch take-over bids against FTEs with a view to ultimately effecting a decapitalization and reaping the benefits for themselves. Once privatized, the asset could be monetized anew in the U.S. capital markets as high dividend paying stock. In some instances, take-over bids may be supported by existing management of the entities.
In this context, the implementation of take-over defenses (including so-called "poison pills") will have to be considered.
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