Originally published in Blakes Bulletin on Tax, January 2007
On December 21, 2006, the Canadian federal Department of Finance released draft legislation to amend the Canadian Income Tax Act to implement the new tax regime for income trusts, royalty trusts and other "specified investment flow-throughs" or "SIFTs". The changes were first announced in a surprise release from Finance on October 31, 2006.
While the draft legislation deals with both SIFT trusts and partnerships, this bulletin provides a detailed review of the proposed taxation of SIFT trusts. As will be seen below, the draft legislation is complex and contains a number of drafting flaws and perhaps unintended consequences which we hope will be corrected.
Application of the New Tax Regime to Existing SIFT Trusts
The new tax regime is intended to stop future conversions of corporate entities into income trusts. In the October 31 release, it was announced that existing trusts which were "publicly traded" before November 1, 2006 would generally not be subject to the new tax regime until 2011. The December 21 draft legislation provides for grandfathering (until 2011) of existing trusts if units in the trust were listed on a stock exchange or other public market before November 1, 2006. Since this refers to units that are "listed" before November 1, 2006, it appears that there is no require-ment that they also be publicly traded before that date. The draft legislation provides that grandfathering will also apply if any other securities of the trust (such as debt) are listed before November 1, 2006. Despite some uncertainty created by the language of the October 31 release, trusts whose units were listed before November 1, 2006 will be grandfathered even if they did not hold any "non-portfolio property" on October 31.
The October 31 release stated that, while there was no intention to prevent grandfathered trusts from undergoing "normal growth" during the transitional period, this may be revisited by Finance if there is any "undue expansion." On December 15, 2006, Finance released further "guidance" on the meaning of "normal growth." The details of the release are discussed in our December Blakes Bulletin on Tax – Department of Finance Provides Guidance on "Normal Growth" for Income Trusts on December 15, 2006. There is no mention in the December 21 draft legislation as to when grandfathering could be denied and it appears that Finance has no current intention to incorporate its "guidance" into the final legislation. As a result, it appears that existing trusts are left with the threat of future amendments to the legislation to deny grandfathering if Finance’s safe harbours as set out in the December 15 release are exceeded.
The December 15 release also mentioned that Finance is considering whether to recommend amendments to facilitate conversions of existing income trusts to a corporate form. This is not dealt with in the December 21 draft legislation.
Outline Of The New Tax Regime
The draft legislation proposes three fundamental changes to the taxation of SIFT trusts and their investors. These are intended to impose taxes on non-portfolio earnings of a SIFT trust in a manner similar to those imposed on a public corporation and its shareholders. As will be seen, the draft legislation extends to trusts other than traditional income trusts and gives rise to many substantive and technical concerns.
Non-deductibility of distributed non-portfolio earnings
At present, income trusts are usually structured so that all of their income for each year is made payable to unitholders. Such distributions are deductible by the trust for income tax purposes and, as a result, the trust avoids paying tax.
The new proposals introduce the new concepts of "non-portfolio property" (NPP) and "non-portfolio earnings" (NPE):
- As discussed below, NPP is intended to cover all of a trust’s Canadian investments, other than portfolio investments.
- NPE includes income from NPP or from a business carried on in Canada, other than taxable dividends received by the trust.
A SIFT trust will not be entitled to deduct the portion of its income for each year that is deemed to be payable out of its NPE. Accordingly, the trust will generally be taxable on its NPE, even if it distributes such amounts to unitholders on a current basis.
One of the concerns with the definition of NPE is that it refers to all income from a "business." This may be problematic because a "business" could include the business of investing in securities. Accordingly, a trust could be considered to carry on a business even if it holds only portfolio investments. It was to address this uncertainty that the rules applicable to the "Canadian securities" election were amended to ensure guaranteed capital gains treatment to electing mutual fund trusts on their transactions in Canadian securities. Now, it appears that SIFT trusts will again have to consider whether, on basic principles, they could be regarded as carrying on the business of investing. If they are carrying on a business, the related income (other than dividends) would be included in NPE and be subject to the special taxes on SIFTs. Further, as discussed below in the section on NPP, a trust that is not otherwise a SIFT would be a SIFT if it "uses" securities in the course of carrying on the business of investing.
Treatment of trust distributions as taxable dividends
Where a SIFT trust has made a non-deductible distribution of NPE to unitholders, such amounts are re-characterized as taxable dividends from a Canadian corporation. As a result:
- Canadian resident individual investors will generally be eligible for the enhanced gross-up and dividend tax credit treatment applicable to "eligible dividends" in respect of such amounts.
- Corporate investors resident in Canada will generally be entitled to deduct such amounts in computing their taxable income, but may be subject to refundable Part IV tax in much the same manner as for dividends from taxable Canadian corporations.
- Non-residents will be subject to dividend withholding tax on such amounts, at a rate which in most cases should be the same as that currently applicable to distributions of trust income.
There are some technical concerns in the drafting of this deeming rule. For example, the total deemed dividend under the draft legislation appears to cover only distributions of income to a unitholder out of NPE. However, the amount of the deemed dividend received by each unitholder is equal to a pro rata portion of all amounts (not just income) "payable" by a trust to its unitholders. Thus the deemed dividend treatment could apply to a portion of what would otherwise be a return of capital or redemption price of units payable by the trust. For example, assume that a SIFT trust earns $100 of NPE in a year, all of which is payable as income distributions to its unitholders in the year, and there is also $900 payable in the same year to unitholders on redemption of units. In that case, the deemed dividend would be $100 and the total amount payable to unitholders would be $1,000. As a result, it appears that the deemed dividend would apply to $10 of the $100 income distribution and $90 of the $900 redemption payment. We expect that this is not the intended result and we hope it will be corrected in the final legislation.
The timing of the receipt of the deemed dividend also raises issues. Under the current rules, amounts received by a unitholder from a trust (including dividends received by the trust and passed through to unitholders) are taxable to the unitholder in the unitholder’s taxation year in which the trust’s taxation year ends. Under the proposed rules, deemed dividends out of a trust’s NPE may be taxable in a different taxation year from actual dividends and portfolio income received by the trust flowed through to unitholders, even though such amounts could be paid at exactly the same time. Generally speaking, an income trust has a December 31 taxation year. Therefore, if a unitholder’s taxation year ends on November 30, amounts of trust income payable to the unitholder in the trust’s taxation year ending December 31, 2011 would not be taxable to the unitholder until its taxation year ending November 30, 2012. Under the December 21 draft legislation, however, deemed dividends out of a trust’s NPE are taxable to unitholders at the time of receipt. This could result in acceleration of such income. It also raises compliance issues, because a SIFT trust may not be able to determine the deemed-dividend component of its distributions until after the end of its taxation year and this could be long after the time that such income must be reported by the beneficiary.
Trust liable to corporate tax
Under the proposals, the trust will be required to pay federal income tax on non-deductible distributions of NPE. The October 31 release stated that this rate is expected to be 31.5% in 2011, comprised of the actual federal corporate tax rate (projected to be 18.5% in 2011) plus a notional provincial corporate tax rate (13%). In addition, undistributed non-NPE income, if any, will continue to be taxed at the highest marginal rate applicable to individuals.
The new tax will apply on a base that is generally a grossed-up multiple of the trust’s non-deductible distributions. In other words, if a trust has NPE of $100 in 2011 and distributes all of its remaining income after paying the new tax, the trust would pay $31.50 of tax and a distribution of $68.50.
It is not clear from the draft legislation how this tax will be integrated with the parallel tax announced by Quebec on December 20, 2006, though it is to be expected that the 13% notional provincial tax component will be adjusted to reflect any provincial taxation of such income.
Definition of a "SIFT Trust"
The new rules apply only to SIFTs, as defined. A Canadian resident trust is a SIFT trust if:
- "investments" in the trust are listed on a stock exchange or other "public market", and
- the trust holds any NPP.
A SIFT trust is defined not to include a "real estate investment trust", as specifically defined. As in the October 31 announcement, the draft legislation proposes an extremely narrow definition of the type of trusts that qualify for this exemption. As a result, many trusts commonly referred to as real estate investment trusts or "REITs" will be exposed to the new tax regime. Notably, Finance has not proposed any liberalization of the definition to accommodate REITs engaged indirectly in management activities associated with hotels, retirement properties or other real property. This would seem to leave Canadian REITs at a distinct disadvantage as compared to U.S.-based REITs subject to the more liberal rules of the Internal Revenue Code. There is also no exclusion for de minimus investments by a REIT in nominee title-holding corporations.
Listed on a Public Market
As discussed above, in order for a trust to be a SIFT, "investments" in the trust must be listed on a stock exchange or other "public market." The new rules define a public market to include any trading system or other organized facility through which securities that are qualified for public distribution may be exchanged. The scope of this definition could be very broad. However, a public market specifically does not include a facility operated solely to carry out issuances or redemptions, thereby excluding conventional redeemable mutual funds if none of their investments is otherwise listed on a stock exchange or public market.
The proposed definition of an "investment" in a trust is extremely broad.
There are two components to the definition:
- An investment includes a "security" in the trust. A security is defined to include not only an income or capital interest in a trust, but also any liability of the trust and any right to acquire an interest in or liability of the trust.
Since debt of a trust is included as a security of the trust, a trust would fall into the new rules if any of its debt is listed on a stock exchange or public market, even if the trust units are not publicly-held. This could create issues, for example, for trusts that are created as a special-purpose entity or other financing vehicle to issue debt, if any of that debt is listed on a public market.
- An "investment" in a trust is also defined to include "a right which may reasonably be considered to replicate a return on, or the value of a security of the trust".
This wording seems to be aimed at derivative instruments, which may in fact be issued by a third party other than the trust itself. As a result, it would seem that structured notes, swaps and other synthetic instruments which mimic a return on any security of a trust could be regarded as investments in the trust. It could also include rights or warrants issued by a third party. If any such instruments are listed on a stock exchange or public market, they could bring an unlisted private trust into the SIFT regime.
Non-Portfolio Property (NPP)
If investments in a trust are publicly traded, the trust will be a SIFT if it holds any NPP. If a trust is a SIFT, income from NPP is included in earnings subject to the new tax.
There are three kinds of NPP contemplated by the draft legislation:
- Any "security" (as defined above) of a "subject entity" (discussed below) is NPP if either:
- the trust’s securities of the entity have a fair market value that is more than 10% of the "equity value" of the subject entity, or
- the total fair market value of securities of the entity (and affiliates) held by the trust is more than 50% of the "equity value" of the trust itself.
For this purpose, "equity value" is defined as the total fair market value of all of the issued and outstanding shares of the capital stock of a corporation, or all of the income or capital interests in a trust, or all of the interests in a partnership. A "subject entity" includes a Canadian resident trust or corporation, a non-resident person whose principal source of income is in Canada, and a partnership that has a sufficient Canadian nexus (which can include either all of its members being residents of Canada, its "mind and management" being in Canada, or it being formed under the laws of a province).
Because of the way the above valuation formula works, one consequence is that, if a trust holds debt of a Canadian corporation or a trust, the debt may be NPP if the amount of the debt represents more than 10% of fair market value of the shares of the corporation or interests in the trust. Thus, debt of a thinly-capitalized corporation or trust could be NPP. In order to determine whether this is case, it will be necessary to know the capitalization of the issuer and this information may not be publicly available. The 50% test seems to require a comparison of the gross asset value of the trust’s investment in another entity to the fair market value of unitholders’ interests in the trust, which could be a concern where investments by a trust are highly leveraged with trust debt. There could also be the concern that a significant decrease in the market value of trust units could put its existing investments offside.
- Canadian real property and resource property is NPP if, at any time in the year, the total fair market value of such property is more than 50% of the trust’s equity value. The definition of Canadian real property and resource property includes shares of a corporation, or interests in a trust or partnership, if more than 50% of the fair market value of the shares or interests is derived, directly or indirectly, from Canadian real or resource property. The definition also includes rights to acquire such shares or interests, so that options or convertible debentures issued by such corporations, trusts or partnerships would also be included.
This 50% test also seems to require a comparison of the gross asset value of the trust’s investment to the market value of unitholders’ interests in the trust. A listed closed-end mutual fund trust that has a diversified portfolio concentrated in Canadian real property or resource property sectors may be (or become) a SIFT even if none of its investments represent more than 10% of the equity value of any issuer or more than 50% of the equity value of the fund.
- Any property used by a trust (or by a non-arm’s length person) in the course of carrying on a business in Canada is NPP.
As discussed above, there is a related concern with respect to the definition of NPE, which is defined to include income from a business.
In general, the December 21, 2006 draft legislation accords broadly with the initial announcement of the new rules on October 31, 2006. The legislation is highly technical, and makes use of a series of defined terms and complex formulae. Any trust whose units, debt or other investments are publicly traded must be alert to these proposals.
It is unfortunate that the draft legislation does not set out statutory language for when grandfather-ing could be denied because of "undue expansion." While it is useful to have the draft legislation for public comment, it is not likely to have any practical effect until 2011. In the meantime, existing trusts are left in the uncertain position of having to interpret the general and imprecise language used in the December 15 guidance, with a possible loss of grandfathering if Finance should disagree with the trust’s interpretation. We hope that, at the very least, Finance will agree to provide "comfort" or "no-action" letters to taxpayers who require assurance as to their status under the grandfathering rules.
The October 31, 2006 release also suggested that the details outlined in that document were subject to change in order to ensure that they meet Finance’s underlying policy objectives. At the time, Finance said that if structures or transactions should emerge that are clearly devised to frustrate those policy objectives, the measures could be changed "with immediate effect." There has been no elaboration of this in public statements by Finance and draft legislation does not contain any specific anti-avoidance provisions per se. Nevertheless, the October 31 statement will continue to create uncertainty about future structures or transactions.
The December 21 release invited interested parties to provide comments regarding these proposals by January 31, 2007. We will be participating in this process. We hope that some of the concerns outlined above will be addressed in the next version of the proposals.
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.