On July 14, 2008, the Minister of Finance released long-awaited draft legislation to amend the Income Tax Act (Canada) and enable the tax-deferred conversion of certain income funds (referred to as Specified Investment Flow-Through entities or SIFTs) as well as real estate investment trusts (REITs) into corporations. The comments made below with regard to SIFTs also apply to REITs, though relatively few REITs are expected to convert.
A tax-deferred conversion to corporate form was promised in the wake of the October 31, 2006 announcement of a special tax applicable to most SIFTs after 2010 — one that would be comparable to the tax borne by corporations in similar circumstances.
Minister Flaherty has been criticized for having taken so long to release these rules. Their absence is said to have hampered many SIFTs' strategic planning.
Those who had hoped for a relatively simple tax-deferral mechanism will be disappointed by the current legislative proposal. It is dense. While the Department of Finance can be largely excused for this as a result of the complexity of the phenomena with which they were dealing, the proposed rules fall short of covering some aspects of expected conversion transactions, and create potentially important distinctions between similar transaction types without apparent justification. Affected taxpayers should proceed with caution. Further amendments are anticipated. Interested parties are invited to make submissions in that regard prior to September 15, 2008.
The conversion rules also raise certain policy issues for continued debate. For example, they provide ample fodder for those who argue that, far from creating a level playing field for SIFTs and corporations, the proposed rules continue to tilt the field in favour of the corporate model. The rules also make the conversion into leveraged corporations more difficult than was expected, indicating a possible policy position that requires examination.
The guts of the proposed rules are two alternative tax-deferred conversion mechanisms.
- A tax-deferred unit for share exchange. SIFT
unitholders will be permitted by amendments to Section 85.1
of the Income Tax Act to exchange their units for
shares of a taxable Canadian corporation on a tax-deferred
basis without going through the cumbersome election procedure
required by subsection 85(1).
- A tax-deferred distribution of corporate shares to
SIFT unitholders. A SIFT may distribute shares of a
taxable Canadian corporate subsidiary to its unitholders on a
tax-deferred basis under proposed subsection 107(3.1). The
SIFT would restructure its holdings before making this
distribution so that this subsidiary owns all of the
Generally, as a result of each type of tax-deferred transaction, SIFT unitholders will dispose of their units without recognizing a gain or loss, and will receive corporate shares that will have the same cost for tax purposes as did the units. Elections are not required to be filed.
To qualify for the deferral, certain conditions must be met. In each case, transactions that would in general lead to the dissolution of the SIFT must be completed within a 60-day period, and before 2013. In the unit-for-share exchange, only a single class of shares may be issued in exchange for the units; only shares may be issued for units that are subject to the deferred exchange, and these shares must have a value equal to the units' value.
Rules to enable the tax-deferred wind-up of trusts will be added in Sections 88.1 and 107. These, along with existing tax-deferred reorganization rules applicable to partnerships and corporations, will enable the streamlining, to a certain extent, of the corporate structures that will result from using either of the two SIFT termination mechanisms.
The proposed rules cover a variety of ancillary issues, including the following:
- Debt forgiveness. The debt-forgiveness rules in
Section 80.01 will be amended to allow for the forgiveness of
underwater debt on the winding-up of one trust into another.
This will allow most SIFTs that use highly leveraged internal
debt, the value of which has fallen below its principal
amount, to eliminate that debt without being penalized by the
- Employee stock options. The application of the
rules in Section 7 governing tax-deferred exchanges of
employee stock options will be extended to corporate shares
into which SIFT units are converted.
- Acquisitions of corporate control. Where the
trustees of a trust that controls a corporation are changed,
an acquisition of control may occur. This issue also arises
where a corporation's shares are distributed by one
trust to another during the course of a SIFT's
wind-up. Proposed subsection 256(7) will be enacted to ensure
that an acquisition of control does not occur in that
- Taxable Canadian property. The taxable Canadian
property status of SIFT units will carry over to corporate
Typical Conversion Transactions
Two conversion scenarios should suffice to bring the proposed mechanisms into focus.
- Unit-for-share exchange. Assume that a SIFT
trust has a number of corporate, partnership and trust
subsidiaries, that the SIFT has determined to convert to a
corporation that will operate the business formerly operated
by the SIFT's subsidiaries, and that the
SIFT's unitholders wish to convert their units into
corporate shares. In this case, the unitholders may transfer
their units to a newly created, publicly traded corporation
in the course of a plan of arrangement, in exchange for
shares of a single class of that corporation. This exchange
should be tax-deferred as a result of the amendments to
Section 85.1. The SIFT's partnerships and corporate
subsidiaries can generally be wound up on a tax-deferred
basis under existing rules. The amendments proposed to
Section 88.1 and subsection 107(3.1) should permit the SIFT
and certain subsidiary trusts to also be wound up on a
tax-deferred basis. Debt between trusts can generally be
eliminated during the winding-up without adverse
debt-forgiveness implications as a result of amendments to
Section 80.01. Existing rules should apply, with similar
effect, to other inter-affiliate indebtedness. The
corporation would continue to carry on the SIFT's
business, and may pay dividends to shareholders to the extent
it determines to do so. This is likely to be the most common
form of conversion.
- Share distribution to unitholders. The
unitholders may achieve the same result in most respects by
causing the SIFT to undertake a plan of arrangement by which
its subsidiaries are reorganized under a single operating
corporation. The structure beneath the operating corporation
could be simplified using the existing reorganization
provisions in the Income Tax Act, as well as those
now proposed. The corporation's shares would then be
distributed to the SIFT unitholders under proposed subsection
107(3.1), and the SIFT would cease to exist.
Holders of securities in subsidiary corporate or partnership entities that are exchangeable for SIFT units should not be negatively affected by either of the alternative conversion transactions. Depending on the reorganization provisions governing the exchangeable securities, the holders may be able to continue holding their exchangeable securities after the conversion. They can also participate in the unit-for-share exchange transaction by transferring their exchangeable securities to the new corporation on a tax-free basis or receive a pro rata distribution of shares in a share-distribution transaction. The latter alternative may pose a greater challenge from a tax perspective.
While the alternative conversion mechanisms work in a similar fashion, in many cases the differences between them will be important. For example:
- Transfer of tax attributes on winding-up. A
winding-up under proposed Section 88.1 will have the effect
of transferring certain tax attributes from a SIFT to its
corporate parent. This is available after a Section 85.1
unit-for-share exchange, but not in anticipation of a
subsection 107(3.1) share distribution. Many resource sector
SIFTs with significant resource tax pools will find this
issue particularly important. We have been informed by a
senior Department of Finance official that the inability to
transfer tax attributes in this fashion as a result of the
operation of proposed subsection 107(3.1) will be given
- Paid-up capital. The proposed rules create a
deemed paid-up capital for each trust being wound up
(essentially, the amount paid to the SIFT on issuance of
units minus distributions of capital). Therefore, where the
value of the SIFT units is below their original issue price,
care should be taken to ensure the wind-up does not trigger a
capital gain. In the corporate context, this issue is usually
avoided by reducing the paid-up capital of the subsidiary
prior to the wind-up. It is unclear whether a comparable
reduction is possible with regard to a trust's deemed
paid-up capital. Furthermore, differences in the paid-up
capital of the corporate shares that result from the
conversion may be material in some cases. As noted, there is
a mandated paid-up capital calculation under Section 85.1
that is based on SIFT capital, whereas under subsection
107(3.1) unitholders get whatever paid-up capital is in the
shares distributed on the winding-up.
- Multiple classes of shares. The opportunity to
use multiple classes of shares (permitted under subsection
107(3.1) but not Section 85.1) may be important to some
- The 60-day window. The 60-day window during
which certain transactions must be completed operates
differently in each case, with Section 85.1's
requirements being easier to meet in some cases. This may
sometimes be important.
In short, SIFTs will need to carefully read each set of provisions in light of their particular circumstances before deciding which conversion alternative to use.
Policy and Technical Issues
The following issues are potentially problematic:
- Time limit to convert may encourage conversion.
The proposed legislation applies generally to transactions
occurring after July 14, 2008. Qualifying transactions must
meet a variety of conditions and must generally occur by the
end of 2012. Since the SIFT tax comes into effect at the
beginning of 2011 for most SIFTs, they have a relatively
short time to convert on a tax-deferred basis. Afterwards,
the difficulty of conversion may relegate them permanently to
SIFT status. Prior to the announcement of the conversion
rules, most observers believed that SIFTs would generally
convert near the end of 2010. The time-limited opportunity
for tax-deferred conversion increases that probability, and
is consistent with the often-heard comment that Canadian
Government policy is to discourage the continued existence of
SIFTs. Department of Finance officials have informally
confirmed this policy.
- Limited opportunity to convert to a leveraged
corporation on unit distribution. Proposed subsection
107(3.1) requires that only corporate shares be issued and
distributed to former SIFT unitholders. Were debt obligations
of the corporation distributed along with the shares, the
corporation could pay tax-deductible interest to its
shareholders, thus making it more tax-efficient. The
requirement that only shares be distributed for purposes of
subsection 107(3.1) raises concerns with regard to how much
time must separate a tax-deferred conversion reorganization
from a distribution of debt to unitholders or shareholders in
order to avoid the application of the general anti-avoidance
rule. The policy underlying the prohibition against the
distribution of debt is difficult to discern, as is the
difference on this point between the apparent operation of
proposed subsection 107(3.1) and Section 85.1(7).
- Issues related to leveraged corporations on unit for
share exchange. Proposed subsections 85.1(7) and (8) are
less clear in their application to debt issued in exchange
for SIFT units. Section 85.1 in general only requires a
share-for-share exchange for the particular shares that are
the subject of the Section 85.1 transaction, and specifically
contemplates that non-share consideration may be received in
respect of other exchanged shares. Proposed subsections
85.1(7) and (8) are consistent with this approach. For
example, subsection 85.1(7) contemplates a "particular
disposition" of SIFT units in respect of which only
shares must be received (see sub-paragraph 85.1(7)(b)(ii)),
and that other exchanges may also occur, as a result of which
all of the transferor's equity in the SIFT is
disposed of during the required 60-day period. There is no
requirement that all exchanges comply with the rules in
Section 85.1. Therefore, prior to the commencement of the
60-day exchange period, it may be possible for a unitholder
to exchange a portion of its units for debt of the
corporation on a taxable basis or use a Section 85 rollover
to exchange units for shares and debt while exchanging the
rest of the units for shares using the rollover afforded by
proposed subsections 85.1(7) and (8). However, the Technical
Notes issued with the proposed rules indicates that in order
to take advantage of the tax deferral offered by subsection
85.1(8), a taxpayer is required to "dispose of all of
its equity in the SIFT ... and receive, as consideration,
nothing other than shares ... ". This conflicts with the
plain reading of subsection 85.1(7) as well as the
architecture of Section 85.1 overall, and creates what is
hoped to be temporary uncertainty. A senior Department of
Finance official advised us that in the interest of levelling
the playing field between SIFTs and corporations, further
consideration will be given to permitting more latitude for
the creation of leveraged corporations during the course of
- Uncertainty regarding leverage may cause some SIFTs
to forego tax-deferred conversion. This would be
regrettable, since there is no apparent policy against the
creation of leveraged corporations, and in fact Department of
Finance officials have indicated that they expect SIFTs to
take on more debt after converting to corporate form/status.
Rules could be drafted to permit the tax-free creation of
corporate debt during the course of a conversion up to the
cost amount of a SIFT unitholders' units, and to
subject the creation of additional corporate debt to tax. In
addition, when engineering transactions of this kind,
taxpayers should bear in mind the Department of
Finance's assertion that any structures that go too
far toward in recreating the SIFT's tax efficiency
while avoiding the SIFT tax should expect new legislation to
bring them within the SIFT rules. Finance officials have
expressed specific concern about "stapled units"
— shares and debt obligations that are irrevocably
joined and trade as a unit.
- Proposed rules apply to SIFT takeovers. Although
the purpose of the rules is stated to be the conversion of
SIFTs into corporations, they apply as well to the
acquisition of a SIFT by an existing public corporation on a
share-for-unit basis. Therefore, one of their side effects
may be to facilitate, and hence encourage, the takeover of
SIFTs by corporations.
- The proposed rules do not apply to many SIFT
subsidiary entities. The trust-winding-up rules that are
intended to assist in the tax-deferred streamlining of
corporate structures apply only to SIFTs and direct, wholly
owned subsidiary trusts. If third-tier trusts exist in a SIFT
structure, the rules do not facilitate their elimination.
Further, if subsidiary trusts are partly owned by subsidiary
partnerships or corporations, the rules likewise do not
apply. It is not possible to rectify the situation by, for
example, winding up an intermediate partnership. Many SIFT
structures have become so complex that they may not be able
to use the proposed rules to streamline their organizational
structures to the desired extent in conjunction with a
conversion transaction. A senior Department of Finance
official has advised us that this issue will be given further
- Acquisition of control. Arguably, the relief
provided with regard to potential acquisitions of control
that may result from a change in the trustees that own
corporate shares does not go far enough. Various other
potential acquisitions of control may arise in the course of
SIFT conversion transactions, such as the transfer of shares
from a SIFT to the corporation into which it will be
converted. A senior Department of Finance official has
informed us that this issue will be further considered.
- 60-day window issues. Many of the proposed rules
provide a 60-day window within which certain transactions
must be completed in order to take advantage of the
tax-deferred conversion. For example, subsection 107(3.1)
requires that the winding-up distribution from a SIFT occur
no more than 60 days after the first distribution the SIFT
received from another SIFT during the course of its wind-up.
This contemplates the kind of serial windings-up or other
reorganization steps that will probably be required to
streamline many SIFT structures in connection with their
conversion to corporate form, and effectively requires that
the entire series of transactions be completed within a
60-day period. There are many circumstances in which one
issue or another could cause taxpayers to fail to meet this
deadline, and there is no safety net. Where each transaction
that must be completed within this time period is subject to
a plan of arrangement, the terms of the plan can generally be
set up to ensure that the required transactions occur on
time. Outside a plan of arrangement, on the other hand, asset
conveyances may require the agreement of security holders,
partners, and other stakeholders. It often takes much more
than two months to clear these hurdles. So, corporate
wind-ups are deemed to be effective at the time certain
resolutions are passed as long as the remainder of the
transactions are completed within a reasonable time. This
often extends well past one year. It will be onerous if
taxpayers are required, prior to a complex restructuring of
the type described above, to do the detailed work required to
ensure that all of the necessary transactions can be
completed within a 60-day span. This will likely cause SIFTs
to strongly prefer to use plans of arrangement. In light of
the importance of the 60-day deadline to conversion
transactions, particular attention will need to be paid to
this issue and the Department of Finance should perhaps
consider a relieving amendment.
Further Planning Consideration
In addition to the issues summarized above, the following may be relevant to some conversion transactions:
- Debt forgiveness. As noted above, the
debt-forgiveness rules will be amended to allow for the
forgiveness of debt between trusts. This does not apply to
underwater debt issued by a corporate subsidiary of a SIFT
that must be converted into shares or otherwise eliminated
during the course of a conversion transaction. Various means
are available to prevent the application of the forgiveness
rules in this context.
- Publicly traded debt. A SIFT with outstanding
publicly traded debt (including convertible debt) will in
most cases wish that debt to be assumed by the continuing
corporation. The unit-for-share conversion transaction will
generally best facilitate this.
- Unitholder approval. Both the unit-for-share and
distribution conversions can be undertaken by way of plan of
arrangement, subject to a 66 2/3rds unitholder vote. As noted
above, the deemed property conveyances pursuant to such plans
may be important to compliance with the 60-day requirement.
In most cases, a special resolution will be required pursuant
to the SIFT's trust deed as well. These also
generally require a 66 2/3rds unitholder approval.
- Unitholder Loss realization. Unitholder losses
will not be generally realized as a result of a conversion
transaction. Unitholders may, however, sell into the market
prior to a conversion transaction to realize their losses. It
may in some cases be feasible to redeem units in exchange for
corporate shares in the course of a conversion transaction.
This would allow the redeemed unitholders to realize their
Prior to the proposed rules announcement, observers generally believed that most SIFTs would convert to corporate form because trusts and limited partnerships are more awkward and expensive to administer as publicly traded vehicles than are corporations. Further, the trust accounting rules are tightening and in some cases may cause additional disclosure. A conversion may allow these to be avoided.
Most SIFTs were expected to delay conversion for as long as possible to maximize the present value of the SIFT tax advantage, stay in the consolidation game as long as possible, and minimize the learning curve costs and other uncertainties associated with being among the first to convert. However, in some cases current opportunities or challenges make early conversion sensible. For example, sometimes the growth or foreign ownership restrictions on SIFTs impede or prevent important transactions. And in some cases, SIFTs have enough tax pools that the present value of the SIFT tax advantage is relatively small.
The only change effected by the proposed conversion rules in this regard is that the incentive to remain a SIFT has further declined as a result of the time-limited opportunity to convert to a corporation on a tax-deferred basis.
The proposed SIFT conversion rules are a significant step in the right direction. Given the complexity of the issues to be dealt with, it would be unusual for a first draft to cover all of the important issues. Senior officials from the Ministry of Finance are soliciting feedback from the tax practitioner community with regard to the rules. We expect further legislative proposals to be forthcoming.
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.