What the Normal Growth Guidelines Say (and Don't Say)
Written by Darcy D. Moch and Daniel V. Lang
Originally Published in Tax Alert March 2007
In November 2006, we reported on the Minister of Finance's announcement to tax Specified Investment Flow-Through (SIFT) income trusts and limited partnerships While controversy and public debate has continued over these proposals, the Department of Finance has released draft legislation on December 21, 2006 to largely reflect the proposals first announced on October 31, 2006. This draft legislation has raised a variety of technical concerns on which submissions have been made by a number of parties including the Canadian Bar Association/Canadian Institute of Chartered Accountants Joint Committee on Taxation.
One of the more controversial aspects raised by the proposals which is not addressed in the December 21, 2006 draft legislation deals with the ability of a grandfathered SIFT to expand during the four year window until the rules take affect without becoming subject to tax under the new rules. In his October 31, 2006 proposals, the Minister of Finance indicated that while existing SIFT entities would not be restricted from “normal growth” during the transitional period ending in 2011, any undue expansion of an existing SIFT could cause that SIFT to become immediately taxable. On December 15, 2006, the Minister of Finance issued a press release (referred to as the Normal Growth Guidelines) that attempts to describe in general terms what would constitute acceptable growth by the SIFT. The suggestion is that if a SIFT does not violate the Normal Growth Guidelines, it will continue to be exempt from the SIFT tax until 2011.
As a general comment, while the Normal Growth Guidelines seem to provide clear guidance on a number of matters and are perhaps even more generous than first thought they might be, the guidelines are far too general to be instructive in a variety of more complicated situations presented by the public marketplace. Moreover, it is surprising that Finance has merely chosen to issue the guidelines as a form of policy statement without legislation or any apparent plans to introduce legislation, leading to continued uncertainty.
What are the Normal Growth Guidelines?
A grandfathered SIFT will not be subject to the new rules prior to 2011, provided that any increases in the SIFT's equity do not exceed the greater of: (i) $50 million, and (ii) the specified “safe harbour” growth limits. The safe harbour growth limits will permit a SIFT to double the value of its issued equity capital, as measured against its October 31, 2006 market capitalization, on a cumulative basis of 40 percent for 2007 and 20 percent for each year thereafter. The percentage increase in equity value (the Equity Value Increase) is to be measured by reference to the market capitalization of the SIFT's issued and outstanding publicly-traded units as at October 31, 2006. Of note, debt (whether or not convertible) and exchangeable securities in place on October 31, 2006 are excluded in the calculation of a SIFT's market capitalization on October 31, 2006.
The following transactions are stated to be exempt from being considered Equity Value Increases and, therefore, represent transactions that a SIFT can do without counting against its safe harbour growth limits:
- Issuing equity to replace debt (whether convertible or not) that was outstanding as of October 31, 2006
- Issuing new debt, provided that it is not convertible debt nor subsequently exchanged for equity units
- Issuing new equity on the exercise by another person or partnership of a pre-existing exchange or conversion right
- Issuing equity in the context of a merger or reorganization of two or more SIFTs that were publicly traded on October 31, 2006, provided that there is no addition to net equity as a result of the merger or reorganization
Ambiguities and Issues
- Issuing Equity to Replace Existing Debt: Both the
issuance of equity to replace pre-existing debt (i.e.,
debt that was outstanding on October 31, 2006) and
the issuance of non-convertible debt will be excluded
from being an Equity Value Increase under the Normal
Growth Guidelines. This result leads to follow-up
issues that require clarification:
- A SIFT may operate as a holding vehicle and use lower-tier entities to carry on the underlying business operations. It is unclear whether the exclusion from the Equity Value Increase will be extended to the issuance of units by a SIFT to repay debt of a lower-tier entity that was outstanding on October 31, 2006.
- The Normal Growth Guidelines are silent as to whether a tracing rule will be applied to determine if equity issued to replace debt is excluded from the calculation of the Equity Value Increase. For example, debt that was outstanding on October 31, 2006 may first be refinanced with new debt, but ultimately replaced with equity. It follows under this example that the particular debt in existence on October 31, 2006 no longer exists after its replacement with new debt. One interpretation is that the subsequent issuance of new equity to repay the replacement debt would be new growth and count against the safe harbour thresholds, as the equity would not specifically or directly replace the debt that was in place on October 31, 2006. On the other hand, a contrary interpretation could focus on the amount of debt that existed on October 31, 2006, and permit that amount of debt to be replaced with equity without the need to specifically identify the debt that was issued before or after October 31, 2006.
- Exercise of Existing Exchangeable Securities: The Normal Growth Guidelines contemplate that units issued on the exchange of exchangeable securities will only be excluded from the Equity Value Increase calculation if the transaction is initiated by the holder of the exchangeable securities. However, there are a number of circumstances where the exchange may occur at the option of the issuer or according to the terms of the exchangeable securities. From a policy perspective, it should not matter who initiates the exchange. The Normal Growth Guidelines should be clarified to confirm that all units issued upon the exchange of exchangeable securities that were outstanding on October 31, 2006 do not count as new growth, regardless of which person initiated the exchange.
- Exercise of Employee Options and New Employee
Options: The Normal Growth Guidelines do not address
whether the issuance of equity units created on
the exercise of employee options that were outstanding
as of October 31, 2006 will be considered to be
the issuance of new equity and, consequently, included
as part of the Equity Value Increase calculation.
From a policy perspective, employee options should
be treated like exchangeable securities; the exercise
of such employee options that were in existence on
October 31, 2006 should not be considered to be part
of a SIFT's Equity Value Increase.
The granting of new employee options following October 31, 2006 may be viewed as new equity for purposes of the safe harbour limits. If so, it is unclear when such employee options will be considered to be the issuance of new equity, since the Equity Value Increase could occur either when the options are issued or when they are exercised.
- Issuer Bids and Redemptions: A SIFT that acquires its units for cancellation pursuant to an issuer bid or a redemption will reduce the amount of its issued and outstanding equity. The Normal Growth Guidelines should be clarified to confirm that the safe harbour limit will not be reduced by such transactions. From a policy perspective, a SIFT should be permitted to subsequently issue new securities up to the amount of any prior repurchases or redemptions before the issuance of new units will be considered as an Equity Value Increase.
- Distribution Reinvestment Plans: Many SIFTs offer a distribution reinvestment plan for their unitholders. It is unclear whether units issued to unitholders that participate in such plans count as new equity for purposes of the Equity Value Increase calculation.
- Mergers: A merger of two or more SIFTs (all of which were publicly-traded on October 31, 2006), or a reorganization of a SIFT, will not constitute an Equity Value Increase provided that there is no net addition to the cumulative equity of the SIFT entities. This relatively simple guideline raises a number of important issues:
- It is unclear how broadly the terms merger or reorganization are to be interpreted. At a basic level, a merger should encompass the situation where two income trusts merge and units in one trust are issued to unitholders of another trust. However, a much broader range of transactions should arguably be included within the scope of the merger or reorganization exception and, in this regard, it would be desirable for the Minister of Finance to provide additional guidance. A merger could include the acquisition of the lower- tier assets of one SIFT in exchange for units, or an acquisition of a SIFT's units or assets in exchange for cash or a combination of cash and units.
- If the SIFT issues new units and the cash proceeds are used to fund the buyout of existing units issued by another SIFT, it should be clarified whether the newly issued units would be considered to be issued in the course of the merger or reorganization and would be exempted from being an Equity Value Increase.
- Rules should be developed to confirm that the ability to issue equity to replace debt that was in place on October 31, 2006, or to issue new units on the exchange of exchangeable securities that existed on October 31, 2006, will be equally applicable on an aggregated basis to the SIFT following the merger or reorganization.
Despite the issuance of the December 15, 2006 press release and the draft legislation on December 21, 2006, the Department of Finance has not released any provisions that address the following matters:
- Guidelines on how a SIFT can be converted, on a
tax-deferred basis, into a corporation. In this respect,
will there be new tax provisions under the Income
Tax Act to govern the conversion, and will the conversion
require the filing of tax election forms?
Other issues that will need to be addressed include whether a SIFT's lower-tier investment entities will also be able to convert to a corporate form on a tax-deferred basis, and whether it will be possible to rollover the employee options issued by the SIFT into options of the new corporation.
- There are no specific anti-avoidance rules in the Normal Growth Guidelines. Rather, there are only vague statements that the Department of Finance will monitor developments to ensure that the policy intent of the draft legislation and the December 15, 2006 press release are respected.
- The Normal Growth Guidelines are simply that. There is no legislation, nor is there any process for a SIFT to obtain binding assurances, either from the Minister or Finance or from the Canada Revenue Agency, as to whether a proposed transaction will be off side the Normal Growth Guidelines. While the Normal Growth Guidelines are clear in a number of straightforward situations, they are ambiguous on other matters and create considerable uncertainty regarding whether any given transaction would impact a SIFT's grandfathered status. This is clearly a problem in a public market environment, where it is critical that there be certainty as to the tax consequences of any transaction.