Written By Darcy D. Moch
It has been a week since the Federal Minister of Finance announced a new taxing regime for publicly-traded income trusts and limited partnerships. The stated goal of the announcement was to "level the playing field" by stopping the spread of income trusts by ensuring that corporations that were considering conversions would abandon their plans, while at the same time providing a limited shelf life for the tax benefits available to existing income trusts and partnerships.
The changes reflect a fundamental shift in the Canadian tax system. The announcement has had a significant impact on public markets (even beyond the market for public trusts) and on business transactions generally. It is still early, but the market capitalization of some trusts and corporations has dropped by as much as 25%. Previously announced transactions have stalled or been abandoned. Purchase and sale transactions, equity offerings and debt financings have been terminated or are in the course of being repriced. Challenges and opportunities are being evaluated as the market transforms itself to this potential new reality.
In his announcement, the Minister of Finance indicated that the measures were meant to "restore balance and fairness to Canada's taxing system". As legal advisors, we do not comment on whether this was necessary or will be achieved. We are, however, able to say with certainty that the playing field has changed and that important legal issues must be addressed, in some cases with a measure of urgency.
We have received a number of questions and have participated in numerous conference calls and meetings in an attempt to respond to the many serious tax and legal concerns of our clients. This Tax Alert provides a summary of these questions and our initial responses. Many of the answers lead to further questions, which may only be resolved as matters proceed. Moreover, draft legislation has not been released, making it difficult to respond to some of the concerns at this time.
What are the Proposals?
The government intends to tax certain public income trusts and limited partnerships in the same manner as corporations by disallowing previously deductible income distributions and imposing a tax on the trusts or limited partnerships at the rate of 34% in 2007, decreasing to 31.5% by 2011, on such income distributions, similar to the tax that would otherwise be payable if the trusts or limited partnerships were corporations. The net after-tax amount available for distribution (other than returns of capital) will be treated as dividends in the hands of the recipient investors and Canadian individuals will be entitled to the dividend tax credit.
Who do the Proposals apply to?
The new regime is meant to apply to certain public income trusts, funds and limited partnerships referred to in the Minister of Finance's announcement as "specified investment flow-throughs" or "SIFTs". As a practical matter, most publicly-listed income funds, trusts and limited partnerships that hold "non-portfolio properties" will be caught. It is important to note that only public entities would appear to be subject to the rules. Non-public operating and investment trusts and partnerships (such as closely-held business partnerships and more broadly held partnerships that are not traded, such as those used in the oil and gas industry to carry on private drilling activities or to hold flow-through shares) do not appear to be caught by the rules.
The concept of a public market for the new rules is intended to be broader than just stock exchanges, and is to include, for example, an organized quotation system that supports over-the-counter trading. Also, there is a statement that the rules may even be broad enough to include securities of other entities, if those securities derive all or substantially all of their value from securities issued by a trust or partnership. Once released, the legislation must be carefully examined to see how the rules will apply on a case-by-case basis.
Are there any Exceptions?
Trusts that are commonly known as real estate investment trusts or REITS are excepted from the new rules, but only if they meet a series of conditions relating to the nature of their income and investments. The difficulty is that some REITS may not qualify for the exception since they have expanded beyond merely holding real property for rent. In some cases, they also hold investments that allow them to indirectly carry on business with the real property that they hold. The legislation will need to be carefully reviewed to determine whether particular entities will qualify as excluded REITs. In certain cases it may be necessary to reorganize particular REITs or dispose of non-qualifying activities to allow the REITs to be excluded from the proposals. We understand that the Department of Finance is prepared to accept submissions on these issues.
The stated reason for the exclusion of REITs is to recognize the "unique history and role of collective real estate investment vehicles". Similar reasoning has not been applied to exclude any other sector, such as royalty and resource funds operating in the oil and gas sector.
Is there any Grandfathering?
Trusts that were publicly-traded on October 31, 2006, will be grandfathered from the new rules for four years until 2011. We anticipate that many of the existing trusts will nevertheless be immediately impacted in a number of significant ways and may need to take action well before this four-year period has expired.
The grandfathering test laid down by the Minister of Finance is a hard-line test. Trusts will only qualify for the four-year window if they were already publicly traded on October 31, 2006, effectively shutting down any trust conversions in process. Unlike many prior changes in Canadian tax legislation, there are no current exceptions for transactions that were well along the way to completion through public announcements and filings.
Will the Changes become Law?
It is conceivable that the minority government that introduced the proposals could be defeated before the legislation is approved or that the policies could be softened or modified. The current government appears firm in its resolve and introduced a motion to have the proposals approved on November 7, 2006, even before the detailed legislation was released. Even if there were to be a change in government, there can be no assurance that a new government would significantly modify the proposals.
What is the Impact of the Proposals?
The proposals will reduce the amount of cash that most public income funds, trusts, and limited partnerships will be able to distribute when the rules begin to apply in 2011. Demand for these investment vehicles is largely driven by the high levels of distributions. Significant reductions in those distributions will likely have a profound impact on valuations, potentially eliminating the use of the vehicles altogether. Some specific impacts may include the following:
- Reduced Distributions to Unitholders – Starting in 2011, the amount that will be available for distribution to unitholders will decline. The rate of tax applicable to trusts that will be applied to distributions of income is 31.5%, resulting in such distributions being reduced by 31.5% at that time. The capital portion of distributions will not be affected. Canadian residents who are fully taxable should be relatively neutral from an after-tax perspective, taking into account the dividend tax credit rules. However, the reduced distributions will represent an absolute cost to lower-income investors who cannot fully benefit from the dividend tax credit rules, tax-exempt investors (such as pension funds and RRSPs), and non-residents.
- Impact of Reduced Distributions – Reduced distributions may lead to adverse tax issues for trusts and partnerships. In some cases, the trusts or partnerships may have income that exceeds the amount of cash which is otherwise available for distribution. In these instances, it may be necessary to consider distributions of property such as additional units, raising significant tax and securities law issues.
- Non-Resident Unitholders - The proposals will not impact non-resident investors directly or specifically. Instead, the impact will be felt through reduced cash distributions. The after-tax amounts that will be distributed by the trusts will be treated as dividends for Canadian tax purposes and will be subject to Canadian withholding tax at rates similar to those currently imposed on distributions to non-residents by trusts (25%, but generally reduced to 15% under the terms of an applicable income tax treaty or convention).;
- Tax-Exempt Investors – Canadian-based tax-exempt investors will be significantly impacted by the proposals. The amount that they will receive from public trusts and partnerships will be greatly reduced, and there will be an element of double taxation since the amounts received by the tax-exempt investors will ultimately be subject to tax when the amounts are distributed to the underlying beneficiaries of the tax-exempt entity. It is anticipated that many larger pension funds will continue to have a preference for more private equity investments structured on a flow-through basis over investing in public flow-through entities, such as trusts and partnerships, where there will be a tax-drag on distributions.
- Impact on Financial Markets - It will likely be harder for public trusts and partnerships to access public markets even before the expiry of the four year window. Existing equity and debt financings have been put on hold or are in the course of being repriced. Reduced distributions will curtail the demand for future financings. Existing financing arrangements must be reviewed to determine the impact of these changes.
- Impact on Existing Debt Instruments – Existing debt covenants must be reviewed to determine if there are any distributable cash, financial ratios, debt-to-equity coverage ratios or other measures that will be impacted or need to be renegotiated. As well, many public trusts and partnerships have significant levels of financing through convertible debentures. In many instances, these have been viewed as alternate equity rather than true debt with an equity sweetener. With the changes, it is possible that the convertible debentures may become more akin to debt, requiring the trusts and partnerships to pay off the debentures with cash. This may have a direct and immediate impact on the amount of cash available for distribution to unitholders.;
- Ability to Expand – Certain sectors of the public trust and partnership market have focused on continued expansion, due to the need to support distributions by constantly acquiring properties that generate large cash flow. This appetite for growth may be curtailed as the four-year window begins to close. Furthermore, the Minister of Finance's announcement suggests that certain growth in existing grandfathered trusts and partnerships may not be permitted. While "normal growth" during the four-year transitional period will be permitted, "undue expansion" through the insertion of a "disproportionately large amount of additional capital" will not be allowed. Existing trusts and partnerships will need to carefully examine the legal scope of the rules once the legislation is available to determine what types of expansion plans will be permitted. This could also impact the ability to raise equity to repay bridge financings that were put in place to fund acquisitions that occurred prior to the new rules being announced. Since a non-qualifying or "undue" expansion could result in the loss of grandfathered status and the immediate application of the new tax regime, any issuances of new securities will need to be carefully considered.;
- Impact on Acquisitions and Dispositions – In the first week we have already seen an immediate impact on transactions. Given that an existing trust or partnership can only achieve a tax flowthrough for a maximum of four years, the price that a trust or partnership is willing to pay for an acquisition appears to have been materially reduced. Moreover, due to market conditions and the "undue expansion" concern, it is uncertain whether these new acquisitions are permissible and how new acquisitions will be funded. Public trusts and partnerships have been significant buyers of assets, particularly in the oil and gas sector. This trend may not continue, impacting both sellers and buyers. Transactions that have been agreed upon but have not yet closed may need to be revisited.
- Trust Mergers and Reorganization Transactions – There have been a number of recent mergers, consolidations and reorganizations of public trusts, some of which were accomplished through the creation of a holding trust. The fundamentals behind such transactions may no longer apply and will need to be reconsidered in the future. • Impact on Employee Stock Options - Many employee stock options and unit plans for trusts and partnerships are no longer "in-the-money" as a result of reductions in unit prices. This may have a significant impact on the ability to retain key employees. It may be necessary to consider repricing stock options or creating other employee incentive plans, all of which will require a detailed review from a tax, securities and employment law perspective.;
- Impact on External Management Arrangements and Sponsored Trusts – Some public trusts and partnerships operate with external management. As well, some trusts operate on a sponsored basis, with a main investor that provides management and support to the structure. These arrangements will need to be addressed in any future planning or transactions.
- Impact on Financial Statements, Public Disclosure, Governance and Fiduciary Duties – Accounting and audit standards require disclosure of future liabilities and exposures including liabilities for future taxes, which may be impacted by the changes. Securities laws call for public disclosure of material events and governance rules impose many obligations on the directors, trustees and management of public entities, all of which require prompt review and attention.;
- Exchangeable Interests – A number of public trusts operate with exchangeable securities that were created as a means of offering a limited deferral from the liability for tax that would otherwise be realized by the shareholders on the conversion into a trust. It is possible that the new proposals will not have an immediate impact on such securities, but such securities will need to be addressed depending on what happens with the applicable trusts.;
- Capital Losses – Some investors will be sitting in a loss position with respect to their investments in public trusts and partnerships. It may be appropriate to consider realizing the losses at this time by selling the securities before year-end. It will be necessary to carefully consider the application of the "superficial" loss rules that generally require that same or similar securities not be repurchased by the unitholder or an affiliated person for a period of 30 days.
What do we think existing Trusts should do or may be forced to do?
In the short term, many trusts should simply maintain a status quo position until the uncertainty regarding the introduction of the proposals has been resolved and the legislation is in draft form (or better yet, enacted). Maintaining the status quo may not, however, mean that existing trusts can continue to expand and carry out transactions that they would otherwise have been implemented.
In the longer run, many trusts and partnerships may prefer to convert back to corporate form. The reduced values may make certain trusts and partnerships attractive take-over targets, particularly for private equity funds, pension funds and foreign investors. There appears to be no simple way to dissolve a trust and distribute its underlying assets on a tax-free basis. One would hope and anticipate that the Department of Finance will consider bringing in rules to allow this to take place on a tax deferred basis. Special rules and differences will also arise as between trusts and partnerships, all of which will require a detailed tax review.
Some key points and alternatives for existing trusts and partnerships include the following:
- Maintain a Status Quo Position for the Four-year Period – It is conceivable that many trusts and partnerships can continue to operate in the normal course without any changes until 2011 when the new rules take effect. Market pressures and the need to expand (without any real economic ability to do so and with the potential risk of losing grandfathered status if the expansion is "undue") will likely be the main driver behind this decision.;
- Remain as a Trust or Partnership Beyond 2011 – Trusts and partnerships may cease to exist, or at least no longer continue to operate the way they currently do, beyond 2011. It is possible that some trusts and partnerships could continue to survive as an alternative structure to corporations due to the fact that they may still provide an effective means of providing a high-yield return to investors in comparison to corporations. Public corporations cannot generally distribute or return capital to their shareholders without such amounts being treated as dividends for tax purposes unless such returns are accomplished through "normal course issuer bids". However, the proposals indicate that trusts and partnerships will continue to be able to return capital free from tax, with such returns being treated as a reduction in the tax cost of the units to investors (potentially only giving rise to capital gains if such tax cost amounts go negative or, in the case of trusts, potentially giving rise to a special 15% withholding tax on distributions of capital to non-residents). One possible advantage of a continued trust or partnership structure, therefore, is that if the market continues to have a strong demand for high distribution investments, a trust or partnership may be an attractive alternative over the corporate model as a portion of the high-yield distributions will likely be a return of capital.;
- Liquidation of Trust or Partnership and Distribution of Shares or Securities of Underlying Company – There is currently no simple tax-free way to liquidate or dissolve a public trust. While there are mechanisms to do a tax-free liquidation of a Canadian partnership, the rules are quite complicated. One would hope and anticipate that the Department of Finance will introduce rules to enable the process for conversion back to corporate form on a tax-free basis, but this is far from certain.;
- Conversion to Corporate Form – The simplest way to convert back to corporate form is by having a new or existing corporation acquire the public units in exchange for shares. There is no automatic "unit for share" rollover, but it should be possible for taxable unitholders to file a joint tax election with the acquiring corporation to provide for a tax-deferred rollover on the exchange. Following that, the company could operate with the existing trust or partnership kept intact or alternatives could be considered to dissolve the trust or partnership when it is a wholly-owned entity. There will invariably be a number of split-up scenarios to consider, including perhaps even breakups of existing trusts into separate entities or among separate potential buyers. Conversions back into corporate form may require a review of employee stock option or unit plans in terms of change of control provisions.;
- Corporate Conversion Mechanics - The reorganization of an income trust or partnership into a corporation may be able to be effected by exchange offer, plan of arrangement and/or amendment to the governing documents of the trust or partnership. A reorganization may also require approval by special resolution of the unitholders of the trust or partnership at a special meeting called for that purpose. The corporate conversion mechanics will likely be unique for each issuer and will require detailed review from a tax, securities and corporate law perspective. An analysis of the text of the implementing legislation for the proposal will be required to guide any reorganization, as the legislation may provide relief for various elements of the transaction, such as more simplified deferred "roll-over" mechanics for unitholders.;
- Distribution of Subordinated Debentures – Given the appetite for high distribution investments, it is possible that a market for high-yield subordinated debentures issued by corporations will develop. The interest on such debentures would be paid to public debentureholders to achieve a shifting of corporate income to the public in much the same way that income funds currently operate. Such securities currently exist in the marketplace and provide a tax-efficient means of distributing income to Canadian tax exempt and foreign resident investors. In considering these alternatives, it will be important to heed the warning from the Minister of Finance that "if there should emerge structures or transactions that are clearly devised to frustrate" the government's apparent policy objectives, the measures may be changed "with immediate effect".;
- New Buyers – Private equity funds (including funds with large pension backing) and nonresident entities may emerge as potential buyers. Also, existing corporations that operate with tax losses or other available tax deductions may be attractive to buyers in a retracting trust market. Structuring such purchases and sales can lead to a host of tax, corporate and securities law considerations.