Foreign Investments in and Acquisitions of Publicly Traded Canadian Flow Through Entities

Articles Canada Nathan Boidman* Foreign Investments in and Acquisitions of Publicly-Traded Canadian Flow-Through Entities: Impact of Recent Controversies and Proposed Changes rations. The comparison with a straight investor seems Contents to be relatively straightforward, and the main focus 1. Overview and Introduction (where the challenges are greatest) is on total foreign 2. Flow-Through Entities in Canada – Domestic Perspective 2.1. Overview and the basic situation takeovers and acquisitions. Where the target is a pub- 2.2. Publicly-traded flow-through approaches licly-traded Canadian corporation, the objective from 2.2.1. Overview of the recent phenomena: “income the Canadian tax standpoint is to establish an acquisi- trusts or funds” tion structure (that often entails a special purpose Cana- 2.2.2. Specific concepts and rules – current law dian (acquisition) corporation) which provides for: 2.2.3. The Halloween Night proposals 3. Effects on and Implications for Foreign Investors in (1) tax-free repatriation of the investment (acquisition Publicly-Traded Canadian Trusts price) – whether stemming from post-acquisition 3.1. Current law operating profits, unwinding sandwich structures or 3.2. The Halloween Night proposed law divesting of unwanted assets; 4. Foreign Takeovers of Publicly-Traded Canadian Trusts? (2) effective financing arrangements – whether at the 4.1. Basic considerations 4.2. Takeovers of MFTs operating through own lower-tier point of acquisition or post-acquisition debt push- corporations down; 4.2.1. Acquisition of stock and loans of lower-tier (3) basis step-ups and related questions when unwind- corporations ing sandwich structures or divesting of unwanted 4.2.2. Acquisition of the units of the MFT assets; and 4.3. Takeovers of MFTs not involving lower-tier corporations (4) rollover treatment – through exchangeable shares – 4.3.1. Overview of basic conflict of the parties’ tax of the target shareholders in a stock-for-stock deal interests or when structuring dividend access share arrange- 4.3.2. Perspective of target’s unitholders ments. 4.3.3. Perspective of acquirer – asset deals 4.4. Additional considerations if the acquirer pays with its Separately, in choosing a location for the party that stock emerges on top in a merger of equals, priority may be 4.4.1. For the trust and its unitholders given to the location that will eliminate or minimize cer- 4.4.2. For the foreign acquirer 4.5. Other types of taxes that might arise tain CFC-type rule issues going forward. 5. The September 2005 Aborted Attack on MFTs Where a publicly-traded Canadian target carries on its 6. Interim Government Decision, 23 November 2005 – The Shoe Does not Drop business in a form (most often a trust whose units are 7. The Shoe Drops – 31 October 2006 listed on a stock exchange) which provides for flow- 7.1. The 31 October 2006 announcement through tax treatment,2 the issues for a foreign acquirer 7.2. Detailed draft legislation – 21 December 2006 may well intensify. 7.3. Effect on foreign investors in MFTs 7.4. Effect on foreign acquisitions of MFTs 8. Summary Comments * © Nathan Boidman, 2007. Davies Ward Phillips & Vineberg, LLP, Montreal, Quebec. The author would like to acknowledge that several of 1. Overview and Introduction the thoughts and views expressed in this article stem from his discussions with his partners, Neal Armstrong, Fred Purkey and Alan Shragie of This article focuses on the implications of controversial Davies Ward Phillips & Vineberg, LLP – for which the author is grateful – although they did not have occasion to read the manuscript before it was proposed tax changes for foreign investors in, or foreign submitted for publication. The author takes sole responsibility for its con- acquirers of, Canadian businesses carried on through tents. publicly-traded flow-through trusts. These proposals This article reflects developments to 9 March 2007. would terminate flow-through tax treatment1 and sub- 1. As explained below, this means that the trust’s profits are not taxed (or stitute tax effects comparable to those historically appli- not fully taxed) in its hands or at the level of a lower-tier entity in the group, but are flowed through and taxed in the hands of its investors. cable to publicly-traded taxable Canadian corporations. 2. In Canada, flow-through tax treatment may be total or partial. Partial The issues are examined in the context of a comparative flow-through structures are, in effect, hybrid situations (1) which link (i) the review of Canada’s tax treatment of foreign investors in, organizational and tax effects of operations through ordinarily taxable corporations with (ii) structured investments by investors through upper-tier pub- or foreign acquirers of, publicly-traded Canadian corpo- licly-traded trusts bifurcated between equity and debt slices or elements 182 BULLETIN FOR INTERNATIONAL TAXATION MAY 2007 © IBFD Articles There are two reasons for structuring a Canadian busi- does permit real estate investment to be structured on a ness enterprise through a flow-through entity (FTE) flow-through basis.7 such as a trust. First, in Canada, as in most countries (but not all, see e.g. Argentina, Brazil and the Netherlands), 2. Flow-Through Entities in Canada – Domestic conventionally structured corporate business enter- Perspective prises have resulted, in concept, in a double tax for the 2.1. Overview and the basic situation shareholders – i.e. a corporate-level tax and generally a tax on the dividends distributed by the corporation, usu- Since 1972 (and subject to the changes now being ally without full integration (of the corporate-level tax) phased in, as discussed below), Canadian-based busi- for the taxable shareholders which would provide a full ness enterprises and undertakings carried out in corpo- credit for the corporate-level tax against the tax paid on rate form have resulted in a modified classical double tax the dividends by the shareholder. But as discussed below, as between shareholders and corporations. For example, a result of recent controversies is that this problem is an individual resident in Ontario, Canada’s largest now being addressed. Second, for tax-exempts (e.g. province, may pay aggregate federal and provincial taxes Canadian pension funds) and for taxable investors who of approximately 46% on directly earned business prof- might have their own separate tax-sheltering arrange- its, but before the recent changes explained below, if the ments in place, even if there is no shareholder-level tax profits were earned by a publicly-traded Canadian cor- upon distribution, there will generally be no recovery of poration and then distributed as a dividend to the indi- the corporate-level tax paid. Flow-through entity vidual, the aggregate corporate and personal-level taxes arrangements, in principle, address both of these tax thereon would be about 56%.8 For a tax-exempt, the inefficiencies.3 This study examines six facets of this matter. First, given and (2) which are designed, through the payment of interest on the debt ele- the unusual nature of the tax rules and arrangements ment (to the trust and then to the investors), to effectively move at least some of corporate-level profits into the hands of the investors on a pre-tax basis. that arise where publicly-traded Canadian FTEs are 3. One suggested answer pointed to the advent of low interest rates in the used to carry on various types of business activities, early 1990s. See Brussa, John A., “Royalty Trusts, Income Trusts, and Search there are the basic arrangements and domestic tax rules for Yield: A Phenomenon of a Low-Interest-Rate Environment?”, Report of Proceedings of the Forty-Eighth Tax Conference, Canadian Tax Foundation that govern them. Second, with respect to foreign port- Annual Conference, 1996 (Toronto: Canadian Tax Foundation, 1997), at 19: folio investment in such Canadian entities, there are the 1-27. Although Canada has long had these inefficiencies, it is only recently effects for both the foreign investors and the entity that the use of FTEs has emerged for all manner of business undertakings. The 4 delayed reaction is surprising in that the mechanics to structure FTEs have itself. Third, there are the tax considerations, tactics, long been available. But it is only since the early 1980s that FTEs have gained strategies and obstacles where a total foreign takeover of prominence in Canada and then initially generally only in the resource or real a publicly-traded Canadian FTE is contemplated. (To estate area, and it has been only since the 1990s that they have been used for all manner of business undertakings in the publicly-held and publicly-traded some extent, this aspect of the discussion is speculative sector. because there is, in fact, little experience with such total 4. As discussed below, the tax treatment of a trust may be adversely takeovers.) Fourth, there was the impact of the Fall 2005 affected if the limitation on the level of foreign investors is exceeded. 5. Detailed draft legislation was issued just before Christmas of last year reaction (and initiative) by the Canadian government to amid extremely vocal and concerted efforts by various lobbyist groups to have concerns it had been developing regarding this type of those changes aborted. arrangement. Fifth, there was the manner in which that 6. See Scoon, Iain and Fiona Montagu, “U.K. Government Affirms Com- mitment to REITs”, 38 Tax Notes International, No. 7 (16 May 2005), at 552. initiative (subsequently aborted) played out in late 2005, 7. Not unrelated to this discussion is the recent legislation in Belgium which saw the government decide not to change the tax which allows Belgian corporations to deduct amounts, as notional interest, treatment of flow-through trusts, but instead to try to determined by reference to their share capital.

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