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 corpo- rations 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. As explained in Isenbaert, Mathieu, “Belgium Deduction for Risk Capital Strikes Balance between Debt level the playing field by reducing the tax on corpora- and Equity”, 38 Tax Notes International, No. 7 (16 May 2005), at 547: “the bill tions and their shareholders. Sixth, there is what can be would reduce the tax treatment imbalance that exists between debt financing termed the “2006 Halloween Night Massacre” when, on and equity financing ...”. 8. That aggregate rate assumes that the corporation operated only in 31 October 2006, the government announced a firm Ontario. At the corporate level, the combined (integrated) federal and provin- intention to put a stop to flow-through treatment for cial rates of tax on corporate profits range, in general, from a low of approxi- publicly-traded trusts, an initiative to which (at this mately 32% on the profits attributable to operations carried out in the provinces of Alberta and Quebec to a high of about 39% on the profits attrib- time) the government (notwithstanding substantial utable to operations carried out in Saskatchewan. In Ontario, the profits 5 opposition ) is steadfastly adhering and attempting to attributable thereto are taxed, overall, at a rate of roughly 36%. (At this point, finalize. This development is seen by the business and the rate is actually 36.12%, made up of the federal component of 22.12% and the Ontario component of 14%. But the planned phased-in reductions of the investment community to mean that there will be sub- federal component would reduce the aggregate rate to 32.5% by 2011.) A stantial foreign takeovers of such Canadian businesses highest-taxed individual living in Ontario (subject to a marginal combined now being conducted through publicly-traded trusts. federal and Ontario personal tax rate of e.g. 46%) would be subject to an effec- tive rate of about 31% on a 64¢ dividend, having regard to the partial imputa- Finally, by way of overview, the themes and factors dis- tion of the corporate-level taxes (the “imputation”, by way of a gross-up (of a dividend received) by 25% and a credit (for roughly the gross-up amount), cussed below can be considered in light of the experi- applies regardless of the actual corporate taxes). A shareholder that is a pub- ence of other countries respecting flow-through tax licly-traded Canadian corporation, or a privately-held one owning shares treatment. Australia and the United States generally ter- with more than 10% of the votes and value of the distributing corporation, will pay no tax on the dividend (see Sec. 112 of the Income Tax Act (Canada), minated such treatment in the 1980s, although in both R.S.C. 1985, Chap. 1 (5th Supp.), as amended (“the Act”)), but a privately-held countries and in many other countries (recently the corporation owning less than that threshold will have to pay a special tax at a United Kingdom6 and Germany), the domestic tax law rate of 33%, which tax is fully refundable to the corporation when it pays a

© IBFD BULLETIN FOR INTERNATIONAL TAXATION MAY 2007 183 Articles overall rate would be 36%.9 Another base factor is the result for a foreign investor in a fully taxable (e.g. Ontario-based) Canadian corpora- taxable dividend to its shareholders (see Part IV of the Act). It can be seen tion. A 64¢ dividend distribution to that shareholder is therefore that, for an individual shareholder in Ontario, the combined effec- subject to a tax of 25% on the gross amount (i.e. another tive tax rate on a dollar of pre-tax corporate profit is 36% + [31% x 64%], or overall 56%. 16¢ of tax) for an overall tax of 52% unless reduced by a 9. For example, a pension fund for employees of a Canadian corporation 10 tax treaty. For a foreign portfolio investor, the maxi- that is registered under and for purposes of the Act. See Sec. 149(1)(o) et seq. mum tax reduction by a treaty would be to a rate of 15%. 10. See Part XIII of the Act. The rate under a treaty is generally 15%, but a rate of 5% or 10% may apply to certain corporate shareholders. For a treaty-based foreign shareholder of an Ontario- 11. Publicly-traded flow-through arrangements most often have taken the based corporation, this would result in another 10¢ of form of a trust. Much less frequently, flow-through treatment for publicly- Canadian tax – for overall Canadian taxes of about 46%. traded businesses has been provided through the use of publicly-traded lim- ited partnerships. This is based on the simple notion that a partnership is not a separate taxpayer and its income is taxed in the hands of its partners (see e.g. 2.2. Publicly-traded flow-through approaches the definitions of “taxpayer” and “person” in Sec. 248(1) and the partnership flow-through rules in Sec. 96 of the Act). Unlike the US, which also features 2.2.1. Overview of the recent phenomena: “income trusts that basic rule in the US Internal Revenue Code (IRC), such transparent sta- or funds” tus has not been lost in Canada (as it may be in the US) by reason of whether or not its units are publicly traded. (Under IRC Sec. 7701(4), if the interests in The latter corporate-related tax effects spawned the a partnership are publicly traded, the partnership is deemed to be an associa- tion taxable as a corporation.) But the Halloween Night proposals discussed development of the publicly-traded trust structure since below would curtail this. There is also the “mutual fund corporation” used in the early 1980s with respect to resource and real estate conjunction with securities investments (mutual funds). For some insight to activities and since the mid-1990s in any field of busi- the use of mutual fund corporations, see Fyfe, Stephen J. and Craig J. Webster, 11 “Current Mutual Fund Developments and Products”, Report of Proceedings of ness activity. The structure provides an individual in the Fifty-Second Tax Conference, Canadian Tax Foundation Annual Confer- Ontario with a pre-tax dollar of profit that is subject to ence, 2000 (Toronto: Canadian Tax Foundation, 2001), at 21:1-60. Another tax at 46%, leaving the individual with 54¢, as compared approach, a derivative of the trust approach, where the target business is in the US, but the acquisition is structured for Canadian investors, is to dispense with to the result through a conventional taxable corporation, the trust and instead have a publicly-traded corporation with the investors where the net take is only 44¢; in the case of a tax- owning both its stock and interest-bearing debt (referred to as an “income par- exempt, the result is realization of the full dollar of pre- ticipating securities (IPS) structure” if the parent corporation is formed in Canada, and as an “income deposit securities (IDS) structure” if the parent is tax profit without any tax at all. formed in the US. This model has apparently been adopted to respond to cer- tain US tax considerations. Because such arrangements do not involve prima- Publicly-traded trusts involved in owning and operating rily Canadian business operations and are not, per se, the object of the new pro- 12 rent-producing real estate are, in principle, permitted posals and because they raise an entirely additional/different set of by the relevant tax rules to own such property directly. In structuring investment and takeover considerations, they are beyond the scope of this article. such a case, or where the trust can structure its affairs to 12. Commercially referred to as “real estate investment trusts” or REITs. operate through lower-tier (sub-)trusts or partnerships 13. Although, as noted, publicly-traded trust-based arrangements com- (and with no corporation in the chain of ownership), menced primarily in the early 1980s in the resource and real estate sectors, the preponderant business types that have gone public over the last several years there can be a total flow-through of income to the bene- have been in sectors other than those two. See Ebden, Theresa, “Paving the ficiaries/investors. That involves specific rules allowing Way for a Fair Exchange”, Globe & Mail, 29 June 2005, at E-1, Report on trusts to flow through income to beneficiaries, or those Income Trusts – noting that trusts now represent 8% of the total TSX market capitalization, 13% of TSX issuers and 8% of the total volume traded on the specific rules together with those above for partnerships. exchange. See also Berman, David, “Income Trusts Are New Kings”, National Post, 13 July 2005, at FP18. In Trichur, Rita, “Income-Trust IPOs Dominate Where the latter type of direct or indirect ownership is Market”, Montreal Gazette, 6 July 2005, at B-5, the author reported on a Price- precluded, publicly-traded trusts will use a wholly- waterhouseCoopers survey of Canadian IPO activity for the first half of 2005. owned corporation to carry on any manner of busi- See PricewaterhouseCoopers, “Survey of IPOs in Canada in 2004: A Detailed 13 Review of Initial Public Offerings Completed in 2004 on the Country’s Prin- ness. Here, the flow-through element in principle is cipal Stock Exchanges”, 2005. only partial. It is effectuated by interest-bearing debt 14. In general, under Canada’s thin capitalization rules in Sec. 18(4) et seq. investment by the trust in such wholly-owned corpora- of the Act, limitations may arise on the deductibility of such interest only where non-resident shareholders are involved. For a detailed discussion, see tions. The (partial) flow-through element stems from Boidman, Nathan, Robert E. Culbertson, Harry J. Hicks, III, E. Daniel Leight- the combined utilization of the trust rules and the basic man and Diana L. Wollman, “U.S. Inversions and Earnings Stripping Initia- right of a corporation to deduct from its taxable profit tives: A Forum for International Commentary (Part 1 of 5)”; and Boidman, 14 Nathan, “Inversions, Earnings Stripping – Thin Capitalization and Related the interest paid to shareholders. Matters – An International Perspective”, 29 Tax Notes International, No. 9 (3 March 2003), at 875 and 879, respectively. 2.2.2. Specific concepts and rules – current law 15. Secs. 104(1) and (2) of the Act. Under that rule, the trust is generally taxed as though it were an individual. The threshold tax factor that governs publicly-traded 16. Secs. 104(6) and (13) of the Act. The underlying character of trust income, taxed in the hands of its beneficiary, is lost (see Sec. 108(5)) and trust-based arrangements is the basic statutory rule gov- instead becomes “income from property”, taxed according to the beneficiary’s erning the taxation of traditional privately-held family status (see Sec. 12(1)(m)). An exception, where tax can be imposed on a trust trusts. According to the basic rule, the income derived by notwithstanding that it has distributed its income to its beneficiaries, applies 15 if there are non-resident beneficiaries and the trust has derived or realized a trust is taxed in its own hands as a separate taxpayer, certain Canadian-nexus income or gains. In such a case, a tax of 36% is unless the trust either chooses (if it is a discretionary imposed by Part XII.2 of the Act. But significantly that tax does not apply to a trust) or is required (if it is a non-discretionary trust) to trust that qualifies as a “mutual fund trust”, which (as discussed below) is the status that all trusts used in the public domain seek to achieve. As well, there are distribute its income to its beneficiaries, in which case circumstances – beyond the scope of this article – in which the parties can the income is taxed in the beneficiaries’ hands and not in and may elect to have distributed income taxed in the hands of the trust rather the hands of the trust.16 That elemental rule, together than its beneficiaries.

184 BULLETIN FOR INTERNATIONAL TAXATION MAY 2007 © IBFD Articles with some others which apply to a trust that meets the whether the income comprises interest paid by a lower- requirements for “mutual fund trust” (MFT) status,17 tier captive corporation in the group) which is distrib- provides the cornerstone for the publicly-traded trust uted to a Canadian beneficiary/investor is taxed in the scene in Canada today – although, as discussed below, hands of the latter, not in the hands of the trust. The all of this will change soon. MFT status is particularly effects of this system for non-resident investors are crucial when there are non-resident investors because examined below. without it: (1) the basis (explained below) for exclusion Generally, a Canadian investor who disposes of an inter- from Canadian tax upon dispositions of interests in a est in an MFT (e.g. through a securities market) is Canadian trust by non-residents would not arise, and (2) accorded capital gains treatment no different than if he as noted above (see footnote 16), the trust would be sub- had sold the stock of a publicly-traded Canadian corpo- ject to a special 36% tax (under Part XII.2 of the Act) on ration. The trust arrangements may also provide for the certain types of Canadian-nexus income distributed to a buy-back of the trust units, satisfied by distributing cash non-resident beneficiary/investor. and/or the trust’s underlying property. In the latter case, To qualify for MFT status, a key restriction under cur- the overall results may be complex and are beyond the rent law is that an MFT may not, loosely speaking, be scope of this study. established and operated primarily for non-residents (a subjective test), unless all or substantially all of the trust’s 2.2.3. The Halloween Night proposals property does not comprise most forms of Canadian- As noted earlier and as discussed in 7., on 31 October nexus property other than Canadian portfolio invest- 2006 the government moved to terminate the foregoing ments.18 Another important restriction, to comply with flow-through tax benefits. the MFT requirements, is that the trust may not, loosely speaking, carry on business unless it entails certain real 3. Effects on and Implications for Foreign estate undertakings. The manner in which this restric- Investors in Publicly-Traded Canadian Trusts tion affects the organization and operation of MFTs engaged in business beyond the real estate category is 3.1. Current law discussed elsewhere herein. A threshold factor is that the trust arrangement itself A trust arrangement will provide the optimum Cana- (and its status as an MFT) may be adversely affected if dian tax results if it does not entail a lower-tier operating there are foreign investors whose interests exceed cer- corporation, which, however, sometimes cannot be tain levels. This was discussed above. There are two basic avoided. In principle, an MFT may not directly own tax considerations for a foreign investor: (1) Canadian and/or operate assets or activities other than straight rental real estate (which is capital property to the trust, not inventory).19 This may result in structures involving 17. See prior note. The requirements to be a mutual fund trust include a restriction in some, but not all, circumstances respecting the maximum less than totally tax-efficient trust-owned operating cor- amount of non-resident investor interests in the trust. See Sec. 108(2) regarding porations, although some deals have proceeded on the “unit” trust status and Sec. 132(6) et seq. of the Act; the latter provisions define basis that lower-tier (sub-)trusts (which are also flow- “mutual fund trust” and include activity limitations and the condition that the MFT not be established or maintained principally for the benefit of non-resi- throughs) and limited partnerships (which are flow- dent persons. (See below for the forthcoming amendments to this rule.) For a throughs) can be an effective way of avoiding a corpora- detailed discussion, see Kandev, Michael and Fred Purkey, “Practical Applica- tion in the chain of ownership.20 tions of Trusts”, Report of Proceedings of the Fifty-Sixth Tax Conference, Cana- dian Tax Foundation Annual Conference, 2004 (Toronto: Canadian Tax A separate factor may result in the use of a lower-tier Foundation, 2005), at 40:1. 18. See prior note and Sec. 132(7) of the Act Under the proposals in the corporation, even where the business/assets would read- March 2004 Federal Budget, which have been deferred for further study, ily qualify for an MFT structure without a taxable cor- mathematical tests would be substituted which would limit non-resident porate subsidiary. This is when the MFT structure stems unitholders to 50%, unless no more than 10% of the trust’s property comprises such Canadian-nexus property. See Budget of 23 March 2004, 6 December from a conversion and an initial public offering (IPO) of 2004, Department of Finance Press Release; and Budget of 23 February 2005. an existing publicly or privately-held traditional taxable 19. It is not clear whether resource assets can be directly held. For a discus- corporation, which cannot be readily liquidated without sion, see Boidman, Nathan, “Cross-Border Investment in and Acquisitions of 21 Public Flow-Through Entities: Canada”, 39 Tax Notes International, No. 6 (8 tax. August 2005), at 499, footnote 30. 20. For a discussion of an MFT (Davis + Henderson Income Fund) which Where lower-tier taxable corporations are used in the converted a taxable subsidiary into such a structure, see Ruby (infra note 41) structure, the flow-through effect is achieved by having and Sec. 253.1 of the Act. See also published Income Tax Ruling, E2003- the trust hold, to the maximum extent possible, the 0053981R3(E), Advance Income Tax Rulings, reference date, 1 January 2004. Investment in resource industry-related income-producing assets or com- interest-bearing loans made to the taxable corporation mercial real estate assets has been amenable, in whole or in part, to acquisition (with the view of flowing out its profit through interest and holding without a subsidiary corporation; the operation of a hotel or real payments). There are no domestic thin capitalization estate where substantial services are provided to a tenant may lead to a bifur- cation of the ownership of the underlying property and the carrying on of the rules to restrict the proportion of MFT investment in its activity with third parties as between the MFT and a subsidiary corporation controlled corporation which can be debt-funded. (linking the two through net leases, etc.). 21. However, the Davis + Henderson conversion (see prior note) of a taxable In summary, the income of the trust (whether from corporation into a sub-trust and partnership by converting the latter into a direct operations or investments or flowed through to it mutual fund corporation (by merger under Sec. 131) and then a merger with the MFT by a Sec. 132.2 plan of reorganization might achieve this (generally from a lower-tier trust or flow-through partnership, or involving a ruling from the Canada Revenue Agency).

© IBFD BULLETIN FOR INTERNATIONAL TAXATION MAY 2007 185 Articles taxation of distributions and (2) Canadian taxation of siderations where there is a total takeover of a publicly- dispositions of an interest in the trust (whether sold to a traded Canadian corporate group. third party or redeemed by the trust). The results are From the standpoint of the shareholders of a Canadian generally straightforward for cash distributions stem- corporate target or of a Canadian merger party who take ming from the MFT’s ordinary income and for disposi- the stock of the foreign party, rollover or deferral treat- tions to a third party. In other situations, complexity may ment can be provided only through a cumbersome arise. exchangeable share mechanism. Current law does not A distribution of cash from ordinary income by an MFT provide rollovers for straight exchanges of domestic to a non-resident beneficiary/investor is subject to a 25% stock for foreign stock.30 Separately, there may be various withholding tax unless reduced by a treaty (often to tax inefficiencies for a Canadian shareholder who owns 15%).22 The distribution eliminates tax at the MFT level. shares of a foreign acquirer – particularly respecting In general, the sale by a foreign beneficiary/investor of such person’s share of the profits of the combined group an interest in an MFT is exempt from Canadian tax (having regard both to the tax laws of Canada and to unless a 25% ownership level is exceeded.23 The non-res- those applicable to the foreign acquirer).31 ident may not own together with affiliated persons at the time of disposition or during the preceding five years 25% or more of the units of the trust.24 The 25% tax also 22. Secs. 104(6) and (13) and 212(1)(c) of the Act. 23. Listing the units for trading on a prescribed stock exchange is not a applies to most distributions stemming from an MFT’s requirement for the latter exemption from Canadian tax for non-residents 25 capital gains. who own and then sell the units. This is surprising because such listing is required for exclusion where a non-resident sells shares of a Canadian resi- Part XIII.2 of the Act also imposes a tax at the rate of dent corporation. 15% where (1) the trust is an MFT that is listed on a pre- 24. See Sec. 248(1) of the Act respecting the definition of “taxable Canadian property” and Secs. 2(3) and 115(1). scribed stock exchange; (2) the trust’s property is princi- 25. This results from the proposals made in the March 2004 Federal Budget, pally Canadian real property, Canadian resource prop- set forth in draft legislation in September and December 2004 and enacted erty or timber resource property; and (3) the trust (Bill 33) on 13 May 2005 (with effect no later than the beginning of 2005). Prior to the latter, there could have been a total exclusion from Canadian tax distributes amounts to a non-resident not subject to Part on the portion of the capital gains realized by an MFT on a sale of capital XIII (Sec. 212(1)(c), as described above). In other words, property and distributed to a non-resident unitholder (see Secs. 104(6), (13) the 15% tax may apply to amounts distributed by an and (21) and 212(1)(c), prior to amendment). Under new Sec. 132(5.1), the 26 entire capital gain derived from “taxable Canadian property” (such as shares of MFT which are not otherwise taxable. The tax can be a private Canadian company or Canadian real estate) is now subject to a 25% reduced or recovered by reference to the non-resident’s withholding tax under Part XIII, which may be reduced to 15% under a treaty. losses from dispositions of interests in the MFT, entail- But this tax will not apply if not more than 5% of the units are held by non-res- 27 idents. (Technically, the new regime applies by reference to whether more ing the filing of a tax return. than 5% of the total of all amounts designated under Sec. 104(21) are in respect of non-resident persons. Assuming only one class of units of an MFT, The foregoing rules operate so that there is no Canadian this would translate into a reference to the percentage of units held by non- tax on a capital gain realized by an MFT if there are no residents.) more than 5% non-resident unitholders and the trust’s 26. For example, this may apply to the tax-free capital gain illustrated above where new Sec. 132(5.1) does not apply, to cash flow sheltered by depreciation, property does not exceed the specified 50% Canadian or to a return of capital. level. In such a case, neither Sec. 132(5.1) nor Part XIII.2 27. For purposes of Part XIII.2, the status of an MFT where its value is applies. attributable primarily to Canadian real property or Canadian resource prop- erty or timber resource property or where its property is “Canadian property mutual fund investment” – see Sec. 218.3(1) of the Act. The provisions contain 3.2. The Halloween Night proposed law a number of new concepts and terminology: “assessable dividend”, deemed dispositions of notional “taxable Canadian property”, “assessable distribution”, For the effects of the 31 October 2006 announcement on “deemed gain” of that notional disposition at that deemed amount of the dis- non-resident investors, see 7. position, “Canadian property mutual fund losses” and “unused Canadian property mutual fund losses”. 28. There have been some very high-profile completed or aborted foreign 4. Foreign Takeovers of Publicly-Traded takeovers in the Canadian resource sector (see e.g. Falconbridge and Inco in Canadian Trusts? 2006) and continuous interest by foreign investors (and recently by major for- eign REITs) in the Canadian real estate sector. But the majority of foreign 4.1. Basic considerations takeovers of Canadian targets have been, and presumably will continue to be, in sectors other than those two. There is substantial concern that the govern- Over the years, there has been an ongoing stream of for- ment’s Halloween Night proposals will see even more foreign takeovers in the energy sector. See e.g. Francis, Diane, “Tory income trust policy is flawed: Tax- eign acquisitions of publicly-traded Canadian business ing trusts will not lead to tax fairness”, National Post, 2 December 2006, at FP2; corporations –whether for cash, stock or a combina- and Francis, Diane, “Trust tax threatens to sell out Canada – Billboard cam- tion.28 But notwithstanding the widespread adoption of paign to outline threat”, National Post, 3 March 2007, at FP2. 29. But see prior note regarding the prognosis for the future. Separately, the MFT approach to publicly-owned and publicly- there have been several mergers entailing one REIT taking over another, but traded businesses, the phenomenon is sufficiently recent few involving cash and/or stock. that it has yet to mature into widespread takeovers 30. The Department of Finance announced in October 2000 that it would enact rules accommodating the latter, but at the time of writing, no draft pro- (either domestic or foreign) of businesses conducted posals have been issued. It is unknown whether such rules would also apply to 29 through such arrangements. Consequently, there has exchanges of units in MFTs for foreign stock. been little experience respecting the tax effects of for- 31. For a discussion, see Boidman, Nathan, Olivier Delattre, Stephen Edge, Richard Gelski, Jürgen Killius, Jean-Pierre Le Gall, Jerome Libin, Howard eign takeovers of MFTs, and it may be useful to consider Liebman, Guglielmo Maisto and Stef van Weeghel, “Tax Treatment of Target the effects in a comparison to the tax strategies and con- or Merger Party Shareholders Who Take Foreign Acquirers’ or Merger Party Stock”, 38 Tax Notes International, No. 6 (9 May 2005), at 493.

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Considerations for the foreign acquirer of a Canadian dents, with the same tax effect as if they had sold their corporate target from the Canadian tax law standpoint units. (leaving aside that in its own country) pertain to eventu- But for any non-resident unitholders of the target MFT, ally repatriating the investment, achieving basis step-up there would be a Part XIII withholding tax of 25% (on (for example, to unwind “sandwiches”), effectuating effi- the full amount of the gain) unless reduced by a treaty – cient internal financing arrangements and foreseeing and unless non-residents do not own more than 5% of eventual divestitures. The Canadian rules can accom- the MFT.34 If the debt portion of the properties sold in modate, on a tax-efficient basis, several of these factors this type of deal carries a value equal to its face, there is or objectives, such often entailing the establishment of a no gain or loss for any party, but if that is not the case, Canadian acquisition corporation, funding it with new Sec. 132(5.1) should not apply because the debt equity and/or debt and then acquiring the target. should not comprise “taxable Canadian property”. It will be seen that, in some cases, comparable results may be available for foreign acquisitions of MFTs. From 4.2.2. Acquisition of the units of the MFT the standpoint of the investors in an MFT, there is a Would the results differ for either party if the acquisition threshold question even where it is an all-cash deal. In a took the form of acquiring the units of the MFT? The takeover of a publicly-traded corporate group, with rare results should be neutral for its Canadian investors and exceptions, the deal will involve a disposition of the tar- may be superior for the foreign unitholders.35 The com- get’s stock by its shareholders, not a sale of assets.32 This parative results for the foreign acquirer may also be neu- is the discipline of the market and provides selling share- tral. Because the foreign acquirer would pay the full holders with capital gains treatment, which is generally market value for the units of the MFT, it could be superior to any alternative. But the paucity of income unwound on a tax-free basis (provided it is acquired trust takeovers to date means that no generally accepted through a Canadian acquisition corporation (a special approaches have emerged to effectuate them – as purpose vehicle or SPV)). between a sale of the MFT units (which would produce capital gains treatment) or, instead, a sale by the MFT of The liquidating distribution (comprising stock or debt) its assets followed by a distribution of the sale proceeds may give rise to a liquidating trust-level gain, attributa- and then its liquidation (which may not). ble to the acquirer (through a special purpose Canadian acquisition corporation), which is a capital gain in char- 4.2. Takeovers of MFTs operating through own acter and can therefore be offset by outside losses, that is, lower-tier corporations in the units that were acquired from the public.36 The other important question is whether the SPV would take 4.2.1. Acquisition of stock and loans of lower-tier a stepped-up basis in the distributed shares of the lower- corporations tier operating corporation of the target MFT – and if The proposed (Halloween Night) changes may well see a affirmative, whether (in contrast to an acquisition of a significant number of foreign takeovers of Canadian targets in businesses other than real estate which are structured as publicly-traded MFTs that own the equity and debt of one or more lower-tier operating taxable 32. For a rare exception, see the takeover of publicly-traded Telesystems 33 International Wireless Inc. (of Canada) by Vodafone Group PLC (of the UK) Canadian corporations. by way of a roughly USD 3.5 billion cash acquisition of assets (comprising lower-tier wholly-owned foreign subsidiaries of the Canadian target), follow- If cash is the consideration paid by a foreign acquirer ing which the target liquidated and distributed the cash proceeds from the and it establishes a Canadian corporation to purchase sale to all of its shareholders in both Canada and other countries. Regarding the shares and debt of the Canadian operating corpora- the deal, see “Shareholders Information Circular”, dated 18 April 2005. 33. One such cash takeover saw Iron Mount (US) acquire FACS in 2000 by tion from the MFT, the Canadian tax results should be acquiring all of the stock and debt that FACS owned in a lower-tier operating satisfactory for all concerned, except possibly the foreign Canadian corporation (which itself had a US subsidiary). See FACS Records unitholders of the target. This structure should render Storage Income Fund – 22 December 2000 Special Meeting and Information Circular. The purchaser, Iron Mount and Iron Records Management Inc., applicable to the acquirer all of the results where a for- established a special purpose acquisition corporation “Iron Mount Canada eign acquirer purchases a Canadian corporate target. Corporation” to carry out the acquisition pursuant to a purchase agreement (For example, the basis would be established to do a tax- dated 13 November 2000. 34. See note 25, supra. free unwind of any “sandwich” structure that would 35. For Canadian investors, the same net capital gains treatment should result from the target MFT’s Canadian corporation arise; for foreign unitholders who do not exceed the 25% threshold discussed owning a non-Canadian subsidiary.) above, there would be an exclusion from Canadian tax – whereas they would be taxed on an asset sale unless the 5% non-resident ownership threshold is For the MFT and its unit owners, the Canadian flow- not exceeded. 36. This would entail, inter alia, Secs. 104(6), (13) and (21) and rules which through tax treatment as described above should pro- would see the MFT-level capital gain (both the taxable half and the tax-free vide the same Canadian tax treatment as would arise if half) distributed without a reduction in the SPV’s bases in the units and, upon the deal took place at the level of the units of the MFT. In the liquidation of the MFT, an offsetting capital loss. Whether the SPV will take the shares of the Canadian corporation at a stepped-up basis is consid- particular, any capital gain realized by the MFT in dispos- ered below as well as whether there can be a basis step-up in the shares of ing of the stock would flow through and be taxed in the lower-tier subsidiaries. The latter question would be affected adversely if the hands of those of its investors who are Canadian resi- SPV paid for the units with the stock of its foreign parent. These principles could also apply to liquidations of lower-tier trusts or partnerships, provided the distributed property is non-depreciable capital property.

© IBFD BULLETIN FOR INTERNATIONAL TAXATION MAY 2007 187 Articles corporate target) such a step-up could also be achieved That transaction entailed a cash offer by Canadian- if the MFT directly owns more than one lower-tier cor- based parties for a REIT, organized by the Toronto- poration (Canadian or foreign),37 even where the con- based Olympia & York group. That group had initiated a sideration for the acquisition is the acquirer’s stock.38 proposal to sell, for cash, both a publicly-traded operat- The answer to the basic question respecting a step-up in ing real estate corporation (“O&Y Corp.”) and a publicly- basis is clear for the direct subsidiary of the MFT, but for traded REIT (“O&Y REIT”) in which O&Y Corp. owned a second-tier subsidiary, it may not be without doubt, 42% and the public 58%.42 The first offer by the purchas- although there are cogent arguments for an affirmative ing group (led by Canadian-based Brookfield Proper- determination.39 ties), which eventually made the acquisition, was, according to the public documents (i.e. the Shareholder Even if the trust cannot be unwound (which would pre- Information Circular), to the REIT for its properties, clude tax-free basis step-up procedures), the interest with the idea that the REIT would then liquidate and expense on the acquisition debt can be offset against the distribute the cash proceeds to its unitholders. A trans- interest income from the debt owned in the operating action of this type gives rise to taxable income at the corporation if a Canadian acquisition corporation is used. If contrary to the suggestion (above), a step-up in basis is not achieved, provided a Canadian acquisition corporation is used, it and the target lower-tier operat- 37. But there could be Canadian tax reasons why a foreign subsidiary would be owned through a Canadian corporation, in which case an acquisition with ing corporation could be merged after the acquisition so the foreign acquirer’s stock would preclude a tax-free step-up (as explained in as to make effective use of the interest expense on acqui- the next footnote). sition debt as an offset against or reduction in the oper- 38. Under Sec. 88(1) of the Act, there would be no basis step-up in the stock of lower-tier corporations owned by a Canadian parent corporation which is ating profits of the target lower-tier corporation on a go- acquired in a share-for-share deal. forward basis. 39. For example, if there can be a step-up in the basis of the shares (to their fair market value at the time of the takeover) of a foreign operating subsidiary Finally, see the discussion below on whether any of these of a directly-held Canadian subsidiary of the target MFT, distributed to the results will change if the target is subject to the 31 Octo- special purpose Canadian acquisition corporation on the liquidation of both the MFT and the directly-held Canadian subsidiary, that would allow for a ber 2006 proposed changes, as described in 7. But this tax-free unwinding of the structure. This may be quite relevant in the case of question may not arise in the near term given (1) the certain income trust arrangements that have targeted US operating busi- four-year deferral of the proposals for pre-Halloween nesses. The basic step-up in basis rules in Sec. 88(1) of the Act are a minefield of restrictions and traps (exacerbated here by the presence of the MFT Night trusts and (2) the likelihood that the new MFTs between the acquisition corporation and the shares to be stepped up), but an that come to the market will likely be restricted to the analysis of the constituent rules indicates that a step-up may well be capable REITs qualified to be exempt from the new rules.40 of being achieved in such shares of such a second-tier (e.g. foreign) subsidiary. It may assist in the analysis if steps are taken to acquire, at the time of acquir- ing the units of the MFT, legal control of the MFT. It seems that (whether or 4.3. Takeovers of MFTs not involving lower-tier not such latter steps can be incorporated into the acquisition structure) there corporations is no rule that would automatically deny a step-up in the basis. The relevant rules to be considered (revolving around the notions of e.g. “ineligible 4.3.1. Overview of basic conflict of the parties’ tax property”, “series of transactions”, “specified person”, “specified shareholder” and “substituted property”) involve, inter alia, Secs. 88(1)(c)(vi), (1)(c.2) interests and (1)(c.3) and (1)(d.2) (for purposes of Sec. 88(1)(d)(ii)) and perhaps also Sec. 256(9) (which deals with an election respecting the time that control of a Some MFTs which a foreign acquirer may wish to pur- target is acquired). chase do not involve (or involve only in part) lower-tier 40. It is possible that a grandfathered pre-Halloween Night trust will be cov- corporate subsidiaries. Instead, they may own (in the ered by the government’s threats examined below respecting undue expansion so that the trust will become subject to the rules before the end of the four- case of real estate operations) assets directly or through year period or that a new REIT will fail to meet all the requirements for an sub-trusts and partnerships. In such transactions, sub- exemption from the new rules. stantial conflicts can arise between the tax-related objec- 41. As noted above, the few deals involving mergers/takeovers of one REIT 41 by another do not, per se, provide guidance with respect to a foreign cash (or tives of the two parties. stock) takeover of a publicly-traded REIT (or other MFT-based arrangement) because the rules governing such mergers/takeovers are particular to them 4.3.2. Perspective of target’s unitholders and are not relevant to a foreign takeover for cash or stock. See Sec. 132.2 of the Act. For detailed discussions of past deals of this type, see Armstrong, Simply put, a cash takeover of an MFT operating directly Neal, “Real Estate Investment Trust Mergers Rely on Section 132.2”, X Corpo- rate Finance (Federated Press), No. 2 (2002), at 942; and Ruby, Stephen S., or through lower-tier trusts or partnerships presents a “Recent Transactions of Interest”, Report of Proceedings of the Fifty-Sixth Tax potential dilemma for the unitholders of the MFT – Conference, supra note 17, at 4:1. For an excellent discussion of the issues that whether the acquirer is Canadian or foreign. The issue is arise in such Sec. 132.2 mergers by reason of non-resident ownership of units of the merging REITs, see Ruby, Stephen and Alan Shragie, “Policy Forum: that the acquirer may be willing to pay more for the Hidden Tax Traps in Section 132.2 Mergers – Trusts, REITs, and Other Busi- assets (of the MFT or lower-tier trust or partnership) nesses”, 54 Canadian Tax Journal, No. 2 (2006), at 450. than for the units of the MFT – for the reasons examined 42. O&Y REIT had entered into a joint process on 15 February 2005 with O&Y Properties Corp. to sell both entities. Reflected in a notice of the annual below – but for the unitholder, a sale by the MFT of its meeting (see e.g. National Post, 25 June 2005, at FP3) was a proposal being put assets will likely lead to greater overall tax than a sale of to the unitholders to accept an offer from a consortium led by a subsidiary of the units of the MFT. It is trite to observe that this Brookfield Properties Corp., Canada Pension Plan Investment Board and ARCA Investments, which would purchase all the assets and assume all the becomes a question of bottom-line dollars and the very liabilities of O&Y REIT and subsequently redeem all the outstanding limited dynamic seen in considering a particular 2005 transac- voting units of O&Y REIT for (effectively) CAD 15.50 cash per limited voting tion. unit. At the 7 July 2005 meeting, the O&Y REIT unitholders rejected the takeover offer. But as noted below, a revised offer for units of the REIT was subsequently accepted.

188 BULLETIN FOR INTERNATIONAL TAXATION MAY 2007 © IBFD Articles level of the REIT, which is then flowed through to the cumstances, a Canadian resident trust (with or without unitholders. To the extent the income is a capital gain in an upper-tier Canadian corporate beneficiary) or a non- nature, a Canadian unitholder should realize the same resident trust) in conjunction therewith would provide result as though he had sold the REIT units. However, in the basis to achieve the broad range of objectives out- the O&Y matter, according to the information available, lined above. The objectives could be achieved whether a portion of the income (roughly CAD 2.60/unit out of the assets acquired are commercial real estate (in a REIT an offer price of CAD 15.50/unit) would have com- situation), resource property (in a royalty trust situa- prised a recapture of depreciation and thus ordinary tion), or a broad range of assets comprised of a business income. Such income, in the hands of Canadian in other sectors (in an income fund/trust situation, unitholders on a flow-through basis, gives rise to a including perhaps shares of foreign operating sub- higher amount of tax than if the entire proceeds had sidiaries which, likely for basic Canadian tax-planning taken the form of a capital gain. This offer was rejected. purposes, would be owned by the MFT through a Cana- dian holding company). In such an (asset) transaction, the results for the non- resident unitholders of a target REIT, under the 13 May Where, instead, an all-cash takeover of such an MFT 2005 amendments, would be exposure to Canadian tax, takes the form of an offer for units, although both the namely, the Part XIII (Sec. 212(1)(c)) 25% withholding Canadian and non-resident unitholders would achieve tax on all items of income, whether capital gain or recap- optional treatment (as above), the position of a foreign tured depreciation (subject to treaty reduction) or, if not acquirer, emerging as the 100% owner of the MFT which more than 5% of the units are owned by non-residents, directly or through sub-trusts or partnerships owns to the Part XIII tax on the recapture portion and the new depreciable property or inventory or intangibles, aside Part XIII.2 tax on the capital gain portion. In any situa- from any non-depreciable capital property, would in tion similar to the O&Y case, if either the offer is for the principle be less advantageous. The principal issue is REIT units or a non-resident sells his units on the mar- that, regardless of how the acquisition of the target units ket before the takeover is effectuated, there would be no is structured (with or without Canadian SPVs, see Canadian tax on the non-resident (assuming the non- above), a tax-free step-up in the cost base of the underly- resident does not exceed the 25% ownership level ing depreciable property, inventory or intangibles would referred to above). not be achieved. This either reduces the write-offs for Canadian tax purposes going forward or raises the spec- What if the target’s business involves other types of tre of a taxable gain on any disposition or divestiture of appreciated property, such as inventory or intangibles such assets. If the MFT (which ordinarily would lose that (including commercial goodwill), which, if purchased status with certain potential negative effects, see below) from an MFT (or lower-tier (sub-)trust or partnership), is not liquidated, the carryover of basis in such assets gives rise to items of income other than capital gains? cannot be changed by any post-acquisition reorganiza- For Canadian unitholders, the results, depending on the tional strategy. If the MFT is liquidated instead, that particular facts, would likely, at best, be comparable to a would immediately trigger ordinary items of income sale of the units and, at worst, inferior in comparison (measured by the excess of the fair value of the relevant thereto. For non-resident unitholders, it is likely that the assets over the tax basis before the transaction) which results would be inferior to a takeover effectuated by an cannot (as in the case of liquidating an MFT owning acquisition of the MFT units from their holders. only non-depreciable property, see above) be offset by Instead of offering the assets of the REIT, if the offer is capital losses arising from the acquirer’s basis in the for the units of the REIT, the selling investors would acquired units of the MFT. If, however, the MFT is realize straight capital gains, and non-residents whose acquired through an SPV in the form of a Canadian cor- interest is less than 25% would be exempt from Cana- poration (or a combination of that and a lower-tier dian tax. This is exactly what happened in the O&Y mat- Canadian resident trust), the income from the contin- ter: when the consortium led by Brookfield Properties ued operations of the MFT target could be offset by the revised its offer to one for units, the offer was accepted interest payments on the acquisition debt (including the and the transaction consummated.43 Since the 2005 portion of the acquirer’s acquisition price which is inter- O&Y matter, there have in fact been a few accepted all- nally structured to be loans to the Canadian SPV).44 As cash offers for real estate MFTs apparently operating well, the spectre of the special Part XII.2 tax (see foot- without lower-tier corporations – the offers being for note 16) would make it inadvisable for the MFT units to the MFT units. That simplifies the tax position of the be acquired directly unless liquidation of the MFT is in target (and, in particular, its unitholders), but raises order, having regard to the comments above. Instead, to potential inefficiencies for the acquirer. This is discussed next.

4.3.3. Perspective of acquirer – asset deals 43. See news release of 26 August 2005, “Brookfield Consortium Announces New Agreement to Acquire O&Y REIT and a Revised Agreement to Acquire If a foreign acquirer could successfully structure an asset O&Y Properties”. That agreement was subsequently approved by the investors. acquisition (like the initial, rejected, O&Y REIT offer), 44. Unexpected and clearly unintended issues could arise, however, if loans the use of an SPV (Canadian-formed acquisition corpo- are made to an SPV that is a Canadian resident trust, as a result of certain rules ration or perhaps, depending on all the facts and cir- respecting loans to shareholders under Sec. 15(2) of the Act.

© IBFD BULLETIN FOR INTERNATIONAL TAXATION MAY 2007 189 Articles avoid that tax, the acquisition structure would ordinarily would defer gain until such time as they cause an include a Canadian corporation, a Canadian resident exchange of the shares for shares of the foreign acquirer. trust or both a Canadian corporation and resident trust. If, however, the deal is at the level of the trust, with it tak- ing the exchangeable shares as consideration for the The loss of MFT status (and becoming an ordinary non- transfer of its assets (whether the shares of an operating personal (commercial) trust) would normally follow corporation, partnership interests or directly-held unless steps were taken to maintain the minimum num- assets), the rollover (and deferral) that would operate at ber of unitholders – at least 150, with at least 100 units the level of the MFT would be lost upon a redistribution of worth CAD 500. Such a transaction would not per se the exchangeable shares to its own unitholders.47 trigger a deemed disposition by the MFT of its prop- erty.45 The go-forward (i.e. ongoing) Canadian tax treatment of Canadian unitholders that take the foreign acquirer’s The converse of the foregoing is that if the foreign stock directly (not through exchangeables) could be par- acquirer acquired the units directly (without an SPV and ticularly disadvantageous.48 The main issue is the spec- assuming no liquidation), no basis step-up would be tre of increased overall taxation of an investor’s interest available and, in addition: (1) there would be no poten- in the profits of the overall enterprise (particularly the tial to offset the interest on the acquisition debt against portion of distributions stemming from operating the the income realized from the arrangement, and (2) the Canadian target).49 That concern would be ameliorated trust income would be subject to both Part XIII tax if an exchangeable share deal is used.50 (under Sec. 212(1)(c), as described above with respect to MFT distributions) and to the special 36% tax under Part XII.2 (see footnote 16), a rule that does not apply to income derived and distributed by MFTs. 45. Although a 100% takeover of an MFT would see loss of that status, it would remain a unit trust and, as a result, the 21-year deemed disposition rule The discussion above (see footnote 39 and the related would continue to be inapplicable. If a Canadian acquisition corporation (or Canadian trust) is used, the taxes under Parts XII.2, XIII and XIII.2 would not text respecting basis step-ups) is, in part, applicable here. arise. Whether or not it remains an MFT, the foreign-owned special purpose A Canadian acquisition corporation’s stepped-up cost Canadian acquirer would be able to offset the interest paid on internal or base in shares of Canadian subsidiaries or interests in external borrowings to acquire the units against the income that would remain distributable to it by the trust. partnerships may (subject to the lack of certainty dis- 46. For a discussion, see e.g. Boidman, Nathan, Richard Gelski, Jean-Pierre cussed above) be turned into a stepped-up cost base in Le Gall, Howard Liebman, Guglielmo Maisto, Michael Mollerus, Lewis Stein- any non-depreciable Canadian property that the latter berg, Edward Troup and Stef van Weeghel, “Can Stockholders Avoid Target Country Tax on a Cross-Border Share-for-Share Acquisition or Merger?”, 34 have by, in turn, liquidating them under Sec. 88(1) or Tax Notes International, No. 10 (7 June 2004), at 1015. 98(5) of the Act. But for the property held directly by the 47. That disposition would be taxable, thereby rendering ineffective the MFT (or sub-trust) which is other than non-depreciable objective of delivering rollover treatment to the target and its unitholders. Only if the MFT remains in existence (holding the exchangeable shares) capital property – so that the character of the deemed would the deferral be effective. Whether this would make any sense as a busi- disposition income is ordinary (in whole or in part) – ness matter is open to conjecture since this type of deal simply has not yet the integration breaks down because the capital loss sus- been seen. 48. Historically, Canadian tax-exempts, although not requiring rollover, tra- tained by the Canadian corporation in respect of the ditionally preferred to take exchangeables rather than stock directly from the MFT units (as described above) does not offset such foreign acquirer because of the limitations on the portion of a pension fund’s flowed-through ordinary income. assets that could be invested outside Canada, i.e. in “foreign property”. The limitations were abolished in 2005 (see Bill C-43, assented to on 25 June 2005). Now Canadian tax-exempts should have no particular reason for, or 4.4. Additional considerations if the acquirer pays advantage in, requiring or taking exchangeables rather than the stock of the with its stock foreign acquirer itself, at least with respect to the direct or immediate effects of the acquisition. The 23 March 2004 Federal Budget intended to limit What are the results if a foreign acquirer wishes to pay investment by pension funds in MFTs to no more than 1% of the book value of the pension fund’s assets with a penalty of 1% applicable to the excess. It was stock for an MFT? also proposed that investment by pension funds be limited to 5% of any par- ticular income fund, again subject to a 1% penalty on the excess. On 18 May 4.4.1. For the trust and its unitholders 2004, the Department of Finance announced that these proposals were sus- pended pending further study. In the 23 February 2005 Federal Budget, the For the target and its unitholders, a straight exchange for Minister reiterated the position that the Department is studying the matter. 49. The extent of inefficiency would be governed by the interrelated effects the acquirer’s stock by either the unitholders or the MFT of three factors. First, there could be Canadian entity-level tax and/or with- would attract the exact same treatment and considera- holding tax on the distributions. Second, the foreign acquirer’s country might tions as just discussed with respect to cash takeovers. levy a corporate-level tax on the realization and/or distribution of the MFT’s profits or a withholding tax on dividend payments stemming therefrom. That means immediate taxation for the target and/or its Third, what measure of tax credit or tax deduction relief would be available in owners. However, it may be possible to defer taxation by Canada for such taxes? These questions could be addressed only in the con- utilizing “exchangeable share” arrangements of the type text of the particular facts and circumstances, including the precise way in which the acquirer structured the takeover and the tax laws in its home coun- that has been developed where the target is a Canadian try. Concerns can also arise with respect to the tax results of a future divesti- corporation. A special purpose Canadian acquisition ture of the stock, the go-forward issues concerning the foreign-income attri- corporation is established, and it would, inter alia, issue bution rules or reporting of foreign investment, or the go-forward issues for individuals concerning taxes at death. For a discussion, see Boidman et al., special preferred (exchangeable) shares to unitholders in supra note 31. exchange for their units in the MFT, carried out pur- 50. But under the proposed amendments, now before Parliament, to the suant to the elective rollover rules in Sec. 85(1) of the Sec. 94.1 offshore fund rules respecting portfolio-type investment in foreign 46 offshore funds (to be known as the “Foreign Investment Entity” Rules), the Act. The unitholders taking the exchangeable shares notional or actual income or mark-to-market inclusions could apply not only

190 BULLETIN FOR INTERNATIONAL TAXATION MAY 2007 © IBFD Articles

4.4.2. For the foreign acquirer voices in the investment community that harboured concerns that the trust model was distorting business When a foreign acquirer’s stock is offered without an and investment activities and decisions because the exchangeable share option, the results for the foreign allure of tax benefits, by maximizing profit distribution, acquirer would, in general, be those discussed above for often clashes with and overrides the need to retain prof- cash takeovers. This could include the anomalous result its for research and development, expansion, etc., which that a basis step-up is available in directly-held corpo- retention generally arises from operations structured rate subsidiaries which does not arise in a conventional through publicly-traded taxable corporations.57 taxable corporate takeover for stock. However, a step-up would not be available with respect to the stock of a sec- The consultation paper contained but a brief reference ond-tier corporation (as explained above), i.e. a sub- as to what the government may have had in mind: sidiary of an MFT-owned corporation. The focus of this paper is to assess the tax and economic effi- When an exchangeable share option is also offered for ciency implications of FTEs to determine if the current tax sys- tem is appropriate or should be modified. If it is determined that the acquisition of an MFT’s property (whether lower- the tax system needs to be modified, the question arises as to the tier corporations or direct assets), it would be possible to potential policy approaches. This section lists some policy marry external and internal debt financing with opera- approaches that are relevant to the issues identified in this paper. tions going forward, but in principle no step-ups in the Although not an exhaustive list, policy approaches that derive underlying basis of any property acquired would be from the discussion of issues in this paper include: limiting the deduction of interest expenses by operating entities, taxing available. But this is no different than the results for an exchangeable share acquisition of a regular taxable cor- porate target. This is because, at the extreme, whether the acquisition is at the level of the units or the trust’s assets, to interests in straight offshore mutual funds or hedge funds, but also (some- the Sec. 85(1) rollover would carry over the historical what incredulously) to directly-held stock, or rights therein through cost base to the SPV in the units or assets acquired, exchangeables, in foreign, high-tax country-based industrial or commercial thereby eliminating the grounds for a step-up (or at least corporations. 51. Significantly, except perhaps in Ontario, such a tax is not applicable to a full step-up). trusts. 52. Some of these issues are discussed in detail in Armstrong, supra note 41. Finally, from the foreign acquirer’s standpoint, 53. Department of Finance News Release, 8 September 2005, No. 2005-055: exchangeable share arrangements limit (or defer imple- “Department of Finance Launches Consultations on Issues Related to Pub- mentation of) structuring strategies with respect to licly Listed Flow-Through Entities (Income Trusts and Limited Partnerships)” and the accompanying consultation paper, “Tax and Other Issues Related to group financing arrangements and investment and/or Publicly Listed Flow-Through Entities (Income Trusts and Limited Partner- profit repatriation. ships)”; and Department of Finance News Release, 19 September 2005, No. 2005-059: “Government Postpones Advance Rulings on Income Trusts and Other Flow-Through Entities: Emphasizes Importance of Consultations”. 4.5. Other types of taxes that might arise See Watkins, Donald H. and Sasha N. Nowicki, “Canada Issues Paper on Flow-Through Entities”, 39 Tax Notes International, No. 12 (19 September Aside from the income tax considerations discussed 2005), at 1059; and Scales, Sirena J., “Advance Rulings for Trusts Put on above, a takeover could give rise to certain other types of Hold”, 39 Tax Notes International, No. 13 (26 September 2005), at 1148. See Canadian taxes, including taxes on capital levied by also Boidman, Nathan, “Canadian Trust Controversies: Implications for For- 51 eign Investors or Acquirers”, 40 Tax Notes International, No. 4 (24 October some of the provinces, transfer taxes applicable to 2005), at 375. transfers of real property or resource property, and 54. The first, on 8 September 2005, entailed a consultative process intended Canada’s goods and services tax (GST) and the provin- to result in a specific tax policy respecting flow-through entities going for- ward which may or may not change the current applicable framework. The cial counterparts, akin to the European VAT in some second, on 19 September 2005, announced a moratorium on the issuance of 52 respects. rulings being sought for certain new or revised deals. That related to the rela- tively narrow situation where an existing trust (or perhaps one being formed) 5. The September 2005 Aborted Attack on MFTs sought to utilize certain specific rules in the Act to emerge with a trust arrangement that did not have a subsidiary operating corporation in order to achieve maximum flow-through of the underlying business profits. See Continuation of the trust phenomenon, as described note 20, supra (respecting Davis + Henderson). But most deals establishing above, was put into question by the September 2005 MFTs did not require rulings. announcements of the Canadian government,53 which 55. The consultation paper referred to CAD 300 million of lost revenue for 2004. As pointed out in Watkins and Nowicki (supra note 53, at 1061), the raised the spectre of adverse changes to the taxation of government’s paper itself put into question the CAD 300 million estimate, cit- 54 MFTs. How could these two announcements impact ing sources that indicated it may be higher or lower; in particular, see foot- on foreign investors in Canadian-based businesses car- notes 2 and 3 in Watkins and Norwicki (which reproduced footnotes 25 and 26 in the government’s paper). Such estimates may not reflect the offset- ried on through publicly-traded flow-through entities ting tax revenue that may be generated by taxes on gains derived by investors or on the overall Canadian tax considerations respecting from selling interests in trusts at market valuations which are driven up by the foreign takeovers of such businesses? trust format. 56. See Boidman, supra note 19, footnote 58 and related text. See also The September 2005 consultation paper expressed con- note 48, supra. 55 57. The consultation paper (at 17, Sec. 6) discussed “Economic Efficiency cern about the erosion of the tax revenue base. That Issues Related To FTEs” and noted that, in assessing the impact on the econ- concern had also underlain the announcement in the omy of the turn to carrying on business as publicly-traded trusts, “arguments March 2004 Federal Budget that pension funds would be have been made on both sides of this issue”; that is, “... some have argued that the tax treatment of FTEs leads to greater economic efficiency – at least for limited in the amount they could invest in publicly- certain types of businesses – while others have argued that this tax treatment traded trusts – an initiative that was then deferred for distorts investments and decisions which relate to reduced economic effi- further consultation and study.56 The paper also echoed ciency”.

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FTEs in a manner similar to a corporation, or better integrating It was the second approach (taxing the trust in a manner 58 the personal and corporate income tax system .... similar to a corporation) which could well, at least in In the international context, the consultation paper concept, affect the structuring strategies of acquiring reached out, in developing its initial commentary, to the publicly-traded trusts. But the range of possible specific experience with flow-through vehicles in other coun- rules and effects made it difficult to foresee how acquisi- tries and discussed Australia, the United Kingdom and tions would be affected. the United States. The paper concluded that, in the coun- tries it examined, either no publicly-traded FTEs are uti- 6. Interim Government Decision, 23 November lized to conduct domestic business or, where they 2005 – The Shoe Does not Drop appear, they are restricted to investment in real estate or The controversies spawned by the September 2005 to certain other passive or niche situations (e.g. in Aus- announcements, swirling around Canadian businesses 59 tralia, to venture capital). carried on through publicly-traded trusts, and the impli- What changes could arise for foreign investors as a result cations of the controversies for foreign investors in, or of the consultation process? The first approach (“limit- acquirers of, such trusts63 were, at least temporarily, put ing the deduction of interest expenses by operating enti- to rest on 23 November 2005. But then there was the ties”) would not, per se, affect trusts that operate without question whether they would erupt again in the near lower-tier corporations. For that format, any such term, having regard to the then concomitant demise of change in the law would not affect the present structure the minority Liberal government and the forthcoming and results of the trust or any of its beneficiaries, resi- January 2006 general election. dent or non-resident. In the case of trusts operating On 23 November 2005, six weeks before the initially through lower-tier corporations, the effect for all announced deadline (31 December 2005) for consulta- investors would (in the relevant factual situations) be tions and submissions arising out of the 8 September taxation at the corporate level of more profit than at 2005 consultation paper, the government announced a present; for foreign investors, the portion of corporate- decision not to change, in any fashion, the tax rules relat- level profit that could not be extracted by the interest ing to publicly-traded trusts and, instead, chose the third paid to the upper-tier publicly-traded trust would (once option set out above, namely, a plan to reduce the tax distributed effectively as a dividend by the corporation paid by Canadian resident individuals on dividends to the trust and then distributed to the beneficiary) received from Canadian corporations. In other words, attract overall Canadian taxes in the area of about 50% the government decided to try to “level” the playing field (see above), subject to reduction of the withholding tax by not increasing the taxes applicable to businesses car- component if the beneficiary is in a treaty country. ried on in the trust format, but rather reduce those appli- Obviously, such a change would, among other things, be cable to traditional corporate-owned operations. adverse to foreign investors. That choice seemingly stemmed from two factors. One If the change took the form of taxing the trust in a man- was an (obviously) unexpected, politically sensitive, ner similar to a corporation (the second approach), pre- backlash from small investors (particularly those in sumably the results described above for foreign retirement mode) who saw a threat to their financial investors in taxable Canadian corporations would arise, security because of substantial investments in publicly- which is obviously far inferior to the present status. But traded trusts. The second was the then imminent demise would that simply lead to more debt investment than of the minority Liberal government and call for a new equity investment or approaches to combine the two through bifurcated instruments (e.g. income participat- ing securities (IPS) or income deposit securities (IDS) 58. Consultation paper, at 3. Then the paper (at 19) repeated the foregoing 60 and elaborated with the following statement: “Improving the integration of arrangements)? the personal and corporate income tax systems would make the tax system more neutral between all forms of business organizations. These approaches The third approach (“better integrating the personal and may be complex as they would have to take into account a variety of factors, corporate income tax systems”)61 would see trust such as different types of FTEs and the tax status of investors in these entities. They may also be costly in terms of foregone federal tax revenues or have a arrangements left intact, but changes made to improve significant impact on the FTE market.” the overall taxation of those who invest in the businesses 59. See note 6, supra, and related text. of publicly-traded corporations. To that extent, would it 60. The latter could then run up against existing thin capitalization rules simply open up additional possible alternatives for effec- with respect to foreign investors (as described) or beefed-up restrictions on 62 corporate-level interest deductions. But such a dynamic cycle of action and tive foreign investment in Canada? reaction precluded any type of precise prognostication at that time. 61. For think tank and media financial writers who apparently favoured What effects were foreseen for foreign acquirers of pub- dealing with the matter this way, see e.g. Mintz, Jack M., Duanjie Chen, Yvan licly-traded Canadian trusts in light of the possible Guillemette and Finn Poschmann, “The 2005 Tax Competitiveness Report; Unleashing the Canadian Tiger” (C.D. Howe Institute, 2005); and Tait, Carrie, changes suggested in the 2005 consultation paper? In “Assessing the Goodale effect”, National Post, 26 September 2005, at SR1. principle, neither the first nor the third approach (limit- 62. Countries that reduce or eliminate the tax on dividends in specified cir- ing the deduction of interest expenses by operating enti- cumstances include Australia, Chile, Mexico, the United Kingdom, the United States, Argentina and Brazil. See Reports on Subject I: Trends in ties or better integrating the personal and corporate company/shareholder taxation: single or double taxation?, Cahiers de droit fis- income tax systems) would have any conceptual or cal international, Vol. LXXXVLLLa (2003) (57th Congress of the International mechanical relevance to the factors that would arise at Fiscal Association, Sydney, 2003). the point of taking over a publicly-traded trust. 63. See Boidman, supra note 53.

192 BULLETIN FOR INTERNATIONAL TAXATION MAY 2007 © IBFD Articles general election. That, in fact, occurred the following whether or not a treaty applies). These investors will week. Was the outgoing minority Liberal government continue to have a clear preference to participate in seeking to curry favour with those they had disaffected Canadian businesses through publicly-traded trusts with their September action?64 But the true nature and rather than through taxable Canadian corporations. extent of the controversy spawned by the government’s But what was the long-term prognosis? Would the shoe September actions were not evident from the Minister eventually drop? Observers were quick to point to the of Finance’s rather innocuous press release on 23 politically charged circumstances surrounding the gov- November 2005 announcing the policy choice: ernment’s 23 November 2005 decision and announce- The Minister of Finance, Ralph Goodale, today responded to ment, and speculation arose immediately as to whether, concerns regarding income trusts and other flow-through enti- in the fullness of time (particularly if the minority Lib- ties by announcing reduction in personal income taxes on divi- dends, which will help level the playing field between corpora- eral government were re-elected and, particularly, if re- tions and income trusts. elected with a majority), the matter would be revisited and the spectre for more invasive changes, as described “Given the uncertainty surrounding how long the session of Parliament will last, as well as a need for greater certainty and above, could be resurrected. The clear benefit to Cana- stability in the income trust market, there is a clear case for dian tax-exempts and non-residents, just noted, would immediate action. The overwhelming consensus of submissions obviously continue to draw attention, in one fashion or received in our consultation process was to reduce personal another, and it should be borne in mind that, in its income tax on dividends”, said Minister Goodale. “Today’s March 2004 Federal Budget, the government had announcement acts on that consensus and ends the consulta- tion process.” announced an intention (since postponed) to restrict the ... amount of pension fund (e.g. tax-exempt) investment in trusts because of lost tax revenues to the government. “Reducing the tax individuals pay on dividends will encourage savings and investment and will help establish a better balance Those proposals were criticized and withdrawn for fur- between the tax treatment of large corporations and that of ther study, which is ongoing. With respect to foreign income trusts,” said Mr. Goodale. “This action will benefit Cana- investors, there have been at least two headline reports dians and result in bottom-line tax savings for them.”65 of potential “hits”, one by the province of Alberta and one In concept, this was an excellent development for for- a private-sector suggestion of how non-residents who invest in Canadian flow-through trusts should be eign investors who, with respect to publicly-traded trust 69 investments, would continue to enjoy the relatively sig- taxed. As discussed below, less than a year later (31 nificant tax advantages from the Canadian perspective October 2006 – Halloween Night) the shoe dropped. of such investments as opposed to acquiring stock in publicly-traded business corporations. For foreign 7. The Shoe Drops – 31 October 2006 acquirers of Canadian businesses conducted through It appears that the era of the publicly-traded Canadian publicly-traded trusts, the various possible strategic trust phenomenon is coming to an end. The continuing structuring opportunities and facilities, discussed above, would remain intact. The move to reduce the tax on div- idends paid by Canadian individuals would have no 64. For an example of the controversy, see Tait, Carrie, “Trusts Lose $9 B direct impact or relevance to foreign investors in pub- After Ottawa Stops Tax Rulings”, National Post, 27 September 2005, at FP1; and Willis, Andrew, Eric Reguly, Sinclair Stewart and Grant Robertson, “Ottawa’s licly-traded Canadian corporations. They will continue move on income trusts throws sector into disarray”, Globe & Mail, 28 Septem- to be subject to a 25% withholding tax (subject to treaty ber 2005, at B-1. reduction, generally to 15%66) on dividends from Cana- 65. See Department of Finance Release, 24 November 2005, No. 2005-082, “Minister of Finance Acts on Income Trust Issue”. The specific proposals to dian corporations. implement and the related provincial government reactions are discussed in the next section. See Boidman, Nathan, “Canadian Trust Controversies: The objective of these changes to dividend tax treatment Update for Foreign Investors or Acquirers”, 39 Tax Notes International, No. 6 for Canadian resident individuals was to eliminate the (26 December 2005), at 1175. double tax element explained above (see 1.) and produce 66. The treaty rate for parent-subsidiary dividends is generally, but not in all cases, 5%. an overall aggregate corporate and individual-level 67. As explained in 2.1., an individual resident in e.g. Ontario would effective rate of tax on the pre-tax profit of the distribut- pay 46% on the income distributed, without entity-level tax, by a publicly- ing corporation equal to the rate the individual would traded trust, but would pay an overall rate of about 56% on the profits earned and then distributed by a corporation in Ontario. pay on the direct receipt of income, such as in the case of 68. This change, requiring coordinating legislation by the provinces, has flow-through of income by a publicly-traded trust.67 been largely enacted. Bill C-28, Budget Implementation Act, 2006, No. 2, That would level the playing field as between trusts and which contains the federal portion of this change, received Royal Assent on 21 68 February 2007 and is now S.C. 2007, Chap. 2. See Ayayo, Herman P., “Canadian corporations for Canadian resident individuals. Finance Minister Announces Increased Dividend Credit”, 40 Tax Notes Inter- national, No. 10 (5 December 2005), at 858, noting that the 23 November 2005 It was clear, however, that the playing field would not be announcement did not indicate whether the government would resume issu- levelled at all for Canadian tax-exempts (which pay no ing rulings (the moratorium in respect of which had, as detailed in Boidman, tax on distributions by a trust, but would suffer, indi- supra note 53, played a significant role in the controversy surrounding trusts). However, that did occur within days of the 23 November 2005 announce- rectly, the corporate-level tax on a corporate invest- ment. ment) and for non-residents (who incur overall Cana- 69. See Brethour, Patrick and Steven Chase, “Alberta Minister Pushes a Trust dian taxes on their Canadian corporate investments, Tax”, Globe & Mail, 15 October 2005, at B-5; and Ebner, Dave, “Let U.S. Investors Take Trust Tax Hit, Ottawa Urged: Precision Drilling Boss Says having regard to both the corporate-level tax and the That’s Easiest Way To Resolve Canadians’ Concerns”, Globe & Mail, 1 Novem- withholding tax of between 45% and 50%, depending on ber 2005, at B-8.

© IBFD BULLETIN FOR INTERNATIONAL TAXATION MAY 2007 193 Articles differences in the after-tax returns from Canadian cor- 7.2. Detailed draft legislation – 21 December 2006 porations and trusts to Canadian taxable investors, to The details of these proposals were set out in draft legis- Canadian tax-exempts and to non-residents noted lation issued on 21 December 2006.76 At the time of above, accompanied by the Fall 2006 announced inten- writing, controversial reaction to the proposed legisla- tion of Canada’s two largest telecommunications com- tion77 has seen a report, issued on 28 February 2006, by panies (Telus and BellTel) to convert into trusts, the Finance Committee of the House of Commons spawned a sudden and more radical change, marking the (dominated by members of the Opposition78) severely end of the flow-through trust structures as the market criticizing the proposed rules and suggesting very sub- has known them. stantial changes and modifications, including a deferral Specifically, on Halloween 2006, the January 2006 of the regime for existing flow-through entities for at elected minority Conservative government announced that the widely available Canadian tax benefits inherent in the publicly-traded trust structures would be nar- rowed considerably.70 The announcement was surpris- 70. See Department of Finance Release, 31 October 2006, No. 2006-061, “Canada’s New Government Announces Tax Fairness Plan”. ing in light of the government’s election platform not to 71. See e.g. Carrick, Rob, “Income Trust Tax Rebellion Fails to Impress Vot- change the taxation of trusts, but yet an almost ers”, Globe & Mail, 12 December 2006, at B-15, reporting that, since the Hal- inevitable event in light of the underlying factors. It loween Night announcements, “... the S&P/TSX, capped income trust index is down about 9.5%, although it was off as much as 18% at one point”; Berman, caused a massive and substantial adjustment to the mar- David, “Market Carnage: Who Won, Who Lost – Trust Sector Down $19B”, 71 ket values of those trusts. National Post, 2 November 2006, at FP1; MacDonald, Don, “Treasure Hunters Mind the Trust Bust – Sector Has Lost 16% in Two Days”, Montreal Gazette, 3 November 2006, at B-1; and Cattaneo, Claudia, “Trusts Demand PM Hear 7.1. The 31 October 2006 announcement Their Side – A $30 Billion Rebuttal”, National Post, 4 November 2006, at FP1, reporting that the fallout from the Halloween Night announcement was a loss Citing precedents in Australia (in the early 1980s) and of “... $30 billion in market value, mostly from the pockets of small investors”. 72 the US (the 1986 Tax Reform Act), the Canadian gov- 72. The prominent role played by the expected tax benefits of trusts to US ernment announced it would remove most of the tax investors in the government’s recent decision and announcement is of inter- est. The release of the Department of Finance stated that, although the benefits of such trusts by taxing their distributed profits November 2005 proposed changes to the taxation of dividends received by as though they had been earned and distributed by a tax- taxable Canadian individuals “... has eliminated much of the impetus for tax- able Canadian corporation.73 Under the new rules, only able Canadian residents to prefer FTE [flow-through entity] investments ...”, this was not the case for non-residents. A table in the release (at 4) indicated “... existing and qualifying newly created REITs will escape that non-residents (represented here by a taxable United States investor) and the change. Other publicly-traded trusts (and partner- tax exempt entities can obtain a sizable tax advantage if they invest in an FTE ships) will be classified as a “specified investment flow- rather than a corporation”. The table showed that a taxable US investor pays only 15% on the pre-tax profits earned through a publicly-traded trust. (More through” entity (SIFT), and their income will be taxed in on this below.) This focus on US investors was also reflected in Table 2, deal- the manner just noted. ing with the effects of the proposal, in terms of its effects on “taxable U.S. investors”. (The same theme is reflected in Table 5.) A further “U.S. theme” Existing publicly-traded trusts (i.e. those whose units were appeared in the decision to exempt real estate trusts under “... conditions that listed on a stock exchange on 31 October 2006) will be the United States applies to U.S. real estate investment trusts ...”. Department of Finance Release, supra note 70, at 10-11. given an exemption up to four years from the effective date 73. This will not entail specifically deeming a trust to be a corporation. of the new rules. Until then, the current rules may con- 74. Indeed, and obviously most frustrating, headline stories in the Canadian tinue to apply, provided there is not an “undue expan- media the next day reported the fate of an organization called Extendicare that was ready to list its units, on conversion from a taxable corporation, on sion” in the business (see below). Since one impetus for the very next day, 1 November 2006. Unless the government retreats, that deal this sudden move was to block two of Canada’s largest has been struck down and will be subject to the new rules starting in 2007 companies from converting into trusts, no grandfather- with no transitional relief whatever. See Marr, Garry, “Extendicare Yanks Con- 74 version in 11th Hour”, National Post, 2 November 2006, at FP1. ing of any deals in process is expected. 75. In a case of publicly-traded partnerships (of which there are few), because partnerships are not, per se, taxpayers under the Act, a special new The mechanics will not entail a statutory deeming or part of the statute (Part IX.1) will effectively tax them on the same basis and as treatment of such entities as corporations, but rather though they were separate taxpayers which are corporations. But the propos- there will be tax rules respecting their income which als are not totally clear. It seems that, under proposed Sec. 96(1.11), the SIFT income of a partnership (less the SIFT tax payable by the partnership) is have that effect. In the case of trusts, this will be achieved deemed to be a dividend received by the partnership from a taxable Canadian by disallowing, as a deduction from the income other- corporation and the deemed dividend is then allocable to the partners. To that wise taxable in the hands of the trust, amounts that it has extent, a non-resident partner would be required to file a tax return in Canada because the partnership is carrying on business in Canada. But this would be distributed. Instead, the distributed income will be illogical. The drafting defect is that the dividend deemed received by the part- taxed, as between the trust as a separate taxpayer and the nership does not appear to be paid by a corporation resident in Canada; thus, beneficiary with respect to receipt of the distribution, as Part XIII would not appear to be applicable. 76. Department of Finance Release, No. 2006-086, “Canada’s New Govern- though the income were the income of a corporation ment Releases Draft Legislative Proposals to Implement the Distribution Tax and the distribution were a dividend paid by the corpo- on Income Trusts and Partnerships”, in Special Report: Draft Legislation and ration to a shareholder. The intention is that the overall Explanatory Notes Re: Distribution Tax on Income Trusts and Partnerships, 21 December 2006, at v. tax as between the trust and a beneficiary be approxi- 77. Parkinson, David, “Flaherty contradicted by his own department on mately the same as the overall tax on corporate profits as trust tax-leakage methodology”, Globe & Mail Update, 1 February 2007. between the corporation and a shareholder upon receipt 78. Government of Canada – House of Commons, “Taxing Income Trust: Reconcilable or Irreconcilable Differences”, Report of the Standing Committee of an after-tax distribution of those profits as a divi- on Finance (Chair: Brian Pallister, MP), 39th Parliament, 1st Session, February 75 dend. 2007; Chase, Steven, “Income trust tax slammed as ‘devastating’”, Globe & Mail Update, 28 February 2007.

194 BULLETIN FOR INTERNATIONAL TAXATION MAY 2007 © IBFD Articles least ten years as opposed to the proposed four-year altering substance’ of trust decision”, National Post, 31 January 2007, at FP1. But interestingly, opposition may also be coming from the governing party’s grandfather period proposed by the minority Conserva- own members; see Francis, Diane, “All Is Not Well in the Tory Heartland – tive government. The government responded by indicat- Income trust tax leading to talk of ‘spoiler’ candidates”, National Post, 9 ing that it may now make this a point an election issue by March 2007, at FP2. 80. In this respect, see Armstrong, Neal, “No Real Tax Exemption for including the proposals in the 19 March 2006 Federal REITs’,25 Legal Alert (Carswell), No. 11 (February 2007), at 81; Perkins, Tara, 79 Budget and forcing a vote of confidence on the Budget. “REITs Fear Hit From Income Trust Tax – Pressing Ottawa for Clarity on Accordingly, at the time of writing, it is very difficult to Exclusion Due to Potential Limitations on Their Growth”, Globe & Mail, 5 March 2007, at B-1; and Perkins, Tara, “REITs Confident of Trust Tax Exemp- forecast when and in what form the rules for flow- tion – Private Equity Lurking in Case Ottawa Disappoints Property Firms”, through entities will actually be enacted. (The Budget Globe & Mail, 8 March 2007, at B-9. did reaffirm the government’s intention to proceed with 81. The announcement of 15 December 2006, Release 2006-082, “Guidance Provided on ‘Normal Growth’ for Income Trusts and Other Flow-Through the proposal as is.) Entities” reads in part: Following the close of financial markets today, the Department of The draft legislation confirmed that there will be a delay, Finance provided further guidance on “normal growth” in respect of the until 2011, of the application of the new rules to MFTs tax measures announced on October 31, 2006 regarding income trusts whose units or interests were publicly traded on 31 and other flow-through entities .... The deferred application of these measures is, however, conditional on existing SIFTs respecting the pol- October 2006 and that there will be an exemption for icy objectives of the proposals. Materials released with the Minister’s MFTs which restrict their activities to real estate invest- announcement indicated that, for example, the undue expansion of an ment and comply with rather rigid limitations on their existing SIFT might cause the deferral to be rescinded. On the other hand, the continuation of the normal growth of a SIFT would not raise activities – ones which presumably will be liberalized if concerns .... Specifically, the Department will not recommend any 80 this legislation is, in fact, enacted. But on 15 December change to the 2011 date in respect of any SIFT whose equity capital 2006, the government threatened to deny the four-year grows as a result of issuances of new equity, in any of the intervening periods described below, by an amount that does not exceed the greater deferral for existing trusts if they “unduly” expand of $50 million and an objective “safe harbour” described below. The safe (“undue expansion”) their capital base and businesses harbour amount will be measured by reference to a SIFT’s market capi- during the four-year period.81 But no actual relevant talization as of the end of trading on October 31, 2006. Market capital- ization is to be measured in terms of the value of a SIFT’s issued and out- rules for effectuating “undue expansion” were tabled in standing publicly-traded units. For this purpose, it would not include 82 the 21 December 2006 proposals. debt (whether or not that debt carried a conversion right or was itself publicly-traded), options or other interests that were convertible into As noted above, the proposed legislation characterizes a units of the SIFT. For the period from November 1, 2006 to the end of publicly-traded trust or partnership that comes within 2007, a SIFT’s safe harbour will be 40 percent of that October 31, 2006 benchmark. A SIFT’s safe harbour for each of the 2008 through 2010 cal- the purview of the rules as a “specified investment flow- endar years will be 20 percent of that benchmark, together allowing 83 through” entity (SIFT), and in the usual – but unfortu- growth of up to 100 percent over the four-year transition period .... Con- nate – expansive manner of the anti-avoidance legisla- sistent with the objectives of Tax Fairness Plan, the Department of Finance will monitor developments in the market and will take action tion in Canada, the proposals tabled on 21 December accordingly to ensure that this guidance is respected. 2006 may create some very surprising results. For exam- It may be noted that this announcement also confirmed the government’s ple, they may render the new rules applicable to a pri- intention to enact rules, if necessary, to enable MFTs which become SIFTs to convert into corporations without incurring any tax liability. vately-held partnership or trust where the majority 82. For a critique of the 15 December 2006 announcement, see “Submission owner/investor is itself publicly-traded, even if it is a for- of the CIBC-CBA Joint Committee on Taxation, December 15, 2006 Guid- eign party and even if traded in a foreign market.84 A ance on ‘Normal Growth’ for Income Trusts and Other Flow-Through Enti- ties”, 21 February 2007. submission by a committee made up of lawyers and 83. A “SIFT trust” is defined in proposed Sec. 122.1 as a trust which is resi- 85 accountants pointed out these drafting excesses, and dent in Canada, has its interests “listed on a stock exchange or other public hopefully any final legislation will cut down the ambit of market” and owns “one or more non-portfolio properties”. The notion of “other public market” is defined very broadly as including “any trading system or the possible applicability of the new rules to the circum- other organized facility through which securities that have qualified for pub- stances actually contemplated. lic distribution may be exchanged, but does not include a facility that is oper- ated solely to carry out the issuance of a security or its redemption, acquisition or cancellation by its issuer”. Furthermore, the Canada Revenue Agency takes 7.3. Effect on foreign investors in MFTs the view that “securities that are qualified for public distribution” include those that merely have been acquired pursuant to a private placement offering Under current law, as discussed in 3., the effective tax memorandum which has qualified for an exemption from the securities law rate on a non-resident’s share of the pre-tax income of a rules governing the issue of securities. The notion of “non-portfolio property”, publicly-traded Canadian trust may be as low as 15%. In which involves the underlying definitions of “subject entity” and “securities of a subject entity”, is defined in a way that is intended to capture virtually any contrast, a foreign investor’s overall Canadian tax with investment other than pure portfolio investments and even then could apply respect to a share of the pre-tax profit of an operating to the latter if, for example, a trust owns, as to more than 50% of its overall Canadian corporation may be more in the area of at least property, shares of a single issuer no matter how small the interest of that issuer. A qualifying real estate trust will not be a SIFT if it meets the definition 45% (made up of e.g. corporate-level taxes of 35% and a of “real estate investment trust” in proposed Sec. 122.1, but the definition as initially proposed is so restrictive that it might well serve to exclude any nor- mally operated real estate business. 84. This issue arises from the role in the SIFT definition of the separate def- inition of the term “investment” in proposed Sec. 122.1 (which contemplates 79. Vieira, Paul, “‘Inclined’ to include trust tax plan in budget: Flaherty not only a security issued by a relevant trust or partnership, but also one could set stage for federal election fight”, National Post, 1 March 2007, at FP4; issued by another party “... which may reasonably be considered to replicate a Chase, Steven, “Committee calls for trust tax reduction: Report authored by return on, or the value of, the security of the trust or partnership”, as well as to Opposition MPs”, Globe & Mail, 1 March 2007, at B-4 (“Separately yesterday, the proposed definition of “security”). the Harper government suggested it may include the income trust legislation 85. “Submission of the CICA-CBA Joint Committee on Taxation, Decem- in the March 19 budget bill. This would force MPs opposed to the tax to either ber 21, 2006 Draft Legislative Proposals Concerning Specified Investment back the full budget or defeat the entire fiscal plan – and trigger an election”); Flow-Through Trusts and Partnerships”, 31 January 2007. Egan, Louise, “No Means No: Flaherty: Committee Hearings: ‘No intention of

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15% (treaty rate) withholding tax on the distribution of the same tax objectives in a trust takeover as in a corpo- the balance of 65% of the pre-tax corporate profit). rate takeover, particularly in sectors (other than real estate or resources) where the trust arrangement typi- For foreign individual investors who qualify for a treaty cally entailed the trust owning 100% of an operating cor- rate of 15% (the statutory rate is 25%) on trust distribu- poration (“stripping” its income through interest-bear- tions, the SIFT legislation will mean that, rather than ing debt, which would not bear a trust-level tax).91 In real paying Canadian income tax at 15% on the income of estate or resources, where there is typically no underly- Canadian businesses, there will be an entity-level tax ing operating corporation, tension can arise between the (intended to decline by 2011 to about 31.5%86), just as interests of a foreign acquirer and the Canadian trust though the investee were a regular corporation, plus the unitholders (who would at least seek to avoid ordinary (treaty) 15% withholding tax on the distribution, just as income on any recapture). though it were a dividend from a regular taxable Cana- dian corporation. The government illustrated this (in Because REITs will generally be excluded from the new respect of a US individual) in Table 5 of its 31 October rules and no new publicly-traded pass-through entity 2006 release, showing the overall tax for a US investor will be available for energy resource properties, the increasing from CAD 15 per 100 of pre-tax profit to prospects for effective takeovers of grandfathered trusts CAD 41.5 (which is but half a percentage point less than (which would include both energy resource and other the table shows for the overall taxes paid today by a US non-real estate sectors) should entail a continuing com- investor with respect to a share of a regular publicly- bination of these two dynamics. traded Canadian corporation). In other words, “the game For the non-resource sector industries, which typically is over” in terms of the very substantial net tax benefits have involved underlying subsidiaries or corporations, that taxable US individual investors had been able to there should be little friction in achieving the same achieve from Canadian businesses carried on through a results as under current law because the new hit at trusts publicly-traded trust. is relevant only as long as the trust is a publicly-traded The distributed income of a trust will bear both the cor- one. Once it is taken over by a single acquiring party, it porate-like entity-level tax and the secondary withhold- becomes subject to the same rules as existed before the ing tax87 because, under the SIFT proposals, the SIFT is implementation of the new rules, providing the same denied a deduction for its distributions in computing its platform for the strategies and techniques referred to taxable income.88 above. In the energy or mineral resource sector, where there may be significant assets not held in “corporate The SIFT proposals do not appear to change Part XIII.2, solution”, the issues and challenges in structuring effec- which therefore will continue to apply to distributions to tive takeovers may well be greater. But this was already non-residents in respect of a “Canadian property mutual the case under current law. fund investment” that is not otherwise taxable to the non-resident. Given, however, that the non-portfolio Will the proposed SIFT rules either exacerbate the issues earnings distributed by a SIFT trust are taxable as a divi- where assets are not held in corporate solution or limit dend under Part XIII, Part XIII.2 should not apply to the results which may be available under current law? such distributions. Because a SIFT trust will no longer have a basis to make a designation under Sec. 104(21) (since an amount distributed is deemed to be a dividend under the new SIFT rules), there should not be an over- 86. The proposed revisions of Sec. 122 of the Act establish the proposed tax lap with Sec. 132(5.1), which deals with capital gain dis- rate of 31.5% (through a complicated formula that envisages integrating agreements with the provinces). That rate, having regard to the legislative tributions and results in non-residents being subject to plans to reduce the net federal corporate tax rate on profits which are also Part XIII on the full gain (subject to non-residents own- subject to provincial taxes to 18.5% by 2011, contemplates an average 13% ing less than 5% of the MFT). provincial tax rate component. 87. Under proposed Sec. 104(16), the SIFT trust distribution is deemed to be a taxable dividend paid by a taxable Canadian corporation such that the 7.4. Effect on foreign acquisitions of MFTs distribution will be subject to the non-resident withholding under Sec. 212(2), which applies to corporate dividends. This is further highlighted by How will this development affect foreign parties inter- Sec. 104(16)(d), which specifically deems the amount to be paid by a corpora- ested in acquiring publicly-traded trusts? There are two tion resident in Canada for purposes of Part XIII. 88. The taxation of “non-portfolio earnings” of an MFT that is a SIFT, at the dimensions. First, the market value of Canadian busi- level of the MFT, is established by proposed Sec. 104(6)(b)(iv), which serves to nesses carried on through such trusts dropped following limit the amount of trust income which, if distributed, is otherwise deductible the 31 October 2006 announcement, as reflected in the from the income taxable in the hands of the trust under Sec. 104(6); and the targeted income (the “non-portfolio earnings”, as defined in proposed Sec. trading prices of publicly-traded trusts which decreased 122.1) essentially comprises any income of the trust which is not derived from by an average of nearly 20% overnight, notwithstanding either pure portfolio investments or certain limited excepted sources. Under the four-year grandfathered protection.89 There was current and proposed law, if the trust does not distribute its income, it pays tax at rates ranging up to 50% thereon which, in principle, will still make a distri- immediate speculation that this development would bution strategy more favourable than a retention strategy, although the very spawn a host of foreign takeovers. How that actually substantial difference will be significantly reduced and narrowed. plays out, only time will tell.90 89. See note 71, supra. 90. See note 28, supra. The second dimension is the “tax technology”. As 91. But again, see note 39, supra, respecting the potential limitations on a step-up in basis of the stock of a second-tier operating corporation where the detailed above, there is a firm basis to achieve many of acquisition entails the purchase of the units of the trust.

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Clearly, the takeover of a fund before it becomes a SIFT whole taxation year. This means that the foregoing (e.g. until after the four-year grandfather period) will not strategies with respect to foreign acquisitions of MFTs be affected by the SIFT rules. What of a SIFT takeover? that are not SIFTs will have to be modified, at a mini- As noted above, this may be rare, but could arise. mum, by deferring a distribution (in liquidation or oth- erwise) by the target MFT of any of its property (e.g. The status of a SIFT (whether a trust or partnership) can shares of lower-tier operating subsidiaries) until the tax- change from year to year, but once it is a SIFT at any time ation year of the MFT which commences after the takeo - during the taxation year, it is considered a SIFT for the ver.

8. Summary Comments The tax benefits for Canadian taxable and tax-exempt to the four-year deferral for existing MFTs, the tax investors in publicly-traded Canadian business treatment will be comparable to that applicable to a enterprises which provide flow-through tax treatment publicly-traded corporation. have spawned a proliferation of two distinct With respect to takeovers, the overall tax efficiencies approaches to the legal format and structures in from the standpoint of both targets and their which such arrangements are carried out. The first investors and a foreign acquirer may, depending on approach provides total flow-through treatment and, the particular arrangements of the target, be quite where that is not feasible or available, the second similar to that which would arise for the parties (on provides partial flow-through treatment. At the top of both sides) in the case of a takeover of a the enterprise, there is always (except as noted below) conventionally structured taxable Canadian a publicly-traded trust that seeks the particular corporate group. This is particularly so where the benefits of “mutual fund trust” status. The first arrangement involves an MFT that carries on its approach entails situations (often in real estate business through lower-tier corporations, although it investment) where no lower-tier corporation is is not entirely clear that this will be the case in respect required in the structure, with activities being carried of a basis step-up if the MFT has a double-tier lower out by the MFT itself or lower-tier sub-trusts or subsidiary structure and the takeover entails an partnerships. The second, involving lower-tier acquisition of the units of the MFT. But where the corporations (which cannot be avoided), limits the MFT carries on business without any subsidiary extent to which overall flow-through treatment can corporations, the tax effects may be quite different be achieved. As well, a small number of arrangements and may lead to suboptimization and/or inordinate (not focused on above) involving publicly-traded complexity. The analysis shows as well that partnerships or the “IPS” or “IDS” approach (that has “exchangeables”, which have become an important been used to marry Canadian investor appetite for way of providing Canadian shareholders of Canadian flow-through arrangements and US business targets) corporate targets with rollover treatment in a share- has also been seen (see footnote 11). for-share takeover, can also play a role where a foreign Although MFT structures have been designed acquirer of an MFT uses its stock to pay the primarily for Canadian investors, they can provide acquisition price. relatively significant net tax benefits to foreign The implications of the 31 October 2006 proposals investors. Operating or investment income which, if for foreign takeovers of MFTs are threefold. First, as a earned through a publicly-traded taxable pure business matter, there is an expectation (and, in corporation, would attract corporate-level tax rates some circles, concern) that takeovers will proliferate. ranging from 30% to 40% (and secondary dividend Second, the specific tax considerations should not withholding tax) can flow through to non-resident change if the target MFT is not subject to the new investors’ MFTs and be taxed at a maximum rate of rules (e.g. if it is in the four-year deferral period 25%, often reduced to 15% if a treaty applies. If, before 2011). Third, even if it is subject to those rules, however, the capital gains realized by such MFTs flow the only specific effect may be that unwinding the through to their foreign investors, the gains are MFT structure may have to be delayed until the year generally no longer tax free in their hands, although a following that in which the acquisition is sale by such an investor of a less than 25% interest in consummated. an MFT is excluded from Canadian taxation. Finally, at the time of writing, concerted opposition to But the Halloween Night announcements (respecting the government’s proposals make it unclear whether SIFTs), if enacted, mean that (except perhaps with the SIFT legislation will be enacted in its present respect to real estate activities) all such advantageous proposed form, in substantially modified form, or not flow-through tax benefits (for both Canadian and at all. foreign investors) will be terminated. Instead, subject

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