Canada US Tax Practice Tax Management International Journal November 2006
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CANADA-U.S. TAX PRACTICE ARTICLE FOR TAX MANAGEMENT INTERNATIONAL JOURNAL Edited by Nathan Boidman, Esq. Davies Ward Phillips & Vineberg LLP Montreal, Canada and Peter Glicklich, Esq. Davies Ward Phillips & Vineberg LLP New York, N.Y. CANADA TERMINATES FLOW-THROUGH TRUSTS: IMPACT ON U.S. INVESTORS AND OTHER IMPLICATIONS by NATHAN BOIDMAN and PETER GLICKLICH I. OVERVIEW, BACKGROUND AND CONTEXT In last December’s issue of the Journal, this column reviewed the Canadian and U.S. tax aspects of publicly-traded, flow-through business trusts carrying on business in Canada1. Relevance arose from the confluence of two factors. First, U.S. investors frequently acquire interests in publicly-traded Canadian equity securities. Second, the Canadian markets had recently seen explosive growth in those trust structures.2 The proliferation of trusts in Canada3 was widely understood as driven by their greater tax efficiency. This led the Canadian government in the Fall of last year, however, to begin 4 a study on the impact trusts had on Canadian tax revenues and implications for the Canadian economy. Many feared that the study might recommend substantial or even radical changes to the tax treatment of trusts, corporations, or both. Yet, on November 23, 2005, the government first announced that it would not change the tax rules on publicly-traded trusts; instead, it would level the playing field between public corporations and publicly-traded trusts by reducing taxation on corporate dividends (and assuming that a 15% levy would apply to non-resident investors in trusts)5. Those changes reduced the tax differences for taxable investors in Canadian corporations and trusts. 1 Nathan Boidman and Peter Glicklich “U.S. Investment in or Acquisitions of Canadian Publicly-Traded Business Trusts – Cross-Border Tax Considerations”, Tax Management International Journal, Vol. 34, No. 12, December 9, 2005, p. 693. 2 About 10%, (by market cap), of the Toronto Stock Exchange is represented by publicly-traded trusts, which, in general, flow-through income for Canadian tax purposes and avoid entity-level tax. For details see: Nathan Boidman “Cross-Border Investment in and Acquisitions of Public Flow-Through Entities: Canada”, Tax Notes International, Volume 39, No. 6, August 8, 2005, p. 499. See also Boidman, Note 5. This article does not deal with trusts that have been established for Canadian investors who acquire and operate U.S. business and seek, from the tax standpoint, to merge the Canadian flow-through effects of a publicly-traded trust and, from the U.S. tax standpoint, efficient internal debt leveraging of a foreign owned U.S. business, nor with derivative arrangements for such investment, involving a Canadian corporate issuer of “income participating securities” (IPS) or a U.S. corporate issuer of “income deposit securities” (IDS) where investors own debt and equity units of the issuer. 3 Such Canadian publicly-traded trusts are commonly referred to as "REITS" or "royalty trust" (for the two sectors where trusts were first used- energy and real estate) or for other sectors (to which the format has been rapidly extended in the past five to ten years) as "income funds", "income trust", or "business trust". 4 Department of Finance News Release, September 8, 2005, No. 2005-055: SEE December 05 column for details. For a discussion, see Nathan Boidman "Canadian Trust Controversies: Implications for Foreign Investors or Acquirers?” Tax Notes International, October 24, 2005 at page 375, Vol 40, No 4. 5 See Nathan Boidman, “Canadian Trust Controversies: Update for Foreign Investors or Acquirors”, Tax Notes International, Vol. 39, No. 6, December 26, 2005 at page 1175. 2 More recently, continuing differences in the after-tax returns from Canadian corporations and trusts to Canadian taxable investors, to Canadian tax-exempts and to non-residents, accompanied by the recently announced intention of two telecommunications companies (Telus and BellTel) to convert into trusts spawned sudden and more radical change, marking the end of the flow-through trust structures as the market had known them. Specifically, on Halloween 2006, the newly elected minority conservative government announced that the widely available Canadian tax benefits inherent in the publicly-traded trust structures would be narrowed considerably.6 (Details are provided below). The announcement was totally surprising in light of the government’s election platform not to change the taxation of trusts. It caused a massive and substantial adjustment to the market values of those trusts. Of particular interest to U.S. readers may be the prominent role that the expected tax benefits of trusts to U.S. investors played in the government’s recent decision and announcement. The Release stated that, although the proposed November 2005 changes to the taxation of dividends reviewed by Canadian taxable individuals “... has eliminated much of the impetus for taxable Canadian residents to prefer FTE [flow through entity] investments ...” that was not the case for non-residents. At page 4, there is a table that indicates “... that non-residents (represented here by a taxable United States investor) and tax exempt entities can obtain a sizable tax advantage if they invest in an FTE rather than a corporation”. The table shows that a taxable U.S. investor pays only 15% on pre-tax profits earned through a publicly-traded trust. (More on this below.) This focus on U.S. investors is also reflected in Table 2, dealing with the effects of the proposal, in terms of its effects on “taxable U.S. investors”7. A further “U.S. theme” appears in the decision to exempt real estate trusts under “...conditions that the United States applies to U.S. real estate investment trusts ...”. (at page 10-11 of the Release). 6 See “Canada’s New Government Announces Tax Fairness Plan”, Department of Finance release 2006-061, October 31, 2006 7 The same theme is reflected in Table 5. 2 3 This report briefly reviews remaining opportunities for U.S. investors in Canadian publicly- traded, flow-through vehicles under the new rules, and explores some of the implications for M&A activity affecting those trusts.8 II. OPPORTUNITIES FOR U.S. INVESTORS UNDER PRE-EXISTING LAW Typically, a taxable U.S. individual investor who owns eligible for Canada-U.S. treaty benefits9 paid, in general, paid no more than 15% Canadian tax, and no U.S. federal income tax10 on its share of income distributed by Canadian income trust. This is a much lower rate than the rate borne by earnings through a taxable Canadian corporation. On the U.S. side, an investor may well pay no further U.S. tax.11 On the U.S. side, a U.S. citizen or individual resident investor could receive and keep as much as $85 per $100 of pre-tax trust income (net of the Canadian 15% withholding), assuming no other internal Canadian tax. Since a publicly-traded trust would typically be treated as a corporation in the U.S., a typical individual investor would qualify for the 15% maximum U.S. federal income tax rate on qualified dividends, leaving no additional U.S. federal income tax.12 This rate could be as 30 percentage points lower than taxes imposed on a comparable amount of 13 business income earned through a taxable Canadian corporate structure. 8 Partnership format can also provide flow-through treatment under Canadian tax law, but has not generally been utilized in publicly-traded business arrangements. But they are also affected by the proposal. 9 Such trust arrangements are always structured to qualify for “mutual fund trust” (“MFT”) status – under section 132 of the Income Tax Act (Canada), R.S.C. 1985, Chap. 1 (5th supp.), as amended (herein “the Act” or “ITA”) – which, inter alia, provide foreign investors the basis for exemption from Canadian tax upon a sale of an interest in the trust. 10 U.S. State income tax would commonly be exigible. There is no State tax credit for taxes paid to Canada. 11 The 15% tax results from a 25% withholding on the distributed income, under Part XIII of the Act, which is reduced to 15% under Article XXII of the Treaty, and, in general, will apply to the full share of the investor's interest in the earnings from the business where the trust operates without a lower-tier subsidiary or, where it does, on that portion of corporate profit that can be extracted by the trust through internal debt leverage and after-tax dividends. For a detailed explanation of these two different formats, see Boidman, Note 2. 12 The 15% maximum non-corporate federal rate on dividends is currently scheduled to revert to 35% in 2009, but proposals have been made to extend the special rate indefinitely. Note that the 15% rate does not apply to a passive foreign investment company (a "PFIC"), or to U.S. corporate taxpayers. 13 One assumption made here is that the Canadian corporate tax otherwise due by a corporation can be reduced substantially by financing or other techniques used by the trust. 3 4 As gain upon disposition, there is generally no Canadian tax for a non-resident (without regard to treaty) disposing of a (less than 25%) interest in a publicly-traded Canadian corporation or a similar interest in a Canadian income trust. In the U.S., the individual would be on the same tax treatment. If long term capital gain, he or she would be taxable at a 15% maximum U.S. federal income tax rate (though U.S. corporate taxpayers pay up to 35%) .14 What about M&A?15 Where the target is a Canadian corporation and the acquirers from the U.S., there commonly are four tax objectives: (1) tax-free recovery of the investment, (2) basis step-up for various purposes including unwinding “sandwich” structures, (3) merger of external or internal acquisition debt with target’s profits going forward, and (4) establishment of basis for a future exit strategy.