CANADA-U.S. TAX PRACTICE

ARTICLE FOR TAX MANAGEMENT INTERNATIONAL JOURNAL

Edited by Nathan Boidman, Esq. Davies Ward Phillips & Vineberg LLP Montreal, 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 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 (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 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 "" (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 ( 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 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.

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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 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 business income earned through a taxable Canadian corporate structure.13

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 “ 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.

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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. Invariably these require, from the Canadian perspective, both the establishment of a Canadian acquisition corporation and a merger (by liquidation or Canadian corporate statutory “amalgamation”), of the acquisition corporation and the Canadian corporate target. For U.S. tax purposes, consideration would often be given to using an or Nova Scotia unlimited liability company16, or Code Section 338(g) election to obtain a basis step up, and various financing techniques would be used.

Where the target is a Canadian publicly-traded trust that carries on its business through one or more lower-tier corporations, similar acquisition structures would be used. But where the target trust operates through lower-tier trusts and/or partnerships, rather than corporate subsidiaries, there are more obstacles to achieving the same Canadian tax results without compromising the favorable capital gains tax treatment of the target’s typical Canadian unitholders.17

14 The December 05 column (footnote 1) also examined the net benefits for other types of U.S. investments – eg corporations and tax exempts. In Canada, since last year, an allocation to a non-resident beneficiary of a capital gain realized by a mutual fund trust would be subject, in its entirety, to Part XIII withholding tax of 25% subject to reduction of 15% under article XXII of the Treaty. 15 For a discussion of the only completed prior foreign cash takeover of a trust – FACS Records Storage Income Fund in 2000 – see Boidman, Note 1, at pages 509 and 510. 16 These qualify for disregard or flow-through partnership status under Treasury Reg. sections 301.7701-2 et seq. 17 If a trust realizes a capital gain (say from disposition of a piece of real estate), the overall Canadian/U.S. tax results, for U.S. investors, respecting the distributed gain would be the same as with respect to ordinary

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Where the currency for the acquisition is stock of a U.S. or other foreign acquirer, roll-over treatment for Canadian taxable investors of the target may only be also available if the transaction is structured using the relatively cumbersome (but well worn) exchangeable share approach. (Under current law, an offer of exchangeables by a special purpose Canadian acquisition corporation established by a U.S. acquirer might be equally effective where the deal involves an acquisition of trust units, but probably not where it involves an acquisition of assets or property of the trust).18

In summary then, under current law, U.S. investments structured through publicly-traded Canadian business trusts can provide substantially lower overall taxes than through taxable Canadian publicly-traded corporations.

III. THE OCTOBER 31ST ANNOUNCEMENT

Citing precedents in Australia (in the early 80s) and in the U.S. (the 1986 Tax Reform Act), the

Canadian government just announced its intention to remove most of the tax benefits of such

trusts by taxing their profits and distributions as though they had been earned and paid by a taxable Canadian corporation.19 Under the new rules, only existing and newly created REITs

will escape the change. Other publicly-traded trusts (and partnerships) will likely be classified

as a "Specified Investment Flow-Through" (SIFTs), and their income will be taxed in its own

hands as well as in the hands of its owners. Under the rules, however, a heavier tax will be

imposed on SIFT income that is not distributed.

income, with respect to the full amount of the gain realized. More precisely, it is required that the disposing non-resident own less than a 25% interest in any class of stock of the publicly-traded corporation and the stock disposed of be listed on a prescribed stock exchange- and that such threshold be met both at the point of a disposition and during the immediate 5-year period and takes into account interests of not only the seller but, as well, those of certain affiliated parties. See section 248(1) of the Act. 18 See discussion in Boidman, Note 2 In this respect, the public is still awaiting release by the Department of Finance of proposals, promised in October 2000, that would permit a direct exchange of stock of a Canadian corporation for stock of a foreign acquirer. Whether such would apply to the exchange of units of a trust for such foreign stock is actually an open question. 19 It appears that this will not entail specifically deeming of a trust to be a corporation.

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For U.S. individual investors, this will mean that, rather than paying combined Canadian and

U.S. federal income tax at 15% on the income of Canadian business profits, there will be an

entity level tax (in the area of some 34% - declining by 2011 to some 31% just as though the

investee were a regular corporation), plus a withholding tax upon the distribution (generally

15% for a U.S. treaty resident) – just as though it were a from a regular taxable

Canadian corporation20. The government illustrates this in Table 5 of its release – showing the

overall tax for a U.S. investor increasing from $15 per $100 of pre-tax profit to $41.5 (which is

but one-half percentage point less than the table shows for overall taxes paid today by a U.S.

investor with respect to a share of a regular publicly-traded Canadian corporation). In other

words, "the game is over" in terms of the very substantial net tax benefits that taxable U.S.

individual investors had been able to achieve from Canadian businesses carried on through a

publicly-traded trust.

It is important to note that existing publicly-traded trusts are given up to a four-year exemption

from the effective date of the new rules. Until then, the current rules may continue to apply, as long as there is not an "undue expansion" in the business. Since one impetus for this sudden move was to block two of Canada’s two largest companies from converting to trusts, no grandfathering of any deals in process is expected.21

20 Since a trust would still typically be considered a corporation for U.S. tax purposes, interest foreign tax credits could only be available to 10% of U.S. corporate shareholders. 21 Indeed, and obviously most frustrating, headline stories in the Canadian media the next day reported the fate of an organization called Extendicare Inc. which was ready to list its units, on conversion from a taxable corporation, on the very next day, November 1st. It has recently been reported in the press that Extendicare Inc. will proceed with their conversion to a trust even if they are not grandfathered.

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How will this development affect U.S. and other foreign parties interested in acquiring publicly-

traded trusts? There are two dimensions. First, Canadian businesses carried on through such

trusts may become less valuable following the announcement, as reflected in the trading prices

of publicly-traded trusts which decreased by an average of nearly 20% overnight,

notwithstanding the four-year grandfathered protection. There was immediate speculation that

this development would spawn a host of foreign takeovers. How that actually plays out, only

time will tell.

The second dimension is the “tax technology” where, as detailed in the December ‘05 column

(note 1) and summarized above, the interrelated effects of U.S. and Canadian law appear to provide a firm basis to achieve many of the same tax objectives in a trust takeover, as in a corporate takeover, particularly in sectors (other than real estate or resources) where the trust arrangement typically entailed the trust owning 100% of an operating corporation (“stripping” its income through interest-bearing debt, which would not bear a second level tax). In real estate or resources where there is typically not an underlying operating corporation, tension could arise between the interest of a foreign acquiror and the Canadian trust unitholders (who would at least seek to avoid ordinary income on any recapture).

Because REITs will generally be excluded from the new rules and no new publicly-traded pass-

through for energy or resource properties will be available, the prospects for effective takeovers

of grandfathered trusts (which would include both energy resource and other non-real estate

sectors) will entail a combination of these two dynamics.

In the case of non-resource sector industries, which typically have involved underlying

subsidiaries or corporations, there should be little friction in achieving the same results as under

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Once it is taken over by a single acquiring party, it becomes subject to the same rules as existed prior to the implementation of the new rules, providing the same platform for the strategies and techniques referred to above. In the energy or mineral resources sector, where there may be significant assets not held in “corporate solution” the issues, the challenges in structuring effective take-overs may well be greater. This was already known under current law. Whether the new SIFT rules exacerbate the matter will only be knowledgeable after detailed draft legislation is released.

IV. CONCLUSION

Halloween changed the future tax landscape for U.S. investors in Canadian trusts. How quickly trusts assets find their way back to corporate solution remains to be determined. Meanwhile, let's let the fun begin.

NB/PG/vrc

Montreal

November 21, 2006

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