On July 20, 2011, the Department of Finance Canada (Finance) announced proposed amendments intended to eliminate the tax advantages of stapled security transactions. The Press Release and accompanying Backgrounder can be viewed on Finance’s website. Draft legislation has not yet been released.
PROPOSED AMENDMENTS AFFECTING STAPLED SECURITIES
Stapled security structures began to appear in the market in recent months in response to the SIFT rules. Those rules, which were announced by Finance in 2006 and were fully implemented as of January 1, 2011, were intended to create a level playing field between income trusts and corporations by subjecting income trusts to entity level-tax at rates similar to corporate rates. When it announced the SIFT regime, Finance indicated that it would take corrective action if any structures or transactions emerged to frustrate its policy objectives in enacting the SIFT regime.
Many former income trusts have been restructured into corporate form in response to the SIFT rules. In some of these transactions the issuer has used publicly-traded stapled securities to recapture or replicate some of the pre-SIFT economics of income trusts. Typically such structures involve the use of publicly-traded stapled securities issued by a new corporation. On the reorganization, unitholders receive a stapled security consisting of a common share and a high-yield debt obligation of the corporation in exchange for a trust unit, and entity level taxation is minimized through the payment of deductible interest on the debt to holders of the stapled securities. A bonus of this structure is greater tax efficiency for non-resident investors, as interest payments on the high-yield debt are not subject to Canadian non-resident withholding tax, whereas distributions under the old income trust structure were subject to 25% (reduced to 15% under some treaties) withholding tax. The proposed rules will eliminate the tax advantage of the stapled security in this structure by denying the issuer an interest deduction for interest paid on the stapled high-yield debt.
REITs are exempt from the SIFT rules provided that they satisfy a number of tests related to the character of income earned and the type of property owned. In order to satisfy these tests, some REITs also restructured using stapled securities to move non-qualifying REIT assets and businesses to a taxable corporation or other entity in order to comply with the conditions for the REIT exemption. Under this type of arrangement, the REIT typically leases real property to the corporation or other entity, and REIT units and securities of the other entity are stapled and trade together under a single trading symbol. The proposed rules will eliminate the tax advantage in this structure by denying a tax deduction for the rent (or any related payment) paid by the corporation or other entity to the REIT or a subsidiary of the REIT.
It is not clear from the announcement whether there will be a corresponding reduction of income to the recipient of the payment. If there is not, double tax would result.
With the July 20 News Release, Finance has moved to shut down these types of stapled security transactions. The rules make no attempt to distinguish aggressive from non-aggressive stapled security structures: they will apply to all. Finance’s approach is arguably at odds with favourable CRA rulings issued on some stapled security transactions which dealt with policy concerns by ensuring that reasonable transfer pricing principles are respected and an appropriate level of corporate tax is paid.
For the purposes of the new rules, a stapled security consists of two separate securities that are stapled together such that they are not freely transferable independently of each other. A stapled security that may be unstapled at the option of the investor or the issuer, will, if unstapled, continue to be a stapled security unless the unstapling is permanent and irrevocable.
A security will be a stapled security if the following conditions are met:
- it is a security issued by a trust, corporation or partnership,
- one or more of the stapled securities is listed or traded on a stock exchange or other public market; and
one of the following applies:
- the stapled securities are both issued by the entity;
- one of the stapled securities is issued by the entity, and the other stapled security is issued by a subsidiary of the entity in which the parent holds directly or indirectly more than 10% of its equity value, or
- one of the stapled securities is issued by a REIT or a subsidiary of a REIT.
Finance has confirmed that the new rules are not intended to affect stapling arrangements that involve only shares issued by publicly-traded corporations, the distributions on which are treated as dividends for tax purposes.
The new rules apply to an entity in respect of an amount that is paid or becomes payable on or after July 20, 2011, unless the amount is paid or becomes payable during, and is in respect of, the entity’s transition period. An entity has a transition period only to the extent that it had issued and outstanding stapled securities on July 19, 2011, or it is obligated to issue, and issues, stapled securities in specified circumstances on or after July 20, 2011. Generally, the transition period will end on July 21, 2012. However, the transition period will end on January 1, 2016 for securities that were outstanding and stapled on October 31, 2006. Notwithstanding these general transition period rules, a transition period would immediately end on the date that a stapled security of the entity is materially altered.
OTHER PROPOSED CHANGES TO THE SIFT RULES
The remaining proposed amendments alter existing rules under the SIFT regime.
First, Finance intends to expand the circumstances in which a privately held trust or partnership may qualify as an “excluded subsidiary entity” which is exempt from the SIFT rules. The definition of “excluded subsidiary entity” will be amended to expand the list of permissible interest holders in the entity to include a person or partnership that does not have any security or right in the entity that is (or includes) a right to acquire, directly or indirectly either (i) any security of any entity that is publicly traded or (ii) any property the amount (or fair market value) of which is determined primarily by reference to any security that is publicly traded. This amendment is deemed to come into force on October 31, 2006, subject to an entity electing to have it apply only for taxation years beginning after July 20, 2011.
Second, Finance proposes to amend the SIFT rules to clarify that “non-portfolio property” (NPP) of a corporation has the same meaning as it does in respect of a trust or a partnership. This change is intended to provide greater certainty as to which corporations qualify as “portfolio investment entities”, interests in which are excluded from being NPP.
This change is relevant for the purposes of determining whether an entity holds NPP and is therefore subject to the SIFT rules.
Finally, Finance proposes to change the tax instalment payment obligations of SIFTs from quarterly to monthly payments to mirror the obligations of publicly-traded corporations. This amendment will apply to taxation years of SIFTs beginning after July 20, 2011.