On July 20, 2011 the Department of Finance (“Finance”) announced proposed changes to the Income Tax Act which would effectively deny tax benefits associated with “stapled securities”. Stapled securities are currently used by certain SIFTs, including real estate investment trusts (REITs), and corporations. Stapled securities that include interest bearing debt provide the flow through tax treatment and efficiency associated with income trusts that were very popular in the past. It is expected that the amendments are driven more to stop a perceived trend rather than adversely affect a relatively small number of funds.

This e-lert is based on the Department of Finance’s announcement. The draft legislation has not been introduced yet, but is expected in the near future.

What are “stapled securities”?

In general terms, Finance states that a “stapled security” involves two separate securities that are “stapled” together such that the securities are not freely transferable independently of each other. The proposed amendments would apply to the stapled securities of an entity that is a trust, corporation or partnership, if

  1. one or more of the stapled securities is listed or traded on a stock exchange or other public market, and
  2. any of the following applies:
    1. the stapled securities are both issued by the entity,
    2. one of the stapled securities is issued by the entity, and the other by a subsidiary of the entity, or
    3. one of the stapled securities is issued by a REIT or the subsidiary of a REIT.  

Interest deduction denied in respect of debt portion of stapled securities

The proposed amendments target such stapled securities, which include debt.  In these cases, interest that is paid or payable on the debt comprising the stapled securities will not be deductible in computing the income of the payer. The amendments do not change the tax treatment to the holders of the debt.

Stapled securities that involve two equity instruments stapled together will not be affected by the amendments.

Deduction denied in respect of certain amounts paid to REIT where REIT’s securities are stapled together with securities of another entity

The proposed changes also relate to situations where a REIT (or a subsidiary of a REIT) issues a security that is “stapled” together with an interest in another entity, such as a trust or a corporation. Typically, the other entity, directly or through its subsidiaries, carries on a business or holds property that the REIT could not carry on or hold directly without losing its status as a REIT. In these cases, the amendments propose that any amount (including, but not limited to rent) that is paid or payable by the other entity (or its subsidiaries) to the REIT (or its subsidiaries, and including “back-to-back” intermediary arrangements) will not be deductible in computing the income of the payer for income tax purposes.

What is the effective date of the proposed amendments?

The proposals would 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 would have a “transition period” if stapled securities of the entity were issued and outstanding on the day immediately before July 20, 2011. If those stapled securities include securities that were also issued and outstanding and stapled securities of the entity on October 31, 2006, the entity’s transition period would be the period that starts on July 20, 2011 and ends on January 1, 2016. Otherwise, the entity’s transition period would be the period that starts on July 20, 2011 and ends on July 20, 2012. Notwithstanding these general rules, an entity’s transition period would end on the earliest day after July 20, 2011 on which either a security of the entity becomes a stapled security of the entity or a stapled security of the entity is materially altered.

If the subsidiary of an entity does not itself otherwise have a transition period, the subsidiary’s transition period would be that of its parent entity, except that the subsidiary’s transition period would end on the earliest day after July 20, 2011 on which either a security of the subsidiary becomes a stapled security of the subsidiary, or the subsidiary ceases to be a subsidiary of the parent entity.

Comments

The impact of the proposed amendments on existing issuers of stapled securities will have to be assessed on a case-by-case basis. In some cases restructuring may be required where possible. There would be increased tax costs for the issuer and this could adversely affect its trading prices. In general, it would be tax inefficient to have an interest deduction denied for the issuer but for the holder to be fully taxable on interest income.

The proposed amendments are based upon securities being "stapled". Undoubtedly, advisors will focus on “de-stapling” securities when structuring a financing in order to avoid the amendments. Until draft legislation is released, it is speculative whether such strategies will be effective.