On July 14, 2008, the Minister of Finance released long-awaited draft legislation to amend the Income Tax Act (Canada) and enable the tax-deferred conversion of certain income funds (referred to as Specified Investment Flow-Through entities or SIFTs) as well as real estate investment trusts (REITs) into corporations. The comments made below with regard to SIFTs also apply to REITs, though relatively few REITs are expected to convert.
A tax-deferred conversion to corporate form was promised in the wake of the October 31, 2006 announcement of a special tax applicable to most SIFTs after 2010 — one that would be comparable to the tax borne by corporations in similar circumstances.
Minister Flaherty has been criticized for having taken so long to release these rules. Their absence is said to have hampered many SIFTs' strategic planning.
Those who had hoped for a relatively simple tax-deferral mechanism will be disappointed by the current legislative proposal. It is dense. While the Department of Finance can be largely excused for this as a result of the complexity of the phenomena with which they were dealing, the proposed rules fall short of covering some aspects of expected conversion transactions, and create potentially important distinctions between similar transaction types without apparent justification. Affected taxpayers should proceed with caution. Further amendments are anticipated. Interested parties are invited to make submissions in that regard prior to September 15, 2008.
The conversion rules also raise certain policy issues for continued debate. For example, they provide ample fodder for those who argue that, far from creating a level playing field for SIFTs and corporations, the proposed rules continue to tilt the field in favour of the corporate model. The rules also make the conversion into leveraged corporations more difficult than was expected, indicating a possible policy position that requires examination.
The guts of the proposed rules are two alternative tax-deferred conversion mechanisms.
- A tax-deferred unit for share exchange. SIFT unitholders will be permitted by amendments to Section 85.1 of the Income Tax Act to exchange their units for shares of a taxable Canadian corporation on a tax-deferred basis without going through the cumbersome election procedure required by subsection 85(1).
- A tax-deferred distribution of corporate shares to SIFT unitholders. A SIFT may distribute shares of a taxable Canadian corporate subsidiary to its unitholders on a tax-deferred basis under proposed subsection 107(3.1). The SIFT would restructure its holdings before making this distribution so that this subsidiary owns all of the SIFT’s assets.
Generally, as a result of each type of tax-deferred transaction, SIFT unitholders will dispose of their units without recognizing a gain or loss, and will receive corporate shares that will have the same cost for tax purposes as did the units. Elections are not required to be filed.
To qualify for the deferral, certain conditions must be met. In each case, transactions that would in general lead to the dissolution of the SIFT must be completed within a 60-day period, and before 2013. In the unit-for-share exchange, only a single class of shares may be issued in exchange for the units; only shares may be issued for units that are subject to the deferred exchange, and these shares must have a value equal to the units’ value.
Rules to enable the tax-deferred wind-up of trusts will be added in Sections 88.1 and 107. These, along with existing tax-deferred reorganization rules applicable to partnerships and corporations, will enable the streamlining, to a certain extent, of the corporate structures that will result from using either of the two SIFT termination mechanisms.
The proposed rules cover a variety of ancillary issues, including the following:
- Debt forgiveness. The debt-forgiveness rules in Section 80.01 will be amended to allow for the forgiveness of underwater debt on the winding-up of one trust into another. This will allow most SIFTs that use highly leveraged internal debt, the value of which has fallen below its principal amount, to eliminate that debt without being penalized by the debt-forgiveness rules.
- Employee stock options. The application of the rules in Section 7 governing tax-deferred exchanges of employee stock options will be extended to corporate shares into which SIFT units are converted.
- Acquisitions of corporate control. Where the trustees of a trust that controls a corporation are changed, an acquisition of control may occur. This issue also arises where a corporation’s shares are distributed by one trust to another during the course of a SIFT’s wind-up. Proposed subsection 256(7) will be enacted to ensure that an acquisition of control does not occur in that case.
- Taxable Canadian property. The taxable Canadian property status of SIFT units will carry over to corporate shares.
Typical Conversion Transactions
Two conversion scenarios should suffice to bring the proposed mechanisms into focus.
- Unit-for-share exchange. Assume that a SIFT trust has a number of corporate, partnership and trust subsidiaries, that the SIFT has determined to convert to a corporation that will operate the business formerly operated by the SIFT’s subsidiaries, and that the SIFT’s unitholders wish to convert their units into corporate shares. In this case, the unitholders may transfer their units to a newly created, publicly traded corporation in the course of a plan of arrangement, in exchange for shares of a single class of that corporation. This exchange should be tax-deferred as a result of the amendments to Section 85.1. The SIFT’s partnerships and corporate subsidiaries can generally be wound up on a tax-deferred basis under existing rules. The amendments proposed to Section 88.1 and subsection 107(3.1) should permit the SIFT and certain subsidiary trusts to also be wound up on a tax-deferred basis. Debt between trusts can generally be eliminated during the winding-up without adverse debt-forgiveness implications as a result of amendments to Section 80.01. Existing rules should apply, with similar effect, to other inter-affiliate indebtedness. The corporation would continue to carry on the SIFT’s business, and may pay dividends to shareholders to the extent it determines to do so. This is likely to be the most common form of conversion.
- Share distribution to unitholders. The unitholders may achieve the same result in most respects by causing the SIFT to undertake a plan of arrangement by which its subsidiaries are reorganized under a single operating corporation. The structure beneath the operating corporation could be simplified using the existing reorganization provisions in the Income Tax Act, as well as those now proposed. The corporation’s shares would then be distributed to the SIFT unitholders under proposed subsection 107(3.1), and the SIFT would cease to exist.
Holders of securities in subsidiary corporate or partnership entities that are exchangeable for SIFT units should not be negatively affected by either of the alternative conversion transactions. Depending on the reorganization provisions governing the exchangeable securities, the holders may be able to continue holding their exchangeable securities after the conversion. They can also participate in the unit-for-share exchange transaction by transferring their exchangeable securities to the new corporation on a tax-free basis or receive a pro rata distribution of shares in a share-distribution transaction. The latter alternative may pose a greater challenge from a tax perspective.
While the alternative conversion mechanisms work in a similar fashion, in many cases the differences between them will be important. For example:
- Transfer of tax attributes on winding-up. A winding-up under proposed Section 88.1 will have the effect of transferring certain tax attributes from a SIFT to its corporate parent. This is available after a Section 85.1 unit-for-share exchange, but not in anticipation of a subsection 107(3.1) share distribution. Many resource sector SIFTs with significant resource tax pools will find this issue particularly important. We have been informed by a senior Department of Finance official that the inability to transfer tax attributes in this fashion as a result of the operation of proposed subsection 107(3.1) will be given further consideration.
- Paid-up capital. The proposed rules create a deemed paid-up capital for each trust being wound up (essentially, the amount paid to the SIFT on issuance of units minus distributions of capital). Therefore, where the value of the SIFT units is below their original issue price, care should be taken to ensure the wind-up does not trigger a capital gain. In the corporate context, this issue is usually avoided by reducing the paid-up capital of the subsidiary prior to the wind-up. It is unclear whether a comparable reduction is possible with regard to a trust’s deemed paid-up capital. Furthermore, differences in the paid-up capital of the corporate shares that result from the conversion may be material in some cases. As noted, there is a mandated paid-up capital calculation under Section 85.1 that is based on SIFT capital, whereas under subsection 107(3.1) unitholders get whatever paid-up capital is in the shares distributed on the winding-up.
- Multiple classes of shares. The opportunity to use multiple classes of shares (permitted under subsection 107(3.1) but not Section 85.1) may be important to some taxpayers.
- The 60-day window. The 60-day window during which certain transactions must be completed operates differently in each case, with Section 85.1’s requirements being easier to meet in some cases. This may sometimes be important.
In short, SIFTs will need to carefully read each set of provisions in light of their particular circumstances before deciding which conversion alternative to use.
Policy and Technical Issues
The following issues are potentially problematic:
- Time limit to convert may encourage conversion. The proposed legislation applies generally to transactions occurring after July 14, 2008. Qualifying transactions must meet a variety of conditions and must generally occur by the end of 2012. Since the SIFT tax comes into effect at the beginning of 2011 for most SIFTs, they have a relatively short time to convert on a tax-deferred basis. Afterwards, the difficulty of conversion may relegate them permanently to SIFT status. Prior to the announcement of the conversion rules, most observers believed that SIFTs would generally convert near the end of 2010. The time-limited opportunity for tax-deferred conversion increases that probability, and is consistent with the often-heard comment that Canadian Government policy is to discourage the continued existence of SIFTs. Department of Finance officials have informally confirmed this policy.
- Limited opportunity to convert to a leveraged corporation on unit distribution. Proposed subsection 107(3.1) requires that only corporate shares be issued and distributed to former SIFT unitholders. Were debt obligations of the corporation distributed along with the shares, the corporation could pay tax-deductible interest to its shareholders, thus making it more tax-efficient. The requirement that only shares be distributed for purposes of subsection 107(3.1) raises concerns with regard to how much time must separate a tax-deferred conversion reorganization from a distribution of debt to unitholders or shareholders in order to avoid the application of the general anti-avoidance rule. The policy underlying the prohibition against the distribution of debt is difficult to discern, as is the difference on this point between the apparent operation of proposed subsection 107(3.1) and Section 85.1(7).
- Issues related to leveraged corporations on unit for share exchange. Proposed subsections 85.1(7) and (8) are less clear in their application to debt issued in exchange for SIFT units. Section 85.1 in general only requires a share-for-share exchange for the particular shares that are the subject of the Section 85.1 transaction, and specifically contemplates that non-share consideration may be received in respect of other exchanged shares. Proposed subsections 85.1(7) and (8) are consistent with this approach. For example, subsection 85.1(7) contemplates a "particular disposition" of SIFT units in respect of which only shares must be received (see sub-paragraph 85.1(7)(b)(ii)), and that other exchanges may also occur, as a result of which all of the transferor’s equity in the SIFT is disposed of during the required 60-day period. There is no requirement that all exchanges comply with the rules in Section 85.1. Therefore, prior to the commencement of the 60-day exchange period, it may be possible for a unitholder to exchange a portion of its units for debt of the corporation on a taxable basis or use a Section 85 rollover to exchange units for shares and debt while exchanging the rest of the units for shares using the rollover afforded by proposed subsections 85.1(7) and (8). However, the Technical Notes issued with the proposed rules indicates that in order to take advantage of the tax deferral offered by subsection 85.1(8), a taxpayer is required to "dispose of all of its equity in the SIFT … and receive, as consideration, nothing other than shares … ". This conflicts with the plain reading of subsection 85.1(7) as well as the architecture of Section 85.1 overall, and creates what is hoped to be temporary uncertainty. A senior Department of Finance official advised us that in the interest of levelling the playing field between SIFTs and corporations, further consideration will be given to permitting more latitude for the creation of leveraged corporations during the course of tax-deferred conversions.
- Uncertainty regarding leverage may cause some SIFTs to forego tax-deferred conversion. This would be regrettable, since there is no apparent policy against the creation of leveraged corporations, and in fact Department of Finance officials have indicated that they expect SIFTs to take on more debt after converting to corporate form/status. Rules could be drafted to permit the tax-free creation of corporate debt during the course of a conversion up to the cost amount of a SIFT unitholders’ units, and to subject the creation of additional corporate debt to tax. In addition, when engineering transactions of this kind, taxpayers should bear in mind the Department of Finance’s assertion that any structures that go too far toward in recreating the SIFT’s tax efficiency while avoiding the SIFT tax should expect new legislation to bring them within the SIFT rules. Finance officials have expressed specific concern about "stapled units" — shares and debt obligations that are irrevocably joined and trade as a unit.
- Proposed rules apply to SIFT takeovers. Although the purpose of the rules is stated to be the conversion of SIFTs into corporations, they apply as well to the acquisition of a SIFT by an existing public corporation on a share-for-unit basis. Therefore, one of their side effects may be to facilitate, and hence encourage, the takeover of SIFTs by corporations.
- The proposed rules do not apply to many SIFT subsidiary entities. The trust-winding-up rules that are intended to assist in the tax-deferred streamlining of corporate structures apply only to SIFTs and direct, wholly owned subsidiary trusts. If third-tier trusts exist in a SIFT structure, the rules do not facilitate their elimination. Further, if subsidiary trusts are partly owned by subsidiary partnerships or corporations, the rules likewise do not apply. It is not possible to rectify the situation by, for example, winding up an intermediate partnership. Many SIFT structures have become so complex that they may not be able to use the proposed rules to streamline their organizational structures to the desired extent in conjunction with a conversion transaction. A senior Department of Finance official has advised us that this issue will be given further consideration.
- Acquisition of control. Arguably, the relief provided with regard to potential acquisitions of control that may result from a change in the trustees that own corporate shares does not go far enough. Various other potential acquisitions of control may arise in the course of SIFT conversion transactions, such as the transfer of shares from a SIFT to the corporation into which it will be converted. A senior Department of Finance official has informed us that this issue will be further considered.
- 60-day window issues. Many of the proposed rules provide a 60-day window within which certain transactions must be completed in order to take advantage of the tax-deferred conversion. For example, subsection 107(3.1) requires that the winding-up distribution from a SIFT occur no more than 60 days after the first distribution the SIFT received from another SIFT during the course of its wind-up. This contemplates the kind of serial windings-up or other reorganization steps that will probably be required to streamline many SIFT structures in connection with their conversion to corporate form, and effectively requires that the entire series of transactions be completed within a 60-day period. There are many circumstances in which one issue or another could cause taxpayers to fail to meet this deadline, and there is no safety net. Where each transaction that must be completed within this time period is subject to a plan of arrangement, the terms of the plan can generally be set up to ensure that the required transactions occur on time. Outside a plan of arrangement, on the other hand, asset conveyances may require the agreement of security holders, partners, and other stakeholders. It often takes much more than two months to clear these hurdles. So, corporate wind-ups are deemed to be effective at the time certain resolutions are passed as long as the remainder of the transactions are completed within a reasonable time. This often extends well past one year. It will be onerous if taxpayers are required, prior to a complex restructuring of the type described above, to do the detailed work required to ensure that all of the necessary transactions can be completed within a 60-day span. This will likely cause SIFTs to strongly prefer to use plans of arrangement. In light of the importance of the 60-day deadline to conversion transactions, particular attention will need to be paid to this issue and the Department of Finance should perhaps consider a relieving amendment.
Further Planning Consideration In addition to the issues summarized above, the following may be relevant to some conversion transactions:
- Debt forgiveness. As noted above, the debt-forgiveness rules will be amended to allow for the forgiveness of debt between trusts. This does not apply to underwater debt issued by a corporate subsidiary of a SIFT that must be converted into shares or otherwise eliminated during the course of a conversion transaction. Various means are available to prevent the application of the forgiveness rules in this context.
- Publicly traded debt. A SIFT with outstanding publicly traded debt (including convertible debt) will in most cases wish that debt to be assumed by the continuing corporation. The unit-for-share conversion transaction will generally best facilitate this.
- Unitholder approval. Both the unit-for-share and distribution conversions can be undertaken by way of plan of arrangement, subject to a 66 2/3rds unitholder vote. As noted above, the deemed property conveyances pursuant to such plans may be important to compliance with the 60-day requirement. In most cases, a special resolution will be required pursuant to the SIFT’s trust deed as well. These also generally require a 66 2/3rds unitholder approval.
- Unitholder Loss realization. Unitholder losses will not be generally realized as a result of a conversion transaction. Unitholders may, however, sell into the market prior to a conversion transaction to realize their losses. It may in some cases be feasible to redeem units in exchange for corporate shares in the course of a conversion transaction. This would allow the redeemed unitholders to realize their losses.
Prior to the proposed rules announcement, observers generally believed that most SIFTs would convert to corporate form because trusts and limited partnerships are more awkward and expensive to administer as publicly traded vehicles than are corporations. Further, the trust accounting rules are tightening and in some cases may cause additional disclosure. A conversion may allow these to be avoided.
Most SIFTs were expected to delay conversion for as long as possible to maximize the present value of the SIFT tax advantage, stay in the consolidation game as long as possible, and minimize the learning curve costs and other uncertainties associated with being among the first to convert. However, in some cases current opportunities or challenges make early conversion sensible. For example, sometimes the growth or foreign ownership restrictions on SIFTs impede or prevent important transactions. And in some cases, SIFTs have enough tax pools that the present value of the SIFT tax advantage is relatively small.
The only change effected by the proposed conversion rules in this regard is that the incentive to remain a SIFT has further declined as a result of the time-limited opportunity to convert to a corporation on a tax-deferred basis.
The proposed SIFT conversion rules are a significant step in the right direction. Given the complexity of the issues to be dealt with, it would be unusual for a first draft to cover all of the important issues. Senior officials from the Ministry of Finance are soliciting feedback from the tax practitioner community with regard to the rules. We expect further legislative proposals to be forthcoming.