The new rules regarding the taxation of "specified investment flow-through" entities (the "SIFT Rules") originally introduced on October 31, 2006, became law on June 22, 2007.

On December 20, 2007, the Minister of Finance (Canada), announced proposed technical amendments to clarify the SIFT Rules and address some of the concerns raised by tax professionals. The overriding concern of tax professionals was that the scope of the SIFT Rules went well beyond the tax policy objectives described in the original October 31, 2006 Backgrounder. This Tax Bulletin addresses one such situation, being the unintended application of the SIFT Rules to closed-end investment funds which make diversified portfolio investments in energy and real estate securities.

The Department of Finance considered a number of submissions on the issue, and chose to address these concerns by amending the definition "Canadian real, immovable or resource property" to exclude from the definition, shares of taxable Canadian corporations and interests in SIFTs.

The proposed amendments will, as is the case with the existing rules, apply to taxation years that end after 2006 (with a delayed application, generally, to 2011 for trusts and partnerships that were publicly traded on October 31, 2006).

The Minister intends that the actual draft legislation needed to give effect to these announced amendments will be brought forward at the earliest opportunity in 2008.

Background

A SIFT trust is defined to mean a trust, if at any time during the taxation year:

(a) the trust is resident in Canada;

(b) investments in the trust are listed on a stock exchange or other public market; and

(c) the trust holds one or more "non-portfolio properties"

A closed-end investment fund and a non-listed regular mutual fund often overlap in terms of investment strategy and targeted investors. However, the broad application of the cumulative rule in the non-portfolio property definition, as described below, meant that they would have substantially different tax treatment. A regular mutual fund was specifically excluded from the application of the SIFT Rules, because its units were not traded on a "public market". But for this definition, there was no logical reason to differentiate between the two types of investment funds, for the purpose of applying the SIFT Rules.

To qualify as a SIFT trust, the trust must hold one or more non-portfolio properties. The definition of "nonportfolio property" includes three types of properties:

(a) a security of a "subject entity" (a corporation, trust or partnership resident in Canada or a non-resident whose principal source of income is in Canada) where one of two ownership tests is satisfied – either the Fund owns more than 10% of the equity value of the subject entity, or securities of the subject entity (and affiliates) represents more than 50% of the equity value of the Fund;

(b) a "Canadian real, immovable or resource property" if at any time in the taxation year the total fair market value of all such properties held by the Fund is greater than 50% of the equity value of the Fund; e.g. the "cumulative rule"; and

(c) the property a Fund uses in the course of carrying on a business in Canada.

The cumulative rule was particularly challenging because the expansive definition of "Canadian real, immovable or resource property" included direct and indirect interests of any value or ownership percentage in any corporation, partnership or trust which had a significant weighting in real estate, or resource property.

Definition of Canadian Real, Immovable or Resource Property

The definition of "Canadian real, immovable or resource property" includes not only direct, indirect and contingent ownership of such properties, but an investment in an entity which derives its value primarily from a Canadian resource property, or real property situated in Canada. A "Canadian real, immovable or resource property" is defined to include:

(a) a real or immovable property situated in Canada;

(b) a Canadian resource property; 

(c) a timber resource property; and

(d) a share of a corporation, an interest in a trust, or an interest in a partnership, if more than 50% of the fair market value of the share or interest is derived from one or any combination of properties described in (a) to (c) above.

Consequently, a closed-end investment fund which held shares of a corporation, or interests in a trust or partnership whose value was derived from any combination of a real or immovable property situated in Canada, a Canadian resource property, and a timber resource property, would be considered to hold non-portfolio property, if the aggregate value of such investments exceeded 50% of that Fund’s equity value. A closed-end investment fund holding stocks of Canadian corporations, with no link to the income trust market could be caught by the cumulative rule, if those stocks represented investments in Canadian real estate or resource properties.

A closed-end investment fund which had significant weightings in the resource and/or real estate sectors would likely find it impossible to ensure that the value of those investments, did not at any time in the year, exceed more than 50% of the fair market value of its units. The Fund could not control sudden movements in either its unit price or the value of individual positions in its underlying portfolio. Because the cumulative rule did not take into account leverage at the Fund level, a sizeable cushion would be needed to stay onside the cumulative rule, very likely distorting the investment strategy of the Fund.

For a closed-end investment fund that was in existence on October 31, 2006, it would have to manage the issue of its treasury units to stay onside the "normal growth guidelines" of December 15, 2006 in order to avoid the application of the SIFT Rules prior to 2011. This meant limiting any treasury units issued on exchange offerings, or as part of a distribution reinvestment plan, or in the normal course of distributing year-end income to investors. Any minor slip in this regard, would have draconian consequences for the Fund.

The only effective way of ensuring continuous compliance with the SIFT Rules was to abstain from investing in Canadian issuers that have significant weightings in Canadian real estate or resource properties, or using the less tax-efficient mutual fund corporation to implement the investment strategy.

SIFT Relief: Changing the Definition of Canadian Real, Immovable or Resource Property

The Department of Finance considered these issues, and considered submissions that suggested changes to the definition of SIFT trust to exclude a closed-end investment fund, or more targeted changes to the cumulative rule. It appears that they chose the latter approach, as described in Department of Finance News Release 2007-106 and associated Backgrounder.

The proposal is to amend the definition of "Canadian real, immovable or resource property" to exclude shares of taxable Canadian corporations and interests in entities which are themselves a SIFT. As a result, those shares and interests will not be included in applying the cumulative rule to determine if an entity holds non-portfolio property.

It is important to note that the shares and interests may still be non-portfolio property under the concentration rules or the carrying-on-business rule, but that would usually not be a concern for a closed-end investment fund, since its investment guidelines generally prohibit both business type activities, and concentrated investments.

The following is an example from the Backgrounder describing the effect of this proposed amendment:

Example: A publicly-traded trust invests exclusively in shares of resource companies, but it does not hold more than 10% of the fair market value of any of the resource companies, and none of the holdings represents more than 50% of the fair market value of the trust. Nor does it use those holdings in carrying on a business in Canada. Under the new rule none of the trust’s holdings will be considered to be nonportfolio property, and it will not be a SIFT.

Close attention will need to be paid to the draft legislation when it is introduced. Based on the Backgrounder, we would expect to see a specific paragraph added to the definition of “Canadian real, immovable or resource property” which excludes an interest in a SIFT trust or a SIFT partnership and shares of a taxable Canadian corporation for the restricted purpose of applying the cumulative rule to a potential SIFT trust.

Other Proposals Effecting Closed-End Investment Funds

The definition of non-portfolio property will be amended to exclude a concentrated investment in a "portfolio investment entity". This will be defined as an entity which holds no non-portfolio properties. It is expected that this change will provide relief for fund-on-fund structures.

The following is an example from the Backgrounder describing the effect of this proposed amendment:

Example: A publicly-traded trust holds as its only property a significant (more than 10%) interest in another trust. The other trust holds no non-portfolio properties. Under the current rule, the publicly-traded trust’s investment in the other trust is a non-portfolio property, and the publicly-traded trust would be a SIFT. Under the new version of the non-portfolio property test, the investment in the other trust would not be a non-portfolio property, and the publicly-traded trust would not be a SIFT.