On July 14, 2008, the Department of Finance released the long-awaited draft amendments (the "Conversion Amendments") to the Income Tax Act (Canada) (the "Act"), allowing the conversion of certain income funds into corporations on a tax-deferred basis.
On October 31, 2006 the Department of Finance announced that certain publicly listed or traded trusts and partnerships (collectively referred to as "SIFTS"), would be taxed in the same manner as corporations in respect of taxable distributions and unitholders and would be treated as having received dividends of such amounts. A grandfathering period was provided whereby existing SIFTs would not be subject to these new tax rules ("SIFT Rules") until 2011, subject to compliance with certain growth guidelines. Real estate investment trusts ("REITs") are exempt from the SIFT rules where they satisfy certain conditions.
As a result of the new tax treatment it was expected that SIFTs would want to convert into corporations prior to 2011. The Conversion Amendments were necessary to facilitate conversions prior to 2011 without unitholders or SIFTs having adverse tax implications.
The Conversion Amendments apply to conversions which occur after July 14, 2008 and before 2013, and are applicable to SIFT trusts, SIFT partnerships or REITs that are in existence at any time between the period of October 31, 2006 and July 14, 2008 (a "Qualifying SIFT").
The Conversion Amendments allow for a conversion by permitting either (a) a tax-deferred exchange of units of a Qualifying SIFT for shares of a taxable Canadian corporation (the "Corporation") (the "Exchange Method") followed by a tax-deferred wind-up of the Qualifying SIFT, or (b) a transfer by a Qualifying SIFT of its property to a Corporation for shares followed by a distribution of such shares to the unitholders (the "Distribution Method"). As drafted, there are important differences between the two methods. A Qualifying SIFT considering converting will have to consider the method most appropriate in the circumstances having regard to its ownership structure, tax attributes, amount of income subject to tax under the SIFT Rules, non-resident tax implications and applicable agreements and obligations.
A taxpayer will be permitted to exchange its equity in the Qualifying SIFT for shares of a Corporation on a tax-deferred basis. The Exchange Method is an automatic rollover for which no tax election needs to be filed. The result is that the unitholders become shareholders of the Corporation and the Corporation becomes the sole unitholder of the Qualifying SIFT. Under current law, units of a SIFT could be transferred to a Corporation on a tax-deferred basis provided a joint election under subsection 85(1) of the Act was filed. The Exchange Method is also available to unitholders of REITS and limited partners of a SIFT partnership. It is expected that the exchange would occur under a plan of arrangement.
In order for the Exchange Method to apply, the following conditions must be satisfied:
- during a period of no more than 60 days ("Exchange Period") all of the issued and outstanding equity in the Qualifying SIFT are either sold to the Corporation or redeemed and cancelled by the Qualifying SIFT;
- the taxpayer must dispose of all of its equity in the Qualifying SIFT during the Exchange Period (including voting units);
- the taxpayer receives only shares of the Corporation in consideration for its units in the Qualifying SIFT, and the fair market value of such shares must be equal to the fair market value of the units; and
- all of the shares issued to unitholders of the SIFT must be shares of a single class of the Corporation.
The Conversion Amendments appear to allow for a taxpayer to transfer a portion of its equity on a taxable basis for non-share consideration such as cash or debt if properly structured. This would be consistent with the current rules for tax-deferred share-for-share exchanges. It could be tax advantageous for the Corporation to issue interest-bearing debt to the selling unitholder to generate interest deductions. The accompanying Department of Finance technical notes are not, however, entirely clear regarding the issuance of non-share consideration on a conversion. Hopefully, the Department of Finance will clarify the position that non-share consideration including debt can be issued by the Corporation in respect of a conversion.
The taxpayer will be deemed to dispose of its units for proceeds equal to the cost amount of the units resulting in no taxable capital gain or capital loss. The taxpayer will also be deemed to acquire the shares of the Corporation at a cost equal to such cost amount.
The adjusted cost base of the particular unit to the Corporation will be deemed to be the lesser of the fair market value of the particular unit, and the portion of outstanding capital attributable to the particular unit (i.e. the difference between the consideration received on the issuance of the units, and any returns of capital made to the particular unitholder). There are specific rules to determine the "paid-up capital" of the shares. Also, where the units qualified as "taxable Canadian property" to a taxpayer, the shares will be deemed to be "taxable Canadian property" to the taxpayer.
Wind-up of the Qualifying SIFT
One of the perceived tax impediments to a conversion under current law was the subsequent wind-up of the Qualifying SIFT and any second tier trust. This is now addressed by the Conversion Amendments. There are two methods for a tax-deferred wind-up.
If the Exchange Method is used and the Corporation is the sole beneficiary of the Qualifying SIFT, the Qualifying SIFT can distribute its properties on a tax-deferred basis pursuant to proposed section 88.1. In the case of a second tier trust, it can distribute its properties to its sole beneficiary, a Qualifying SIFT, and subsequently the Qualifying SIFT trust can distribute its properties to the Corporation on a tax-deferred basis.
The Qualifying SIFT can distribute all of its property to its sole beneficiary on a tax-deferred basis pursuant to proposed section 88.1, where the following requirements are met:
- the sole beneficiary is a Corporation, or a trust the only beneficiary of which is a Qualifying SIFT (the sole beneficiary of which is a Corporation); and
- the distribution takes place within 60 days of the first distribution of the property, if any, on the wind-up of a second tier trust (that meets certain conditions).
On the distribution of the Qualifying SIFT's property, the Conversion Amendments provide that the existing wind-up rules under the Act in respect of corporations will apply to the Qualifying SIFT. The Qualifying SIFT will be treated as though it were a Canadian corporation, and the distribution will be as though it was the winding-up into its parent corporation.
The benefit of using this provision is that on the wind-up, the tax attributes of the properties of the Qualifying SIFT, such as the tax cost of the properties and unutilized deductions will flow-through to the Corporation as a result of the distribution.
The tax-deferred conversion may be structured by the Qualifying SIFT redeeming all of its equity in exchange for shares of a Corporation owned by the Qualifying SIFT. The proposed tax-deferred wind-up rules under section 88.1 discussed above cannot be used where there are multiple unitholders. A Qualifying SIFT may still be able to distribute its property on a tax-deferred basis to its unitholders under the Distribution Method pursuant to proposed subsection 107(3.1). In addition, the Distribution Method allows for a tax-deferred wind-up of a second tier trust of a Qualifying SIFT.
If the Qualifying SIFT (or the second tier trust) owned property other than shares of a corporation, it would transfer such property to a wholly-owned subsidiary for shares ("Subco Shares") on a tax-deferred basis. The Subco Shares are transferred to the taxpayer on the redemption of their equity of the Qualifying SIFT.
The Distribution Method is available where:
- the taxpayer disposes of all its equity in the Qualifying SIFT (including voting units);
- the trust distributes the Subco Shares; and
- where the trust is a Qualifying SIFT, the distribution must occur no more than 60 days after the first distribution, if any, of property on the wind-up of the second tier trust.
The Distribution Method does not permit the distribution of interest-bearing debt of the Corporation. It is not clear from a policy perspective why this should not be permitted. The Department of Finance should address this point.
The trust is deemed to dispose of the property for proceeds equal to the adjusted cost base of the property. The taxpayer holding the beneficial interest in the trust is deemed to have disposed of its interest for proceeds equal to the adjusted cost base to the taxpayer (in the case of capital property).
Where the taxpayer is the sole beneficiary of the SIFT trust, and is a Qualifying SIFT (or a public corporation the shares of which were issued for equity of the Qualifying SIFT or distributed on the wind-up of the Qualifying SIFT), the taxpayer is deemed to acquire the property for proceeds equal to the adjusted cost base of the property. In any other case, the taxpayer is deemed to acquire the property at the adjusted cost base to the taxpayer of its interest under the trust.
Where the beneficiary's interest in the SIFT trust was "taxable Canadian property", the property is deemed to be "taxable Canadian property" of the taxpayer.
While the Distribution Method provides for the disposition of shares of a Corporation on a tax-deferred basis, unfortunately, the tax attributes of the Qualifying SIFT do not flow through to the taxpayer under this method. It may also be more complicated to deal with debt owing to the Qualifying SIFT by subsidiaries.
Related Amendments and Observations
Debt Forgiveness Rules
In many income trust structures, the Qualifying SIFT owns all of the units of a second tier trust, which has been financed with loans from the Qualifying SIFT. The Conversion Amendments provide for an exception to the debt forgiveness rules where a second tier trust settles a debt that is owed to its beneficiary (which is a Qualifying SIFT), as a consequence of the distribution of property by the second tier trust. Where the settlement payment is less that the adjusted cost base of the settled debt, and where the Qualifying SIFT so elects in writing, the amount paid in satisfaction of the debt is deemed to be the principal amount of such debt.
Acquisition of Control
The Conversion Amendments provide that the "acquisition of control" rules will not apply, in limited circumstances, on the distribution of shares of a Corporation by a second tier trust to its beneficiary that is a SIFT trust or REIT.
Under existing provisions of the Act, a tax-deferred rollover is provided where employee stock option rights in respect of shares of a corporation are exchanged for a different option to acquire securities in another qualifying person. The Conversion Amendments have expanded this tax-deferred rollover to employees who have exchanged their rights to acquire units of a SIFT trust for rights to acquire public shares of a Corporation.
In many structures, certain taxpayers may hold shares or limited partnership units received on a tax-deferred basis in consideration for the transfer of assets. The Qualifying SIFT directly or indirectly owns the balance of the securities. The Conversion Amendments do not specifically address these exchangeable securities. They may be transferred to the Corporation on a tax-deferred basis under subsection 85(1) of the Act.
Timing of Conversions
With the introduction of the Conversion Amendments, Qualifying SIFTs will start to focus on converting and their long-term strategy. There are many factors which will determine the best method and timing of converting a Qualifying SIFT prior to 2013.
We anticipate that there will be changes to the Conversion Amendments. Interested parties can provide comments to the Department of Finance on the Conversion Amendments by September 15, 2008.