Current market conditions and Canadian tax changes have depressed trading prices of Canadian income funds. Nevertheless, many such funds own businesses that may be attractive targets for Indian strategic buyers looking to make longer-term investments. In acquiring the business of a Canadian income fund, an Indian buyer must, however, understand the structure through which the fund owns the business. Such structures are tax driven, and tax considerations and opportunities are key to getting the deal done.
Until October 31, 2006, publicly traded income funds were popular investment alternatives in Canada to ownership of an incorporated business. In an environment of low interest rates, income funds owning businesses with regularly distributable cash flows were able to provide investors with enhanced yield. Using trusts and partnerships, which were flow through entities for Canadian tax purposes, as well as highly leveraged corporations, income fund structures allowed investors to receive business earnings free of Canadian entity level income taxes.Faced with the prospect of large public corporations converting to income funds, and perceiving billions of dollars in lost tax revenues, on October 31, 2006 the Canadian Minister of Finance announced measures to impose an entity level tax, at a rate comparable to the combined federal provincial corporate tax rate, on “specified investment flow-through entities”, which include publicly traded income funds owning non portfolio assets. These measures, known as the “SIFT Rules”, were enacted on June 22, 2007. The entity level tax is effective in 2007, but income funds that existed on October 31, 2006 are grandfathered until 2011 provided that they undergo only “normal growth” as measured by “Normal Growth Guidelines” which the Minister released on December 15, 2006.
Upon enactment of the SIFT Rules, management of many existing income funds began the process of weighing the advantages and disadvantages of converting to corporations, and on July 14, 2008 the Minister proposed measures to facilitate such conversions on a tax deferred basis (the “Conversion Rules”). Modifications to these proposals were released on November 28, 2008. The Conversion Rules, yet to be enacted, are also significant to a prospective buyer of an income fund’s business, as they will impact the post acquisition process of rationalizing the ownership structure.
While not exhaustive the examples shown above illustrate two common income fund structures. In the “first generation” structure (Example 1), the underlying business is operated by a corporation which is owned by a publicly traded mutual fund trust. The corporation is highly leveraged. Interest on the debt it owes to the fund is set at a rate which eliminates or substantially reduces, through tax deductible interest expense, mainstream corporate level tax. The fund distributes all of the interest to its unitholders, taking advantage of provisions in the Canadian tax legislation which allow a trust to deduct distributions to its beneficiaries and thereby avoid Canadian income tax on the trust.
The “second generation” structure (Example 2) eliminates the corporation. Unitholders own units in a publicly traded mutual fund trust which, in turn, owns units and debt in a subsidiary trust. The subsidiary trust owns limited partnership units representing an interest in a partnership which owns one or more businesses, either directly or through one or more lower tier partnerships. Operating corporations may also exist below the partnerships especially where foreign operations exist. A general partner corporation owns the very nominal general partnership interest. The partnerships are flow through vehicles. Their taxable income is allocated to the subsidiary trust. The subsidiary trust eliminates its taxable income by deductions for the interest and distributions it pays to the mutual fund trust which, in turn, distributes all its taxable income to its unitholders.
Many structures also have exchangeable securities which represent the retained interests of former owners whose businesses were acquired by the fund generally on a tax-deferred basis. In Example 2, the retained interest is represented by units in the partnership that are exchangeable into publicly traded units of the fund.
Considerations for the Buyer
Two principal Canadian tax considerations exist for a prospective buyer. The first is what specific assets or securities the buyer will acquire. The second is how the intermediate structure will be collapsed in the course of or after the acquisition has been completed. Both must take into account the expectations of the fund’s unitholders.
The following discussion assumes the prospective buyer will acquire all of the fund’s business for cash. Where the buyer intends to exchange its shares for the interests of the relevant vendor, the tax analysis and the tax considerations will more likely tend to focus on tax deferrals for the vendor(s). If instead, the buyer wishes only to make a significant investment in the entity which will operate the ongoing business, this will complicate the planning. In this latter case, a newly formed partnership may be used as the acquiring entity in a going private transaction which will involve a series of steps to eliminate the vendor unitholders and convert the remaining unitholders’ interests to interests in the acquiring entity. The options available serve only to illustrate that each prospective acquisition must be specifically reviewed given the objectives of the parties, the value of the business and the tax attributes available to maximize tax efficiency.
(a) What will be acquired
In a cash transaction, unitholders will, generally, not be agreeable to the buyer acquiring the operating assets of the bottom tier corporation (in Example 1) or partnership (in Example 2) if the unitholders would realize a lower after tax return than had the buyer acquired equity interests in an entity in the chain. An asset purchase could produce higher tax cost attributable either (in Example 1) to taxes payable by the corporation, or (in Example 2) to recognition by the partnership, and ultimate taxation to the unitholders, of ordinary income rather than capital gains. In such circumstances, the unitholders’ preference will be for the buyer to acquire (in Example 1), either the shares of the corporation or the units of the fund, and in Example 2, either the partnership interest owned by the subsidiary trust or the units of the fund.
From the buyer’s perspective, if the acquisition price of interests in an upper tier entity exceeds the corporation’s or partnership’s tax basis of the operating assets, generally the buyer will not be able to write up the tax basis of such assets, other than land and any other non-depreciable property. However, in certain circumstances, a buyer can benefit from not acquiring the operating assets directly. If, for example, the acquisition price is less than the tax basis of assets owned in a partnership, by acquiring the partnership units the buyer will gain access to the full amount of the partnership’s unamortized pools of tax depreciation, as well as any undeducted balances of its issue expenses. If the buyer acquires shares of a corporation that has net operating losses, the losses will remain available to the buyer, subject to business continuity requirements.
Typically, the acquisition will be structured so that the buyer, through a Canadian acquisition company, acquires either the publicly traded units of the fund, or (in Example 1) the shares and debt of the corporation, or (in Example 2) the partnership units owned by the subsidiary trust, together with the shares of the general partner corporation and any retained interests of former owners.
(b) Collapsing the structure
The buyer, depending on the level at which the acquisition occurs, may also find that it has assumed responsibility for unwinding the income fund structure. Even where the underlying business has been sold, unitholders may expect prompt distribution of the cash proceeds without holdback for wind up costs and potential tax and other liabilities. In such case, a term of the deal may place the onus on the buyer to ensure a tax effective termination of the fund and any subsidiary trusts.
Appropriate steps to achieve the foregoing must be determined in the context of the specific structure and circumstances. Generally, both existing provisions in Canadian tax legislation and the Conversion Rules contain provisions to facilitate the process, but there may also be hidden traps.
To illustrate, in Example 1, if the buyer’s Canadian acquisition company was to acquire the units of the fund, the buyer would want to terminate the fund, and acquire direct ownership of the shares and debt of the corporation. In these circumstances, existing tax provisions would treat the fund as having disposed of the shares and debt for fair market value proceeds. Upon making appropriate tax designations, any capital gains would flow up to the acquisition company and would not be taxed to the fund. The acquisition company would then have an offsetting capital loss on the acquired fund units when the fund is terminated. Accordingly, the unwind would not be taxable. The proposed Conversion Rules also apply to an unwind. In certain cases, the winding-up of the fund will be treated as a dissolution of a wholly-owned subsidiary into its parent corporation. Generally this can be effected on a non-recognition basis. The Conversion Rules also provide for non-recognition treatment where the only asset distributed is shares of a corporation. These transactions could, however, where the buyer is a non-resident of Canada, have tax consequences in the buyer’s home jurisdiction. Any relevant tax considerations in that jurisdiction will require analysis.
In Example 2, if the buyer’s acquisition company purchases partnership units from the subsidiary trust at a capital gain to the trust, an unwind can be structured such that, through a series of cash distributions, redemptions and tax designations, both the sale proceeds and all capital gains flow out, and are taxed to, the unitholders without tax cost to the subsidiary trust or to the fund. This unwind should be possible without direct involvement of the buyer and should not be complicated by potential buyer jurisdiction tax consequences.
Given current market conditions, a scenario which produces capital losses and results in “underwater” internal debt may be a realistic prospect. This will give rise to additional tax considerations. To illustrate, in Example 2, if the subsidiary trust were to sell the partnership units for less than the amount of debt it owes to the fund, the remaining portion of the subsidiary trust’s debt would have to be forgiven. Canadian debt forgiveness rules require the debtor either to reduce its existing losses and other tax attributes by the forgiven amount or to include 50% of the amount in income. Under existing tax provisions, the subsidiary trust can address the debt forgiveness rules by applying the forgiven amount against the capital loss it realizes on the sale of the partnership units. Pursuant to the proposed Conversion Rules, an election can be filed to exclude the application of the Canadian debt forgiveness rules to the debt of the subsidiary trust.
Other Tax Considerations and Opportunities
A prospective buyer must appreciate that in many respects the acquisition transaction will resemble the takeover of a public corporation. Tax due diligence is critical before the acquisition agreement is signed. Although income funds are structured not to pay entity level Canadian income taxes, liabilities for other taxes may have been incurred, including goods and services, sales taxes and foreign taxes. A buyer must also verify that the fund has not exceeded the Normal Growth Guidelines and become subject to entity level taxes pursuant to the SIFT Rules before the acquisition.
Tax due diligence may also disclose other issues and opportunities for the buyer. Among these:
- The Conversion Rules do not provide relief for forgiveness of corporate debt. Accordingly, debt forgiveness rules may apply in a structure, such as in Example 1, if the debt owing by the corporation to the fund is forgiven or acquired by the buyer at a greater than 20% discount. Pre-closing restructuring may be necessary to eliminate corporate debt in a tax efficient manner.
- Where capital losses must be used in order to unwind the structure on a tax efficient basis, care must be taken not to trigger “stop loss” rules that would deny the losses, as could occur if the buyer’s acquisition company or a related party becomes a beneficiary of the fund or of a subsidiary trust.
- A buyer of units in a limited partnership will become subject to “at-risk” rules which may limit its ability to deduct post-acquisition partnership losses. This concern may be addressed either by structuring the acquisition as a redemption of existing partnership units, or by converting the partnership from a limited partnership to a general partnership after the acquisition.
- Once the Canadian acquisition company owns partnership units, it must consider whether the partnership should also be dissolved. While there are rollover rules for partnership dissolutions, in certain cases those rules will trigger capital gains. As well, if the partnership has unamortized expense pools, the dissolution would cause these tax attributes to be lost.
- Underlying agreements must be reviewed to ensure that the buyer maximizes partnership tax attributes. Typically, limited partnership agreements require the partnership to claim the maximum amount of annual discretionary tax deductions. However, if the fund or a subsidiary trust otherwise has sufficient tax deductions for the final year, the agreements should be amended to preserve partnership tax attributes for the buyer.
- Canadian withholding tax may be payable if the fund’s unitholders include non-residents of Canada. Units of a mutual fund trust generally are not taxable Canadian property. Withholding tax would, therefore, not normally apply on a purchase of units by the buyer’s acquisition company. However, if more than 5% of the units are held by non-residents, withholding tax would apply on a distribution by the fund of capital gains arising on its sale of taxable Canadian property to the acquisition company.
Finally, as in any Canadian acquisition, an Indian buyer must carefully plan its structure for the investment into Canada. Relevant considerations will include the capitalization of the Canadian acquisition company, taking into account the possible application of the thin capitalization rules and interest withholding tax in respect of any debt owing to the buyer or related non-Canadians. The Canada-India Tax Agreement (entered into force in 1997) is one of Canada’s older bilateral arrangements. It does not contain many of the more attractive reductions of Canadian non-resident withholding tax for dividends, interest and royalties which are found in Canada’s more recent treaties. It also has a rather unique capital gains article which permits both Canada and India to tax capital gains in designated Canadian sited assets disposed of by Indian residents. In such cases, foreign tax credit relief will be insufficient to fully address double taxation. Indian buyers may, therefore, wish to consider the use of intermediate holding companies in appropriate tax treaty jurisdictions to maximize tax treaty benefits for dividends or interest paid by the Canadian acquisition company and capital gains realized on a future divestiture.