On July 14, 2008 the Minister of Finance (Canada) released the long anticipated draft legislation and accompanying explanatory notes in connection with the conversion of SIFT trusts and SIFT partnerships into corporations. The draft legislation takes into account the different ownership structures used by income trusts. The principal benefits of the trust conversion rules are that they minimize the administrative burden of individual tax filings otherwise required to facilitate tax deferral, and address some of the technical issues needed to rationalize the income trust structures. Both alternatives, discussed below, provide a 60 day window for completion of the conversion process, and given those time limits, the commercial exigencies of the conversion process will, in each case, have to be carefully examined.
The draft legislation includes proposals to permit tax deferred conversions to occur in two ways: (i) through an exchange of units of a publicly traded income trust or partnership (a "Fund") for shares of a newly created and publicly traded taxable Canadian corporation ("Newco")1, ("Unit Exchange Alternative") followed by a windup of the underlying subsidiary trust and other subject entities or (ii) through the redemption or cancellation of units, followed by a distribution of shares of a taxable Canadian corporation, as payment of the redemption price to the unitholders ("Distribution Alternative"). A Unit Exchange Alternative would likely be implemented through a Plan of Arrangement to secure the necessary 100% participation in the exchange, while a Distribution Alternative could be implemented, either through a Plan of an Arrangement or special unitholder meeting.
UNIT EXCHANGE ALTERNATIVE
Tax Treatment of the Exchange
Similar to the share for share exchange provisions currently in the Income Tax Act (Canada) (the "Act"), the proposals provide for a tax-deferred exchange of units in a "SIFT wind-up entity" for shares in a corporation if certain conditions are satisfied. The deferral is automatic - no election needs to be filed. In general terms, a SIFT wind-up entity is a trust or partnership that is a SIFT trust, a SIFT partnership or a REIT at anytime in the period beginning on October 31, 2006 and ending July 14, 2008. Consequently, a partnership or trust that becomes a SIFT after the announcement date of the legislation cannot take advantage of the Unit Exchange Alternative.
For the deferral to apply, the following conditions must be satisfied:
- the continuing entity, must be a "taxable Canadian corporation" (generally a corporation resident in Canada that is not exempt from tax under Part I of the Act);
- the disposition must occur during a 60 day exchange period at the end of which Newco must own 100% of the equity in the Fund - the legislation contemplates units being either disposed of to Newco or redeemed or cancelled by the Fund;
- the taxpayer must dispose of all of its equity in the Fund during the exchange period;
- the taxpayer must receive, as sole consideration "for the particular disposition" shares of Newco issued during the 60 day period, all of which must be of a single class; and
- shares of Newco must have a FMV equal to the FMV of the "particular unit" before the particular disposition.
If these requirements are met, taxpayers will be considered to have disposed of their units of the Fund for proceeds of disposition equal to the tax cost of the units determined immediately before the "particular disposition" so that no gain or loss is realized on the exchange. The Newco shares acquired by the taxpayer will have an adjusted cost base equal to that same amount.
Newco must calculate the adjusted cost base of the units it has acquired on the exchange, and the paid up capital of the shares it has issued to the taxpayers. The adjusted cost of the units will be the lesser of: (i) their fair market value immediately before the particular disposition; and (ii) their share of the capital of the Fund, being an amount which is generally equal to the subscription price paid for units of the Fund, less any amounts previously distributed by the Fund, other than an amount "that has become payable out of its income". The paid up capital of shares issued by Newco will be limited to this "cost" amount. Where the exchange involves a Fund that is a SIFT Partnership, the tax cost of the partnership units acquired by Newco will be the lesser of: (i) their fair market value immediately before the disposition and (ii) their share of the capital of the Fund, being an amount which is generally the aggregate capital contributions made to the partnership and capital additions on the transfer of property to the partnership, less distributions of capital and profits and any reductions required with respect to the transfer of property to a partnership, and their share of partnership losses for preceding fiscal periods.
The Unit Exchange Alternative will apply to dispositions that occur on or after the announcement date of July 14, 2008 and before 2013. Several conversions have already taken place. In such cases, taxpayers have been offered the choice of transferring their units on a taxable basis or filing a joint election with the Newco under subsection 85(1). The Unit Exchange Alternative will be made available to these transactions, and in situations where a tax election under subsection 85(1) has already been filed in respect of the transaction, both parties may file a written election with the Canada Revenue Agency ("CRA") electing to apply the Unit Exchange Alternative rules.
The Unit Exchange Alternative appears to be more rigid in its requirements than the current share for share exchange provisions. The share for share exchange rules do not apply in circumstances where an election is filed under subsection 85(1), the vendor and purchaser do not deal at arm’s length, the vendor controls the purchaser after the exchange, or the vendor simply reports the gain or loss in its tax return. By contrast, the Unit Exchange Alternative deems subsections 85(1) and (2) not to apply with respect to a particular disposition, with the result that a taxpayer cannot elect to recognize a partial gain on the exchange, or to realize a loss that has accrued on his or her units. The Unit Exchange Alternative thus eliminates the administrative burden of filing elections under subsections 85(1) or (2). However, where unitholders wish to have the flexibility to recognize a gain or loss on the sale of their units, specific planning will be required or unitholders seeking such flexibility will have to sell their units prior to the conversion process to trigger the gain or loss (incurring ruling commissions and other costs of disposition).
In situations when both debt and shares of Newco are delivered in exchange for units, to obtain the deferral for those units exchanged for shares of Newco, there will have to be a separate disposition of units for subordinated notes issued by Newco and the other requirements of the deferral will have to be met. It is interesting to note that the Unit Exchange Alternative includes a requirement that the fair market value or the shares of Newco, must be equal to the fair market value of the units for which they are exchanged, in respect of each particular disposition. This requirement, if not met, would disqualify a particular exchange from the rollover rules.
Rationalization of Income Trust Structure: Wind-up Rules
The Unit Exchange Alternative, on its own, would leave in place an unnecessarily complicated ownership structure. The Act does not currently permit commercial trusts to distribute property on a tax-deferred basis. The conversion rules facilitate a clean up of the organization structure by adopting the reorganization rules applicable to amalgamations or wind-ups of closely held corporations in proposed section 88.1 (the "Windup Rules"). However, the Wind-up Rules could also be used where the Fund becomes a wholly owned subsidiary of Newco in circumstances where taxpayers have exchanged their Units for shares in reliance on subsection 85(1) or on a fully taxable basis.
The Act already contains provisions that permit the tax-deferred dissolution of a partnership in specific circumstances. For example, a Canadian partnership can distribute its property on a tax-deferred basis to a single partner which chooses to carry on the partnership business as a sole proprietor.
The proposals permit a "SIFT wind-up entity" to be treated as a taxable Canadian corporation for the purpose of applying those wind-up provisions provided the following conditions are satisfied:
- the distribution must be a "SIFT trust wind-up event" i.e. the distribution of property by the trust must occur before 2013, there must be a resulting distribution of all of the taxpayer’s interest as a beneficiary under the trust and the trust must be either a SIFT wind-up entity (i.e. the Fund) or a trust, the only beneficiary of which during the period that begins on July 14, 2008 and ends at the time of distribution, is a SIFT wind-up entity;
- the trust making the distribution must either be a SIFT wind-up entity, whose only beneficiary is a taxable Canadian corporation, or a trust, the only beneficiary which in turn is a SIFT wind-up entity;
- any distribution of property by the trust must take place within 60 days of the first distribution of property made by the trust and that distribution must be a SIFT trust wind-up event;2 and
- if the property distributed is shares of capital stock of a taxable Canadian corporation such shares are not being distributed under "Distributions Alternative" described below, the trust must elect in writing that the Wind-up rules apply to the distribution.
These conditions mean that both the subsidiary trusts, and the Fund can effectively merge into Newco without recognizing any gain or loss on the property they own, by making use of the Wind-up rules. If these conditions are satisfied, the Wind-up rules will apply to a distribution of property by the subsidiary trust to the Fund, and by the Fund to Newco, as if:
- the trust were a taxable Canadian corporation that is not a private corporation.
- where the taxpayer is a SIFT wind-up entity, the taxpayer was a taxable Canadian corporation that is not a private corporation.
- the distribution was the winding-up of a subsidiary corporation.
- the taxpayer’s interest as a beneficiary under the trust was shares of a single class of shares in the capital of the subsidiary owned by the taxpayer.
In general terms, those provisions permit a tax-deferred liquidation of a subsidiary into a parent corporation.3 Under the proposals, various tax accounts and attributes of the subsidiary trust and the Fund will carry forward to the Newco. Once the Fund and subsidiary trust have been wound up, partnerships and corporate subsidiaries can, also, be wound up as required without immediate tax consequence.
The Distribution Alternative facilitates a conversion to a corporate structure through a direct distribution of shares of a wholly owned taxable Canadian corporation directly to multiple unitholders. Under the Distribution Alternative, a Fund can redeem or cancel its units, and deliver to multiple unitholders, all of its property, provided such property consists entirely of shares of a single taxable Canadian corporation, at the unitholders’ cost amount of their units. The tax deferral is automatic—no election is required.
The Distribution Alternative could serve to accommodate the first generation of income trust structures, which involve a Fund owning shares and debt of an operating company. As a preliminary step, the operating company would have to convert its debt to shares. That step would require consideration of the debt forgiveness rules discussed below.
Second generation income trust structures could also make use of this alternative by first transferring the units and subordinated debt they hold in a subsidiary trust together with any other assets, on a tax deferred basis to a newly formed taxable Canadian corporation ("Newco"). The subsidiary trust would then make use of the Distribution Alternative and distribute the shares of Newco to the Fund which in turn could distribute to the unitholders, all on a tax deferred basis.
The Distribution Alternative must satisfy the definition of SIFT trust Wind up event (which requires a distribution of property before 2013), and meet the following additional conditions:
- the only property distributed must be shares of a taxable Canadian corporation;
- if the trust is a SIFT wind-up entity, all distributions that are part of the SIFT trust wind-up event must occur within a 60 day period; and
- the Wind-up rules described above must not apply to the distribution.
If these conditions are satisfied, the Fund and/or the subsidiary trust will be considered to have disposed of the distributed property for proceeds of disposition equal to the tax cost of the property immediately before the disposition so that no gain or loss will be realized. The former unitholders of the Fund will be considered to have disposed of their units for proceeds of disposition equal to their tax cost, so that no gain or loss will be realized on the distribution.
It is not clear whether the Distribution Alternative could accommodate a distribution of shares of two different taxable Canadian corporations. Such an arrangement might have been useful where there were advantages in separating two different businesses currently carried on inside the Fund structure into separate operating companies.
Unlike the procedure described for Wind-up rules (see above), the tax attributes of any SIFT trust using the Distribution Alternative will not carry forward to Newco and be available for future use. Consequently, the Distribution Alternative would not be an ideal alternative for a Fund with significant unclaimed financing expenses, resource pools, or loss carry forwards.
The other disadvantage of the Distribution Alternative is that if the value of the Fund’s units are primarily attributable to Canadian resource properties, timber resource properties and/or real or immovable property situated in Canada, the distribution of Newco shares made to non-residents would be subject to the 15% distribution tax, to the extent that the distribution was not already subject to Canadian income or nonresident withholding tax.
Where a debt owed to a Fund by a subsidiary trust is settled as a result of a distribution that qualifies as a SIFT trust wind up event, and the debt is settled for less than its tax cost, the Fund may elect that the settlement payment is deemed to equal the tax cost plus any received but unpaid interest included in the income of the SIFT trust. Dealing with the debt of the subsidiary trust, other than as part of a distribution that qualifies as a SIFT trust wind-up event, would trigger possible application of the debt forgiveness rules, should the settlement payment be less than its tax cost.
It is noteworthy that the proposals do not address indebtedness between a SIFT entity and a corporation and, consequently the debt forgiveness rule, must be considered in these circumstances.
Acquisitions of Control
Where shares of a corporate subsidiary are distributed from a wholly-owned subsidiary trust to the Fund, the proposals are intended to ensure no acquisition of control occurs. However, no allowance is made for other transfers of corporate shares that might be made by other entities in the income trust structure, including transfers made by a subsidiary trust, which is not wholly owned by the Fund.
The proposals will permit the current rules governing employee stock options to include the corporate shares into which SIFT units are converted.
An income trust structure will often include significant value held an operating partnership or an operating company through securities which are exchangeable into securities of the Fund. Often these exchangeable securities are supported by special voting units issued by the Fund. Such special voting units must be either exchanged under the Unit Exchange Alternative for shares of equal value, or redeemed under the Distribution Alternative. However, the exchangeable securities could remain outstanding if the operating partnership or operating company is not merged or wound up. In such a case, holders might consider contributing the exchangeable securities on a tax-deferred basis to Newco under existing tax rollover provisions.
Many of the Funds have issued public debt, including convertible debentures. Newco, which continues in place of the Fund, will have to make arrangements to assume that debt.
Using Trust Conversion Rules in M&A Transactions
The Unit Exchange Alternative does not appear to contemplate the use of an existing taxable Canadian corporation (a "purchaser"), in the role of Newco. The Unit Exchange Alternative requires that Newco deliver shares with a value equal to the units of the Fund being transferred as part of the "particular disposition" and does not appear to leave any room for rounding errors. A purchaser entity could just as easily, however, find its way to the desired end structure by making an offer for the underlying operating subsidiaries of the Fund which it is seeking to acquire.
Taxable Canadian Property
Generally, if the SIFT units were taxable Canadian property to a unitholder, the corporate shares resulting from a conversion will also be taxable Canadian property.
It is not a foregone conclusion that all Funds will choose to convert to corporations. That decision, will be largely driven by a number of factors, including the need for access to cost efficient capital. Some Funds may decide to delist units but retain the trust as an efficient conduit for private investors.
If, as is expected, most Funds choose to convert to a corporate structure, the remaining question is when should that conversion take place? Timing will, to a large extent, depend on the characteristics of each particular Fund. Generally, a Fund will prefer to defer conversion as long as possible to avoid paying entity level tax, unless it has sufficient tax attributes to shelter income which would otherwise be subject to that tax. Funds with significant income from foreign subsidiaries which can flow such income through an income trust structure, or which make substantial non-taxable returns of capital to unitholders, will also wish to retain the income trust structure as long as possible. Funds which are potential acquisition targets for pension funds and private equity funds, would also consider retaining a conduit structure to attract those types of bidders.
However, an earlier conversion may be beneficial where a Fund is unable to comply with the normal growth guidelines or where restrictions on Canadian ownership are a consideration. Early conversion may also be prompted by such considerations as the belief that a corporate structure will assure broader access to debt and equity capital markets, more certainty in regard to governance issues and more flexibility in management of cash flows to assure growth.