On July 25, 2012, the Department of Finance Canada (“Finance”) released draft legislation to amend the Income Tax Act (Canada) (the “Act”) to eliminate the tax advantages of stapled security transactions. The press release, draft legislation and accompanying explanatory notes can be viewed on Finance’s website (at http://www.fin.gc.ca/n12/12-082-eng.asp). The draft amendments are generally consistent with the proposals announced by Finance on July 20, 2011, and are effective on July 21, 2011. Their principal thrust is to deny the deduction of amounts paid by the issuer of a stapled security in a variety of circumstances. The term “stapled securities” refers to different securities that commercially are required to trade or be transferred together, and cannot be traded or transferred independently.
Rationale for the Proposed Amendments
As discussed in our July 2011 tax law bulletin, Finance proposed these amendments to address transactions which it believes circumvent the policy objectives of the specified investment flowthrough trust (SIFT) rules. The SIFT rules, which were announced in 2006 and fully implemented as of January 1, 2011, were introduced to equalize the tax treatment of income trusts and corporations by subjecting income trusts and their unitholders to entity level and distribution tax at rates similar to corporate and dividend rates.
The proposed amendments target two general types of recent transaction structures that used publicly traded stapled securities to replicate some of the pre-SIFT economics of income trusts.
The first type involved restructuring former income trusts into corporate form to avoid the SIFT rules. In these restructured vehicles, unitholders received stapled securities consisting of a common share and a high-yield debt obligation of a new corporation in exchange for their existing trust units. Entity level taxation was minimized by paying deductible interest on the debt to holders of the stapled securities. The proposed amendments eliminate the tax advantage of this type of structure by denying the issuer’s interest deduction.
The second type of transaction involved real estate investment trusts (“REITs”). REITS are exempt from the SIFT rules if they satisfy certain tests related to the character of their income and the type of property they own. In order to meet these tests and avoid SIFT tax, some REITs restructured by moving non-qualifying REIT assets and businesses to a taxable corporation or other taxable entity. The shares or units of the other entity and the REIT’s units were then stapled together and traded under a single trading symbol. Under these structures, the REIT typically leased real property to the other entity. The resulting lease payments were deductible by the lessee, and “good” revenue for the REIT under the REIT tests. The proposed amendments eliminate the tax advantage of this type of structure by denying the tax deduction for any otherwise deductible amount – not just lease payments – paid or payable by the corporation or other entity to the REIT or to a subsidiary of the REIT. There is no relieving provision for amounts paid to the REIT on arm’s length commercial terms.
What is a Stapled Security?
In general, a stapled security consists of two or more separate securities that as a commercial matter trade together.
The new rules will define a particular “security” of a corporation, trust or partnership (termed an “entity”) to be a “stapled security” if all of the following three conditions are met:
Both the particular security and some other security (termed the “reference security”)
- are required to be transferred together or concurrently, or
- are listed or traded on a stock exchange or other public market under a single trading symbol;
- the particular security or the reference security is listed or traded on a stock exchange or other public market; and
any of the following situations applies:
- the particular security and the reference security are both issued by a single corporation, SIFT partnership or SIFT trust;
- the particular security and the reference security are issued by separate entities one of which is a “subsidiary” of the other, and either the parent or the subsidiary is a corporation, SIFT partnership or SIFT trust; or
- the particular security and the reference security are issued by separate entities one of which is a REIT or a “subsidiary” of a REIT.
For these purposes,
- a “security” of an entity means a liability of the entity, a share or right to control the voting rights of a share of a corporation, an income or capital interest in a trust, and an interest in a partnership (but not, according to the explanatory notes released with the draft proposals, a right to, or to acquire, any of the foregoing, such as a simple right to acquire equity in a convertible debenture),
- a receipt or similar instrument representing all or some of a particular security will effectively be treated as the particular security, and
- an entity will be a “subsidiary” of another entity if the other entity directly or indirectly holds securities of the first entity representing more than 10% of the first entity’s equity value.
What are the Tax Consequences to an Issuer of a Stapled Security?
Subject to the transitional relief discussed below, the proposed amendments prohibit an entity from deducting certain kinds of otherwise deductible expense:
- any interest paid or payable on a liability of the entity that is a stapled security, unless each reference security in respect of the stapled security is a liability; and
- any amount paid to a REIT or a subsidiary of the REIT (including indirectly through a back-to-back arrangement) if securities of the entity (or the entity’s subsidiary or parent) are stapled to the REIT’s securities.
These deduction denial rules are consistent with Finance’s prior statement that the new rules are not intended to affect stapling arrangements that involve only shares issued by publicly traded corporations, the distributions on which are treated as dividends for tax purposes, or stapled securities that consist only of debt.
The proposed rules apply even where the denied expense is on arm’s length terms. Further, the recipient of the payment is not entitled to a corresponding income reduction, and consequently the proposed rules result in double tax.
What are the Transitional Rules for Issued and Outstanding Stapled Securities?
The new rules apply to payments made on or after July 21, 2011, subject to limited transitional relief for existing stapled security structures that were in place on that date.
Specifically, the draft legislation will provide a “transition period” for an entity during which the stapled securities rules will not apply in any of the following three specific circumstances:
- the entity had one or more stapled securities outstanding on both October 31, 2006 (the announcement date of the SIFT rules) and July 19, 2011 – in this case the entity’s transition period will end at the latest on July 1, 2016, and may end earlier;
- the entity had one or more stapled securities outstanding on July 19, 2011 but none on October 31, 2006 – in this case the entity’s transition period ended at the latest on July 20, 2012, and may have ended earlier; and
- in any other case, if the entity was a subsidiary of another entity on July 20, 2011 and the other entity has a transition period – in this case the subsidiary’s transition period will end at the latest when the other entity’s transition period ends, and may end earlier if it ceases to be a subsidiary of the other entity.
An entity’s transition period is subject to earlier immediate termination on the date that
- a stapled security of the entity is materially altered, or
- any security of the entity becomes a stapled security other than by way of
- a transaction under an agreement in writing entered into before July 20, 2011 which all parties are legally obligated to complete, or
- the issuance of the security in satisfaction of an amount payable by the entity before July 20, 2011on another of its securities, if the other security was a stapled security on July 20, 2011 and the issuance was made under a term or condition of the other security in effect on July 20, 2011. (This exception is intended to accommodate post July 20, 2011 distributions of stapled securities under a distribution reinvestment plan (DRIP), as long as the distribution under the DRIP was declared before July 20, 2011.)
How Can These Rules Be Avoided?
The stapled securities rules will cease to apply to an issuer when it permanently and irrevocably “unstaples” its stapled securities.
In this regard, a special anti-avoidance rule will apply to any issuer who temporarily unstaples its securities and subsequently restaples them or substitutes other stapled securities. In this case a “look-back” rule will effectively disregard the original unstapling if it is not carried out permanently and irrevocably, and require the entity to add back into income all relevant amounts deducted during the temporarily unstapled period, plus a notional interest charge related to reduced taxes during the period. The income inclusion will also apply where the entity or another entity issues a different security for the originally stapled security and the other security becomes a stapled security in a later year.