On July 14, 2008 Canada’s Minister of Finance, the Honourable James M. Flaherty, released draft tax rules (the SIFT conversion rules) that will facilitate the restructuring of income trusts so as to convert them into corporations. The draft rules have been anticipated since October 31, 2006 when the Government of Canada first proposed to impose an entity-level tax on income trusts. (See the November 2, 2006 Osler Update, “Canadian Government Announces New Tax on Publicly-Traded Income Trusts and Partnerships.”) The new rules are intended to “reflect the Government’s commitment to ensure that existing SIFTs can choose to reorganize as corporations without undue tax effects.”
If enacted as proposed, the SIFT conversion rules would generally allow existing income trusts (SIFT trusts) to convert to corporate form on a tax-efficient basis during a five-year window beginning on the date of the announcement and ending December 31, 2012. Existing income trusts that are currently liable for SIFT tax will be able to take advantage of the new rules. Also, income trusts that are currently “grandfathered” from SIFT tax until 2011 will be able to undergo conversions in advance of 2011 before they become liable for SIFT tax. The 2012 deadline for the rollover relief provided in the new draft rules may give rise to a difficult choice for some income trusts as to whether to reorganize before that date. Many energy-based (and other) trusts, for example, do not expect to pay significant amounts of SIFT tax, at least until beyond the 2011 grandfathering date.
The press release accompanying the draft SIFT conversion rules indicates that they are expected to form part of a bill to be introduced in the House of Commons later in 2008. The Department of Finance has requested that comments on the draft rules be provided by September 15, 2008.
Two Options for Conversion
The new draft rules will permit a SIFT trust to adopt either of two approaches to achieve a conversion into corporate form on a tax deferred rollover basis. The first method (a Unit-for-Share Exchange) involves the exchange of units of a SIFT trust for shares of a corporation. The second method (a Share Distribution) involves the distribution to the SIFT trust’s unitholders of shares of an underlying corporation. While a Unit-for-Share Exchange may, in some circumstances, be more complex to effect than a Share Distribution, it may also carry some advantages over the Share Distribution alternative, such as allowing the resulting corporation to inherit many of the tax attributes (such as loss carry-forwards and undeducted issue expenses) of the SIFT trust.
The income trust conversions that have occurred to date have been implemented under a plan of arrangement. It is anticipated that this will continue to be the preferred approach under the new tax rules, although it may be possible to effect a conversion transaction through changes to the trust deed without requiring a plan of arrangement. However, in either case, and under either of the proposed approaches under the new rules, it will be necessary to hold a meeting of the unitholders of the income trust at which unitholder approval will be required, typically by a 66?% vote in favour of the proposed conversion.
The proposed rules do not address the tax treatment of exchangeable shares or partnership units, or the elimination of special voting units. The result is that consideration will need to be given to the effect and treatment of such securities prior to any conversion transaction.
The Unit-for-Share Exchange alternative allows a tax-deferred rollover for unitholders of a SIFT trust where they exchange their units of the SIFT trust for shares of a corporation (referred to as a SIFT corporation) where certain conditions are met. Such rollover treatment will apply automatically (i.e., without the need to file an election, as was the case with conversions effected under this structure prior to these proposals) to a unitholder in respect of a particular exchange of units for shares if:
- The exchange occurs during a specified 60-day period (the exchange period) at the end of which the SIFT corporation owns 100% of the units of the SIFT trust;
- The unitholder disposes of all of his or her units in the SIFT trust during the exchange period;
- The unitholder receives no consideration on the exchange, other than shares of the SIFT corporation that are issued during the exchange period;
- The shares received by the unitholder have the same fair market value as the units of the SIFT trust for which they are exchanged; and
- All of the shares issued to unitholders of the SIFT trust on the exchange are of the same class.
In these circumstances, a unitholder would be deemed to have disposed of his or her units for proceeds equal to the cost amount of the units, and to have tax cost in the acquired shares of the SIFT corporation equal to the same amount.
The requirement that the shares issued to unitholders have the same fair market value as the units of the SIFT trust may cause valuation issues, particularly where the exchanging corporation holds assets other than the newly acquired units of the SIFT trust. Also, the requirement that all unitholders receive shares of the same class seems to prevent the use of multiple classes of shares, preferred shares and/or debt directly as part of the exchange; however, it is likely that a subsequent share reorganization could be effected on a rollover basis. The Unit-for-Share Exchange alternative would be available for a disposition that occurs on or after July 14, 2008 and before 2013. For a transaction that has already occurred (between December 19, 2007 and July 14, 2008) in which units of an income trust have been exchanged for shares of a corporation, an election may be available to have the rollover treatment in the new Unit-for-Share Exchange provision apply to such transaction.
An important change under the proposed rules is that following such a Unit-for-Share Exchange, the resulting SIFT corporation can wind up the SIFT trust and/or a subsidiary trust on a tax-deferred basis. Under the current tax rules, the pre-existing trust structure could not be wound up on a tax-efficient basis.
The wind-up may be effected under one of two provisions. Under the first (the Flow-through Provision) for which a tax election must be filed, rules would apply that are generally similar to those applicable to the winding-up and dissolution of a taxable Canadian corporation into its Canadian parent. As a result, the tax attributes of the SIFT trust (and a subsidiary trust), such as loss carry-forwards and undeducted issue expenses, would generally flow through to the corporation. The Flow-through Provision is available on an elective basis if the following requirements are met:
- The corporation must hold all of the units of the SIFT trust (and, in the case of a subsidiary trust, the SIFT trust must hold all of the units of the subsidiary trust); and
- The SIFT trust is wound up before 2013 and the wind-up results in all units in the SIFT trust being disposed of (and all of the SIFT trust’s property being disposed of) to the corporation.
Similar requirements apply with respect to the winding up of a trust that is a subsidiary of the SIFT trust, with the additional requirement that such subsidiary trust must be wound up before the SIFT trust.
The second provision (the Wind-up Provision) for distributing all of the property of the SIFT trust to the corporation on a tax-deferred basis can apply where the foregoing Flow-through Provision would not be available or is not elected. This option for a tax deferred wind-up has similar requirements to those outlined above relating to ownership, timing and dispositions. In addition, this option requires that the only property of the SIFT trust to be distributed to the corporation on the wind-up consists of shares of another corporation. This latter requirement could require a pre-wind-up reorganization (such as the capitalization of debt or asset transfers) to ensure that the SIFT trust holds only shares of a corporation. As with the Flow-through Provision, the Wind-up Provision allows the distribution of the property of a SIFT trust or subsidiary trust to the corporation on a tax-deferred basis, but does not allow the tax attributes of the SIFT trust or subsidiary trust to flow through to the beneficiary.
Although the SIFT Conversion Rules as currently drafted provide for the wind up, on a tax-deferred basis, of both a SIFT trust and a second-tier trust, it is not evident that such treatment is available in respect of lower-tier trusts. It is not clear whether this result is intended; it is hoped that future drafts of the SIFT Conversion Rules will provide clarification on this point.
The Share Distribution alternative provides a second approach to the tax-deferred conversion of a SIFT trust to a corporation. The Share Distribution rules allow a tax-deferred rollover on the distribution by a SIFT trust to its unitholders of shares of a corporation held by the SIFT trust. The Share Distribution alternative applies automatically (i.e., without the need to file a tax election) if:
- The only property of the SIFT trust is shares of a taxable Canadian corporation; and
- The distribution occurs prior to 2013 and results in the disposition of all of the unitholders’ units of the SIFT trust as well as the distribution of all of the SIFT trust’s property.
Where the conditions described above are met, the Share Distribution provision would afford full tax deferral for the unitholders whose tax basis in their units would flow through to the shares of the corporation received by them on the distribution, and for the SIFT trust which would realize no gain or loss on the disposition by it of the shares of the corporation.
To take advantage of the Share Distribution alternative, a SIFT trust that holds assets other than shares of a Canadian corporation must first restructure its affairs so that its only property is such shares. For example, even if the SIFT trust already holds the underlying corporation directly, any outstanding debt of the corporation held by the SIFT trust must first be capitalized. Further, if the SIFT trust holds the underlying business assets through a trust or partnership, then the assets must be restructured (including, potentially, through the use of the Flow-through Provision or the Wind-up Provision described above) so that the business assets are held by the SIFT trust in corporate form.
Unlike a Unit-for-Share Exchange, a Share Distribution transaction would not result in the corporation becoming a unitholder of the former SIFT trust. Thus, the corporation could not access the tax attributes of the SIFT trust, such as loss carry-forwards and undeducted issue expenses. Also, unlike a Unit-for-Share Exchange, the Share Distribution method requires that the SIFT trust distribute all of its property as part of a single transaction.
The SIFT Conversion Rules contain a number of other proposals designed to facilitate the restructuring of SIFT trusts. The most notable provisions are outlined below.
A provision is proposed that, in certain circumstances, would prevent the application of the debt forgiveness rules where a wind-up of a subsidiary trust results in the settlement of a debt issued by a subsidiary trust, the face amount of which exceeds the fair market value of the underlying entities. It is not proposed that this provision would apply in the case of debt issued by an underlying corporation.
Acquisition of Control
The SIFT Conversion Rules also propose a narrow amendment to rules that deem an acquisition of control of a corporation not to have occurred under certain circumstances. These relieving provisions are not drafted as broadly as might have been expected. If they are not broadened, in any conversion transaction that involves a corporation, attention will need to be paid to the possible application of the acquisition of control rules which could limit the survival of certain tax attributes of the corporation.
The SIFT Conversion Rules contain a proposal that would generally facilitate the exchange of existing employee options on a tax-deferred basis where unit options issued to employees by a SIFT trust could be exchanged for stock options issued by the surviving public corporation. This rollover provision would apply in the case of either the Unit-for-Share Exchange or Share Distribution alternatives discussed above.
The draft rules do not specifically address the treatment of long term incentive plans (LTIPs) in a conversion. As LTIPs are common income trust compensation mechanisms, SIFT trusts should consider the impact of the draft conversion methodologies on their LTIPs.
Implications for Takeover Transactions
The application of the draft rules is not limited to a transaction that is simply a SIFT trust conversion transaction. Accordingly, subject to the requirements and restrictions contained in them, the new rules might be used to facilitate reorganizations in the context of a takeover of an income trust by an existing Canadian corporation.