Sorting out the tax fairness plan

By Warren Pashkowich
Illustration: Gary Clement

As a result of the government’s new measures, it’s expected many income funds will simply convert back to corporate form

On October 31, 2006, Minister of Finance Jim Flaherty announced a Tax Fairness Plan, which included a distribution tax on publicly traded income trusts and limited partnerships classified as specified investment follow-throughs (SIFT). This was followed up with his release of Legislative Proposals Concerning Specified Investment Flowthrough Trusts and Partnerships on December 21, 2006. For SIFTs that begin trading after October 31, 2006, these measures will apply beginning with their 2007 taxation year. For existing SIFTs there will be a four-year transition period; the provisions will apply beginning with their 2011 taxation year.

The impact of the proposed measures on the market capitalization of income funds has been profound. In his background information to the Tax Fairness Plan, the finance minister appears to assume that Canadian individual investors, in particular, should not be negatively impacted by these proposals from an overall tax perspective. While that may be true, this disregards the fact that income funds historically traded largely on the basis of pre-tax distributions and as of the date of writing the income fund index has seen a decline in market capitalization of about 10% and retail individual investors have all but abandoned the sector and have been, for the most part, re-placed by hedge funds looking to capitalize on depressed unit prices.

A trust or partnership will be a SIFT if its securities are listed on a stock exchange or other public market, it holds nonportfolio property (NPP) and, in the case of a trust, if it is resident in Canada and, in the case of a partnership, if it is a Canadian partnership for purposes of the Income Tax Act, a partnership formed under the laws of a province or a partnership that would be resident in Canada for purposes of the act if it were a corporation. NPP is defined as including Canadian resource properties, Canadian timber properties and Canadian real estate, as well as certain investments, including debt and other investments, in other entities, called “subject entities.”

In the case of a SIFT partnership that is neither a Canadian partnership nor a partnership formed under the laws of a province, it appears that the proposed legislation is trying to catch partnerships having their central management and control in Canada. In general, a limited partnership is managed and controlled by its general partner and does not have its own mind and management separate and apart from its general partner. Thus in determining whether the partnership is managed and controlled in Canada one would need to look to where the general partner is managed and controlled.

The definition of a SIFT trust and partnership is intentionally very broad and potentially catches entities that are not income funds. A partnership having public debt will be a SIFT, even if it is wholly owned by corporations within a corporate group. Representations have been made to Finance to exclude such partnerships from the SIFT definition and it is possible that changes in this area will be made.

An investment in a subject entity is defined as an NPP if the SIFT, directly or indirectly, owns security interests in the entity representing greater than 10% of the equity value of the entity, or if more than 50% of the equity value of the SIFT is attributable to the securities of the entity held by the SIFT. In addition, any property used in carrying on a business in Canada by the SIFT or a person or partnership not at arm’s length with the investor will be an NPP.

A Canadian resource property, Canadian timber property or Canadian real property will be an NPP where the aggregate value of such property exceeds 50% of the equity value of the SIFT itself, and any property the value of which is derived principally from Canadian resource properties, Canadian timber properties or Canadian real properties will be treated as being such properties.

It is clearly intended that the NPP definition be very broad, so that SIFTs will essentially be defined to include all entities commonly known as income trusts as well as most publicly traded limited partnerships. One important exception to the entities that would otherwise be classified as SIFTs applies to real estate investment trusts (REITs) that meet certain criteria.

Typically, an income trust that distributes its income and taxable capital gains to its unitholders or beneficiaries is currently entitled to a deduction for tax purposes in a particular taxation year equal to the amount of such distributions paid or payable for the taxation year. Any income that is not so distributed is generally taxed in the trust at the highest federal and provincial income tax rates that are applicable to individuals.

A trust that is a SIFT will not be entitled to a deduction in respect of its distributed income or taxable capital gains to the extent that such amounts relate to income or taxable capital gains from NPP, (referred to as nonportfolio earnings). Nonportfolio earnings will therefore include income from businesses carried on by the SIFT trust in Canada, income from NPPs and taxable capital gains on dispositions of NPPs.

To avoid double taxation, the SIFT trust will be entitled to a deduction for dividends that would be deductible if it were a corporation. The SIFT will not be taxed on its nonportfolio earnings at the rates typically applicable to individuals, but instead such distributed nonportfolio earnings will be taxed federally at a rate equivalent to the general corporation tax rate, plus 13% (being a proxy for the provincial tax rate). The 13% will be distributed by the federal government among the provinces in a manner yet to be determined.

In the traditional income fund structure, which has a trust owning all of the securities of a wholly owned subsidiary corporation, there is the potential for increased tax cost where the provincial tax rate is less than the proxy rate of 13%. For example, the provincial tax benefit of an interest deduction to a corporation carrying on business in Alberta is 10%, whereas the trust receiving the interest income will be taxed at a rate of 13% in lieu of provincial tax. In income fund structures having a trust owning a limited partnership that carries on business in Alberta, it may be beneficial to transfer such a partnership to a corporation so that the income is taxed at 10% rather than 13%.

Only distributed earnings will be taxed under these new proposals; earnings that are retained by the trust will continue to be taxed at the highest federal and provincial rates that currently apply to such earnings.

Distributions that are paid by a SIFT trust that are not deductible by virtue of these proposals will be treated as taxable dividends from taxable Canadian corporations. For Canadian resident individuals such dividends will be subject to the gross-up and tax-credit provisions, which effectively provide a lower rate for dividend income than for other sources of income. For Canadian corporations such dividends will be deductible in computing income. For nonresidents, the distributions will be subject to withholding taxes at the same rates as apply to dividends and will be eligible for any tax treaty-based rate relief.

In addition, trusts commonly make distributions in amounts greater than their income. These excess distributions are effectively treated as a distribution of capital for tax purposes, reducing the adjusted cost base of the trust unit to the unitholder. In some cases involving nonresident unitholders, these distributions can be subject to tax. It appears there is no intent to change the manner in which these distributions of capital are treated for tax purposes.

Similar provisions will apply to SIFTs that are partnerships as are proposed to apply to SIFT trusts, with the exception that SIFT partnerships will be taxed, at the same rates that apply toSIFT trusts, on all their nonportfolio earnings, whether or not distributed. Partnership income subject to such tax will be re-characterized as dividend income to the limited partners of the partnership.

Perhaps the most controversial aspect of the Tax Fairness Package is the threat by the finance minister that the deferred application of the Distribution Tax to 2011 is conditional on existing SIFTs respecting the policy objectives of the proposals. In the background information to the Tax Fairness Package, the minister indicated that undue expansion of an exiting SIFT might cause the deferral to be rescinded. Understandably, advisers to entities caught by the new rules were concerned with the vagueness of the minister’s comments and it is understood officials from Finance fielded a significant number of queries in this regard. To deal with the uncertainty, the minister released the Normal Growth Guidelines on December 15,2006.

The guidelines effectively allow a grandfathered SIFT to double its October 31, 2006 equity by 2011 based on the closing unit price on October 31, 2006. Percentage growth in new equity from 2007to 2010 will be limited to 40% in 2007 and 20% in each of the following three years, and such percentages will be cumulative to the extent the prior year’s safe harbour is not used. SIFTs whose October 31, 2006 market capitalization did not exceed $250 million will be allowed an annual growth amount of $50 million; however, the $50-million safe harbour is not cumulative to the extent the previous year’s amount is not used.

Excluded from new equity is equity issued after October 31, 2006 to satisfy an obligation to issue shares pursuant to a convertible debenture and an exchangeable share or partnership interest. Mergers of grandfathered SIFTs and equity issued to convert debts outstanding at October 31 and owed by the SIFT to equity will also not be considered to be new equity. The conversion of October 31 debt into equity was intended to be a narrow exception and applies only to debt owed by the SIFT and not debts owed by any other entity owned directly or indirectly by the SIFT.

In the context of a merger of two SIFT trusts, it is understood based on discussions with officials from Finance that the 40%/20%/20%/20% safe harbour amounts are to be added together to determine the safe harbour amounts of the continuing trust. However, the $50-million safe harbour does not increase to $100 million for the continuing trust. Further, it is understood that the word “merger” is to be interpreted broadly so the actual steps undertaken to facilitate the merger are not an issue (e.g., if a mutual fund corporation is used to facilitate the merger).

The total impact to the income fund sector of the tax fairness measures is yet to be seen. Notwithstanding the release of the guidelines, growth of income funds has stagnated since October 31 largely due to limited access to capital and the great uncertain-ty around the rules. While it is expected that there will be significant consolidation of income funds, many funds will simply hoist the white flag and convert back to corporate form.

Warren Pashkowich, CA, provides services through Warren Pashkowich Professional Corp., a partner of Ernst & Young LLP

Technical editor: Trent Henry, leader of international tax services, Ernst & Young in Toronto