Exposures or opportunities?

By Sania Ilahi
Illustration: John Sapsford

Thanks to a hot M&A market, taxpayers and advisers will need to devote more time to analyzing transaction cost issues

The past few years have seen an explosion in the number of public offerings involving an income trust structure. Traditionally, income trust structures were used primarily in the real estate and oil gas sectors. More recently however, income trust structures have been adopted by a wide range of business sectors, including retail and manufacturing, restaurants, private assisted-living centres, etc., and such nontraditional uses of the income trust structures have been on the incline. However, the growth of income trusts will likely be curtailed as a result of the tax measures introduced on October 31, 2006 (the draft legislation was released on December 21, 2006). In response to a perceived tax imbalance resulting from publicly traded trusts and partnerships, the government introduced a number of measures intended to curb the tax benefits associated with income trust structures. The measures include a new distribution tax to be applied on certain distributions and allocations from publicly traded trusts and partnerships. The tax will generally take affect beginning with the 2007 taxation year for trusts that begin trading after October 31, 2006, but will only apply beginning with the 2011 taxation year for pre-existing publicly traded trusts and partnerships.

As income tax savings usually drive income trust structures, income tax implications are routinely considered at each stage of a conversion to an income trust. GST implications, however, are just as often overlooked. Ignoring the GST issues can lead to potentially significant exposures. With the income tax announcements, it is an opportune time to review GST issues that may be applicable. There are GST issues that affect existing and proposed income trusts as well as key issues affecting the unravelling of income trusts.

In short, an income trust is a financing vehicle for certain types of businesses, the objective of which is to distribute cash flows of an underlying entity to investors in an income tax efficient manner. A plain vanilla income trust structure involves an income trust that owns all the shares of an operating entity and involves investors that hold units of the income trust. Generally, the operating entity is a corporation or partnership.

Although the new income tax measures will likely curtail new income trust conversions, it is important to review GST issues affecting existing and any planned income trusts. One area of concern is the initial offering costs. Typically, offering costs involve legal, accounting and advisory services. However, underwriting services, normally the largest single expense of an offering, are exempt from GST as they are considered to be financial services. Merger and acquisition advisers and other dealmakers usually consider the structure on a consolidated basis rather than on an individual entity basis. In most cases, offering costs are allocated among the various entities in the structure. The allocation decision is typically made after the conversion, in anticipation of filing the income tax return. However, for GST purposes, each legal entity in the structure is considered to be a separate person and the tax issues are considered for each entity rather than on a consolidated basis. An allocation of costs may be considered a supply for GST purposes. Identifying the recipient of a particular supply is key to determining the GST implications of that supply.

For an example of a typical income trust structure please see the chart on page 40.

In this case, an income trust wholly owns the operating company (Opco) that is engaged exclusively in commercial activities (as defined for GST purposes), for example furniture manufacture. Public investors purchase units in the income trust. Third-party suppliers include accountants, lawyers, advisers and underwriters. These suppliers may invoice Opco or the fund directly (supply No. 1 on the diagram). In turn, Opco and/or the fund may allocate a portion of the costs to the other entity (supply No. 2 represented by dotted lines). The concern is whether GST will apply on the allocation of the costs between the entities.

If, for example, the fund receives accounting services and subsequently allocates a portion of the costs to Opco, the fund may be resupplying the accounting services to Opco. Thus, the fund would be required to register for GST purposes and begin collecting and remitting GST on the resupply. Alternatively, the fund may receive services from Opco, on which it will be required to pay GST. This GST may represent an additional cost to the fund, since the fund is usually not entitled to recover the GST it pays as an input tax credit. This issue is further complicated when exempt financial services are allocated between the entities. The concern is whether an exempt supply will retain its exempt status when it is resupplied. The Canada Revenue Agency may take the position that the nature of the supply changes when it is resupplied, and look to tax that resupply. This can result in a significant GST cost, specifically when the fund receives underwriting services as these services are initially exempt, but may become taxable when allocated between entities.

In addition to the one-time offering costs, assets and/or services are often supplied between entities on an ongoing basis. For example, the operating entity may provide management/administrative services to the income trust, which typically does not have any employees. As discussed above, generally, any transfer of goods and services between legal entities constitutes a supply for GST purposes, and potentially triggers GST.

The new income tax rules will likely lead to the conversion of some income trust structures back to traditional corporate structures. While Finance guidelines state it is intended that conversions to a corporation take place without any tax consequences to investors, there is no reference to the possible tax consequences at the entity level upon such a conversion.

As with any restructuring, GST implications should not be ignored. Administrative matters, such as cancelling GST registrations of entities being dissolved and registering new entities, can be overlooked, often leading to potential penalties or missed opportunities. Furthermore, any assets in an entity being wound-up or dissolved may be transferred to another entity within the group. In certain situations, such a transfer may occur on a tax-free basis, but only if appropriate steps take place in the planning process.

As an example, the entities may be able to use provisions in the GST legislation that allow for the tax-free transfer of assets of a business. Section 167 of the Excise Tax Act (ETA) permits a supplier to supply a business or part of a business to a recipient with no GST payable if certain conditions are met and the parties jointly file an election. These conditions include:

• the recipient must be registered for GST purposes at the time of the sale;
  
• the transaction constitutes a sale of a business; and
  
• the recipient is acquiring ownership, possession or use of at least 90% of the property needed to carry on the business.

Thus, if the fund is unwinding and transferring its assets to another entity, the two parties may be entitled to use Section 167 provisions to transfer the assets on a tax-free basis. The cash-flow benefits of this election can be significant.

If the parties are not eligible to elect under Section 167, GST must be collected and remitted by the vendor. The recipient should ensure it is registered for GST purposes as of the date of the sale so that it is entitled to claim any available input tax credits.

It is possible that a Section 167 election was used during the formation of the income trust structure. It is important to not assume that eligibility to file the election at the time of formation results in eligibility during the dissolution or conversion of the structure. For example, at the time of formation, all the assets of one entity may have been allocated to another entity and the conditions met to file the election. However, upon dissolution of the structure, if the assets are being distributed among several companies, the criteria requiring the recipient to acquire all or substantially all the assets may not be satisfied.

The possible use of a Section 167 election is just one area that demonstrates that the dissolution of the income trust structure cannot be assumed to be just the inverse of the formation of the structure.

When comparing income trust and corporate structures, under the previous income tax rules, the income trust will typically come out ahead in terms of income tax benefits. However, from a GST perspective, there may be significant disadvantages to an income trust structure when compared with a similar corporate holding-company structure. This is due to the ability of a corporate holding company to recover GST paid on expenses incurred. A typical corporate group consisting of a corporate holding company holding a corporation engaged in taxable activities may be eligible to make use of subsection 186(1) of the ETA to recover GST paid on expenses incurred at the holding-company level. This provision also allows ITCs in a multitiered structure of one or more holding companies that ultimately hold a corporation engaged in commercial activities. A requirement of subsection 186(1) is that both entities (e.g., the holding company and operating company) be corporations. This requirement is often not met in the case of an income fund structure since the intermediary entities, which effectively hold the ultimate operating company, are often not corporate entities (e.g., partnerships and trusts).

While income trust structures may continue in some form, their popularity will likely be curbed in light of the income tax announcements. Likely more income trusts will revert to corporate structures. For existing income trust structures, it is wise to review the formation costs and any allocations of costs to ensure appropriate GST treatment. Overlooking this may result in unforeseen additional costs. For income trust structures that are unwinding or reverting to a corporate structure involving a corporate holding company, it is important to consider any GST issues that arise. Also, GST on costs previously unrecoverable by the income trust may be recoverable by the corporate holding company. It is important to consider the GST impact of all such transactions.

Sania Ilahi is a tax senior manager (financial services) with Ernst & Young LLP, in Toronto

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