Department Of Finance Clamps Down On Stapled Securities

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The Department of Finance announced this morning that it will amend the Income Tax Act (Canada) (the "Tax Act") in response to certain transactions involving "stapled securities" that it considers to be end runs around its efforts to tax income trusts.
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The Department of Finance announced this morning that it will amend the Income Tax Act (Canada) (the "Tax Act") in response to certain transactions involving "stapled securities" that it considers to be end runs around its efforts to tax income trusts. On October 31, 2006 (often referred to as the "Halloween massacre"), the Minister of Finance announced legislation (the "SIFT Legislation") taxing Canadian income trusts, essentially putting an end to tax advantages they had enjoyed as flow-through entities for tax purposes. The rules allowed for a transition period for existing income trusts and introduced a carve-out for qualifying real estate investment trusts ("REITs"). While much focus since the Halloween massacre has been on transitioning to the new regime, some have looked to "stapled" structures as alternatives. Two income trusts recently converted into structures involving publicly traded units consisting of stapled debt and equity components (similar to a number of offerings several years ago of Canadian corporations carrying on U.S. businesses). In addition, earlier this year two REITs adopted a structure involving REIT units stapled with units of a taxable entity in order to qualify a portion of their operations for the exception from entity-level taxation for qualifying REITs. Today's announcement puts an end to both of these structures.

A stapled debt/equity structure generally involves a public corporation issuing a unit comprised of a common share and a subordinated high-yield debt instrument. The corporation's taxes are reduced or eliminated through deductible interest payments on the subordinated debt to holders of the stapled units. This result is similar to the flowing-out of income that occurred under the income trust structure. Today's announcement denies the corporation a deduction for interest paid on the stapled subordinated debt. As a result, stapled debt/equity structures will be less efficient than pure equity capitalization for taxable Canadian investors, who are generally taxed at a higher rate on interest than on dividends from Canadian corporations.

The stapled structure adopted by some REITs serves a different purpose. The conditions for REITs to be exempt from the SIFT Legislation are very restrictive, essentially limiting REITs to earning passive income and precluding them from undertaking development activities or holding operating real estate assets (e.g., hotels, seniors housing, health care facilities, etc.). The REIT stapled structure involves a REIT spinning off its non-qualifying assets and operations to a separate taxable entity, with the securities of the REIT and the sister entity trading together as stapled units. The REIT rents its real property to the sister entity and the sister entity operates the facilities. The new legislation provides that any payments (including rent) made by the sister entity to the REIT will not be deductible. Thus, while the status of the REIT itself is not affected by these changes, the earnings represented by the non-deductible payments from the sister entity will now be taxed twice - once in the sister entity and once in the hands of the REIT unitholders.

The new legislation provides a transition period before the rules become effective for existing stapled structures. For those that were in existence on October 31, 2006, the legislation will not apply until January 1, 2016 and for those that came into existence after October 31, 2006 but before July 20, 2011, the legislation will not apply until July 21, 2012.

Today's announcement also contains minor technical changes to the SIFT Legislation, and moves SIFTs onto a corporate instalment regime (i.e., monthly rather than quarterly tax instalments).

For a more detailed discussion of income trusts, the SIFT Legislation and the two stapled unit structures described above see our article titled "The Rise and Fall of Income Trusts" (available at http://www.dwpv.com/en/17623_24341.aspx).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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