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canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 2, 247 - 88
247
Stapled Securities—“The Next Big Thing” for Income Trusts? Useful Lessons from the US Experience with Stapled Shares
Reuven Avi-Yonah, Tim Edgar, and Fadi Shaheen*
P r é c i s
Le ministère des Finances (« le ministère ») a présenté deux séries distinctes de mesures législatives qui, ensemble, visent à étouffer la demande sur le marché des fiducies de revenu (mais avec des conséquences différentes au chapitre du revenu). Cependant, ni la législation proposée ni l’actuelle Loi de l’impôt sur le revenu ne contiennent de règle visant la nouvelle qualification des capitaux propres. Par conséquent, les résultats fiscaux associés aux structures standards des fiducies de revenu et des fiducies de redevances peuvent encore se matérialiser avec des structures de participation directe où l’utilisation d’une fiducie comme mécanisme de mise en commun est éliminée et où les investisseurs détiennent directement une obligation spéculative à rendement élevé combinée à un nombre déterminé d’actions de l’émetteur. Jusqu’à maintenant, ces structures d’obligation spéculative étaient principalement utilisées à des fins de placement transfrontalier aux États-Unis pour éviter l’impôt sur le revenu des sociétés américain sans perte significative des attributs autres que fiscaux. Mais l’élimination des restrictions sur la détention de biens étrangers dans le cadre de régimes de report du revenu exonéré d’impôt, comme les régimes de pension agréés et les régimes enregistrée d’épargne-retraite, signifie qu’il y a très peu de contrainte dans la législation fiscale à l’acquisition de substituts à ces obligations spéculatives par cette catégorie d’investisseurs dans le contexte canadien.
L’article met en lumière l’utilisation de titres combinés (de participation et d’emprunt) comme structure de participation directe pour éviter l’application du traitement fiscal des dividendes à des structures de fiducie de revenu ciblées, comme le prévoit la dernière proposition législative du ministère. Les auteurs laissent entendre que le ministère devra probablement modifier la législation proposée pour tenir compte précisément de ces structures de propriété combinée. Ils montrent comment l’expérience américaine avec des actions combinées, en particulier la réponse législative du Congrès fournit un modèle
* ReuvenAvi-YonahistheIrwinI.CohnProfessorofLawatTheUniversityofMichiganLawSchool,AnnArbor.TimEdgarisoftheFacultyofLaw,TheUniversityofWesternOntario,London,andaseniorfellow,TaxationLawandPolicyResearchInstitute,MonashUniversity,Melbourne.FadiShaheenisanSJDcandidateatTheUniversityofMichiganLawSchool.Theauthorswouldliketothanktwoanonymousrefereesforvaluablecommentsonanearlierdraftofthisarticle.
248 n canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 2
pratique viable pour les modifications à apporter. Cependant, ce modèle législatif ne porterait que sur les titres combinés dans le cadre de structures intermédiaires. On a aussi besoin d’une certaine forme de règle de nouvelle qualification des capitaux propres pour tenir compte de l’utilisation de participations combinées dans des structures autres qu’intermédiaires pour assurer l’efficacité de la législation proposée.
A b s t r A c t
The Department of Finance (“the department”) has introduced two separate sets of legislation that together attempt to limit demand in the income trust market (though with very different revenue consequences). However, neither the proposed legislation nor the existing Income Tax Act contains an equity recharacterization rule. Consequently, the tax results associated with the standard income trust and royalty trust structures can still be realized with direct holding structures, in which the use of a trust as a pooling mechanism is eliminated and investors hold directly a combination of high-yield junk debt and a specified number of shares of the issuer. Until now, these junk bond structures have been used primarily for cross-border investment into the United States, to avoid the US corporate income tax without any significant loss of non-tax attributes. But the elimination of the foreign property holding restrictions for tax-exempt deferred income plans, such as registered pension plans and registered retirement savings plans, means that there is very little in the way of any tax-law constraint on the acquisition of direct junk bond substitutes by this class of investors in a domestic context.
This article highlights the use of stapled securities as a particular direct holding structure that could be used to avoid the application of the department’s latest legislative proposal, which applies dividend tax treatment to targeted income trust structures. The authors suggest that the department will most likely have to modify this draft legislation to specifically address stapled security structures. They illustrate how the US experience with stapled shares, and particularly the congressional legislative response, provides a workable template for the necessary modifications. However, this legislative template would only address the use of stapled securities in intermediated structures. Some form of equity recharacterization rule to address the use of stapled securities in disintermediated structures is also needed to ensure the target effectiveness of the draft legislation.
Keywords: Income trusts n shares n securItIes n transactIonal substItutIon n specIfIed
Investment flowthrough n non-portfolIo propertIes
c o n t e n t s
Introduction 249Income Trust Structures as an Example of Tax-Driven Transactional Substitution 252Using Stapled Securities To Avoid the Application of the Draft Legislation 260US Experience with Stapled Shares 267
Stapled REIT Structures 267Stapled Foreign Corporation Structures 271
Avoiding Subpart F 271Avoiding Withholding Tax and Retaining the Benefit of the DRD 272
US Congressional Reaction to Stapled Share Structures 274Case Law Preceding the Enactment of IRC Section 269B 274IRC Section 269B 276
stapled securities—“the next big thing” for income trusts? n 249
intro duc tio n
OnOctober31,2006,theDepartmentofFinance(“thedepartment”)issuedapressrelease1andanaccompanyingsetoflegislativeproposalsintendedtoshutdowndemandintheincometrustmarketfromtheremainingtaxclienteleforthisstruc-ture—namely,non-residentandtax-exempt investors, includingdeferred incomeplanssuchasregisteredpensionplans(RPPs)andregisteredretirementsavingsplans(RRSPs).Theseproposals,whichhavebeencarriedforwardandmodifiedindraftlegislationreleasedonDecember21,20062andagainonMarch27,2007,3attempttorealizethisresultbyapplyingdividendtreatmenttodistributionsfromcertainpubliclytradedtrustsandpartnerships.Theresultingentity-leveltaxisintendedtosupplement the enhancement of the dividend tax credit for resident individuals,whichwastheimmediatelypreviouslegislativeresponsefocusedonthedemandsideoftheincometrustmarket.4Budgetaryconstraintsapparentlypreventedtheexten-sionofthecreditonarefundablebasistotax-exemptandnon-residentinvestors,5necessitatingafurtherresponsetoaddresscontinueddemandfromtheseinvestors.
Extending the Draft Legislation To Address the Use of Stapled Securities 279Addressing Stapled Securities in Intermediated and Disintermediated Structures 279Maintaining the Exception for REITs 284
Appendix IRC Section 269B 288
1 Canada,DepartmentofFinance,News Release2006-061,October31,2006(hereinreferredtoas“theOctober2006proposals”).
2 Canada,DepartmentofFinance,News Release2006-086,December21,2006andtheaccompanyingdraftlegislationandexplanatorynotes(hereinreferredtoas“theDecemberdraftlegislation”).
3 Canada,DepartmentofFinance,News Release2007-026,March27,2007andtheaccompanyingNoticeofWaysandMeansMotionToImplementCertainProvisionsoftheBudgetTabledinParliamentMarch19,2007—BudgetImplementation2007,March27,2007(hereinreferredtoas“theMarch2007noticeofwaysandmeansmotion”).TheMarch2007noticeofwaysandmeansmotionhassincebeenenactedbyBillC-52,BudgetImplementationAct,2007;SC2007,c.29.LegislativereferenceshereinhavenotbeenupdatedtoreflectthepassageofBillC-52,whichfollowedthewritingofthisarticleanditspreparationforpublication.
4 Canada,DepartmentofFinance,News Release2005-082,November23,2005(hereinreferredtoas“theNovember2005proposal”).Theproposalwasimplementedinlegislationeffectivefordividendspaidafter2005.SeeSC2007,c.2,sections44(1)and48;andCanada,DepartmentofFinance,News Release2006-028,June29,2006andtheaccompanyingdraftlegislationandexplanatorynotes.TheNovember2005proposalwasbroughtforwardbythenewConservativegovernmentinitspost-electionbudget.Canada,DepartmentofFinance,2006Budget,BudgetPlan,May2,2006,231-32andtheaccompanyingNoticeofWaysandMeansMotionToAmendtheIncomeTaxAct,resolution(20).
5 Foradiscussionofasystemoffullintegrationasasystemicresponseintendedtoeliminatetheincometrustmarket,seeJackM.MintzandStephenR.Richardson,“IncomeTrustsandIntegrationofBusinessInvestorTaxes:APolicyAnalysisandProposal”(2006)vol.54,no.2Canadian Tax Journal359-406;andLalitAggarwalandJackMintz,“IncomeTrustsand
250 n canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 2
Thislatestvolleyfromthedepartmentmaysignalamercifulendtotheincometrustsaga.Onecanonlyhopethatitdoes,aftermonthsofargumentsindefenceofincometrusts,diligentlyreportedbyanoftensympatheticpopularpress.6Yetthedraftlegislationleavessomegapingholes.7Insteadofclosingthoseholeswithspecificlegislation,thedepartmentissuedawarninginthepressreleaseaccompanyingtheOctober2006proposals:“[I]fthereshouldemergestructuresortransactionsthatareclearlydevisedtofrustratethosepolicyobjectives[thedeathoftheincometruststructure],anyaspectofthesemeasuresmaybechangedaccordinglyandwithim-mediateeffect.”Itremainstobeseenwhetherthisstatementconstitutesasufficientmarketchilltokillthedemandforincometrusts.Ifthereisnosucheffect,thein-cometrustsagacouldmoveintoanewstapledsecuritiesand/orjunkbondphase.8
Giventheunderinclusivenessofthedraftlegislation,webelievethatitisunlikelytobesuccessfulinultimatelyeliminatingtheincometrustmarket.Thislatestresponseisentirelycharacteristicofthedepartment’sapproachthroughouttheincometrustsaga,whichhasbeenmarkedbytwodefiningfeatures.Onefeatureisahesitancytodoanythingaheadofdevelopmentsinthefinancialmarkets.Thishesitancyhasleftthedepartmentcontinuallyonthebackfoot.Theotherfeatureisapreferencefor
ShareholderTaxation:GettingItRight”(2004)vol.52,no.3Canadian Tax Journal792-818.BudgetaryconsiderationsmayalsobeafactorinrecentlegislativeproposalsintheUnitedStatestodenythelowrateofpersonaltaxondividendsforincometrustdistributionsreceivedbyUSinvestors.SeeCarrieTait,“USBillDoublesTrustTaxto35%,”Financial Post,March28,2007.
6 Forarefreshinglyindependentview,seeEricReguly,“TrustLobbyists,That’sEnoughofYourFury,”Globe and Mail,December19,2006.(“Someoneshouldencaseincometrustlobbyistsinconcreteandflingthemoffabridgeintodeepwater.Onsecondthought,forgetit;eventhatwouldn’tstopthemisguidedcreatures.Houdini-like,theywouldsomehowbreakfreeandcallforJimFlaherty’s[theFinanceMinister’s]headthemomenttheirlipsbrokethesurface.Theyareunstoppableandinsatiable.”)
7 Thedraftlegislationhasalreadybeenthesubjectofanextensivedescriptiveliterature.Foragoodreviewofthedraftlegislation,includinganalysesofvariouslegislativepressurepoints,seeCorradoCardarelli,“IncomeTrustandMutualFundTrustDevelopments,”inReport of Proceedings of the Fifty-Eighth Tax Conference,2006ConferenceReport(Toronto:CanadianTaxFoundation,2007),10:1-19.
8 Theimperativetofindtax-effectivesubstitutesforincometruststructuresthataresubjecttothedraftlegislationmaybemutedsomewhatbythegeneroustransitionalrelief.Inparticular,applicationoftheproposeddistributionstaxisdeferreduntil2011fortargetedentitiesthatwerepubliclytradedasofOctober31,2006.Moreover,thedepartmenthasexpandedthescopeofthefour-yearsunsetclausetoaccommodatethe“normalgrowth”ofgrandfatheredentities.Thedepartmenthasproposedadefinitionofsuchgrowthasnewequityissuesequaltothegreaterof(1)$50millionand(2)100percentofthemarketcapitalizationofanentityattheendoftradingonOctober31,2006.The100percentsafeharbouristobespreadona40/20/20/20basisfor2007throughto2010.SeeCanada,DepartmentofFinance,News Release2006-082,December15,2006.TheseproposalswerecarriedforwardintheMarch2007noticeofwaysandmeansmotion.Curiously,theywerenotbroughtforwardinlegislativeform.Instead,thegeneralwordingoftheguidelinesinthepressreleaseisincorporatedbyreference.
stapled securities—“the next big thing” for income trusts? n 251
incrementalresponsesthattargetparticulartaxpayersonthedemandsideofthein-cometrustmarketinthehopethatdoingsowilltakesufficientairoutofthemarket.9Theseresponseshaveinvariablybeenunderinclusiveandhaveallowedtheincometrustmarkettocontinuetogrowattheexpenseofthecorporateincometaxbase.Underlyingbothofthesefeaturesisasubstantialpoliticaldimension,reflectedpartlybytherepresentationsofvocalandpersistent“paperentrepreneurs”(investmentbankers,accountants,andlawyers)and“thegreypowerset.”10Theformerhaveen-joyed a presumably profitable role in creating and marketing the income truststructureaswhathasbeenperceivedtobeanecessaryelementintheinvestmentportfoliosofthelatter,whetherhelddirectlyorthroughRPPsorRRSPs.
Thisarticlehighlightsthepossibleuseofstapledsecuritystructuresasatechniquetoavoidtheapplicationofthedraftlegislation.Thefirstpartofthediscussionde-scribesthedevelopmentofthegeneralfeaturesoftheincometruststructureasanexampleoftax-drivenfinancialinnovationinvolvingthesubstitutionofalower-taxedtransactionalformforahigher-taxedtransactionalform.Thesecondpartreviewsthedraftlegislationasanattempttoequatethetaxonincometruststructuresandconventionalcorporatestructuresbyraisingthetaxontheformer.Thefailureofthelegislationtoapplytothefullrangeofpotentialtransactionalsubstitutesisem-phasized;inparticular,thedraftlegislationleavesthedooropentotheuseofstapledsecuritiesasatax-effectivesubstituteforanincometruststructure.Stapledsecuritiesaresecuritiesoftwoormoreformallyseparateentitiesthatarecontractuallystapledtogethersothattheymaynotbeowned,held,sold,orpurchasedseparately.
ThethirdpartofthearticledescribestheUSexperiencewithstapledsharesin-cluding,inparticular,thelegislationintroducedbyCongresstopreventtheiruseastax-effectivetransactionalsubstitutesinboththedomesticandinternationalcontexts.ThefourthpartconsidershowtheUSlegislativeresponsetostapledsharestruc-turesmightbeincorporatedinthedraftlegislationinanefforttoimproveitstargeteffectiveness.Wenotethatextensionofthedraft legislationtostapledsecurities
9 Theincometrustsagaisnotthefirsttimethatthedepartment’spolicy-makingeffortsinresponsetotax-drivenfinancialinnovationhavebeenmarkedbythesetwofeatures.Apastexamplewithalltoomanyparallelsisthepreferredsharesaga,whichunfoldedfrom1974to1987.Thisperiodsawaseriesofunderinclusive,incrementalresponsestotheuseofpreferredsharesastax-effectivedebtsubstitutes.Demandwasnotshutdownuntil1987,withtheintroductionofacomprehensivedistributionstaxapplicabletodividendspaidontaxablepreferredshares(broadlydefinedasanyshareotherthanafullyparticipatingcommonshare).SeeTimEdgar,“TheClassificationofCorporateSecuritiesforIncomeTaxPurposes”(1990)vol.38,no.5Canadian Tax Journal1141-88,at1149-57.
10 MuchoftheorganizedrepresentationefforthasbeenspearheadedbytheCanadianAssociationofIncomeFunds.However,therehasbeennoshortageofcommentarygeneratedbyindividualsactingindependentlyofthisloosecoalition(thoughalsoapparentlymotivatedbyself-interest).ThelobbyistsfoundawelcomingaudienceamongpoliticiansduringparliamentaryhearingsontheDecemberdraftlegislation.Thehearingsculminatedinananalyticallythinreport:Canada,HouseofCommons,Taxing Income Trusts: Reconcilable or Irreconcilable Differences?ReportoftheStandingCommitteeonFinance,39thParl.,1stsess.,February2007.
252 n canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 2
wouldstillleavethedirectholdingofhigh-yieldjunkdebtasapossibletax-effectivesubstitute.Intheabsenceofanysignificantnon-taxconstraintsontheuseofsuchdebt,afurtherlegislativeresponsemayberequired.Butthisresponsewouldhavetobemuchdifferent,bothconceptuallyandinitsdesignfeatures,fromthedraftlegis-lation,evenifthelegislationweresupplementedwithadditionalprovisionsaddressingtheuseofstapledsecurities.Inparticular,anextensionofthedraftlegislationtostapledsecuritieswouldsomehowhavetobesupplementedwithafurtherextensiontosecuritiesthatareheldproportionallybyinvestors,butarenotformallystapledtogether.
Thefourthpartofthearticlealsoincludesabriefdiscussionoftheexceptioninthedraftlegislationforrealestateinvestmenttrusts(REITs),11whichthesuggestedmodificationstoaddresstheuseofstapledsecuritystructureswouldleaveinplace.ThesemodificationswouldbelimitedtoadenialoftheavailabilityofexemptREITstatusinthecontextofstapledsecuritiesusedtoavoiddividendtaxtreatment.
income trus t s truc t ure s A s A n e x A mPle of tA x-driven tr AnsAc tionAl substitution
Thecommonfeatureofincometruststructuresistheelimination(orsubstantialreduction)oftheunintegratedportionofthecorporateincometaxbysubstitutinghigh-yield, subordinated junkdebt foradirect share investment inanoperatingcorporation. In addition, the vast majority of income trust structures include apooledinvestmenttrusttoholdthedebtandanyremainingequity.Thesubstitu-tionisthatofa lower-taxedtransactionforahigher-taxedtransactionalongtwodifferentboundaries,oneithersideofwhichisadifferenttaxtreatmentundertheIncomeTaxAct.12
Thesubstitutionofhigh-yieldacquisitionindebtednessforsharesofanoperatingcorporationfocusesonadiscontinuityalongthedebt-equityboundary.Inparticular,thepatternofcashflowsassociatedwiththerelevantsharesisalteredbysubstitut-ingafixedpaymentintheformofinterestontheacquisitionindebtedness.Withbusinessesthatrequirelittleornoretentionofearningsforcapitalexpenditures,thesacrificeinthedesiredpatternofcashflowsissmall,yetthedebt-for-equitysubstitu-tionresultsinasignificantanddisproportionatechangeintaxtreatment(deductibleinterestexpenseatthecorporatelevelversusnon-deductibledividendpayments).Thesubstitutionofatrustforaholdingcorporationasavehicletopoolthecapitalofinvestorsacquiringthesharesoftheoperatingcorporationfocusesonaninconsistencyinthetaxtreatmentofthecashflowsdistributedfromthesetwoorganizationalforms.Withoutanysacrificeinthedesiredpatternofcashflows,distributionsfromthe
11 ThechangestothedraftlegislationproposedintheMarch2007noticeofwaysandmeansmotionprimarilyaddressthescopeofthisexception.Seeinfranotes41and42and110to119andtheaccompanyingtext;andAlanBowman,JonNorthup,andJarrettFreeman,“GovernmentReleasesRevisedIncomeTrust/REITRules”(2007)vol.46,no.2Tax Notes International143-45.
12 RSC1985,c.1(5thSupp.),asamended(hereinreferredtoas“theAct”).Unlessotherwisestated,statutoryreferencesinthisarticlearetotheAct.
stapled securities—“the next big thing” for income trusts? n 253
trustaredeductibleandarenotsubjecttoanyentity-leveltax,whiledistributionsfromacorporationarenon-deductibleandsubjecttothecorporateincometax.
Atabroadconceptuallevel,theincometruststructureisanexampleofaparticulartypeofbehaviouraladjustmenttotaxesthatissometimesreferredtointheliteratureas“transactionalsubstitution.”13Asoneparticularcategoryofsuchanadjustment,transactional substitution involves the substitutionof a lower-taxed transactionalformforahigher-taxedformininstancesofperfect(ornear-perfect)substitutabilityorinstancesofimperfectsubstitutability.14Theprincipaldifferencebetweenthesetwotypesofsubstitutionliesinthesacrificeofdesirablenon-taxattributesassociatedwithahigher-taxedtransactionthatmustbemadeinordertoaccessthetaxsavingassociatedwithalower-taxedsubstitute.Thisdifferenceinnon-taxattributesrep-resentstheefficiencyloss(referredtointheeconomicsliteratureas“excessburden”or“deadweightloss”)associatedwiththebehaviouraladjustmenttotheparticulardifference in tax treatment. In both instances, the substitution of a lower-taxedtransactionresultsinrevenuelossequaltothetotaloftheexplicittaxessaved.Be-causethesubstitutabletransactionshavedifferentnon-taxfeaturesininstancesofimperfectsubstitutability,efficiencylossesarisedirectlyfromthesubstitution.15
Thedevelopmentoftheincometruststructureis,inlargepart,thestoryoftheattempttorefinethesestructurestomorecloselyreplicatethenon-taxattributesofthehigher-taxedholdingofsharesofacorporationinbothintermediatedanddis-intermediatedforms.Theincometrustsagabeganinnocentlyenoughwithataxrulingin1986thatblessedaroyaltytruststructurecreatedinCalgaryfortheacqui-sitionofoilandgasassetsinAlberta.16Thestructurestrippedtheprofitsfromthe
13 See,forexample,TimEdgar,“DesigningandImplementingaTarget-EffectiveGeneralAnti-AvoidanceRule,”inDavidG.DuffandHarryErlichman,eds.,Tax Avoidance in Canada After Canada Trustco and Mathew(Toronto:IrwinLaw,2007),221-58(categorizingtax-avoidancetransactionsastax-attributecreationtransactions,tax-attributetradingtransactions,andtransactionalsubstitutions);andMichaelBrooksandJohnHead,“TaxAvoidance:InEconomics,LawandPublicChoice,”inGraemeS.Cooper,ed.,Tax Avoidance and the Rule of Law(Amsterdam:IBFDPublicationsBV,1997),53-91(cataloguingthedifferenttypesoftax-avoidancebehaviourthatarethefocusofeconomicsandlaw).
14 SeeBrooksandHead,supranote13(describingsimilarconsequentialattributessharedbythedifferenttypesoftax-avoidancebehaviour).
15 Themostobviousconsequentialattributeofinstancesofperfect(ornear-perfect)substitutabilityistherevenuelossattributabletothesubstitutionofthelower-taxedforthehigher-taxedasset,item,ortransactionalformwithequivalentnon-taxfeatures.Becausethealternativeshaveequivalentnon-taxfeatures,noefficiencyeffectsresultdirectlyfromthesubstitution.Buttheremaybeindirectefficiencyeffectswherethegovernmentoperatesunderabudgetconstraint.Underthosecircumstances,therevenuelosscausedbythesubstitutionmayhavetobemadeupwithothertaxesthatcanhaveefficiencyeffectsassociatedwiththebehaviouraladjustmentstosuchtaxes.Alternatively,therevenuelosscanresultinexpenditurecuts,withincomeandwealthdistributioneffects(andevenefficiencylosseswheretherelevantspendingprogramsaddressmarketfailures).SeeJamesM.Buchanan,“ExternalityinTaxResponses”(1966)vol.33,no.1Southern Economic Journal35-42.
16 JacquieMcNishandBeppiCrosariol,“ATaxingWeek,”Globe and Mail,November8,2006.
254 n canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 2
propertiesbypayingtax-deductibleroyaltiestoamutualfundtrust,whichdistributedtheroyaltiestotheunitholdersonatax-deductiblebasis.Thecombinationofthetax-deductionfortheroyaltypaymentsandtheflowthroughtreatmentoftheincomedistributedbythetrustavoidedtheunintegratedportionofthecorporate-leveltax,whichwouldhavebeenpayableiftheassetshadbeenacquiredbytheinvestorsincorporateform.Forseveralyears,erosionofthecorporate-leveltaxthroughtheuseoftheroyaltytruststructureremainedconfinedtotheoilandgassector;however,intheearlytomid-1990s,thisstructurewasmodifiedtosubstitutehigh-yield,sub-ordinatedjunkdebtforaroyaltyagreementinwhatcametobecalledan“incometrust”structure.
Developmentoftheincometruststructureasamodificationoftheroyaltytrustismarkedbythreegeneralphasesortypesofstructures.17Thefirststageofdevelopmentproducedthestandardincometruststructure(seefigure1),whichwasinitiallyusedinshareacquisitionsanddebt-for-equityrecapitalizationsofcorporationscarryingonmaturebusinesseswithstablecashflowsandlittleinthewayofcapitalinvest-mentrequirements.Thecommonfeatureofthisfirstgenerationofincometruststructureswastheelimination(orsubstantialreduction)oftheunintegratedportionofthecorporateincometaxbysubstitutingjunkdebtforashareinvestmentinanoperatingcorporation.18Inaddition,thisbasicstructureincludedapooledinvest-menttrusttoholdthedebtandanyremainingshares.
Thesecondgenerationofincometruststructures(seefigure2)combinedthetax-deductiblepreferred share featureof the junkdebt in the standard structurewiththeuseofapartnershiptorealizeasimilarlytax-efficientstructuringofthedistributionofthatportionoftheearningsofabusinessthatrepresenttheriskier
17 Thistaxonomyofincometruststructuresisanadmittedoversimplificationofthetransactionaldetails.Thereisawiderangeofstructuresdifferingincertainrespects.Forexample,intheUScontext(discussedlaterinthisarticle)differentstructuraldetailsareinvolvedwithUSlimitedliabilitycompaniesandUSCcorporationstructuresusedintheacquisitionofaUSbusinessinanassetsaleorasharesale.Anothervariationinvolvestheuseofaroyaltytruststructuretoacquirecertainoperatingbusinesses,ratherthanresourceproperties.Thesestructurescannonethelessbeclassifiedwithinoneofthethreegeneralcategoriesdescribedhere(aswellastheroyaltytruststructure)forthepurposesofillustratingthetargetingissuestheypresent.See,inthisrespect,SimonRomanoandJeffreySinger,“CanadianIncomeTrustsComeofAge”[March2005]International Financial Law Review53-56(characterizingincometruststructuresasvariationsononeoftwothemes:(1)theuseofacorporationtoowntheunderlyingbusinessassets;and(2)theuseofalimitedpartnershiptoholdtheunderlyingbusinessassets).
18 Insomeearlyadvanceincometaxrulings,therewerequestionscentredonthereasonablenessoftheamountoftheinterestexpensefordeductionpurposesunderparagraph20(1)(c).Forareviewoftheformalisticcharacterizationapproachofjunkdebtinthecontextofincometruststructures,seeDouglasA.Cannon,“IncomeTrusts:TheInterest(Deduction)Continues—AReviewofWestshoreTerminalsIncomeFundandSuperiorPropaneIncomeFund,”inCurrent Issues in Corporate Finance,1997CorporateManagementTaxConference(Toronto:CanadianTaxFoundation,1998),4:1-28,at4:8-13.SeealsoPaulD.Hayward,“IncomeTrusts:A‘Tax-Efficient’ProductortheProductofTaxInefficiency?”(2002)vol.50,no.5Canadian Tax Journal1529-69,at1551-53.
stapled securities—“the next big thing” for income trusts? n 255
growthelementand/ortheassociatedretentionofearningsforcapitalexpenditures.Moreparticularly,these“incometrustwithapartnership”structurescontinuedtoinvolvetheissuanceofhigh-yieldjunkdebttostripouttheexpectedreturnonassetsheldindirectlyinapartnershipthroughanoperatingtrustandanupper-tiermutualfundtrust.Inthestandardpartnershipstructure,thehigh-yielddebtisissuedattheleveloftheoperatingtrust,whiletheunexpectedreturnispassedonbydistributingthereturnonthepartnershipinterestheldbytheoperatingtrusttotheupper-tier
FIGURE 1 Standard Income Trust Structure
Opco
Mutual fund trust
Investors
1. Common shares2. Subordinated debt
Business assets
FIGURE 2 Income Trust with a Partnership Structure
Sellco
Mutual fund trust
Operating trust
1. Trust units2. Subordinated debt
Business assets
Partnership
Investors
256 n canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 2
mutualfundtrustandontotheholdersofinterestsinthattrust.19Thus,throughthecombinationofanincometrustandapartnershipstructure,themarketdevel-opedameanstostripoutfromthecorporateincometaxbaseboththecompetitivereturnandanyeconomicrentsofabusiness,aswellasthereturnontheassumptionofrisk.Inshort,thewholeoftheunintegratedportionofthecorporateincometaxoneitherofthesereturnscouldbeeliminated.
Thethirdgenerationofincometruststructureseliminatedtheuseofatrustasapoolingmechanism,with investorsholdingdirectly a combinationofhigh-yieldjunkdebtandaspecifiednumberofsharesoftheissuer,referredtoas“incomede-positsecurities”(IDS)20(seefigure3)or“incomeparticipatingsecurities”(IPS)21(seefigure4).Untiltheeliminationofthetax-lawconstraintprovidedbytheforeignpropertyrules(discussedbelow),thesejunkbondstructureswereusedprimarilyinacross-bordercontextforinvestmentintotheUnitedStatesinordertoavoidtheUScorporateincometax.22Thesetransactionsrealizedthesametaxbenefitassoci-atedwiththestandardincometruststructurebysubstitutingfortheintermediarytrustadirectholdingbyinvestorsofacombinationofthehigh-yieldjunkdebtandthesharesoftheoperatingcorporation,whichwouldotherwisebeheldproportion-allybythetrust.
Asmentionedabove,the2005budgetproposaltorepealtheforeignpropertyholdingrestrictionsfordeferredincomeplans23openeduptherangeofsubstitutable
19 TheoperatingtrustwasinterposedbetweenthepartnershipandthemutualfundtrustinordertoensurethatthetrustunitsacquiredbyRPPsandRRSPswerenotforeignpropertyforthepurposesofthelimitationsontheamountofsuchpropertythatthesedeferredincomeplanscouldhold.Seeinfranote23andtheaccompanyingtext.
20 See,forexample,JackBernsteinandBarbaraJ.Worndl,“Cross-BorderAcquisitions:TheEvolutionfromCanadianIncomeTruststoIncomeDepositSecurities”(2003)vol.31,no.2Tax Notes International143-45;KenSnider,“TheEvolvingMarketofCanadianIncomeTrustsandIncomeDepositSecurities”(2004)vol.17,no.6Journal of Taxation and Regulation of Financial Institutions5-12;ChristopherJ.Steeves,“IncomeDepositSecurities—ANewHybrid”(2003)vol.8,no.4Corporate Structures and Groups450-53;andIanKarleff,“Canadian-StyleTrustsHeadSouth,”National Post,July23,2003.
21 IPSsaresimilartoIDSsandhavebeenusedasasubstituteforthestandardIDSstructure.SeeJackBernsteinandBarbaraWorndl,“Canadian-U.S.Cross-BorderIncomeTrusts:NewVariations”(2004)vol.34,no.3Tax Notes International281-84;andSandraRubin,“IncomeTrusts’NextBigThing,”National Post,May5,2004.
22 AversionoftheIDS/IPSstructurewasusedinadomesticcontextbyTimberWestForestCorp.SeeSinclairStewartandAndrewWillis,“BayStreetEyesPlanB,”Globe and Mail,November8,2006.
23 Canada,DepartmentofFinance,2005Budget,BudgetPlan,NoticeofWaysandMeansMotionToAmendtheIncomeTaxAct,resolution(5),February23,2005,effectiveJanuary2005.RPPsremainsubjecttoinvestmentrestrictionsundertherelevantnon-taxregulatoryregime.RRSPsandotherdeferredincomeplansremainsubjecttoatax-lawrequirementthattheirinvestmentsbe“qualifiedinvestments.”Mostimportantly,sharesordebtofanon-residentcorporateissuerarequalifiedinvestmentsonlyiflistedonaprescribedexchange.Interestsinnon-residentpartnershipsandtrustsarenotgenerallyqualifiedinvestments.
stapled securities—“the next big thing” for income trusts? n 257
structuresbymakingavailabletotheseinvestorsdirectholdingstructureslikeIDSandIPS.Infact, theeliminationof theforeignpropertyholdingrestrictionsalsoopenedupthepossibilityofthedirectsubstitutionofthelimitedpartnershipformforthecorporateform,exposingyetanotherboundaryinthetaxlaw.Ineffect,adir-ectsubstitutionofaflowthroughentityforthecorporateformcouldbeusedforabroadrangeofinvestorstorealizetheresultotherwiseavailablewiththeuseofeitherhigh-yieldjunkdebtinastandardincometruststructureorthecombinationofdebtandapartnershipinterestintheincometrustwithapartnershipstructure.
Eachoftheseiterationsoftheincometruststructureisaccuratelycharacterizedastax-driven;eachinvolvesthedevelopmentofredundantsecuritiesororganizational
1. Common shares 2. Subordinated debt to create IDS
FIGURE 3 IDS Structure
Issuer Corp
Opco
Business assets
Investors
2. Subordinated debt to create IPS
1. Common shares
FIGURE 4 IPS Structure
Canco
Investors
US Limited Liability Company
Business assets
Partnership
258 n canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 2
formsthatareusedpredominantlyforthetaxsavingthattheyaccess.24Indeed,thedevelopmentoftheincometruststructurefollowsacommonpatternoftax-drivenfinancialinnovation,wherebyalatentinconsistencyordiscontinuityinthetaxlawbecomesthefocusofstructuredfinancetransactionsdesignedtocapitalizeontheparticularinconsistencyordiscontinuity.Theimpetusfortheinnovationisoftenfoundinaparticularmarketdevelopmentorenvironment;forexample,alow-yieldorlow-interestenvironmentissaidtohavebeentheimpetusforthegrowthofin-cometrusts(andtheirolderroyaltytrustcousins).Nonetheless,thefocusoftheseredundantsecurities(ororganizationalforms)remainsthetaxbenefitthattheyaredesignedtoaccess.25
Intermsofthebroaddesignfeaturesofalegislativeresponsethatistarget-effective,incometrustspresentaclassiccaseoftheproblemoflinedrawinginthetaxlaw—thatis,thedifficultyofdrawingaboundarybetweentwodifferenttaxtreatmentswheretheprecisedetailsoftheboundaryatanygivenpointlackmuchinthewayofnormativecontent.Giventhelackofsuchcontent,theprecisedimensionsoftheboundarywillnecessarilybesomewhatarbitrary.Ontheassumption,however,thatthesekindsofboundariesarenottobeeliminatedintheshorttothemediumterm,certainoftheliteraturedrawsontheinsightsofoptimaltaxtheoryasthebasisforanapproachtolinedrawingthatenhancesefficiency.26Verygenerally,thisliterature
24 Atagenerallevel,however,someoftheliteraturesuggeststhatincometrustscanbecharacterizedasefficiency-enhancingbecauseoftheeliminationoftheunintegratedportionofthecorporateincometax;ineffect,theyareseenasaformof“self-help,”or“homemade”integrationofthecorporateandshareholder-leveltaxes.Theyarecharacterizedasefficiency-enhancingbecausetheyeliminatewelfarelossesconventionallyattributedtothreestandardbiasesassociatedwithanunintegratedcorporateincometax:(1)abiasinfavouroftheunincorporatedsector;(2)abiasinfavourofdebtoverequityinvestment;and(3)abiasinfavouroftheretentionofearningsratherthantheircurrentdistributiontoshareholders.Welfarelossesarisetotheextentthatinvestorswouldpreferthecorporateform,equityinvestment,orcurrentdistributionofearnings,butthetaxsystemaltersthatchoicebecauseofapreferencefortheunincorporatedsector,debtinvestment,andtheretentionofearnings.Aswiththeuseofhigh-yieldjunkdebtinleveragedbuyouts(LBOs)anddebt-for-equityrecapitalizations,themoreparticularized(andmoreprominent)versionofthisefficiencycaseforincometrustsistheargumentthattheyreduceagencycostsbyimposingoncorporatemanagementthedisciplineofrequiredcashflowdistributions.Inshort,managementispreventedfromwastingor“burning”excesscashflows,whichmustinsteadbedistributedtoinvestors.See,forexample,PaulHalpernandOyvindNorli,“CanadianBusinessTrusts:ANewOrganizationalStructure”(2006)vol.18,no.3Journal of Applied Corporate Finance66-75,at71.
25 AnexcellentaccountofthisdevelopmentprocessintheUnitedStatesmaybefoundinMarkP.GergenandPaulaSchmitz,“TheInfluenceofTaxLawonSecuritiesInnovationintheUnitedStates:1981-1997”(1997)vol.52,no.2Tax Law Review119-97.Otherpastexamplesofthispatternofdevelopmentoftax-drivenfinancialinnovationinCanadaare(1)theuseofpreferredsharesasasubstituteforloantransactionsand(2)theuseoffinanceleasesasasubstituteforleveragedassetpurchases.
26 See,forexample,DavidA.Weisbach,“LineDrawing,Doctrine,andEfficiencyintheTaxLaw”(1999)vol.84,no.6Cornell Law Review1627-81;andDavidA.Weisbach,“AnEfficiencyAnalysisofLineDrawingintheTaxLaw”(2000)vol.29,no.1Journal of Legal Studies71-97.
stapled securities—“the next big thing” for income trusts? n 259
suggeststhatdeadweightlossesassociatedwiththemaintenanceofboundariesinthetaxlawcanbeminimizedbytaxingclosesubstitutesconsistentlyinanefforttorealize a level of “transactional neutrality.” This general approach addresses therevenuelossattributabletothesubstitutionoflower-taxedforhigher-taxedformsoftransactions,whileeliminatingthetransactioncostsofsuchsubstitutions.More-over,totheextentthatthesubstitutioninvolvessacrificesinnon-taxfactors,increasingthetaxonthelower-taxedsubstituteeliminatestheefficiencylossesassociatedwiththesesacrifices.
Fortaxpolicymakers,drawingthetax-lawboundarylinesforsubstitutabletrans-actionsisespeciallyproblematicifthereisarangeofalternativetransactionsthatincludesbothcloseand imperfect substitutes.Wheresuch transactionsexist, in-creasingthetaxonalower-taxedsubstitutetoequalthatonahigher-taxedformmayonlyinducethesubstitutionofalternativetransactionsthatarelightlytaxedbuthaveassociatedefficiencylossesattributabletotheirimperfectsubstitutabilityfrom a non-tax perspective. Tax policy makers must therefore first identify therangeofclosesubstitutesthatcandefensiblybetaxedsimilarly.Inaddition,taxpol-icymakersmustidentifytherangeofalternativetransactionsthatprovideimperfectsubstitutes.Thesetransactionsshouldbetaxeddifferentlyonly if thesacrifice innon-taxfactorsissignificantenoughtoconstrainthesubstitutabilityofsuchtrans-actions.Inshort,tax-lawboundariesshouldbedrawnwheretaxpolicymakerscanhavesomeconfidencethatidentifiednon-taxfactorsserveasarobustconstraintonsubstitutability.27Otherwise,thelegislativeresponseexecutingtheline-drawingexer-cisewillbeunderinclusive.
Althoughtheremaybesomecostsassociatedwiththeundesirabilityoftheprivate-lawattributesofincometruststructures,itisclearthattheyhavenotoperatedasanespeciallyrobustconstraintonthetax-drivenadoptionofsuchstructures.28During
27 Foradiscussionofthesignificanceofnon-taxconstraintsor“frictions”generallyfortax-planningpurposes,seeMyronS.Scholes,MarkA.Wolfson,MerleErickson,EdwardL.Maydew,andTerryShevlin,Taxes and Business Strategy: A Planning Approach,3ded.(UpperSaddleRiver,NJ:PrenticeHall,2003),chapter6.Foradiscussionofthesignificanceofsuchconstraintsfromapolicyperspective,seeDavidM.Schizer,“FrictionsasaConstraintonTaxPlanning”(2001)vol.101,no.6Columbia Law Review1312-1409.
28 Muchofthenon-taxlegalliteratureemphasizesthedifferencesingovernancestructures,includingtheliabilityissueforbeneficiariesinanincometruststructure.Inthisrespect,oneofthemoresignificantdevelopmentsfortheincometrustmarketwastheadoptionbytheAlbertaandOntariogovernmentsoflegislationprovidinglimitedliabilityprotectionforincometrustunitholders.SeetheIncomeTrustsLiabilityAct,2004,tabledintheAlbertalegislatureonMay6,2004;andtheTrustBeneficiariesAct2003,tabledbytheOntariogovernmentwiththeMarch27,2003budget.Theliabilityissueapparentlyservedasabarrierfortheacquisitionoftrustunitsbycertainregisteredpensionfundsandpreventedlistingoftrustunitsinstockindexes.Thislatterbarriermayhaveexacerbatedliquidityriskassociatedwiththinsecondarymarketsfortrustunits,whichmayhaveservedtoconstrain,tosomeextent,theuseofincometrusts.Byclarifyingtheliabilityissueandopeningthewaytostockindexlisting,thistypeofprivate-lawlegislationapparentlydeepenedthetax-clienteledemandforincometruststructures,withanincreaseinsupplyandassociatedrevenueloss.
260 n canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 2
thefirstgenerationoftheincometruststructure,themostsignificantnon-taxcon-straintontheiradoptionwasanapparentmarketperceptionthatthecashdistributionrequirementslimitedtheirusetothosebusinessesthathaverelativelystablecashflows,facelimitedcompetition,andhaveverylittleinthewayofcapitalexpendi-turesthatrequiretheretentionofaportionofthecashflowsofthebusiness.Intheabsenceofanyappreciabletax-lawuncertaintyandanysignificantcostsattributabletotheprivate-lawattributesoftheincometruststructure,anumberofthesebusi-nesseseffectively“checkedthebox”toeliminatetheunintegratedportionofthecorporate income tax.This effective electionwasmadeby adopting the incometruststructure,withthecostbeingtheassociatedtransactioncostsandanyefficiencylossesattributabletotheprivate-lawattributesofthestructure.
The initial perception that the income trust structure was suitable only forbusinesseswithstablecashflowswasbasedonthepremisethatthereturnontheacquisitionindebtednesscouldbeusedtostripoutthecompetitiveornormalreturnontheunderlyingassets(thatis,thestablecashflow).Asnotedabove,thesecondgenerationofincometruststructurescombinedthetax-deductiblepreferredsharefeatureofthestandardstructurewithasimilarlytax-efficientstructuringofthedis-tributionofthatportionoftheearningsofabusinessthatrepresentedtheriskiergrowthelementandtheassociatedretentionofearningsforcapitalexpenditures.Thedevelopmentofthesepartnershipstructuresunderlaythespreadoftheincometruststructuretobusinesseswithgrowthpotential.Thepreciseparametersofanymarketconstraintonthisformoftheincometruststructurewereexceedinglyun-clear. Indeed, thesubsequentdeepeningof the incometrustmarketwasentirelyconsistentwithapatternofincrementaldevelopmentoftax-drivenfinancialinnov-ationgenerally,suggestingthat,intheabsenceoftheintroductionofanytax-lawconstraint,marketswillcontinuetomassageavailabletax-effectivestructuresinanefforttoextendtheiradoption.
Asdescribedinthenextsection,thedraftlegislation,asanexampleofanefficiency-basedexerciseinlinedrawing,isflawedinitsfailuretoapplytostapledsecuritystructures.Inparticular,thefailureofthedraftlegislationtoextendtostapledsecur-ities leavesopen theiruse as tax-effective substitutes for income trust structuressubjecttothelegislation.Giventhatthereappeartobenoobviousnon-taxconstraintsonsuchsubstitution,thisunderinclusivenessispotentiallyfatal,andthedepartmentcouldbeforcedtolegislateretroactively,unlessthethreatintheOctober2006pro-posalstodojustthatservesitsostensiblepurpose.
using s tA Pled securitie s to Avo id the APPlic Ation of the dr Af t legisl Ation
Asaresponseintendedtoshutdowndemandfromtax-exemptandnon-residentinvestors,thedraftlegislationattemptstoraisethetaxonarangeofincometruststructuresconsistentwiththetaxondividenddistributionsinacorporatecontext.Incontrast,theNovember2005proposalattemptedtorestoreameasureofconsist-encyinthetaxtreatmentofcorporatestructuresandincometruststructuresby
stapled securities—“the next big thing” for income trusts? n 261
reducingthedividendtaxontheformer.Inadditiontothedifferentrevenueconse-quences,thedraftlegislationandtheNovember2005proposaldifferimportantlyintheirrespectivetargetingdimensions.Enhancingthetaxcreditfordividenddistribu-tionsinvolvessometargetingissuesassociatedwiththeneedtoensurethatunderlyingcorporateincomeissubjecttoastatutorytaxrateconsistentwiththegross-upandcreditrateattheshareholderlevel.29Muchmoreproblematictargetingissuesarguablyarisewiththeattempttoensurethatthetaxonincometruststructuresfortax-exemptandnon-residentinvestorsisincreasedtoalevelconsistentwithdividenddistributions.Mostimportantly,anysuchlegislativeresponsemustensurethatitappliestothefullrangeofpossiblesubstitutes.Inthisrespect,theavailabilityofawiderangeofclosesubstitutesforthestandardincometruststructuremeansthatatarget-effectivere-sponsewillinevitablybesomewhatinelegant.Butgivenanacceptanceofarevenueconstraintthatprecludesalowertaxondividenddistributionsfortax-exemptandnon-residentinvestors,theneedforsuchlegislationisunavoidable.
Indeed,inthepresenceofahighdegreeofsubstitutabilityoftheincometruststructureforthepubliccorporation,theNovember2005proposaltoenhancethedividendtaxcreditwasafalsestep:itsacrificedrevenuewithoutstoppingfurtherbleeding fromagrowing income trustmarket.Witha significantportionof thecorporaterevenuebaseremainingatrisk,thedraftlegislationproposestoraisethetaxonincometruststructuresusedassubstitutesforthecorporateforminapub-liclytradedcontext.Thisresultisrealizedbyapplyingdividendtreatmenttodistri-butions of income of a “specified investment flow-through” (SIFT) trust orpartnershipfromits“non-portfolioproperties.”30
Asitsprincipaltargetingmechanism,thedraftlegislationdefinesaSIFTtrustorpartnershipasaresidententitythatholdsanynon-portfoliopropertywhereinvest-mentsintheentityarelistedfortradeonastockexchangeorotherpublicmarket.31“Non-portfolioproperty”isdefined32as
n theholdingbyasingleinvestorofmorethan10percentoftherelativefairmarketvalueofallissuedsecuritiesofasubjectentity;
n theholdingofsecuritiesofasubjectentity(andaffiliatedentities)wherethesecuritiesconstitutemorethan50percentoftheequityvalueoftheinvestoritself;
29 Thisresultisrealizedthroughthedefinitionsinsubsection89(1)ofthe“generalrateincomepool”ofaCanadian-controlledprivatecorporation(CCPC)andthe“lowrateincomepool”ofanon-CCPC,added(withrelatedamendments)bySC2007,c.2,section47(1).
30 Distributionsofincomefromnon-portfoliopropertiesaretreatedasnon-deductibledividends,subjectingtheunderlyingincometotaxattheentitylevelatarateof31.5percent.Thisrateisintendedtoapproximatethecombinedfederal-provincialtaxonthetaxableincomeofapubliccorporation.
31 Draftlegislation,proposedsection122.1,definitionof“specifiedinvestmentflow-throughtrust,”andproposedsubsection197(1),definitionof“specifiedinvestmentflow-throughpartnership.”
32 Ibid.,proposedsection122.1,definitionof“non-portfolioproperty.”
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n Canadianimmovableorresourcepropertywheresuchpropertyconstitutesmorethan50percentoftheequityvalueoftheentity;and
n propertyusedinthecourseofcarryingonabusinessinCanada.
An“investment”includesa“security”ofthetrustorpartnership,33whichisdefinedtoinclude(1)anincomeorcapitalinterestinatrust,(2)apartnershipinterest,(3)arighttoacquiresuchaninterest,or(4)aliabilityofatrustorpartnership.34Theconceptofaninvestmentisalsoextendedtoincludearightthatmayreasonablybeconsideredtoreplicateareturnon,orthevalueof,asecurityofatrustorpartner-ship.35Investmentsareconsideredtobelistedonapublicmarketiftheyarelistedonastockexchangeoranover-the-countermarket,definedasatradingsystemorotherorganizedfacilitythroughwhichsecuritiesthatarequalifiedfordistributionmaybeexchanged.36
WiththeseconceptsofaSIFTtrustandaSIFTpartnership,thedepartmentessentiallychosetouseanentity-level“dividendtrap”ratherthananequityrechar-acterizationrule37forthejunkdebtheldproportionallywithsharesofanissuerinanincometruststructure.Asexecutedinthedraftlegislation,thisdifferentconcep-tualapproachaddressestheuseofbothroyaltytrustsubstitutesanddirectentityplays inwhichapublicly tradedtrustorpartnership is substituted forapubliclytradedcorporation.Thedraftlegislationalsomanagestoaddresstheuseofhigh-yieldjunkdebtheldinanintermediarySIFTtrustortheuseofapartnershipinterestthatissimilarlyheld.Morespecifically,theconceptofaSIFTtrustoraSIFTpartner-shipaccurately targetsboth the standard income trust structureand the incometrustwithapartnershipstructure.Undertheproposedprovisions,forbothstruc-tures,thereturnonhigh-yieldjunkdebtwillbetreatedasadividendasitpassesthroughapubliclytradedtrustbeforebeingdistributedtoinvestors.Thereturnonpartnershipinterestswillalsobesubjecttothesametreatment,usuallyasitpassesthroughapubliclytradedtrustholdingtheinterest.Whereinterestsinthepartner-shiparethemselvespubliclytraded,thereturnwillbesubjecttodividendtreatmentasitisearnedanddistributedbythepartnership.Infact,thereturnonbusinessescarriedondirectlybypubliclytradedtrustsandpartnershipswillbesubjecttodivi-dendtreatmenttoensurethattheseentitiescannotbesubstituteddirectlyforthepubliclytradedcorporateform.
The draft legislation does not, however, obviously extend to stapled securitystructures,whichcouldpotentiallybeusedtostreamoffbusinessincomeofanen-titydirectlytotheinvestors.Providedthattheincomestreamisdeductibletothe
33 Ibid.,paragraph(a)ofthedefinitionof“investment.”
34 Ibid.,definitionof“security.”
35 Ibid.,paragraph(b)ofthedefinitionof“investment.”
36 Draftlegislation,proposedsection122.1,definitionof“publicmarket.”
37 ThedesignfeaturesofanequityrecharacterizationruleareexploredinTimEdgar,“TheTroublewithIncomeTrusts”(2004)vol.52,no.3Canadian Tax Journal819-52,at843-52.
stapled securities—“the next big thing” for income trusts? n 263
operatingentity,astapledsecuritystructurewouldavoidthedividenddistributionstaxforanintermediarySIFTtrustorpartnershipbutwouldmaintainthenon-taxattributesofanintermediatedinvestmentbystaplingsecuritiesheldbyinvestorsdirectlywiththeirinterestsinthetrustorpartnership.Staplingtheinterestswouldensure proportional holdings without the use of an intermediary pooling entity(whichwouldcreatetheintendeddividendtrapunderthedraftlegislation).Securitieshelddirectlybyinvestorswouldnormallyhavetobedebtsecuritiesthatgiverisetoaninterestdeductionfortheoperatingentity.SubstitutestructurescouldalsouserentalpaymentswherethelessorisanintermediaryREIT.Dividendtreatmentattheleveloftheoperatingentitycouldbeavoidedprovidedthattheissuerisacorpora-tion.Inthatcase,itdoesnotmatterthatitssecuritiesarepubliclytraded,sincethedraftlegislationappliesSIFTstatustopubliclytradedtrustsorpartnerships.More-over, dividend treatment is limited to income from non-portfolio properties oftheseentities.Wheretheoperatingentityisitselfatrustorpartnership,interestsorliabilitiesoftheentitycouldnotbepubliclytradedwithoutattractingSIFTstatus.
Asoneillustrativeexampleofatax-effectivestapledsecuritystructure,thestandardincometruststructurecouldbemodifiedusinganIDSorIPSstructure(figures3and4),asshowninfigure5.38Themodificationwouldinvolvetheissuanceofhigh-yieldjunkdebtbyacorporationdirectlytoinvestors,whowouldotherwiseacquirethe debt of the corporate issuer indirectly through interests in an intermediarytrust.Incomefromthebusinesscouldbestrippedoutofthecorporationasdeduct-ibleinterestexpensepayabletotheinvestors.Thedebtwouldbestapledtounitsofthetrustacquiredbytheinvestors,withtheamountadvancedfortheseunitsbeingusedbythetrusttoacquiresharesoftheoperatingcorporation.Thestaplingofthehigh-yieldjunkdebtandthetrustunitswouldensurethatthecashflows,aswellasmostoftheothernon-taxattributes,ofthestapledstructurewouldreplicatethoseassociatedwithastandardincometruststructure.Becauseinterestonthejunkdebtwouldbepaiddirectlytotheinvestors,andnotthroughtheintermediarytrust,thedraftlegislationwouldnotapplytotreattheincomestreamasadividenddistribu-tionfromthetrust.
Muchthesameresultcouldberealizedbymodifyingtheincometrustwithapartnershipstructure.Forexample,high-yieldjunkdebtcouldbeissuedbyapart-nershipdirectlytoinvestorsratherthanthroughanintermediarytrust.39Aswiththeabove-describedmodificationofthestandardincometruststructure,thedebtcouldbestapledtotrustunitsacquiredbytheinvestors.Thisstructure,however,wouldreplicatetheincometrustwithapartnershipstructureonlytotheextentoftheexpectedreturnonthejunkdebt.Amoretax-effectivesubstitute,showninfigure6,would distribute economic rents and/or unexpected returns associated with the
38 StewartandWillis,supranote22.SeealsoAndrewWillis,“WillBayStreetOutfoxGoodale?Don’tBetonIt,”Globe and Mail,October26,2005.
39 However,thedebtwouldhavetobeunlisted.Ifitwaslistedfortrade,theissuerwouldbeconsideredaSIFTpartnership,andincomefromthebusinessassets,distributedasinterestonthedebt,wouldbetreatedasnon-deductibledividendpayments.
264 n canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 2
growthelementoftheunderlyingbusinessthroughpartnershipintereststhatareissueddirectly to the investors.These interests couldnotbe stapled topubliclytradedjunkdebtofthepartnershipand/ortrustunitsinanintermediarystructure;inthatinstance,thepartnershipintereststhemselveswouldbeconsideredpubliclytradedandthepartnershipwouldbeaccordedSIFTstatus,withdividendtreatmentapplyingtoincomeonitsbusinessassets.Instead,aholdingcorporationcouldbeinterposedbetweentheinvestorsandbusinessassetsheldinapartnership.Investorscouldacquirepartnershipintereststhatarenotlistedfortrade,alongwithpubliclytradeddebtoftheholdingcorporation,whichwouldbestapledtounitsinatrust.Thesameeffectaslistingfortradecouldbeachievedbyprovidingthatthepartner-shipinterestsofinvestorscouldbeexchangedforfurthertrustunitsoracombinationof trustunitsand junkdebtof thecorporate issuer.Providedthat theexchangefeaturewouldnotleadtoacharacterizationofthepartnershipinterestsaspubliclytraded,40thedraftlegislationwouldnotapplytothereturnonthepartnershipinter-estsacquireddirectlybytheinvestors,oranyjunkdebtissuedbytheintermediarycorporation.OnlythereturnthatisdistributedthroughtheintermediarySIFTtrustwouldbesubjecttodividendtreatment.
AthirdillustrativeavoidancetechniqueusingstapledsecuritieswouldinvolveanassetsalewithaleasebackstructureusinganintermediaryREIT,showninfigure7.Moreparticularly,therealestateassetsusedincarryingonabusinesscouldbesold
FIGURE 5 Stapled Version of a Standard Income Trust Structure
Trust
1. Common shares
2. Subordinated debt stapled to trust units
Stapleco
Business assets
Investors
40 Paragraph(e)ofthedefinitionofasecurity,supranote34,includesarighttoacquireanyoftheintereststhatarewithinthedefinition.Itisunclearwhetherthiselementofthedefinitionwouldextendtoarightthatisembeddedinasecurity.Moreover,thereisnothinginthedefinitionofapublicmarket,supranote36,thatwouldextendapubliclytradedcharacterizationtoarighttoacquireasecuritywheretherightisnotitselfpubliclytradedbutthesecuritythatcanbeacquiredispubliclytraded.
stapled securities—“the next big thing” for income trusts? n 265
toaREITandleasedback,withdeductiblerentalpaymentsmadebythepubliclytradedoperatingcorporationtotheREIT.ThedraftlegislationwouldnotapplytotreattherentalpaymentsreceivedbytheREITasdividenddistributionstoinvestorsholdingunitsintheREIT,sincethelegislationspecificallyexcludestheseentitiesfromSIFTstatus.Forthepurposeofthisexception,aREITisdefined41asapubliclytradedresidenttrustthat
n holdsonly“qualifiedREITproperty”42throughoutataxationyear;n earns95percentormoreofitsrevenuefrominterest,royalties,andrentfrom
realproperty,aswellasgainsfromthedispositionofsuchproperty;
FIGURE 6 Stapled Version of an Income Trust with Partnership Structure
Trust
1. Unlisted/exchangeable partnership interests
Holdco
Investors
2. Subordinated debt stapled to trust units
Partnership
Common shares
Business assets
41 Draftlegislation,proposedsection122.1,definitionof“realestateinvestmenttrust.”
42 “QualifiedREITproperty”isdefinedinproposedsection122.1as(1)Canadianrealproperty;(2)securitiesofanentitythatperformsapropertymanagementfunctioninrespectofpropertyofthetrustoritselfsatisfiestheconditionsforREITstatus;and(3)propertythatisancillarytotheearningofrentfromimmovablesandcapitalgainsonthedispositionofimmovables.Forthispurpose,“rentfromrealorimmovableproperties”isdefinedinproposedsection122.1toincludepaymentsforservicesancillarytotherentalfunctionandtoexcludepropertymanagementfees,hotelservicefees,andrentsbasedonprofits.ThesedefinitionswereintroducedintheMarch2007noticeofwaysandmeans.TheDecemberdraftlegislationlimitedqualifiedREITpropertytoCanadianrealproperty.TheexemptstatusofREITs,aswellastheextensionofqualifyingREITactivitiestoincludeapropertymanagementfunctionandservicesancillarytopropertyrental,isdiscussedinfranotes110-119andtheaccompanyingtext.
266 n canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 2
n earns75percentormoreofitsrevenuefromrentsfrom,mortgageson,orgainsfromthedispositionofCanadianrealproperty;and
n derives75percentormoreofitsequityvaluefromCanadianrealproperty,cash,andCanadiangovernmentdebtthroughoutataxationyear.
NothinginthesequalifyingconditionswouldpreventanassetsaleandleasebackstructureusinganintermediaryREITtostreamoffmuchoftheexpectedreturnthatwouldotherwisebepaidoutunderastandardincometruststructureasinterestonhigh-yieldjunkdebt.
Thethreestructuralalternativesdiscussedabovearerefinementsofeitherthestandardincometruststructureortheincometrustwithapartnershipstructure;theyattempttomorecloselyreplicatethenon-taxattributesofthepubliclytradedcorporateformininstancesofperfect(ornear-perfect)substitutability.Eachpresentsmuchthesamerevenueandefficiencyeffectsasexistingincometruststructures.Sincethedraftlegislationisintendedtoeliminatethoseeffects,bytaxingallinvest-orsinsuchstructuresconsistentlywithinvestorsinpubliclytradedcorporations,atarget-effectivelegislativeresponseshouldextendthesametaxtreatmenttostapledsecuritystructures.
Inthisrespect,asstatedabove,thedefinitionofaninvestmentinatrustorpart-nershipextendstoarightthatmayreasonablybeconsideredtoreplicateareturnon,orthevalueof,asecurityinthetrustorpartnership.Thisextensionappearstocontemplatepubliclytradedderivativefinancialinstruments,suchasstructurednotes,swaps,orothersyntheticinstruments,whichreplicatethereturnonaunitinatrustoraninterestinapartnershipthatisnototherwisepubliclytraded.Thederivativeinstrument may be issued by the trust or partnership itself or by a third party,
FIGURE 7 Stapled REIT
REIT
Common shares stapled to trust units
Stapleco
Investors
Lease of real estate
Rental paymentsBusiness assets
stapled securities—“the next big thing” for income trusts? n 267
whetherrelatedorunrelatedtothetrustorpartnership.ExtendingthedefinitionofaninvestmenttopubliclytradedderivativeswouldresultinSIFTstatusfortherel-evanttrustorpartnership;however,itisunclearwhethertheextensionwouldapplytostapledsecuritystructures.Moreover,extensiontoderivativefinancialinstrumentsissuedbyunrelatedthirdpartiescouldwellbeoverinclusivewheresuchinstrumentsareissued,notforthetax-avoidancepurposetargetedbythedraftlegislation,butforlegitimatenon-taxpurposes,suchashedgingtheriskassociatedwithaninvestment.43
Infact,itisunclearwhetherthedepartmenthasstapledsecuritystructuresinmindwiththeextensionofthedefinitionofaninvestmentinatrustorpartnershiptoincludederivativefinancialinstruments.ItismorelikelythattheproductlabelwarningintheOctober2006proposalsregardingsubstitutestructurescontemplatesstapledsecuritystructures,inwhichcasethedepartmenthasmadeitclearthatitiswillingtolegislateretroactivelytoaddresstheiruse.Inourview,theUSlegislativeresponsetostapledsharesisanobviousmodelthatcouldbeusedtotargetstapledsecuritystructuresastax-effectivesubstitutesforincometruststructuressubjecttothedraftlegislation.Inotherwords,extensionofthedraftlegislationbasedontheUSlegislativemodelcouldimprovethetargeteffectivenessoftheproposedmeasuresbyensuringthattheywillapply,explicitlyandmoreprecisely,tostapledsecuritystructures.
us e x Perience with s tA Pled sh A re s
Untilthemid-1980s,stapledshareswereusedintheUnitedStatesforvariousplan-ningpurposesinboththedomesticandinternationalcontexts.Congress,however,effectivelyshutdownthistypeoftax-driven,transactionalsubstitutionin1984withtheintroductionofsection269BoftheInternalRevenueCode.44ThislegislativeresponseshouldserveasacautionarytaleforanyCanadiantaxplannerswhoperceivestapledsecuritiesasanopportunitytoavoidtheapplicationofthedraftlegislation.Indeed,IRCsection269Bprovidesaready-madetemplateforthekindofretroactivelegislativeresponsethreatenedbythedepartmentintheOctober2006proposals.
Stapled REIT Structures
Untilrecently,thecorporateincometaxintheUnitedStateswasaclassicalsystem.Evennow,thecorporateincometaxisonlypartiallyintegratedthroughareducedpersonalincometaxrateondividends.Generally,adomesticcorporation(referred
43 Aproblemofoverinclusivenessalsoseemstoarisebecauseofthebroadbundleofrightsdescribedinthedefinitionofasecurityandthespecificinclusionofliabilitiesofanentity(supranote34andtheaccompanyingtext).Thedefinitionappearstoincludederivativefinancialinstrumentsacquiredbyatrustorpartnershipforhedgingpurposes.Wheretheseinstrumentsareacquiredthroughanexchangeoranover-the-countermarket,theywouldbeinvestmentsinthetrustorpartnershiplistedonapublicmarketandwouldmakethetrustorpartnershipaSIFTtrustorSIFTpartnershipevenwhereunitsinthetrustorinterestsinthepartnershiparenotlistedfortrade.
44 NowcontainedintheInternalRevenueCodeof1986,asamended(hereinreferredtoas“IRC”).
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toasa“USCcorporation”)issubject,asaseparatelegalentity,totaxonitsincomeatamaximumgraduatedrateof35percent.Unlikesalaryandinterestexpense,dividendspaidbythecorporationoutofitsearningsandprofitsarenotdeductibleincomputingtaxableincomeandarealsoconsideredtaxableincometotheshareholders.Corporateincomeistherebytaxedtwice,firstatthecorporatelevelandthenattheshareholderlevel.However,corporateshareholdersareaffordedadividends-receiveddeduction(DRD)inrespectofdividendsreceivedfromaUScorporation.TherateoftheDRDvariesdependingontheshareholdingpercentageinthedistributingcorporation.45
Someentities,suchas“Scorporations,”46partnerships,47andcertaintrusts,48aretreatedasflowthroughentities,withincometaxedonlytotheshareholders,part-nersorbeneficiariesasallocatedordistributedtothem.Othercorporations,suchas regulated investment companies (RICs) investing in securities (that is, mutualfunds)arerelievedfromcorporatetaxondividendsandcapitalgainsdistributedtotheirshareholders.49SimilartreatmentisprovidedforREITs50andrealestatemort-gageinvestmentconduits(REMICs).51
LikeRICsandREMICs,theREITisacreatureoftheIRC.TherearethreebasictypesofREITs:“(1)equityREITs,whichownrealestate,andderiveincomefrompropertyrentals;(2)mortgageREITs,whichinvestinrealestatemortgagesandde-riveincomefromfeesandinterestonloans;and(3)hybridREITs,whichholdbothmortgageandrealestateassets.”52TheREITwascreatedin1960withtwoapparentrationales.53TheprincipalrationalewastheextensiontorealestateinvestorsoftheflowthroughtreatmentaffordedtoRICs,toallowthemtosimilarlypooltheirre-sourceswithouttheimpositionofcorporateorentity-leveltaxation.Ineffect,REITsareintendedtoprovideforsmallrealestateinvestorsthesameadvantagesusuallyavailableforinstitutionalandwealthyinvestors.54AccordingtoCongress,
[t]heseadvantagesincludethespreadingoftheriskoflossbythegreaterdiversificationofinvestmentwhichcanbesecuredthroughthepoolingarrangements;theopportunitytosecurebenefitsofexpertinvestmentcounsel;andthemeansofcollectivelyfinancingprojectswhichtheinvestorscouldnotundertakesingly.55
45 IRCsection243. 46 IRCsections1361to1379. 47 IRCsections701to761. 48 IRCsections641to679. 49 IRCsections851to855. 50 IRCsections856to859. 51 IRCsections860Ato860G. 52 RussellJ.Singer,“UnderstandingREITs,UPREITs,andDown-REITs,andtheTaxandBusiness
DecisionsSurroundingThem”(1996)vol.16,no.2Virginia Tax Review329-45,at330-31. 53 CharlesE.WernIII,“TheStapledREITonIce:Congress’1998FreezeoftheGrandfather
ExceptionforStapledStock”(2000)vol.28,no.3Capital University Law Review717-44,at719. 54 Seeibid. 55 HRrep.no.86-2020,(1960),3-4,citedinWern,supranote53,at719-20.
stapled securities—“the next big thing” for income trusts? n 269
Asecondaryrationalewastheprovisionofinvestorprotectionfromthebusinessrisksassociatedwithrealestateinvestments.ThisgoalisrealizedbylimitingREITstopassiveinvestmentinrealestate.56InprohibitingREITsfromengaginginactivebusinesses,Congressintendedtopreventtheiruseasatax-effectivesubstituteforthecorporateform.57Inthisrespect,Congressstated:
Thisbill[thatis,thelegislationcreatingtheREIT]restrictsthis“passthrough”oftheincomefortaxpurposestowhatisclearlypassiveincomefromrealestateinvestments,ascontrasted to income fromactiveoperationofbusiness involvingrealestate....[A]nyrealestatetrustengaginginactivebusinessoperationsshouldcontinuetobesubjecttothecorporatetaxinthesamemannerasistrueinthecaseofsimilaroper-ationscarriedonbyothercomparableenterprises.58
AREITistaxedasacorporation,butisaffordedadeductionfordividendspaidinataxableyear.59Thedeductionensuresthatdistributedincomeissubjectonlytoinvestor-leveltaxation.REITsaresubjecttoentity-leveltaxation,asregularCcor-porations,onundistributedincome.ToqualifyforREITstatus,acorporation,trust,orassociationmustelecttodosoandmustmeetthefollowingconditions,amongothers:60
n atleast95percentofgrossincomemustbederivedfromdividends,interest,rentsfromrealproperty,gainfromthesaleorotherdispositionofshares,securities,andrealpropertynotheldasinventory,andgainfromthesaleorotherdispositionofanon-prohibitedrealestateasset;61
n atleast75percentofgrossincomemustbederivedfrom“realpropertyrentals,loans,gainsfromthesaleorotherdispositionofrealpropertyorrealestate
56 SeeWern,supranote53,at720.
57 Ibid.
58 HRrep.no.86-2020(1960),3-4,citedinWern,supranote53,at720.TheTaxReformActof1986,Pub.L.no.99-514,enactedonOctober22,1986,allowedREITstodirectlyfurnish“servicescustomarilyfurnishedorrenderedinconnectionwiththerentalofrealproperty,whetherornot...charges[forsuchservices]areseparatelystated”(IRCsection856(d)(1)(B)).REITswerethusabletoprovidesuchservicestotheirtenantswithoutviolatingtheeligibilityconditions,thuseliminatingtheneedtouseindependentcontractors.SeeWern,supranote53,at721.TheMarch2007noticeofwaysandmeansmotionsimilarlyexpandedtherangeofpermissibleservicesforthepurposesoftheREITexemptionunderthedraftlegislation.Seesupranote42andtheaccompanyingtext.
59 IRCsection857.
60 IRCsection856.Inaddition,theentitymust(1)bemanagedbyoneormoretrusteesordirectors(IRCsection856(a)(1));(2)havefullytransferablesharesorcertificates(IRCsection856(a)(2));(3)notbeafinancialinstitutionoraninsurancecorporation(IRCsection856(a)(4));(4)have100ormoreshareholders(IRCsection856(a)(5));and(5)notbecloselyheld(IRCsection856(a)(6)).
61 IRCsection856(c)(2).
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assets,abatementsandrefundsontaxes,andincomeandgainderivedfromforeclosureproperty;62
n atleast75percentoftheassetsmustberealestateassets,cashandcashitems(includingreceivables),andgovernmentsecurities;63
n notmorethan20percentofthevalueofthetotalassetsmaybesecuritiesofoneormoretaxableREITsubsidiaries(TRSs);64and
n exceptforsecuritiesofTRSsandgovernmentsecurities,notmorethan5per-centofassetsmaybesecuritiesofanyoneissuer,andtheentitycannotholdsecuritieswithmorethan10percentofthetotalvotingpowerorvalueoftheoutstandingsecuritiesofanyoneissuer.65
(These conditions are similar to those set out for REIT status under the draftlegislation.)66
In theearly1980s, stapled share structuresweredeveloped toallowREITs tocarryonanactivebusinesswhilecomplyingwiththeprohibitiononsuchactivity,therebymaintainingtheirstatusasREITswiththeassociatedflowthroughtreatment.67As illustratedinfigure7,aREITwouldformastapledentity—that is,a formallyseparatecorporationthesharesofwhichwereheldbytheshareholdersoftheREITandwerecontractuallystapledtothesharesoftheREITsothattheinterestsineachentitycouldnotbetradedseparately.TheREITandthestapledcorporationwereconsideredtwoseparateentitiesinform,butwiththesameshareholdersandman-agement.TheREITwouldownandholdonlyrealestateassets,whichwouldbeleasedtothestapledentitycarryingonaparticularbusiness.Bypayingall,ormost,ofitsincometotheREITasrent,thestapledcorporationwouldgenerateadeductionthateliminated,orsubstantiallyreduced, its taxable income.Theactivebusinessincomeontheunderlyingassetsofthestapledcorporationwouldarguablybecon-vertedintoqualifyingpassiveincome(rent)throughthisstructure,therebyavoidingcorporate-level taxation on the business income distributed by the REIT to theinvestors.
62 IRCsection856(c)(3),andseeSinger,supranote52,at331.
63 IRCsection856(c)(4)(A).
64 IRCsection856(c)(4)(B)(ii).TheconceptofaTRSisdiscussedinfraatnotes110to119andtheaccompanyingtext.
65 IRCsection856(c)(4)(B)(iii).
66 Seesupranote41andtheaccompanyingtext.Additionalconditionssimilartothoselistedinnote60,supra,inrespectofUSREITsmustbemetbyCanadianREITsinordertoqualifyforclosed-endmutualfundtruststatusundertheAct.Seethedefinitionof“mutualfundtrust”insubsection132(6)andregulation4801.
67 SeeWern,supranote53,at725-26.
stapled securities—“the next big thing” for income trusts? n 271
Stapled Foreign Corporation Structures
Avoiding Subpart FUScitizens,residents,anddomesticcorporations(“UStaxpayers”)aresubjecttoUStaxontheirworldwideincome,68withacreditfortaxespaidtothesourcecountry.69Foreign-sourceincomeearnedbyaforeigncorporationisgenerallynotsubjecttoUStaxuntilrepatriatedtoaUStaxpayer.70Since1913,sixanti-deferralregimeshavebeenenactedtolimittheavailabilityofthisdeferral(thoughsomeoftheseprovi-sionsnolongerapply).71OfrelevancetothediscussionhereissubpartFoftheIRC(sections951to964),enactedin1962toeliminatethebenefitofdeferralforcertainoffshorestructures thatCongressconsidered tobeartificial“taxhaven”devicesdesignedtoexploitlowforeigntaxes.SubpartFappliesto“controlledforeigncor-porations”(CFCs)earning“SubpartFincome.”Each“UnitedStatesshareholder”ofaCFCisgenerallyallocatedaproratashareoftheCFC’ssubpartFincome,whetheror not a corresponding distribution is made by the CFC, and must include this
68 IRCsections1,11,and61.
69 IRCsection901.Theforeigntaxcreditissubjecttotwolimitations:thegenerallimitationandthe“baskets”limitation.ThegenerallimitationlimitstheforeigntaxcredittotheUStaxrateontherelevantincome(IRCsection904(a)).Thebasketslimitationappliesthegenerallimitationseparatelytoeachcategoryofincome(basket)(IRCsection904(d)).StartingJanuary2007,therearetwobaskets,thepassiveincomebasketandthegeneralbasket.
70 Adomesticcorporationisacorporationformed,organized,andregisteredintheUnitedStates,regardlessofthelocationofitsmanagementandcontrol,placeofbusiness,etc.Aforeigncorporationisanycorporationthatisnotadomesticcorporation(IRCsections7701(a)(4)and(5)).Thus,thedeterminationofwhetheracorporationisdomesticorforeigndependsonaformalrule:adomesticcorporationisonethatwasincorporatedintheUnitedStates.Astotheclassificationofforeignentities,thecheck-the-boxregulationsundertheIRCgenerallyallowtheshareholdersofsuchentitiestochoosewhethertheentityistreatedforUStaxpurposesasaforeigncorporationorasaforeignpartnership(Treas.reg.sections301.7701-1,2,and3).However,certainspecificforeignbusinessentitiesarenotsubjecttothecheck-the-boxregulations;instead,theyarealwaystreatedasforeigncorporationsforUStaxpurposes.TheseformalrulesmakedeferralofUStaxationarelativelyeasytask,subjecttotheanti-deferralrulesdiscussedormentionedbelow.UStaxpayerscarryingonbusinessoutsidetheUnitedStatesmayincorporateacorporationinaforeignjurisdictionanddeferUStaxationoftheincomefromthebusinessuntilrepatriationasdividendsorliquidationdistributions.Similarly,aUScorporationconductingbusinessthroughabranchinaforeigncountrymaychecktheboxtohavethebranchtreatedasaforeigncorporationforUStaxpurposes,providingthesamedeferralbenefitotherwiseavailabletotheparent-subsidiaryformoforganization.
71 Theaccumulatedearningstax(AET),whichwasenactedin1913(IRCsections531to537)andisrarelyapplied;thepersonalholdingcorporation(PHC)regimeof1937(IRCsections541to547),which,since2001,nolongerappliestoforeigncorporations;theforeignpersonalholdingcorporation(FPHC)regimeof1937(IRCsections551to558),whichwasabolished;theforeigninvestmentcompany(FIC)regimeof1962(IRCsections1246and1247),whichwasabolishedaswell;thesubpartFregime,whichwasenactedin1962(IRCsections951to964);andthepassiveforeigninvestmentcompany(PFIC)regime,whichwasenactedin1986(IRCsections1291to1298).
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amountasordinary income.72SubpartF incomeconsistsprimarilyofpassive in-come73andsalesorservicesincomefromcertainrelated-partytransactionswherethe location of the underlying business activity (that is, where services are per-formed,orwhereproductsaremanufacturedorsoldforuse)isoutsidetheCFC’scountryofincorporation.74
ACFCisdefinedasanyforeigncorporationmorethan50percentofthetotalcombinedvotingpower,orthetotalvalue,ofwhichisowned,orisconsideredtobeowned,byUSshareholdersonanydayduringthetaxableyearoftheforeigncor-poration.75AUSshareholder isaUSpersonwhoowns,or isconsidered toown,10percentormoreofthetotalcombinedvotingpowerofaforeigncorporation.76Thus,thesubpartFrulesapplytotheUSshareholderofaforeigncorporationonlyifmorethan50percentofthetotalcombinedvotingpowerorvalueofthecorporation’ssharesisowned,directlyorindirectly,byUSshareholders,eachofwhomownsatleast10percentofthesharesoftheforeigncorporation.
Stapledsharestructuresweresometimesusedtoavoidtheapplicationofsub-partFbyavoidingCFCstatusforaforeigncorporationcontrolledbyawidelyheldUScorporation.InsteadofformingaforeignsubsidiaryearningsubpartFincome,awidelyheldUScorporationwouldformaforeigncorporationthesharesofwhichwouldbestapledtothesharesof theUScorporation(figure8).SubpartFwouldarguablybeavoided,providedthatno10percentUSshareholderstogetherownedmorethan50percentofthetotalcombinedvotingpoweroftheforeigncorpora-tion,whichwouldbewidelyheldinform.
Avoiding Withholding Tax and Retaining the Benefit of the DRDA foreign person’s “fixed or determinable, annual or periodic” income from aUSsourcethatisnotconnectedwiththeforeignperson’sUSbusinessissubjectto
72 IRCsection951(a).
73 IRCsections952(a)and954(c).SubpartFincomedoesnotincluderoyaltiesandrentsfromactivebusiness(IRCsection954(c)(2)(A))andcertaindividendsandinterestfromcorporationswithinthesamecountryastheCFC(IRCsection954(c)(3)(A)(i)).Fortaxableyearsbeginningin2006,2007,and2008,dividends,interest,rents,androyaltiesreceivedoraccruedfromarelatedCFCarenottreatedassubpartFincometotheextentthattheyareattributabletoincomeoftherelatedCFCthatisneithersubpartFincomenorincomeeffectivelyconnectedwithaUSbusiness(IRCsection954(c)(6)).SubpartFdoesnotapply(1)ifthesubpartFincomedoesnotexceedthelesserofUS$1millionor5percentoftheCFC’sincome(IRCsection954(b)(3)(A));(2)ifthetaxpayercanestablishthattheincomewassubjecttoaneffectiveforeigntaxratethatis90percentormoreoftheUStaxrate(IRCsection954(b)(4));or(3)withrespecttoactiveincomefromabanking,finance,orinsurancebusiness(IRCsections954(h)and(i)).
74 IRCsections952(a)and954(d)and(e).
75 IRCsection957(a).
76 IRCsection951(b).
stapled securities—“the next big thing” for income trusts? n 273
UStaxationonagrossbasisatarelativelyhighwithholdingrateof30percent.77How-ever,“acombinationofsourcerules,statutoryexemptions,andtaxtreatiesresultsin[interest]incomebeinggenerallytaxedonlywhenearnedbyforeignbusinessesaspartoftheiractivebusinessoperations—suchincomegenerallyisnottaxedwhenearnedbyportfolioinvestors.”78
Forforeigndirectinvestors,stapledstockstructurescouldbeusedtoavoidtheapplicationofthisnon-residentwithholdingtaxandretainthebenefitoftheDRDfor US corporate shareholders. For example, assume that a foreign corporation(Forco)andaUScorporation(USco)haveagreedtomergeonashare-for-sharebasis.IfForcoweretoacquireUScoinexchangeforitsshares,dividendsorinterestpaidbyUScotoForco(thenewforeignparent),andprobablysuchpaymentsbyForcotoitsnewUSshareholders,wouldbesubjecttowithholdingtaxes.Moreover,theUScorporateshareholdersofUScoreceivingsharesofForcowouldlosethebenefitoftheDRD.
ToavoidwithholdingtaxandretainthebenefitoftheDRD,thetransactioncouldbestructuredasshowninfigure9.UScowouldfirstissuetoitsshareholders,onaproratabasis,preferredshareswithvotingpowerrepresentinglessthan20percentof thevotingpower inUSco.79Forcowould thenacquire thecommonsharesof
FIGURE 8 Stapled Structure To Avoid Subpart F
Stapled shares of USco and Forco
Forco
USco
Shareholders(public)
Subpart F income
77 IRCsections871(a)and881(a).
78 ReuvenS.Avi-Yonah,“TheStructureofInternationalTaxation:AProposalforSimplification”(1996)vol.74,no.6Texas Law Review1301-59,at1318.SeeIRCsections871(h)and881(c).
79 Thelessthan20percentvotingpowerlimitationisneededinordertoqualifyforaUStax-freereorganizationunderIRCsection368(a)(1)(B),whichrequiresthattheacquiringcorporationhavecontroloftheacquiredcorporationimmediatelyaftertheacquisition.“Control”forthispurposemeans“theownershipofstockpossessingatleast80percentofthetotalcombinedvotingpowerofallclassesofstockentitledtovoteandatleast80percentofthetotalnumberofsharesofallotherclassesofstockofthecorporation”(IRCsection368(c)).However,anumberofotherUStaxissuescouldarise.See,forexample,IRCsections306and367(a).
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USco in exchange for classB common shares of Forco, and the USco preferredshareswouldbestapledtotheForcoclassBcommonshares.Thestapledsharear-rangementwouldprovidethetermsandamountsofthedistributionsoneachclassofshares.Inamergerbetweenequals,theobjectivewouldbetorequireForcoandUScotomakeequaldistributionsthroughtheForcocommonsharesandtheUScopreferredshares,respectively.Theremightalsobeaneedforanequalizationagree-ment between the two corporations that would control the required degree ofidentityordiversityof interestbetweenthetwotypesofshares.80ThisstructurewouldallowtheUScorporateshareholderstocontinuetoreceivedividendsthroughUScoandtheforeignshareholderstocontinuetoreceivedividendsthroughForco.Withholdingtaxondividendswouldbeavoided,andtheUScorporateshareholderswouldretainthebenefitoftheDRD.81
US Congressional Reaction to Stapled Share Structures
Case Law Preceding the Enactment of IRC Section 269BBeforetheenactmentofIRCsection269B,somecaselawconsideredthecharacter-izationofstapledsharearrangements.Theissueinthesefewcaseswaswhethertheformallyseparatenatureofthesharesshouldberespected,andthesharestreatedasinterestsineachoftherelevantentities,orwhetherthesharesshouldbeconsideredasingleinterestinasingleentity.Althoughthedecisionsdidnotaddresstheissue
FIGURE 9 Stapled Structure To Avoid Withholding Tax and Retain the DRD
Class B common shares stapled to USco preferred shares
USco
Forco
USshareholders
Common shares
Preferred shares
80 SeePeterC.Canellos,“CombiningUnitedStatesandUnitedKingdomCorporations”(1988)vol.42,no.4The Tax Lawyer935-60,at956-60.
81 Thereissomesuggestionintheliterature(seeCanellos,ibid.,at958-59)thattheInternalRevenueServicecouldhavechallengedthisstructure.Itissuggestedthatthestructuremightbesubjecttorecharacterization,withdistributionsfromUScotoitsUSpreferredshareholdersbeingdeemedtobedistributedfirsttoForco,andthenfromForcototheUSshareholders.(ThestapledstockissuesofthisstructurerelatedtoIRCsection269Barediscussedbelow.)
stapled securities—“the next big thing” for income trusts? n 275
inatax-avoidancecontext,theapproachtakentothecharacterizationissuewasrel-evanttotheuseofstapledsharestructuresforplanningpurposes.Inthisrespect,thecaselawappearedtoarticulatethesamegeneralprinciple:thatis,thereisnosubstantive difference between a parent-subsidiary structure and a stapled sharestructurethatwouldsuggestthattheyshouldbetreatedinconsistently.Accordingly,astapledsharestructureshouldbeconsideredasingleinterestinasingleentity.
Twocases,inparticular,articulatedthisproposition,albeitnotinastructuredfi-nancecontext.InDe Coppet v. Helvering,82sinceitwasunlawfulforabanktoengageincertaindealingswithsecurities,thedirectorsofthebankheld,astrusteesforthebankshareholders,theoutstandingsharesofaninvestmentcompanythatdealtwithsuchsecurities.Thesharesoftheinvestmentcompanywerestapledtothesharesofthebank.Theinvestmentcompanywaswoundupwithoutassets,andthetaxpayerattemptedtodeductlossesontheshares.Thecourtdisallowedthededuction,hold-ingthat
itwouldcertainlyhavemadeagreatdifferencehowtheinvestmentshareswereheld,if theywerenot lockedtothebankshares.Buttheywere; itwas impossibletosellthemwithoutsellingthebankshares,ortosellthebankshareswithoutsellingthem.Wedonotsaythatnodifferencescanbeconjuredupbetweenthelegalformchosenandtheusualshareholdingofasubsidiary;buttheyareimmaterialtothesubjectathand.Thebeneficialinterestwasasmuchanappurtenanceofthebanksharesasaneasementisoftheservienttenements;itmerelygavethemanaddedvalue,preciselyasitwouldhavedone,hadtheBankbeentheshareholder.Collectivelythesamepersonsmust always be equitable owners of the investment shares and shareholders of theBank, and in the same proportion; there never could be one group holding bankshares,andanotherholdinginvestmentshares.Sofarasacorporationistheaggregateofitsshareholdersinrespectoftheircollectiverightsandobligations,therewasbutonecorporation....
Theimportantmatterisnotwhatformallegaldifferencestherewerebetweenthemodeladoptedandtheordinarycaseofacorporatesubsidiary;butwhethertheinvest-mentwassingle.Itwasiftheinvestorcouldnothavedealtwiththepartsseparately;andtheseinvestorscouldnot.Whenwespeakofaninvestment,wedonotthinkofthevariousventuresinwhichthecompanymaybeengaged,orofthevariouspropertiesitmayhold.Wethinkoftheunitywhichwemustdealwithassuch,regardlessoftheparticularlegalparaphernaliainwhichitisclad.83
In1954,relyingonthefactthatthesubsidiaryshareswerestapledtothebanksharesinDe Coppet v. Helveringandwerenotsubjecttothebank’screditors,depositors,and other third parties, the Internal Revenue Service (IRS) issued the followingruling:
82 108F.2d787(2dCir.1940);aff ’g.38BTA1381(1938):cert.denied,310US646(1940);reh’g.denied,311US725(1940).
83 Ibid.,at788-89(2dCir.).SeealsoMoore v. Hoey,31F.Supp.478(NYDist.Ct.1940);andCommissioner of Internal Revenue v. Hagerman,102F.2d281(3dCir.1939);aff ’g.34BTA1158(1936).
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Thedistributionbyanationalbankofthestockofawholly-ownedsubsidiarycorpor-ationtoatrustcreatedforthepurposeofholdingthestockfortheproratabenefitofshareholders of the bank with control vested in the majority of such shareholdersconstitutes a taxabledividend... to the extentof earnings andprofitsof thebankavailablefordividendseventhoughthedispositionofthestockistiedtoexistingstockownershipinthebank.84
Butin1957,theTaxCourtinEarl R. Wilkinson85heldthatthetransferbyabankofthesharesofitssubsidiarytotrustees,withthebeneficialinterestsoftheshare-holdersofthebankbeingstapledtothebankshares,didnotconstituteataxabledividendpaidtotheshareholders.Thecourtreasonedasfollows:
TheplanintheinstantcasewasadoptedtomeettherequirementsoftheComptrolleroftheCurrency.ItwasaplanwherebytheBankwouldriditselfofSecurities,itswhollyownedsubsidiary,andstill retain for its stockholders thebenefits thathadresultedfromitsbeingaBanksubsidiary.EvidentlysuchatransfersatisfiedtherequirementsoftheComptrollerbutarealisticlookatthetransactionshowsthattoallintentsandpurposesSecuritieswasretainedbytheBankasanavailablemediumtoperformthesameauxiliarybusinessfunctionsaswereperformedbyitbeforethetransfer.
FromtheBankstockholders’position,itisdifficulttoseehowanychangeresultedfromthetransferthatgaverisetotherealizationofgain.Petitioner’sinvestmentwas,insubstance,exactlythesameafterthetransactionasbefore.Beforethetransaction,petitioner’sinvestmentandtheinvestmentofalltheBankshareholdersmightbesaidtobedirectownershipofthestockoftheBankandsolelybyreasonofsuchownership,indirectownershipofthestockofSecurities.Afterthetransfer,petitionerandtheotherBankshareholdershadthesameinvestment,namely,directownershipoftheBankstockandsolelybyreasonofsuchownership,indirectorbeneficialownershipofthestockofSecurities.WhileinformtherewasaseveranceofSecuritiesstockfromtheBankassets,thepetitionerandtheotherstockholdersintheBankreceivednothingtheydidnothavebefore,asaresultofthetransaction.ThebeneficialownershipofthestockofSecurit-ies,afterthetransaction,wasstilllockedintoownershipoftheBankstock.ItwasstillaproratainterestdependinguponownershipoftheBankstock.ThatbeneficialinterestcouldnotbetransferredwithouttransferoftheBankstock.If,thedayafterthetransfer,petitionerhadsoldhisBankstock,hewouldhavetransferredsubstantiallythesameinvestmentastoSecuritiesstockasifthetransferhadbeenmadethedaybefore.86
IRC Section 269BIRCsection269Bcontainsthreeseparaterules,eachofwhichaddressestheuseofastapledsharestructureinaparticularcontext.87Therulesapplyinrespectofa“stapledentity”and“stapledinterests”inanentity.“Stapledentities”aredefinedas
84 Rev.rul.54-140,1954-1CB116.
85 29TC421(1957).
86 Ibid.,at425-26.
87 Thetextoftheprovisionisreproducedasanappendixtothisarticle.
stapled securities—“the next big thing” for income trusts? n 277
anygroupoftwoormoreentitiesifmorethan50percentinvalueofthebeneficialownershipineachconsistsof“stapledinterests.”An“entity”meansanycorporation,partnership,trust,association,estate,orotherformofcarryingonabusiness.
StapledREIT(andRIC)structuresareaddressedbytreatingtheREITandthestapledentityasasingleentity.TheactivitiesofthestapledentityarethusimputedtotheREIT,disqualifyingitfromREITstatuswherethestapledentityengagesinbusinessactivitiesproducingactiveincome.
TheuseofstapledsharestructurestoavoidtheapplicationofthesubpartFregimeisaddressedbyprovidingthat,insuchstructures,astapledforeigncorporationistreatedasadomesticcorporation,therebysubjectingthecorporationtoUSincometaxonitsworldwideincome.However,IRCsection269B(e)excludesfromthisrulethosesituationsinwhichthedomesticandforeignstapledcorporationsarebothforeignowned.Forthispurpose,acorporationis“foreignowned”iflessthan50per-centofitsvotingpowerandvalueisowned(ortreatedasowned)byUSpersons.TherationaleforthisexceptionisthatsubpartFwouldnotapplyinanyevent,be-causeneithercorporationwouldbeaCFC.
AthirdruleaddressestheuseofstapledsharesinthecontextofthedefinitioninIRCsection1563ofa“controlledgroupofcorporations,”whichisrelevanttovariousprovisions. Ingeneral, IRC section1563defines a “controlledgroupof corpora-tions”aseitheraparent-subsidiarycontrolledgroupofcorporations,abrother-sistercontrolledgroup,or a combination thereof (combinedgroup), all subject to theconditionssetoutintheprovision.ForthepurposesofIRCsection1563,astapledcorporationisconsideredasubsidiaryoftheothercorporationtowhichitisstapled.ThisdeemingrulecodifiesthecaselawprecedingtheenactmentofIRCsection269Bdescribedabove.
BecauseaforeigncorporationthatisstapledtoadomesticcorporationwillbetreatedasadomesticcorporationunderIRCsection269B(a)(1),theforeigncorpora-tionwillbedeemedtoconverttoadomesticcorporationinatax-freereorganizationunder IRCsection368(a)(1)(F).88This treatmentcouldallowtheuseofa stapledforeigncorporation’slossestooffsetincomeofothermembersoftheUSaffiliatedgroup.89Topreventsucharesult,theIRSannouncedin1989thatregulationswould
88 SeeRev.rul.89-103,1989-2CB65;seealsoTreas.reg.section1.269B-1(c).UnderUSlaw,corporatereorganizationsgenerallyaretax-freetothecorporationanditsshareholders,butwherethereorganizationhascross-borderaspects,IRCsection367mayrequirethecorporationand/oritsshareholderstoincludecertainamountsingrossincomeortomakecertainotheradjustments.SeeTreas.reg.sections1.269B-1(c),1.367(a)-1T(e)and(f ),and1.367(b)-2(f ).
89 Ingeneral,IRCsection1504definesan“affiliatedgroup”asoneormorechainsof“includiblecorporations”connectedthrough80percentstockownershipinvotingpowerandvaluewithacommonparentcorporationthatisanincludiblecorporation(definedinIRCsection1504(b)).Affiliatedgroupsareaffordedspecialincometaxtreatmentbyfilingoneconsolidatedincometaxreturn(IRCsection1501),withalltheimplicationsthereof.Alossofoneincludiblecorporation,forexample,maybeusedtooffsetlossesofotherincludiblecorporationsintheaffiliatedgroup.
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beissuedunderIRCsection269Bwithrespecttostapleddomesticandforeigncor-porations.90Undertheseregulations,astapledforeigncorporation(whichwouldotherwisebetreatedasadomesticcorporationaccordingtoIRCsection269B(a)(1))istreatedasaforeigncorporationforpurposesofthedefinitionofanincludiblecorporationunderIRCsection1504(b).Thus,unlessaspecialelectionismadeunderIRCsection1504(d),lossesofastapledforeigncorporationthataredeemedtobelossesofadomesticcorporationunderIRCsection269B(a)(1)willnotbeallowedtooffsetincomeofanymemberofanaffiliatedgroup.91
However,thisprovisionfacilitatedaplanningstructurewherebyaUScorpora-tioncouldgainataxadvantagebyformingastapledforeigncorporationtoholdthesharesofitsforeignsubsidiariesand/oritsotherforeignassets.Sincethestapledfor-eignholdingcorporationwasnotanincludiblecorporation,itwasnotconsideredtobepartof theconsolidatedgroup,andthusnoconsolidated interestexpenseswouldbeallocatedtoit.Theresultwasanincreaseintheforeign-sourceincomeofthestapledforeignholdingcorporationandthusintheamountofitsforeigntaxcreditlimitation.92In2003,Treas.reg.section1.269B-1(d)(2)wasaddedtoaddressthisplanningtechnique.Theregulationprovidesthat“aforeigncorporationthatisstapledtoadomesticcorporationwillbetreatedasadomesticcorporationforthepurposesofthedefinitionofanincludiblecorporationundersection1504(b)whenapplying§§1.904(i)-1and1.861-11T(d)(6).”93Thatis,forthelimitedpurposeofdeterminingtheforeigntaxcreditlimitationofaconsolidatedgroup,thestapledcorporationistreatedasanincludiblecorporation.
UnderTreas.reg.section1.269B-1(b)(2),thecommissionermaytreataninterestthatwouldotherwisebeastapledinterestasnotbeingstaplediftheprincipalpur-poseofthestaplingistheavoidanceofUSincometaxation.TheIRShadpreviouslysuggestedinFSA20023301694thatitmaybeabletodisregardareorganizationin-volvingstapledinterestsunderthegeneralshamtransactiondoctrine(alsoknownastheeconomicsubstancedoctrine),accordingtowhichatransactionwillbedis-regardedfortaxpurposeswhenithasnosignificanteconomiceffectsotherthanthecreationoftaxbenefits.ItwasalsosuggestedthattheIRSmaychallengeastapledstructureinotherways:first,bytheapplicationofIRCsection48295toallowthere-allocationofincomeandexpensesbetweenaUScorporategroupandastapledforeign
90 Notice89-94,1989-2CB416.
91 Ibid.SeealsoTreas.reg.section1.269B-1(d)(1).
92 Seesupranote69.
93 SeeNotice2003-50,2003-2CB295.
94 InternalRevenueService,FieldServiceAdvice(FSA)200233016,May9,2002.
95 UnderIRCsection482,theIRSmayexerciseitsauthoritytoreallocateincome,expenses,deductions,credits,orallowancesbetweentwoormoretrades,businesses,ororganizationsthatareownedorcontrolledbythesameinterestsifsuchallocationisnecessarytopreventtaxevasionortoreflectthetrueeconomicallocationofincome.
stapled securities—“the next big thing” for income trusts? n 279
entity;second,bytheapplicationofIRCsection26996todisallowdeductions,credits,orotherallowancesiftheprincipalpurposeofthestapledstructureistosecuretaxbenefits; and third, through thedisqualificationofa transactionasa tax-free re-organizationwhereassetsaretransferredtoastapledentity.
e x tending the dr A f t legisl Atio n to A ddre ss the use o f s tA Pled securitie s
Addressing Stapled Securities in Intermediated and Disintermediated Structures
WithIRCsection269Bavailableasatemplate,itshouldberelativelyeasytodeveloplegislativeprovisionsthatwillblocktheuseofstapledsecuritystructurestoavoidtheapplicationofthedraftlegislation.Forexample,stapledREITstructurescouldbeaddressedbydeemingstapledentitiestobeasingleentityforthepurposesoftheeligibilityconditionsforREITstatus.AprovisionsimilartoIRCsection269B(a)(3)wouldattributethebusinessactivitiesofastapledentitytothestapledREIT,disquali-fyingitfromREITstatus.Otherstapledsecuritystructures,suchasthoseillustratedinfigures5and6,couldbeaddressedusingIRCsection269B(a)(2)asamodel.Inparticular,modificationsof incometruststructuresthatusestapledsecurities tobypassaSIFTtrustorpartnershipandstreamincomedirectlytoinvestorscouldbesubjecttoarulethatdeemsthestapledsecuritiestobeownedbythetrustorpart-nership. Income earned on indebtedness or through a partnership interest heldoutsideaSIFTentitywouldthusbechannelledthroughthatentity,ensuringdeemeddividendtreatment.97
Forthepurposesofthedraftlegislation,thedefinitionsof“stapledentities”and“stapledinterests”setoutinIRCsection269B(c)couldbeused.Somefurthercon-siderationmightbegiven,however,tothearticulationofabrightlinethatwouldresultintheapplicationoftherelevantdeemingrules.Asdescribedabove,IRCsec-tion269Busesa50percenttest:anentityisconsideredastapledentityifmorethan50percentofthevalueofownershipinterests isattributabletostapledinterests.Thisparticularthresholdleavesroomfortheuseofstapledsecurities,apparentlyundertheassumptionthattheymaybeusedinsomeinstancesfornon-taxreasons.This50percentbrightlineessentiallyfunctionsasaprimarypurposetestunderwhichtherelevantdeemingruleswillbeappliedwherestapledinterestscanreason-ablybeconsideredtobeusedprimarilytoobtainataxbenefit.The50percentbright
96 IRCsection269authorizestheIRStodisallowdeductions,credits,orotherallowancesiftheprincipalpurposeoftheacquisitionofcontrolofacorporation,ortheacquisitionbyacorporationofpropertyofanon-controlledcorporationwiththepropertyhavingacarryoverbasisfromthetransferorcorporation,istoevadeoravoidUSincometaxbysecuringthebenefitofadeduction,credit,orotherallowancethatwouldnototherwisebeavailable.
97 Assuggestedbythestructureinfigure6,theconceptof“publictrading”ortheconceptofa“stapledinterest”wouldprobablyhavetobeextendedspecificallytoinvestmentsthatcanbeexchangedforpubliclytradedsecuritiesand/orstapledsecurities.
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linemaybeusedasaproxyforthiskindofpurposetestinanefforttominimizethecomplianceandadministrativecostsassociatedwithamorequalitativeassessment.Absentevidenceoftheuseofstapledsecuritiesgenerallyfornon-taxpurposes,thereseemstobenocompellingcaseforalessrestrictivebrightline,suchasa75percentormoretest.Ontheotherhand,theUSexperiencedoesnotsuggestaneedforalowerthresholdtoextendtheapplicationofIRCsection269Btoarangeoftransactionsinwhichstapledsecuritystructureshavebeenusedastax-effectivesubstitutes.
Changestothedraftlegislationalongthelinesofthosesuggestedimmediatelyabovewouldstillleaveopen,asanavoidancetechnique,thedisintermediatedholdingofjunkdebtinIDSandIPSstructures(figures3and4).Becausethesestructuresdonotinvolvetheintermediatedholdingofdebt,theywouldavoidtheSIFTdividendtrapandcouldcontinuetobeusedasameanstoavoidtheunintegratedcorporateincometax,whethersuchdebtisstapledtosharesoftheissuerorisotherwiseheldproportionallywithitsshares.Indeed,theeliminationoftheforeignpropertyholdingrestrictionsfortax-exemptdeferredincomeplans,suchasRPPsandRRSPs,98meansthatthereisverylittleinthewayofatax-lawconstraintontheacquisitionofdirectjunkbondsubstitutesbythisclassofinvestors.99Webelieve,nonetheless,thattherearedefensiblepolicyreasonsforacceptanceofthisparticularsubstitutestructure,butonlywherethejunkdebtisnotheldproportionallywithsharesoftheissuer.
Acomprehensivelegislativeresponsetothetransactionalsubstitutionscharacteris-ticoftheincometrustphenomenoncannotavoidtheneedtoaddresstwofundamentaldefinitionalissuesthatareendemictoacorporateincometaxsystemthattreatsthereturnondebtandequityinconsistentlyandleavesarangeofentities,suchaspart-nershipsandtrusts,outsidethatsystem.Thedraftlegislationaddressesonlyoneoftheseissuesexplicitly:theconceptofacorporation,theequityinterestsofwhicharesubjecttodividendtaxation.Inthecontextofpubliclytradedentities,thisdefinitionalissueiseffectivelyresolvedbytreatingallpubliclytradedtrustsandpartnershipsascorporationstotheextentofthereturnrealizedfromcarryingonabusiness,eitherdirectlybytheparticularentityorindirectlythroughtheacquisitionofindebted-nessandsharesofahighlyleveragedcorporation.Theotherdefinitionalissue—thedistinctionbetweencorporatedebtandequity—isaddressedonlyasasecondaryeffectofthedefinitionofacorporationinthepubliclytradedcontext.
Asemphasizedinanearlierarticle,100anequityrecharacterizationruleisrequiredtoaddresstheessenceofincometruststructures—namely,thesubstitutionofun-secured,high-yield,andsubordinatedjunkdebtforshares,inanattempttomassagethetax-lawboundarybetweendebtandequityandtakeadvantageofthedifferencesintheirtaxtreatment.ThepopularityofincometrustsinCanadaisreminiscentofthe
98 Seesupranote23.
99 Fornon-residentinvestors,thethincapitalizationrulesinsubsections18(4)to(6)limittheamountofdeductibleinterestonindebtednessheldbycertainnon-residentshareholders(thatis,“specifiedshareholders,”definedgenerallyinsubsection18(5)as25percentormoreshareholdersonavotesandvaluebasis).
100 Edgar,supranote37.
stapled securities—“the next big thing” for income trusts? n 281
leveragedbuyout(LBO)crazeintheUnitedStatesinthe1980s.AsinthecaseofUSLBOs,theundesirableconsequentialattributesofincometrustscanbecompletelyeliminated(assuminganunintegratedcorporateincometax)onlythroughatargetedlegislativeresponsethatrecharacterizesasequitythehigh-yieldjunkdebtcharac-teristicofstandardincometruststructures.However,sucharesponsemustalsobesupportedwithtwoadditionalrules.Onerulewouldaddresstheuseofdebtsubsti-tutes,suchasroyaltyandleasearrangements.Theotherrulewouldaddresstheuseofflowthroughentities,suchastrustsandlimitedpartnerships,asdirectsubstitutesforthecorporateform.Afailuretotreatarangeofroyaltyandleasearrangementscon-sistentwithrecharacterizeddebt,orafailuretotreatarangeoftrustsandlimitedpartnershipsascorporations,wouldmeanthatsucharrangementsorflowthroughentitiescouldbeusedtorealizethesameresultasastandardincometruststructure.
Takentogether,theseelementsofasuggestedlegislativeagendawouldeffectivelykilltheincometruststructure(aswellasitsclosesubstitutes,includingitsolderroyaltytrustcousin)andrestorethecorporateincometaxstatusquoante.Thisparticularlegislativeagendawouldobviouslydifferfromthedraftlegislationinitsuseofanequityrecharacterizationrule.Infact,thedraftlegislation,evenifmodifiedtoad-dressstapledsecuritystructures,remainsnothingmorethanthekindofsupportinglegislation,focusedonentitysubstitution,thatwouldbenecessaryinconjunctionwithanequityrecharacterizationruletoaddressthepossibleuseofsubstitutestruc-turesthatdonotincorporatehigh-yieldjunkdebt.Butasnotedalready,extensionofthedraftlegislationtoaddressstapledsecuritieswouldaddresstheentirerangeofincometruststructuresusinghigh-yieldjunkdebtinanintermediatedinvestmentstructure,aswellasthedirectsubstitutionofthetrustorpartnershipformforthecorporate form in apublicly traded context.Given thisbroad application, therewouldbenoneedforageneralizedequityrecharacterizationrule.TargetingincometruststructuresandtheirclosesubstitutesmayevenbeaneasierlegislativeexerciseusingtheconceptsofaSIFTtrustoraSIFTpartnershipasadividendtrapforincomefromnon-portfolioproperties.101However,therewouldremainaneedforalimitedequityrecharacterizationruleasasupportingruletoaddressthedisintermediatedholdingofjunkdebtasatax-effectivesubstitute.
Thecaseforalimitedequityrecharacterizationruleisbasedonarecognitionthatincometrustspresentatax-drivensubstitutionofadebtinstrumentforshares,
101 Seesupranote43andtheaccompanyingtextforthetargetingdifficultiespresentedbytheuseofderivativefinancialinstruments.Anothertargetingissueariseswithtrustcapitalsecurities,whicharecapitalinterestsofatrusttheproceedsofwhichareusedtoacquiresubordinateddebtofabankorapoolofsecuritizedassetssuchasresidentialmortgages.Thesestructureshavebeenusedprimarilyforregulatorypurposes,withbanksimprovingtheircapitaladequacyratioseitherthroughthequalificationofthesubordinateddebtastier1capitalortheremovaloftherisk-weightedassetsfromthebalancesheet.Withoutanyspecificamendmentstothedraftlegislation,thesetrustswouldbetreatedasSIFTtrustswheretheinterestsarepubliclytraded.Incomeontheunderlyingdebtofthebankorthesecuritizedassetswouldbesubjecttodividendtaxtreatment.Applicationofthedraftlegislationinthesecircumstancesisarguablyoverinclusive,atleasttotheextentthatthestructuresarenottax-drivensubstitutes.
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whichdifferssignificantlyfromthesubstitutionofdebtforequitygenerally.102Thedifferenceisthehigh-yield,subordinatednatureoftheindebtednessusedinincometruststructures,which,whenheldbythetrustinproportiontoanyremainingsharesoftheoperatingentity,mimicscloselythecashflowpatternotherwiseassociatedwithapreferredshareorincomebond.Thereplicationissimplymuchcloserthanthatassociatedwithadebtinstrumentthatisnotheldproportionallywiththeequityofacorporateissuer.Inthelatterinstance,thetaxbenefitotherwiseassociatedwiththecorporateinterestexpensedeductionisaccessedonlyatthecostofsomesacrificeinthecashflowpatternassociatedwithanequityinstrument.Althoughthedifferenceisoneofdegreeandnotofkind,thedifferenceincashflowpatternsofarm’s-lengthdebtandthehigh-yield,subordinatedjunkdebtusedinincometruststructuresmeansthatthelattercandefensiblybecharacterizedas“equityindrag,”103consistentwithmarketperceptions.Nosuchcharacterizationextendstoarm’s-lengthindebtednessgenerally,becauseoftheabsenceofaproportionalholdingofthedebtandsharesoftheissuer.Thedebt-equitysubstitutionassociatedwithincometrustsisthereforequalitativelydifferentfromthatassociatedwiththechoicebetweendebtandequitygenerallyinthecorporatecapitalstructure.
Ifsupplementedwithsomespecificprovisionsaddressingtheuseofstapledse-curitiesinintermediatedstructures,thedraftlegislationwouldapplydividendtaxtreatmenttoalmosttheentirerangeofindebtednessthatcoulddefensiblybechar-acterized as disguised equity because of its proportional holding. Targeting thedisintermediatedholdingofhigh-yieldjunkdebtbyinvestorsand,inparticular,dis-tinguishingitfromdisintermediatedholdingsthatcanberespectedasindebtednesswouldremain,nonetheless,adifficultexercise.Asemphasizedhere,thedistinguish-ingfeatureistheproportionalholdingofdebtandsharesofaparticularcorporateissuer.Moreparticularly,whentherelevantsecuritiesarenotheldproportionally,atsomepointdifferencesinthenon-taxattributesofdebtandequityconstraintax-drivensubstitution.Whendebtandsharesofthesameissuerareheldproportionallybyaninvestor,thesedifferencesareentirelyformalistic.Ineffect,aproportionalhold-ingraisesapresumptionthattheinvestorwillnotexercisetherightsofacreditor,withtheproportionalholdingindicatingatax-drivensubstitutionofdebtforequity.
However,exceptinthecaseofaformalstaplingofsecurities,orapooledholdinginanintermediatedinvestment,itisdifficulttodesignatarget-effectiverequire-mentthatwouldlimitanequityrecharacterizationruletoindebtednessthatisheld
102 Butsee,forexample,AveryShenfeld,“TheEconomicBenefitsofIncomeTrusts,”Economic Perspectives(CIBCWorldMarkets,March7,2003)(arguingthatincometrustsdonotrepresentspecialtreatmentintheabilityofthesestructurestoshelterincomefromcorporate-leveltaxusingtheinterestexpensededuction).Muchthesameargumentwasmadeintheliteratureindefenceoftheuseofhigh-yielddebtinLBOsintheUnitedStates.SeeMichaelC.Jensen,“EclipseofthePublicCorporation”(1989)vol.67,no.5Harvard Business Review61-74.
103 Thischaracterizationofthehigh-yieldjunkdebtusedinLBOsisfoundinJeremyI.Bulow,LawrenceH.Summers,andVictoriaP.Summers,“DistinguishingDebtfromEquityintheJunkBondEra,”inJohnB.ShovenandJoelWaldgogel,eds.,Debt, Taxes and Corporate Restructuring(Washington,DC:BrookingsInstitution,1990),135-66,at152.
stapled securities—“the next big thing” for income trusts? n 283
proportionallywithsharesofanissuer.Toavoidproblemsofunderinclusiveness,therequirementshouldprobablynotbeexpressedintermsofaquantitativebrightline.104Indeed,itisnotevenclearwhatsuchabrightlinemightlooklikeasalegislativestartingpoint.Toconstrainplanningfocusedonaproportionalityrequirement,thelegislativeexpressionofthisrequirementwouldprobablyhavetobecastingeneralterms,suchasarequirementthattheaffecteddebtbestapledwithsharesoftheissuerorotherwiseissuedoracquiredincircumstancesthatmakeitreasonabletoexpectthatitwillbeheldinroughproportionwithsharesoftheissuer.105Applicationofaproportionalityrequirementinthelattercontextwouldbeanadmittedlyindeter-minateexercise.
Thiskindofexpandedlegislativeresponsetoincometruststructureswouldex-plicitlyaddressthedebt-equitydefinitionalissuebyextendingdividendtreatmenttothereturnondebtthatisheldproportionallywiththeequityofanissuer,wheth-erornotstapledtogether.Itwouldlimittheunintegratedcorporateincometaxtopubliclytradedentities,ontheassumptionthatpublictrading,asadefiningfeatureof the tax-lawboundarybetweenflowthrough and separate-entity status, canbeusedbecauseitprovidesarobustnon-taxconstraintonatax-drivensubstitution.Thisassumptionhasbeenchallenged,however,byarecentwaveofleveragedacquisi-tionsofpubliccorporationsbyprivateequityfunds.106Assumingagainthatthereareimportantnormativeargumentsandrevenueconstraintsthatdictatemaintenanceofacorporateincometaxthatistosomeextentunintegrated,107thiswaveofgoing-privatetakeovertransactionsraisestheissueofevenmorefundamentalreform.Given
104 Forexample,theUScourtsappeartohaveadoptedaquantitativelyimpreciseapproachtothearticulationofthecontentoftheproportionalityrequirementintheirapplicationofamultifactordebt-equityanalysis.Thesameapproachisapparentinthedescriptionoftheproportionalityfactortobetakenintoaccountinadebt-equityanalysisunderIRCsection385.
105 Wherehigh-yieldjunkdebtisstapledtoaspecifiednumberofsharesoftheissuerandcannotbeseparatelytraded,arequirementofproportionalholdingisnotespeciallyproblematic.Forexample,theIDSandIPSstructureswerespecificallydevelopedtoavoidtheapplicationofthissamefactorofproportionalholdingarticulatedintheUSdebt-equitycaselaw.Inparticular,thecommonsharescanbeseparatelytraded,ascanthestapledsecurities.Thesubordinateddebtcannot,however,beseparatelytraded,arestrictionthatsignificantlylimits,inpractice,theabilitytoseparatethecomponentpartsoftheIDSorIPS.Intheoryatleast,theabilitytotradethecomponentpartsseparatelymeansthatthehigh-yieldjunkdebtcomponentmaynotnecessarilybeconsideredtobeheldproportionatelywiththesharesoftheissuer.(Snider,supranote20,at10-11,reportsthatinonesuchstructure,amajoraccountingfirmresignedasauditoroftheissuerbecauseofconcernovertheclassificationoftheparticularsubordinateddebt.)
106 See,forexample,LeeA.Sheppard,“MonetizingOldEurope”(2006)vol.44,no.8Tax Notes International587-90.TheacquisitionofCanadianpubliclytradedbusinesses(bothincometrustandcorporatestructures)byforeign-controlledprivateequityfundswasthesubjectofevidencegivenbeforetheHouseofCommonsFinanceCommitteehearingsonincometrusts.SeeTaxing Income Trusts,supranote10,at15-16.
107 ThesenormativeargumentsarecomprehensivelycanvassedinKimBrooks,“LearningToLivewithanImperfectTax:ADefenceoftheCorporateTax”(2003)vol.36,no.3UBC Law Review621-72.
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theseassumptions,amorecomprehensiveequityrecharacterizationrulethanthatsuggestedherewouldberequired,108alongwithexpansionoftheconceptofacor-poration to includea rangeofbusiness trusts andpartnerships, especially in thecontextofinboundforeigndirectinvestment.109
Maintaining the Exception for REITs
OursuggestedmodificationsofthedraftlegislationtoaddresstheuseofstapledsecuritystructureswouldmaintaintheREITexceptionfromSIFTstatus,butonlyoutsidesuchstructures.Thetax-lawboundarythatisimplicatedinthecaseofREITsistheboundarybetweentrustsandcorporationsand,inparticular,theflowthroughtreatmentoftheformerversustheseparate-entitytreatmentofthelatter.Incometrusts (andtheirolderroyaltytrustcousins)substituteatax-deductibleformofsecurity(high-yieldacquisitionindebtednessoraroyaltyinterest)forwhatwouldotherwisebeashareinvestmentintheunderlyingassets.Theunintegratedportionofthecorporateincometaxisavoidedthroughtheconversionofthecashflowsas-sociatedwiththeassetsfromanon-deductibledividenddistributiontoadeductibleinterestexpenseorroyaltydistribution.Fortax-exemptentitiesatleast,thesubsti-tutionisrequiredbecauseofthetax-lawlimitationthatpreventssuchentitiesfromcarryingonabusinessandtherebyholdingtheassetsdirectly.Ineffect,thehigher-taxedcorporateformmustbeused,whichrequiresthesubstitutionofhigh-yieldacquisitionindebtednessoraroyaltyinteresttoavoidtheunintegratedportionofthecorporatetaxonincomefromtheunderlyingassetorassets.Butrealestateisgener-allyaneligibleinvestmentfortax-exemptentitiesandcanbehelddirectlyaspassiveinvestmentsbysuchentities.Thetrustformissubstitutedforthecorporateformtorealizetheeconomiesofscaleandmanagementexpertiseavailablewiththelatterform,whileensuringonlyoneleveloftaxontheearningsoftheunderlyingassets.
Atabroadconceptuallevel,thisdifferentmarginofsubstitutionimplicatedbyREITsdoesnotmeanthat theassociatedpolicy issuesareentirelydifferent fromthoseimplicatedbyincometrustsandroyaltytrusts.110Infact,asasubstituteforthe
108 Asaresponsetoleveragedprivateequitytakeovers,broadlimitationsonthedeductionofcorporateinterestexpensehavebeenproposedinGermanyandDenmark.SeeArneMøllinOttosenandMichaelNørremark,“PrivateEquityFunds—AmendmentstoDenmark’sAnti-AvoidanceLegislation”(2006)vol.60,no.10Bulletin for International Taxation402-10;andMartinA.Sullivan,“Denmark,GermanyToCutInterestDeductions”(2007)vol.114,no.8Tax Notes820-22.
109 Applyingthecorporateincometaxtothereturnoninboundforeigndirectinvestmentwouldrequireextensionofacorporatedeemingruletoalldomesticentitiesthatarecontrolledbynon-residentinvestors.Foradiscussionofthedimensionsofsucharuleanditsassociatedrationale,seeTimEdgar,“CorporateTaxCoordinationasaResponsetoInternationalTaxCompetitionandInternationalTaxArbitrage”(2003)vol.51,no.3Canadian Tax Journal1079-1158.Asdiscussedinthecontextofincometrusts,maintenanceofanunintegratedcorporateincometaxwouldrequireanequityrecharacterizationruleforinterest,rent,androyaltypaymentsmadeinthecontextofinboundforeigndirectinvestment.
110 SeeMartinA.Sullivan,“PassiveActivityorActivePassivity?RisingREITsRocktheCorporateTax”(2003)vol.99,no.9Tax Notes1298-1302.
stapled securities—“the next big thing” for income trusts? n 285
corporateform,REITsresultinthesameavoidanceofanunintegratedcorporatein-cometax,withtheassociatedrevenueloss.REITsmayalsopresentmanyofthesameefficiencyeffectsasincometrustsandroyaltytrusts.111Thesectorbenefitingfromtheallocativeconsequencesoftheiruseisobviouslytherealestatesector,ratherthanbusinesseswithstablecashflowsandmatureproducingassets,whichareperceivedtobeespeciallysuitableforincometrustsandroyaltytrusts,respectively.Butunlikethelattertransactionalforms,itisnotclearthattheuseofREITsimposesefficiencycoststhatwarrantthemovementofthetax-lawboundarybetweenflowthroughandseparate-entitytaxation.Inotherwords,itisnotclearthattheline-drawingexerciseproposedintheOctober2006proposals,andimplementedinthedraftlegislation,shouldbemodifiedinanefforttorealizeameasureofefficiencygains.TheprospectoftheuseofstapledsecuritystructuresusingtheREITexceptionfromSIFTstatusdoesnotalterthisproposition.Becausethesestructurescouldbeusedastax-effectivesubstitutesforincometruststructures,theyshouldbetaxedconsistentlybyextendingtheap-plication of the draft legislation to explicitly include stapled securities using theREITexception.Theneedtoaddresstheuseofstapledsecuritystructuresdoesnot,however,requireeliminationofthegeneralexceptionfromSIFTstatusforREITs.
AssuggestedintheUScontext,thepolicyunderlyingtheflowthroughtreatmentofREITs,112aswellasmutualfundinvestmentsgenerally,appearstobeadesiretoavoidthetaxwedgeandassociateddistortionsotherwiseimposedbyanunintegratedcorporate income tax.Flowthrough treatmentpermits the realizationofcertainefficienciesassociatedwiththepoolingofportfolioinvestmentwhilemaintainingconsistencyoftaxtreatmentwithadirectholdingoftheunderlyingassetsinun-incorporatedform.Inthisrespect,statusasamutualfundtrust(andtheflowthroughtreatmentfollowingfromsuchstatus)islimited,inparticular,byasetofdefinedconditionsthatcanbeseenasanattempttoensurethatthecashflowsfortheholderofatrustunitlargelymimicthosethatwouldbeassociatedwithadirectportfolioholdingofaninterestintheunderlyingassets.SimilareligibilityconditionsinthedraftlegislationforREITstatusperformmuchthesamefunction.113Theuseofstapled
111 Ibid.,at1299-1300.
112 Seesupranotes41and42andtheaccompanyingtext.SeealsotheOctober2006proposals,whichstateonlythattheflowthroughexceptionforREITs“recognizestheuniquehistoryandroleofcollectiverealestateinvestmentvehicles.”EvidencegivenbeforetheHouseofCommonsFinanceCommitteeontherationalefortheREITexceptioninthedraftlegislationwasunenlightening,amountingtonomorethanthepropositionthattheexceptionwasrequiredbecauseothercountries,particularlytheUnitedStates,provideflowthroughtreatment.SeeTaxing Income Trusts,supranote10,at11-12.
113 Themostsignificantconditionsarethelimitationsontheassetsthatcanbeheldbytheentity.Seesupranotes41and42andtheaccompanyingtext.Thelimitationseffectivelydrawaboundarybetweenpassiverealestateinvestmentandthecarryingonofabusiness,withtheformerservingasaproxyfordisintermediatedinvestmentinrealestate.Asindicatedinnote42,theMarch2007noticeofwaysandmeansmotionshiftedthepreviousboundarybyextendingtheclassofeligibleassetstoincludesecuritiesofanentitycarryingonapropertymanagementfunctiononbehalfofaREIT.
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securitystructures,however,requiresamodificationoftheseeligibilityconditionstoensurethatREITstatuscannotbeaccessedtoavoidtheunintegratedcorporatetaxbysubstitutingdeductiblerentalpaymentsforhigh-yieldjunkdebtofacorporateissuer.
Giventheseeligibilityconditions,itissimplynotclear,outsidethecontextofincometrustsandroyaltytrusts,thatmutualfundtrustsingeneral,orREITsinpar-ticular, have involved massaging of the relevant tax-law boundary betweenflowthroughandseparate-entitytreatmentinawaythatattemptstosubstitutethecashflowpatternassociatedwithadirectinvestmentinunderlyingcorporateassetsforthecashflowpatternotherwiseassociatedwithsharesofacorporation.Inshort,apartfromthepossibleuseofstapledsecuritystructures,thereisnoevidencethatREITscanbe,orare,usedassubstitutesgenerallyforthecorporateformofcarryingonabusiness.Noristhereanyevidencethatmutualfundtrusts,withtheexceptionofincometrustsandroyaltytrusts,areusedforanythingotherthantheholdingofwhatwouldotherwisebedisintermediatedportfolioinvestment.
Bywayofcomparison,ithasbeensuggestedthatUSlegislativeamendmentsex-tending the assetbaseof REITs to include securitiesof their taxable subsidiaries(TRSs)couldallowtheexpansionoftheREITstructuretoavoidthecorporatein-cometaxbeyondtherealestatesector.114Apparently,aTRSwouldpermittheuseoftransfer-pricingtechniquessuchasthepaymentofdeductiblerenttotheREITonrealestatepropertiesformerlyownedbytheTRS,aswellasinterestpaymentsondebtof theTRS. Indeed, this structuremimics, toa largeextent, thatof incometrustsandroyaltytrustsandpotentiallypresentsasimilarthreattothecorporateincometaxgenerally.115AnysuchexpansionoftheREITstructureasasubstituteforthecorporateformshouldbeconstrainedinCanadabytheconditionsforqualifica-tionasaclosed-endmutual fund trust,116aswellas theeligibilityconditions forREITstatusunderthedraftlegislation,whichtogetherappeartolimitsubstitutabil-itylargelytotherealestatesector.117
114 Sullivan,supranote110.
115 ButseeSullivan,ibid.,at1300:“Toourknowledge,noMcREITorWalREIThasyettobeformed.Althoughthetaxadvantagescouldbelarge,therearemanycountervailingbusinessreasonsforcorporationstomaintaincontroloftheirrealestate.”
116 ForREITs,themoresignificantconditionsarethoserelatingto(1)thecompositionofeligiblefundassets,whichincluderealestate;(2)therequirementthattrustunitsbelistedonaprescribedshareexchangeinCanada;and(3)thelimitationontheholdingofsecuritiesofasingleissuer(notmorethan10percentoffundproperty).
117 Thispropositionisaccurateprovidedthatapropertymanagementfunctionandservicesancillarytotherentalfunctionareproperlycharacterizedaspartoftherealestatesector.TheextensionofeligibleassetsforREITsintheUnitedStatestoincludesharesofaTRSprovidesforamuchmoreexpansiveconceptoftherealestateinvestmentfunction.Butsee,inthisrespect,TonyM.Edwards,“REITAnalysisWasWrongonManyCounts”(2003)vol.99,no.12Tax Notes1851-52.Inalettertotheeditor,EdwardschallengedSullivan’scontentionregardingtheconversionofUScorporationstoREITs,onthebasisofthefollowingthreeconditionsthatconstrainsuchconversions:(1)nomorethan20percentoftotalassetsofaREITcanbeTRSsecurities;(2)paymentsfromacorporationowned10percentormorebyaREITdonotqualifyas“good”
stapled securities—“the next big thing” for income trusts? n 287
Intheabsenceofanyevidenceof thetax-drivensubstitutionof trusts for thepubliclytradedcorporateformgenerally,itisdifficulttodefendtheapplicationofseparate-entitytreatmenttoREITswiththeassociatedtaxwedgeintheformoftheunintegratedcorporateincometaxfortax-exemptinvestors.118Apolicydecisionwouldhavetobemadethatconsistencyoftreatmentofbusinesstrustsandthecorporateformgenerallyisdesirable,asopposedtoconsistencyoftreatmentofdisintermediatedandintermediatedinvestmentsinthelimitedcircumstancessetoutbytheeligibilityconditionsforREITstatus.119ForREITs,thiskindofmovementoftheboundarybe-tweenflowthroughandseparate-entitytreatmentwouldpresumablycauseashiftofinvestmentoutoftherealestatesector.However,itisnotclearthatanysuchshiftwouldoffsetexistingtaxprovisionsthatinduceaflowofcapitalintotherealestatesector,therebycorrectingexistingdistortions.Intheabsenceofanysuchoffset,itappearsthatmovingthetax-lawboundarybetweenflowthroughandseparate-entitytreatmentinthismannerwouldproducefew,ifany,efficiencygains.
ThebroadertaxtreatmentofREITsbringsusbacktotheissueoffundamentalincometaxreformasanalternativetomorenarrowlyfocusedmeasures.Thelattermerelyattempttoadjustthetax-lawboundariesbetweenthereturnondebtandequitysecuritiesand/orbetweenflowthroughandseparate-entitytaxationoftrusts,partnerships,andcorporations.Thegoalofamorefundamentaltaxreformwouldbetoachieveconsistencyoftaxtreatmentbyeliminatingtheboundariesaltogether.Thereareanumberofapproachesthatcouldbeadoptedtorealizethisbroadpolicygoal.Theseapproacheshavebeenthoroughlyreviewedintheliteratureandarenotdiscussedhere.Inthecontextofthisarticle,theprincipalpointtobeemphasizedisthatthepolicyargumentssupportingfundamentalreformareentirelyindependentofthenarrowerissuespresentedbyincometrustsandroyaltytrusts(andevenREITs).Theallocative,distributional,andrevenueeffectsofbroaderreformmeasuresshouldbeassessedindependentlyofthenarrowersubstitutioneffectsassociatedwiththeproblempresentedbytheseparticularbusinesstrusts.
rentalincome;and(3)a100percentexcisetaxisimposedwhenaREITandaTRSenterintoanon-arm’s-lengthtransaction.Inresponse,SullivanappearedtoacceptthatEdwardswascorrectinhisanalysisoftheeffectofthecurrentREITlegislation,butwarnedthatfurtherlegislativepressuretolooseneligibilityconditionsforREITscouldhavetheeffectofasubstantialdisincorporationofwidelyheld,non-real-estatebusinessesthatwouldotherwisebelimitedtocorporatestatusunderthecheck-the-boxregulations.SeeMartinA.Sullivan,“MartySullivanConvincedButWorried”(2003)vol.99,no.12Tax Notes1852.
118 SeeEdwards,supranote117(arguingthattherealestatesectorispredominantlyorganizedinunincorporatedform,andthatREITsrealizeconsistencyoftreatmentwiththisorganizationalformwhileallowingaccesstoeconomiesofscalethroughpooling).
119 NewZealand,forexample,hasmadeapolicydecisiontorealizeconsistencyoftreatmentofbusinesstrustsandcorporationsgenerally.Inparticular,apolicychoicewasmadetotreatbusinesstrustsascorporationstoensureconsistencyoftreatmentofrealizedcapitalgainsdistributedtoinvestors.However,itisalsorecognizedthatthispolicychoicecreatesabiasfordisintermediatedinvestment,withassociatedinefficiencies.SeeRobinOliver,“CapitalGainsTax—TheNewZealandCase,”paperpreparedfortheFraserInstitute2000SymposiumonCapitalGainsTaxation,September15-17,2000,16.
288 n canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 2
A PPendi x irc sec tio n 269 b(a) GENERALRULE.—Exceptasotherwiseprovidedbyregulations,forpurposes
ofthistitle—(1) ifadomesticcorporationandaforeigncorporationarestapledentities,the
foreigncorporationshallbetreatedasadomesticcorporation,(2) inapplyingsection1563,stockinasecondcorporationwhichconstitutesa
stapledinterestwithrespecttostockofafirstcorporationshallbetreatedasownedbysuchfirstcorporation,and
(3) inapplyingsubchapterMforpurposesofdeterminingwhetheranystapledentityisaregulatedinvestmentcompanyorarealestateinvestmenttrust,allentitieswhicharestapledentitieswithrespecttoeachothershallbetreatedas1entity.(b) SECRETARY TO PRESCRIBE REGULATIONS.—The Secretary shall prescribe
suchregulationsasmaybenecessarytopreventavoidanceorevasionofFederalincometaxthroughtheuseofstapledentities.Suchregulationsmayinclude(butshallnotbelimitedto)regulationsprovidingtheextenttowhich1ofsuchentitiesshallbetreatedasowningtheotherentity(totheextentofthestapledinterest)andregulationspro-vidingthatanytaximposedontheforeigncorporationreferredtoinsubsection(a)(1)may,ifnotpaidbysuchcorporation,becollectedfromthedomesticcorporationre-ferredtoinsuchsubsectionortheshareholdersofsuchforeigncorporation.
(c) DEFINITIONS.—Forpurposesofthissection—(1) ENTITY.—The term “entity” means any corporation, partnership, trust,
association,estate,orotherformofcarryingonabusinessoractivity.(2) STAPLEDENTITIES.—Theterm“stapledentities”meansanygroupof2or
moreentitiesifmorethan50percentinvalueofthebeneficialownershipineachofsuchentitiesconsistsofstapledinterests.
(3) STAPLEDINTERESTS.—Twoormore interestsarestapled interests if,byreasonofformofownership,restrictionsontransfer,orothertermsorconditions,inconnectionwiththetransferof1ofsuchintereststheothersuchinterestsarealsotransferredorrequiredtobetransferred.(d) SPECIALRULEFORTREATIES.—Nothinginsection894or7852(d)orinany
otherprovisionoflawshallbeconstruedaspermittinganexemption,byreasonofanytreatyobligationoftheUnitedStatesheretoforeorhereafterenteredinto,fromtheprovisionsofthissection.
(e) SUBSECTION(a)(1)NOTTOAPPLYINCERTAINCASES.—(1) INGENERAL.—Subsection(a)(1)shallnotapplyif it isestablishedtothe
satisfactionoftheSecretarythatthedomesticcorporationandtheforeigncorpor-ationreferredtoinsuchsubsectionareforeignowned.
(2) FOREIGNOWNED.—Forpurposesofparagraph(1),acorporationisforeignownediflessthan50percentof—
(A) thetotalcombinedvotingpowerofallclassesofstockofsuchcorpora-tionentitledtovote,and
(B) thetotalvalueofthestockofthecorporation,ishelddirectly(orindirectlythroughapplyingparagraphs(2)and(3)ofsection
958(a)andparagraph(4)ofsection318(a))byUnitedStatespersons(asdefinedinsection7701(a)(30)).