Canadian Income Trusts and Their Distributions To Be Taxed by the Federal Government
The Minister of Finance served up his own Halloween trick to income funds and their investors on October 31, 2006, announcing Finance's intention to tax distributions made by publicly traded flow-through entities ("FTE") including income trusts and certain publicly-traded Canadian partnerships.
The Proposed Changes are intended to treat FTEs that are trusts as taxable Canadian corporations in respect of the taxable portion of their distributions. Thus, to the extent that a portion of a distribution from an income trust is taxable, such amount will not be deductible by the trust in computing its income for the year and the trust will be subject to tax in the year in respect of such income. Unitholders of the trust will in essence treat the taxable portion of their share of the distribution as a dividend received from a taxable Canadian corporation. The non-taxable portion of a distribution will continue to be treated in the same manner as before - as a return of capital which reduces the cost base of the trust unit to unitholders.
Similar rules are to apply in respect of FTEs that are partnerships. Under the proposals, a partnership which is ordinarily not liable to tax, will be required to pay a special tax on income from businesses that it carries on in Canada and income from non-portfolio properties other that dividends that, if it were a corporation, would be deductible in computing taxable income. Partnership income subject to the new tax and allocated to a partner will be treated as a taxable dividend.
Finance has indicated that there will be a transitional period such that FTEs that are/were publicly trading prior to November 2006 (and its investors) will not be subject to the tax pursuant to the proposed changes until after 2010. Other FTEs that began to trade publicly after October 2006 (and its investors) will be subject to tax under the new regime in 2007.
Finance also stated that if transactions or structures are developed that would avoid the policy intent of the new rules, any aspect of the proposals will be modified with immediate effect.
Scope of Application - SIFT
The new regime is intended to apply to what Finance has termed "specified investment flow-throughs" or SIFTs. Generally, SIFTs are intended to include publicly traded Canadian resident income trusts and Canadian "resident" partnerships where such entity holds "non-portfolio properties." Non-portfolio properties include investments (including debt instruments) in corporations, trusts or partnerships that are considered to be "resident" in Canada where the SIFT holds more that 10% of the value of such entity and/or such entity comprises more than 50% of the SIFTs total value. So, for example, a common structure where a partnership holds a substantial interest in the shares and debt of a corporation would generally be an SIFT.
Excluded from the proposed changes are real estate investment trusts ("REITs"), provided the REIT does not hold non-portfolio property (other than real estate situated in Canada) and (i) at least 95% of its income must be from property, (ii) 75% of its income must be from real property in Canada, (iii) at least 75% of its assets consist of real estate situated in Canada and Canadian government debt. The exception for REITs will accommodate circumstances where the real property is held directly or through intermediary entities.
Taxation of SIFTs and Investors in SIFTs
Under the current regime, to the extent a trust has taxable income in the year, such amount can be deducted by the trust in computing is taxable income for the year to the extent it pays or makes payable such amount to its unitholders (via distributions) and the unitholders are subject to tax on the amount that has been paid or made payable to them. The Proposed Changes will not permit a trust which constitutes a SIFT to deduct, in computing its income for tax purposes, certain amounts that are otherwise deductible in the manner described above. Specifically, such portions of a trust’s distributions that are attributable to: (a) income from a business carried on in Canada by the SIFT; (b) income from the SIFT's non-portfolio properties (other than dividends that are otherwise deductible by the SIFT in computing its income); and (c) taxable capital gains from the disposition of non-portfolio properties, will not be deductible by the trust.
The tax rate that is applicable to SIFTs on the portion of their taxable income that is not deductible as a result of the Proposed Changes is 34% for 2007, 33.5% for 2008, 33% for 2009, 32% for 2010 and 31.5 % for 2011. Other amounts that are retained by a SIFT trust will continue to be taxed at ordinary federal and provincial tax rates that apply to the taxable income of trusts.
As for unitholders, the amount made payable by a SIFT trust to unitholders and that the trust, as a result of the Proposed Changes, is prohibited from deducting in computing income, will be treated as a taxable dividend (and an eligible dividend for the purposes of the previously proposed enhanced gross-up and dividend tax credit regime) received by the unitholder from a taxable Canadian corporation. Therefore, to the extent that:
- the unitholder is an individual, the taxable portion of the distribution will be considered to be a dividend received by the unitholder and will be subject to tax within the enhanced gross-up and dividend tax credit regime;
- the unitholder is a private corporation, the taxable portion of the distribution will ordinarily be deductible in computing income (but may be subject to tax under Part IV of the Act);
- the unitholder is a non-resident person, the taxable portion of the distribution will be subject to a 25% withholding tax under Part XIII of the Act, potentially subject to reduction under an applicable income tax treaty; and
- the unitholder is a tax-exempt entity (such as an RRSP or registered pension plan), it will not be subject to tax on any portion of the distribution.
Implementation of Proposed Changes
Finance has indicated that there will be a transitional period such that FTEs that are were publicly traded prior to November 2006 (and their investors) will not be subject to the tax pursuant to the Proposed Changes until after 2010. It would seem that a "grandfathered" FTE may issue additional units without losing grandfathered status. Other FTEs that began to trade publicly after October 2006 (and its investors) will be subject to tax under the new regime in 2007.
Finance did note that the transitional period is subject to the possible need to foreclose inappropriate new avoidance techniques such as the insertion of a disproportionately large amount of additional capital by a SIFT. Finance further stated that while it does not intend to curb normal growth of existing SIFTs, it may have an issue with undue expansion. There is no guidance in the published materials as to what Finance considers normal growth versus undue expansion.