The Proposed Income Fund-to-Corporation Tax Conversion Rules
August 28, 2008
Robert D. McCue
James G. Morand
On July 14, 2008, the Minister of Finance released long-awaited draft legislation to amend the Income Tax Act (Canada) and enable the tax-deferred conversion of certain income funds (referred to as Specified Investment Flow-Through entities or SIFTs), as well as real estate investment trusts (REITs) into corporations. The comments made below regarding to SIFTs also apply to REITs, though relatively few REITs are expected to convert.
Those who had hoped for a relatively simple tax-deferral mechanism will be disappointed by the current legislative proposal. It is dense. While the Department of Finance can be largely excused for this given the complexity of the details with which they were dealing, the proposed rules fall short of covering some aspects of expected conversion transactions. They also create potentially important distinctions between similar transaction types without apparent justification. Affected taxpayers should proceed with caution. Further amendments are anticipated.
The guts of the proposed rules are two alternative tax-deferred conversion mechanisms:
- A tax-deferred unit for share exchange. SIFT unitholders will be permitted by amendments to Section 85.1 of the
Income Tax Act to exchange their units for shares of a taxable Canadian corporation on a tax-deferred basis without going through the cumbersome election procedure required by subsection 85(1).
- A tax-deferred distribution of corporate shares to SIFT unitholders. A SIFT may distribute shares of a taxable Canadian corporate subsidiary to its unitholders on a tax-deferred basis under proposed subsection 107(3.1). The SIFT would restructure its holdings before making this distribution so that this subsidiary owns all of the SIFT’s assets.
Generally, as a result of each type of tax-deferred transaction, SIFT unitholders will dispose of their units without recognizing a gain or loss. They will also receive corporate shares that will have the same cost for tax purposes as did the units. Elections are not required to be filed.
To qualify for the deferral, certain conditions must be met. In each case, transactions that would in general lead to the dissolution of the SIFT must be completed within a 60-day period, and before 2013. In the unit-for-share exchange, only a single class of shares may be issued in exchange for the units. As well, only shares may be issued for units that are subject to the deferred exchange, and these shares must have a value equal to the units’ value.
The proposed rules also cover a variety of ancillary issues, including the following:
- debt forgiveness;
- employee stock option;
- acquisitions of corporate control; and
- taxable Canadian property.
In addition, the conversion rules raise certain policy issues for continued debate. For example, they provide ample fodder for those who argue that, far from creating a level playing field for SIFTs and corporations, the proposed rules continue to tilt the field in favour of the corporate model. The rules also make the conversion into leveraged corporations more difficult than was expected, indicating a possible policy position that requires examination.
The proposed SIFT conversion rules are a significant step in the right direction. Given the complexity of the issues to be dealt with, it would be unusual for a first draft to cover all of the important issues. Senior officials from the Ministry of Finance are soliciting feedback from the tax practitioner community on the rules. Further legislative proposals are expected.
For a detailed discussion regarding conversion mechanisms, policy and technical issues, further planning considerations and other ancillary issues, please see the article published on our website.