3 May 2010 External T.I. 2009-0309281E5 - SIFT Partnership Issues

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Could a partnership that has no publicly listed units be a SIFT partnership, if common shares issued by one of its investors is publicly traded? In other words, under what circumstances would the share be viewed as an "investment" in the partnership within the meaning defined in subsection 122.1(1)?

Position: With reference to hypothetical examples, it is discussed when a share would be viewed as a "security" of the partnership, as defined in subsection 122.1(1), or as a right which may "reasonably be considered to replicate the return on, or the value of" a security of the partnership.

XXXXXXXXXX

May 3, 2010

Dear Sirs:

This is in response to your letter dated February 3, 2009 requesting our views on the potential application of the SIFT rules to private partnerships and trusts. The specific concern that you have raised is that, in view of the broad definitions of "security" and "investment" in section 122.1 of the Income Tax Act (the "Act"), a partnership or trust that has no publicly listed units, may be a SIFT partnership or a SIFT trust if a security of one of its investors is publicly traded. You have explained that you are seeking some clarity as to the circumstances under which such entities would be considered SIFT partnerships and SIFT trusts.

We would like to acknowledge our discussions with your members on this subject over the past year, and confirm our appreciation for both your assistance in identifying key concerns raised by the new concepts introduced in the SIFT rules, and for your efforts toward assisting us in defining appropriate tests for interpreting these new concepts. We have particularly appreciated the valuable input you have provided about the nature of, and the potential impact of this legislation on, the commercial structures discussed.

We have set out below our comments and concerns as to whether, in our view, ownership of partnership interests in the following typical business structures would result in the particular partnership being a SIFT partnership. In each case, our review was limited to addressing the question of whether the particular partnership would have an "investment(s)" listed or traded on a stock exchange or other public market [see paragraph 197(1)(b) of the SIFT partnership definition].

For ease of discussion, we have assumed that the partnerships in question would not have any liabilities that would be "investments" listed or traded on a stock exchange or other public market, and we have noted the following definitions in subsection 122.1(1) of the Act:

"investment", in a trust or partnership

(a) means

(i) a property that is a security of the trust or partnership, or
(ii) a right which may reasonably be considered to replicate a return on, or the value of,
a security of the trust or partnership...

"security" of a particular entity means any right, whether absolute or contingent, conferred by the particular entity or by an entity that is affiliated with the particular entity, to receive, either immediately or in the future, an amount that can reasonably be regarded as all or any part of the capital, of the revenue or the income of the particular entity...and for greater certainty includes...

(b) if the particular entity is a corporation,

(i) a share of the capital stock of the corporation...

(d) if the particular entity is a partnership, an interest as a member of the partnership...

Example 1

A Canadian bank with only publicly-listed common and preference shares and over $200 billion in income-producing assets, invests $100 million to acquire a minority interest in a private equity partnership [for our purposes, "minority interest" means an ownership interest in the partnership that would not cause its holder to meet the definition of "majority interest partner" in subsection 248(1) of the Act]. Other investors in the partnership include non-residents, tax exempts, and other funds that may have individuals as investors. None of the interests in the partnership are directly or indirectly exchangeable into securities of the bank. Dividends on the bank's publicly-listed shares do not vary with or depend on the bank's share of the income or capital of the partnership. For greater certainty, in no case do the terms of the shares provide shareholders with any specific legal rights to, or in respect of, a portion of the partnership's capital, revenue or income or to interest paid or payable by the partnership. However, the bank's retained earnings that fund the dividends may reasonably be expected to include amounts received from the partnership.

Our Comments - Example 1

In this example, units in the partnership are not listed or traded on a stock exchange or other public market. Also, since the bank is not a "majority interest partner" (and, it is assumed, not otherwise affiliated with the partnership), the first part of the "investment" definition is not met [referred to herein as the "security test"]. That is, for the purposes of paragraph (b) of the SIFT partnership definition and subparagraph (a)(i) of the "investment" definition, there will not be any "security" of the partnership listed or traded on a stock exchange or other public market.

We must now consider whether the second part of the "investment" definition could or would be met [referred to herein as the "replicate test" - see subparagraph (a)(ii) of the "investment" definition]. To do so involves answering the question "Are there any rights listed or traded on a stock exchange or other public market that may reasonably be considered to replicate a return on, or the value of, an interest in the partnership?" Each share of the corporation is comprised of a bundle of rights [e.g., voting, dividend and liquidation entitlements, etc.] and those shares are rights listed or traded on a stock exchange. The question remains as to whether any of those rights may reasonably be considered to replicate a return on, or the value of, an interest in the partnership. In our view, the question whether a right "may reasonably be considered" to replicate the value of or return on a security of the partnership is an objective determination based on the reasonable expectations of a hypothetical investor. The specific intentions of any one investor would not be determinative; rather, would an investor that is reasonably familiar with the corporation so consider the share? We expect that this would generally be the case where the corporation derives all or most of its value from the partnership or where the corporation's business undertakings are represented wholly or largely by the activities of the partnership. This will always involve a question of fact.

However, the present scenario involves a large corporation operating a multifaceted business with a very small [proportional] investment in the relevant partnership. There does not appear to be any tracking of income, or capital from the partnership to any dividends paid on the corporation's shares and there are no exchange features to allow a partner to exchange their partnership interest for shares of the corporation. With only these limited facts in mind, it would appear unlikely that the publicly-traded bank shares would bestow, on their holders, any rights that may reasonably be considered to replicate a return on, or the value of, an interest in the partnership. Accordingly, the replicate test would not be met and the bank's investment in the partnership would not, in and of itself, cause the partnership to be a SIFT partnership.

Example 2

Same facts as in example 1, except the bank invests $100 million to acquire a majority interest in the partnership.

Our Comments - Example 2

Security test

In this example, the bank is a "majority interest partner" and is affiliated with the partnership. Therefore, we must consider whether the security test is met. That is, for the purposes of paragraph (b) of the SIFT partnership definition and subparagraph (a)(i) of the "investment" definition, will the publicly-traded bank shares be a "security" of the partnership that is listed or traded on a stock exchange or other public market?

While the wording of the "security" definition is quite broad, in this case it is assumed that none of shares are directly or indirectly exchangeable for interests in the partnership, dividends on the bank's publicly-listed shares are not legally tied to the bank's share of the income or capital of the partnership, and the terms of the shares do not provide shareholders with any specific legal rights to, or in respect of, any portion of the partnership's capital, revenue, or income or to interest payable by the partnership. With this in mind, it would not appear reasonable to take the position that a shareholder would have a right to such an amount. Accordingly, the security test would not be met.

Replicate test

For the same reasons as noted under the replicate test in example 1, it would appear unlikely that the publicly-traded bank shares would be a right that may reasonably be considered to replicate a return on, or the value of, an interest in the partnership. Accordingly, the replicate test would not be met and the bank's investment in the partnership would not, in and of itself, cause the partnership to be a SIFT partnership.

Example 3

The facts are similar to those in example 1, except the company is a Canadian mining company with publicly-listed common shares and $1 billion in mining assets that invests $100 million to acquire a minority interest in a partnership that will operate a mine. Another partner in the partnership will be a tax-exempt. Is it relevant that the company derives its earnings from sources of income within the same industry or sector? Would the analysis be different if the $100 million was used to acquire a majority interest in the partnership? Would the analysis be different if the company held $200 million in total assets, rather than $1 billion (i.e. its investment in the partnership represented 50% of its assets at the time of the investment, rather than 10%)?

Our Comments - Example 3

In our view, the fact that the company in this example derives its earnings from sources in the same industry or sector does not change the analysis. The fact that a company acquires a majority interest in the partnership is a relevant consideration in applying the security test. The amount of the company's investment in a partnership is expected to be a relevant, but not necessarily a determinative consideration in applying the replicate test.

Security test

As discussed in example 1, if the company is not affiliated with the partnership, a right conferred by the company will not be considered a security of the partnership. That is, for the purposes of paragraph (b) of the SIFT partnership definition and subparagraph (a)(i) of the "investment" definition, there will not be any "security" of the partnership listed or traded on a stock exchange or other public market.

If the company is a "majority interest partner", then as noted in example 2, the analysis may be different, as a right conferred by the company may also be a security of the partnership. However, in this example, provided the terms of the shares are such that they do not provide shareholders with any legal entitlement to, or in respect of, amounts of capital, revenue or income from the partnership, or interest payable by the partnership, and there are no exchange features, then the security test would not be met. As the example shares are common shares, it is expected that this generally would not be the case.

In contrast, factors that likely would result in the company shares being regarded as a security of the partnership (and, consequently, the partnership to be a SIFT partnership) would include share terms requiring that:

(i) the value of, or return on, a class of shares be specifically based on amounts that
may reasonably be tracked to revenue, income, or capital of the partnership, or to interest payable by it; or

(ii) in the event of dissolution of the partnership, or where the partnership returns
capital to the corporation for whatever reason, shareholders are entitled to receive from the corporation a return of capital or dividend payment equal to a preset amount or a proportionate amount as determined by an existing formula.

Replicate test

As noted, the partnership will be a SIFT partnership if at any time in the year, inter alia, investments are listed or traded on a stock exchange. This would include rights issued by the company that may reasonably be considered to replicate a return on, or the value of, a security of the partnership. As discussed in example 1, it is our view that this would be an objective determination based on the reasonable expectations of a hypothetical investor. We do not think that such expectations would require that there be a 1:1 matching between actual values or returns. However, we agree that it would require that the anticipated values or returns would reasonably be expected to be very close.

In our view, this also means that the actual facts will be key. A hypothetical investor would base expectations upon the facts available at a particular time; the facts that would impact these expectations may change from time to time. As such, it could not be known whether a particular right issued by the company was an investment in a partnership at any time in the year until after the fact, having regard to all relevant indicators i.e. that would have reasonably impacted investor expectations from time to time.

For example, in and of itself, an initial investment by the company of 10% of its assets - or 50% - may not be a sufficient basis for an objective investor to consider that the company's shares would replicate the value of or the return on a security of the partnership, particularly if the company's remaining assets were invested in other commercial undertakings. However, while the proportionate size of a corporation's investment in a partnership i.e. relative to the corporation's asset base - would clearly impact a potential investor's expectations - we think it would not necessarily be determinative. As such, there is no "safe harbour" to be identified based only on this consideration.

Although it is not possible to predetermine all factors that may reasonably be considered to impact values or returns, we anticipate that the following considerations could be relevant:

(a) What are the corporation's other investments or undertakings? Is it reasonable to expect that the corporation will derive all or most of its return or value from the partnership? If so, why?

(b) Do the share terms require the corporation to pay dividends based on its earnings from the partnership? Is there a corporate practice of declaring dividends on that basis?

(c) Are there any indicators that would suggest that any value in the corporation's shares relates only to the partnership?

Example 4

A Canadian corporation acquires a 1% interest in a private equity partnership. One of the partners in the partnership is a tax exempt. None of the interests in the partnership are exchangeable for securities of the corporation. The corporation only has common shares and they become listed on a stock exchange.

Our Comments - Example 4

Our comments on the security and replicate tests are the same as those in example 1. The SIFT rules would apply to the partnership in this example if the corporation, in listing its common shares, has issued a right that would reasonably be considered to replicate the value of or the return on a security of the partnership. We do not know what proportion of the corporation's assets is used to acquire an interest in the partnership. This missing information would be relevant in determining whether the public listing of the shares of a minority corporate partner could result in the application of the replicate test to cause the partnership to be a SIFT partnership. Having regard to our previous comments, the following factors may reduce the potential that the publicly-traded shares would be regarded as investments in the partnership:

(a) the corporation is a large corporation with other sources of income, or the investment in the partnership is a relatively small component of its business;

(b) there are no share provisions or corporate practices in place to track revenue,
income or capital from the partnership, or interest payable by it, to any dividends paid on the corporation's shares or returns of capital paid to shareholders; and

(c) there are no exchange features to allow a partner to exchange their partnership
interest for shares of the corporation.

In contrast, the following factors may increase the likelihood that the replicate test could be satisfied at some time:

(a) the corporation had no other material business undertakings; and

(b) the corporation has a practice of paying dividends based on its earnings from the partnership (by reason of the share terms or otherwise).

Additional Comments

These examples are intended to broadly describe certain common business structures without regard to any unusual or extraordinary factual circumstances. We would reiterate that there may be situations where unique facts would reasonably suggest that any value in a corporation's shares would relate only to the partnership activities. Moreover, a corporation's business practices, such as its investment and dividend practices, may materially impact whether the replicate test would potentially apply to its publicly trading shares as it would impact investor expectations.

In this regard, we would specifically confirm that where it may reasonably be concluded that any of the facts are based on steps taken for the purpose of influencing a tax determination as to whether a share right would otherwise be regarded as an investment in a partnership, such facts may be given little to no weight in applying the replicate test. For example, a recital issued by the corporation warning investors that the shares will not replicate, match, or reproduce the value of or the return on a security of the partnership (or that they are not expected to be very close), will be accorded little weight if all other indicators are that an objective investor would reasonably conclude otherwise.

Similarly, if it may reasonably be concluded that a source of income has been acquired merely as "window dressing" and it is otherwise evident that a corporation's only legitimate commercial undertaking is its partnership activities, the existence of the other source(s) of income will be given little weight in applying the replicate test. In such circumstances, it would remain relevant whether the expectations of a reasonable, objective investor would be materially influenced by the additional source(s) of income.

We will be responding to the remaining issues raised in your letter of February 3, 2009 by separate correspondence, including the application of these rules to private trusts.

Yours truly,

Theresa Murphy
Director
Business and Partnerships Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch