Peter Lee, Paul Stepak, "PE Investments in Canadian Companies", draft 2017 CTF Annual Conference paper

Summaries

Application of 10%-of-voting power test where sister companies held through holding “Aggregator” LP (pp. 5, 9)

[A] PE fund limited partnership agreement ("LPA") (or side-letters relating thereto) will often require (or effectively require) the use of a blocker where an investment would otherwise expose investors to a tax return filing obligation. …

Where a blocker is in place, the applicable treaty should be reviewed to confirm the Aggregator LP does not interfere with any desired treaty benefits. In particular, many treaties provide a 5% reduced rate of withholding on dividends if the recipient controls, directly or indirectly, at least 10% of the voting shares of the payor. In that regard, in one Technical Interpretation [fn 33: … 2014-0563781E5 …] the CRA considered a situation in which a general partner of a limited partnership held a general partnership interest representing 1% of the interests in the limited partnership and, under the terms of the partnership agreement, the general partner had sole authority to manage and control the management activities and affairs of the partnership. Implicit in that authority was the ability to vote any shares of corporations wholly-owned by the partnership. The CRA stated that the general partner in this situation would be considered to control, directly or indirectly, at least 10% of the voting power of a corporation held by the partnership (this technical dealt with the Canada-UK Tax Treaty).

Use of holding “Aggregator” LP to hold CFAs may generate FAPI (pp. 9-10)

The potential FAPI issue arises from the fact that the income of the partners of the Aggregator LP (including any Canadian resident management) is computed "as if” the Aggregator LP was a separate person resident in Canada. As such, the Aggregator LP is capable of having "controlled foreign affiliates", such as USco in Figure 4 [which along with Canco is held by Aggregator LP which in turn is held by management and by a blocker held by the PE LP]. …[I]f USco provides services to Canco and Canco pays USco a fee for such services, that fee may be deemed to be income from a business other than an active business under paragraph 95(2)(b), thus potentially giving rise to FAPI.

Potential adverse thin cap consequences of U.S. lenders pushing for a single U.S. borrower (pp. 10-11)

One of the Canadian tax issues that can arise where a single US borrower on-lends to Canadian sister company is a “thin cap trap”.

In this structure, Sisterco [held by U.S.-controlled Fund LP and resident in the U.S.] borrows from third-party lenders, and on-lends to Holdco [resident in Canada and also held by Fund LP], which on-lends to [to its Canadian-resident subsidiary] Amalco. This can be problematic from a thin cap perspective … . First …:

  • GP controls Holdco through the control provisions in the fund's LPA and, as such, is a "specified shareholder" of Holdco … .; and
  • Sisterco is … not dealing at non-arm's length with GP, and so the Holdco loan is an "outstanding debt to a specified non-resident”.

Second, it appears that there would be no credit for Holdco's PUC in computing Holdco's debt-equity ratio for thin capitalization purposes. This is because Holdco's "equity amount" for purposes of computing that ratio excludes PUC in respect of shares owned by a person other than a "specified non-resident shareholder". CRA's longstanding position is that a partnership is to be looked-through for this purpose. In addition … paragraph 18(7)(a) … deems the partners of a partnership to own their proportionate portion of the underlying shares … [so that the] fund LPs would … be deemed to own their proportionate share of the underlying Holdco shares. Since the fund LPs will normally not be "specified non-resident shareholders" of Holdco, their share of Holdco's PUC would not count for purposes of computing Holdco’s debt-equity ratio….

No s. 245(4) abuse where use of a Canadian GP to avoid FAD rules (pp. 15, 16)

[T]he purpose of the FAD rules is to deter foreign multi-nationals from … benefiting economically by stuffing non-Canadian operating companies under Canada in circumstances where it otherwise would make little or no sense to do so. That harm is quite distant from a PE fund looking to buy a Canadian-owned or public Canadian multinational and then continue to run the business. …

[T]here are [thus] good policy reasons why the FAD rules should not apply to PE funds that are direct owners of Canadian portfolio companies. That same reasoning would support the argument that structuring the Fund to avoid the rules if possible does not violate the object, spirit or purpose of the FAD rules. That result is achieved if there is no non-resident corporation that controls the CRIC. This can be done if, for example the general partner of the Fund is a Canadian corporation… . However, this only works where the general partner can be owned directly by the individual partners/members of the sponsor. If the sponsor happens to be corporate or bank-owned, as some are, then the solution noted above is unlikely to be commercially viable.

Potential unavailability of “bump and run” where management are expected to retain interest in company (p. 15)

Where Target is a 10(f) corporation, then it is likely a good candidate for a "bump and run" in order to efficiently extract the FAs out of Canada (assuming there is no cross-ownership issue sufficient to trigger the bump denial rule). That last assumption may not always be realistic. As noted above, sponsors generally expect existing management to continue on in the business, and for management's economic incentives to align with theirs. Where management were significant Target shareholders pre-closing, a bump may well be unavailable. [fn 55 to p. 13 discussion of s. 88(1)(c)(vi)(B)(II): Even if management is not co-investing in actual equity, the grant of management incentives as part of employment arrangements may constitute “substituted property’ acquired as part of the series for purposes of the bump denial rules (per paragraph 88(1)(c.3)) and therefore threaten the availability of the bump. See … 2006-0196031C6… .]

No relief for a non-s. 87(11) amalgamation of Acquireco, Target and Target subs (p. 15)

[T]here is no explicit relief for an amalgamation is not described in subsection 87(11) in the context of an acquisition, even in circumstances where it is difficult to see where there would be a policy abuse. Many people surprised by the fact that the reorganization rule in subsection 212.3(18) may be of no help. [fn 34: Clause 212.3(18)(a)(ii)(B) of the relieving rule requires that one of two conditions be met, the first of which in subclause (I) - will never be possible where there is an amalgamation of Acquireco, Target and one or more of Target's subsidiaries, since Target and its subsidiaries presumably will be dealing at arm's length with the parent at some point in the series. The second prong of the second condition in subclause (II) contains a requirement that will disqualify the same illustrative amalgamation from the relieving rule since the shareholder of Target's subsidiaries Target will have been dealing at arm's length with the parent.]

Quaere whether FAD rules apply to a non-s. 87(11) amalgamation (pp. 15-16)

[T]here is no explicit relief for an amalgamation is not described in subsection 87(11) in the context of an acquisition, even in circumstances where it is difficult to see where there would be a policy abuse. …

[I]f a. non-87(11) amalgamation is necessary, what is the FAD consequence? The charging provision in subsection 212.3(2)(a) treats as a deemed dividend the "fair market value ... of any property transferred, any obligation assumed or incurred, or any benefit otherwise conferred, by the CRIC ... that can reasonably relate to the investment". On a textual, contextual and purposive reading of the rule, in the context of an amalgamation of a parent and one or more direct or indirect wholly-owned subsidiaries, one could argue that this FMV is nil.

Avoidance of FAD rules where loan made directly by NR parent to CFA (p. 24)

[W]here an FA of Target has existing debt that needs to be funded with buyer cash. [fn 125: Note also the potential application of the upstream loan rules (i.e., subsection 90(6)) if the reverse is true and FA cash is to be used to repay Target debt.] Absent planning, either Target or Acquireco could fund the debt payoff and in doing so inadvertently make an investment in the FA. This can be addressed a number of ways, including by either having Acquireco's non-resident parent loan the funds directly to the FA at closing, or by having Acquireco loan the funds to Target, Target loan the funds to the FA, with Target making a PLOI election.

Scope of requirement for exercise of principal decision-making authority under more closely connected business (MCCB) activities exception (p.19)

[T]here is nothing in the overall scheme of the FAD rules to support the view that the MCCB exception should be read so narrowly as to be virtually meaningless in all but the most extreme, and commercially impractical, of factual circumstances….

[N]o one would be surprised to find that day-to-day operational decisions, including investments for FAD purposes, are made by company management. However, in this context transactions such as add-on acquisitions or refinancings, are a bit different. The key skills and value-add that a PE sponsor brings to the table are transactional: such as negotiating a purchase agreement or a credit facility, or understanding the broader market, and so it is in the best interest of the Canadian company's business that the sponsor be involved in those types of transactions. But that may blur the principal decision-making line. It is unfortunate that utilizing those resources might increase the risk of an adverse FAD result.

Difficulty in having employee optionholders share in post-closing adjustments (p. 24)

Sellers, especially PE sellers, will often expect that optionholders be treated exactly the same as selling shareholders in terms of escrows, post-closing working capital and other price adjustments and indemnities…section 7 only contemplates a single determination of the value of an option (and the related income inclusion), and does not “play well’ with post-closing and other adjustments to that determination. [fn 122 For example, what happens if there is contingent future consideration? CRA’s position is that the present value of the contingent payment must be included in income up front … .]

Difficulty of determining FMV of management’s optioned shares where they rank lower in the waterfall (pp.20-21)

[S]tock options are typically priced at a specific point in time (that is, when issued). This point in time pricing can be difficult to reconcile with the "waterfall" return that PE investors expect, whereby they are entitled to a repayment of their original investment plus a specified hurdle rate of return before other stakeholders (including management, through their management incentives) begin to participate in profits. To account for the waterfall, the pricing of stock options would ideally need to be based on the fair market value of the shares at the time the options are granted, net of the value, discounted back to that time, of the anticipated return of PE investors' original investment and the hurdle rate. However, there is some uncertainty as to whether this pricing approach is justified as a valuation matter, since the waterfall is not normally incorporated into the terms of the shares and hence may not justify a discount in value of the Holdco shares or options. Also, from a practical perspective, it is also not possible to know in advance how many years will elapse before an exit….

An alternative approach is to price the options without taking into account the waterfall. In principle, this is reasonable, since the waterfall normally does not directly affect the value of the Holdco shares. However, the options would need to be re-priced once the original investment and the hurdle rate have been extracted from Holdco and distributed to the PE investors, since this extraction will reduce the value of the shares.

In principle, such re-pricing of stock options is permitted (on a tax-deferred basis and without resulting in a denial of the paragraph 110(l)(d) deduction for employees), provided among other things the "in-the-money amount" of the options does not increase. [fn 99: See subsections 7(1.4) and 110(1.7).]

Use of s. 256(9) election for seller of Target to get benefit of debt repayment by Target immediately before the closing (pp. 22-23)

The payoff of existing target debt may give rise to a deduction for any unamortized financing expenses under paragraph 20(1)(e), but only when such debt is actually repaid. If that only happens after closing (i.e. after the acquisition of control ("AoC"), and the corresponding tax year-end of Target, then the corresponding deduction will arise in a post-AoC year. Since most share deals take an "our watch/your watch" approach to taxes, compensating the sellers for a tax benefit that only arises in a post-closing tax year can get messy….

Fortunately, there is a fairly simple "plumbing" fix: The closing mechanics in the SPA are structured so that, at "closing", the debt payoff occurs first (by way of a loan from Acquireco to Target), with the share transfer occurring immediately thereafter, and Target makes a subsection 256(9) election so that its stub year-end occurs immediately before the share transfer rather than at the end of the previous day. In this way, the debt payoff occurs just before Target's stub tax year-end… .

Efficacy of payments by direction (p. 24)

[W]ires are often made directly from the source of the funds (e.g. the PE [private equity] fund capital account, or the lenders' clearing account) to the ultimate destination for the funds (e.g. Target's old lenders, company and seller advisors, the sellers). This is both logical and prudent, but it is critical that the legal flow of funds be properly documented by way of directions, acknowledgements and receipts, to show each legal step that the cash proceeds take on their way from the first step to the last. [fn 129: Any suggestion that such a properly completed and executed direction from each payment recipient (who accordingly conveys consideration in return) is not to be respected as legally effective is, in our view, unsupportable.]

Difficulty of determining FMV of management’s optioned shares where they rank lower in the waterfall (pp.20-21)

[S]tock options are typically priced at a specific point in time (that is, when issued). This point in time pricing can be difficult to reconcile with the "waterfall" return that PE investors expect, whereby they are entitled to a repayment of their original investment plus a specified hurdle rate of return before other stakeholders (including management, through their management incentives) begin to participate in profits. To account for the waterfall, the pricing of stock options would ideally need to be based on the fair market value of the shares at the time the options are granted, net of the value, discounted back to that time, of the anticipated return of PE investors' original investment and the hurdle rate. However, there is some uncertainty as to whether this pricing approach is justified as a valuation matter, since the waterfall is not normally incorporated into the terms of the shares and hence may not justify a discount in value of the Holdco shares or options. Also, from a practical perspective, it is also not possible to know in advance how many years will elapse before an exit….

An alternative approach is to price the options without taking into account the waterfall. In principle, this is reasonable, since the waterfall normally does not directly affect the value of the Holdco shares. However, the options would need to be re-priced once the original investment and the hurdle rate have been extracted from Holdco and distributed to the PE investors, since this extraction will reduce the value of the shares.

In principle, such re-pricing of stock options is permitted (on a tax-deferred basis and without resulting in a denial of the paragraph 110(l)(d) deduction for employees), provided among other things the "in-the-money amount" of the options does not increase. [fn 99: See subsections 7(1.4) and 110(1.7).]