PE fund investing in Canada gives rise to a range of issues

There has been a recent trend of third-party U.S. lenders pushing for a single U.S. borrower, even where the borrower group is primarily Canadian. This often will create thin cap problems, e.g., where both the U.S. borrower and the Holdco for the Canadian group are held by a private equity LP with a non-resident GP and there is a back-to-back loan from the U.S. borrower to the Holdco and from the Holdco to a Canadian Opco sub.

The “purpose of the [foreign affiliate dumping] rules is to deter foreign multi-nationals from … stuffing non-Canadian operating companies under Canada,” which is remote from the situation of non-resident controlled PE funds buying and continuing to operate a Canadian company. On the basis, there are good policy reasons why the FAD rules should not apply to the latter situation, it can be considered to not be an abusive avoidance of the FAD rules to structure around them by having no non-resident corporation control the CRIC (corporation resident in Canada) in question, e.g., having the general partner of the investing PE Fund be resident in Canada.

A PE fund will often expect management (and other co-investors such as non-management founders) to collectively hold a continuing stake in the acquired Canadian company which may result in the 10% threshold described under the bump-denial rules being exceeded.

Where, for example, there is a desired amalgamation of Acquireco, Target and one or more of Target's subsidiaries holding a non-resident subject corporation, there is no explicit relief from the FAD rules for an amalgamation not described in s. 87(11), and the reorganization rule in s. 212.3(18) may be of no help.

It appears unlikely that the “more closely connected business” exception in “should be read so narrowly as to be virtually meaningless in all but the most extreme, and commercially impractical, of factual circumstances.” Having said that, the PE sponsor may have key transactional skills such as negotiating a purchase agreement or credit facility which, if brought to bear, could increase the risk of an adverse FAD result.

Determining a fair market value exercise price for stock options granted to management of the Canadian investee of a PE fund can be challenging because of 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. The point-in-time rigidity of the employee stock option rules can also be problematic where PE sellers “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.”

Neal Armstrong. Summaries of Peter Lee and Paul Stepak, “PE Investments in Canadian Companies” draft 2017 CTF Annual Conference paper under Treaties – Income Tax Conventions – Art. 10, s. 95(2)(b)(i)(B), s. 18(5) – equity amount – (a)(iii), s. 212.3(1)(b), s. 88(1)(c)(vi)(B)(II), s. 212.3(18)(a)(ii)(B), s. 212.3(16)(b), s. 7(1)(b), s. 6(1)(a), s. 256(9) and s. 110(1)(d)(ii)(A).