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canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 2, 247 - 88

247

Stapled Securities—“The Next Big Thing” for Income Trusts? Useful Lessons from the US Experience with Stapled Shares

Reuven Avi-Yonah, Tim Edgar, and Fadi Shaheen*

P r é c i s

Le ministère des Finances (« le ministère ») a présenté deux séries distinctes de mesures législatives qui, ensemble, visent à étouffer la demande sur le marché des fiducies de revenu (mais avec des conséquences différentes au chapitre du revenu). Cependant, ni la législation proposée ni l’actuelle Loi de l’impôt sur le revenu ne contiennent de règle visant la nouvelle qualification des capitaux propres. Par conséquent, les résultats fiscaux associés aux structures standards des fiducies de revenu et des fiducies de redevances peuvent encore se matérialiser avec des structures de participation directe où l’utilisation d’une fiducie comme mécanisme de mise en commun est éliminée et où les investisseurs détiennent directement une obligation spéculative à rendement élevé combinée à un nombre déterminé d’actions de l’émetteur. Jusqu’à maintenant, ces structures d’obligation spéculative étaient principalement utilisées à des fins de placement transfrontalier aux États-Unis pour éviter l’impôt sur le revenu des sociétés américain sans perte significative des attributs autres que fiscaux. Mais l’élimination des restrictions sur la détention de biens étrangers dans le cadre de régimes de report du revenu exonéré d’impôt, comme les régimes de pension agréés et les régimes enregistrée d’épargne-retraite, signifie qu’il y a très peu de contrainte dans la législation fiscale à l’acquisition de substituts à ces obligations spéculatives par cette catégorie d’investisseurs dans le contexte canadien.

L’article met en lumière l’utilisation de titres combinés (de participation et d’emprunt) comme structure de participation directe pour éviter l’application du traitement fiscal des dividendes à des structures de fiducie de revenu ciblées, comme le prévoit la dernière proposition législative du ministère. Les auteurs laissent entendre que le ministère devra probablement modifier la législation proposée pour tenir compte précisément de ces structures de propriété combinée. Ils montrent comment l’expérience américaine avec des actions combinées, en particulier la réponse législative du Congrès fournit un modèle

* ReuvenAvi-YonahistheIrwinI.CohnProfessorofLawatTheUniversityofMichiganLawSchool,AnnArbor.TimEdgarisoftheFacultyofLaw,TheUniversityofWesternOntario,London,andaseniorfellow,TaxationLawandPolicyResearchInstitute,MonashUniversity,Melbourne.FadiShaheenisanSJDcandidateatTheUniversityofMichiganLawSchool.Theauthorswouldliketothanktwoanonymousrefereesforvaluablecommentsonanearlierdraftofthisarticle.

248 n canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 2

pratique viable pour les modifications à apporter. Cependant, ce modèle législatif ne porterait que sur les titres combinés dans le cadre de structures intermédiaires. On a aussi besoin d’une certaine forme de règle de nouvelle qualification des capitaux propres pour tenir compte de l’utilisation de participations combinées dans des structures autres qu’intermédiaires pour assurer l’efficacité de la législation proposée.

A b s t r A c t

The Department of Finance (“the department”) has introduced two separate sets of legislation that together attempt to limit demand in the income trust market (though with very different revenue consequences). However, neither the proposed legislation nor the existing Income Tax Act contains an equity recharacterization rule. Consequently, the tax results associated with the standard income trust and royalty trust structures can still be realized with direct holding structures, in which the use of a trust as a pooling mechanism is eliminated and investors hold directly a combination of high-yield junk debt and a specified number of shares of the issuer. Until now, these junk bond structures have been used primarily for cross-border investment into the United States, to avoid the US corporate income tax without any significant loss of non-tax attributes. But the elimination of the foreign property holding restrictions for tax-exempt deferred income plans, such as registered pension plans and registered retirement savings plans, means that there is very little in the way of any tax-law constraint on the acquisition of direct junk bond substitutes by this class of investors in a domestic context.

This article highlights the use of stapled securities as a particular direct holding structure that could be used to avoid the application of the department’s latest legislative proposal, which applies dividend tax treatment to targeted income trust structures. The authors suggest that the department will most likely have to modify this draft legislation to specifically address stapled security structures. They illustrate how the US experience with stapled shares, and particularly the congressional legislative response, provides a workable template for the necessary modifications. However, this legislative template would only address the use of stapled securities in intermediated structures. Some form of equity recharacterization rule to address the use of stapled securities in disintermediated structures is also needed to ensure the target effectiveness of the draft legislation.

Keywords: Income trusts n shares n securItIes n transactIonal substItutIon n specIfIed

Investment flowthrough n non-portfolIo propertIes

c o n t e n t s

Introduction 249Income Trust Structures as an Example of Tax-Driven Transactional Substitution 252Using Stapled Securities To Avoid the Application of the Draft Legislation 260US Experience with Stapled Shares 267

Stapled REIT Structures 267Stapled Foreign Corporation Structures 271

Avoiding Subpart F 271Avoiding Withholding Tax and Retaining the Benefit of the DRD 272

US Congressional Reaction to Stapled Share Structures 274Case Law Preceding the Enactment of IRC Section 269B 274IRC Section 269B 276

stapled securities—“the next big thing” for income trusts? n 249

intro duc tio n

OnOctober31,2006,theDepartmentofFinance(“thedepartment”)issuedapressrelease1andanaccompanyingsetoflegislativeproposalsintendedtoshutdowndemandintheincometrustmarketfromtheremainingtaxclienteleforthisstruc-ture—namely,non-residentandtax-exempt investors, includingdeferred incomeplanssuchasregisteredpensionplans(RPPs)andregisteredretirementsavingsplans(RRSPs).Theseproposals,whichhavebeencarriedforwardandmodifiedindraftlegislationreleasedonDecember21,20062andagainonMarch27,2007,3attempttorealizethisresultbyapplyingdividendtreatmenttodistributionsfromcertainpubliclytradedtrustsandpartnerships.Theresultingentity-leveltaxisintendedtosupplement the enhancement of the dividend tax credit for resident individuals,whichwastheimmediatelypreviouslegislativeresponsefocusedonthedemandsideoftheincometrustmarket.4Budgetaryconstraintsapparentlypreventedtheexten-sionofthecreditonarefundablebasistotax-exemptandnon-residentinvestors,5necessitatingafurtherresponsetoaddresscontinueddemandfromtheseinvestors.

Extending the Draft Legislation To Address the Use of Stapled Securities 279Addressing Stapled Securities in Intermediated and Disintermediated Structures 279Maintaining the Exception for REITs 284

Appendix IRC Section 269B 288

1 Canada,DepartmentofFinance,News Release2006-061,October31,2006(hereinreferredtoas“theOctober2006proposals”).

2 Canada,DepartmentofFinance,News Release2006-086,December21,2006andtheaccompanyingdraftlegislationandexplanatorynotes(hereinreferredtoas“theDecemberdraftlegislation”).

3 Canada,DepartmentofFinance,News Release2007-026,March27,2007andtheaccompanyingNoticeofWaysandMeansMotionToImplementCertainProvisionsoftheBudgetTabledinParliamentMarch19,2007—BudgetImplementation2007,March27,2007(hereinreferredtoas“theMarch2007noticeofwaysandmeansmotion”).TheMarch2007noticeofwaysandmeansmotionhassincebeenenactedbyBillC-52,BudgetImplementationAct,2007;SC2007,c.29.LegislativereferenceshereinhavenotbeenupdatedtoreflectthepassageofBillC-52,whichfollowedthewritingofthisarticleanditspreparationforpublication.

4 Canada,DepartmentofFinance,News Release2005-082,November23,2005(hereinreferredtoas“theNovember2005proposal”).Theproposalwasimplementedinlegislationeffectivefordividendspaidafter2005.SeeSC2007,c.2,sections44(1)and48;andCanada,DepartmentofFinance,News Release2006-028,June29,2006andtheaccompanyingdraftlegislationandexplanatorynotes.TheNovember2005proposalwasbroughtforwardbythenewConservativegovernmentinitspost-electionbudget.Canada,DepartmentofFinance,2006Budget,BudgetPlan,May2,2006,231-32andtheaccompanyingNoticeofWaysandMeansMotionToAmendtheIncomeTaxAct,resolution(20).

5 Foradiscussionofasystemoffullintegrationasasystemicresponseintendedtoeliminatetheincometrustmarket,seeJackM.MintzandStephenR.Richardson,“IncomeTrustsandIntegrationofBusinessInvestorTaxes:APolicyAnalysisandProposal”(2006)vol.54,no.2Canadian Tax Journal359-406;andLalitAggarwalandJackMintz,“IncomeTrustsand


Thislatestvolleyfromthedepartmentmaysignalamercifulendtotheincometrustsaga.Onecanonlyhopethatitdoes,aftermonthsofargumentsindefenceofincometrusts,diligentlyreportedbyanoftensympatheticpopularpress.6Yetthedraftlegislationleavessomegapingholes.7Insteadofclosingthoseholeswithspecificlegislation,thedepartmentissuedawarninginthepressreleaseaccompanyingtheOctober2006proposals:“[I]fthereshouldemergestructuresortransactionsthatareclearlydevisedtofrustratethosepolicyobjectives[thedeathoftheincometruststructure],anyaspectofthesemeasuresmaybechangedaccordinglyandwithim-mediateeffect.”Itremainstobeseenwhetherthisstatementconstitutesasufficientmarketchilltokillthedemandforincometrusts.Ifthereisnosucheffect,thein-cometrustsagacouldmoveintoanewstapledsecuritiesand/orjunkbondphase.8

Giventheunderinclusivenessofthedraftlegislation,webelievethatitisunlikelytobesuccessfulinultimatelyeliminatingtheincometrustmarket.Thislatestresponseisentirelycharacteristicofthedepartment’sapproachthroughouttheincometrustsaga,whichhasbeenmarkedbytwodefiningfeatures.Onefeatureisahesitancytodoanythingaheadofdevelopmentsinthefinancialmarkets.Thishesitancyhasleftthedepartmentcontinuallyonthebackfoot.Theotherfeatureisapreferencefor

ShareholderTaxation:GettingItRight”(2004)vol.52,no.3Canadian Tax Journal792-818.BudgetaryconsiderationsmayalsobeafactorinrecentlegislativeproposalsintheUnitedStatestodenythelowrateofpersonaltaxondividendsforincometrustdistributionsreceivedbyUSinvestors.SeeCarrieTait,“USBillDoublesTrustTaxto35%,”Financial Post,March28,2007.

6 Forarefreshinglyindependentview,seeEricReguly,“TrustLobbyists,That’sEnoughofYourFury,”Globe and Mail,December19,2006.(“Someoneshouldencaseincometrustlobbyistsinconcreteandflingthemoffabridgeintodeepwater.Onsecondthought,forgetit;eventhatwouldn’tstopthemisguidedcreatures.Houdini-like,theywouldsomehowbreakfreeandcallforJimFlaherty’s[theFinanceMinister’s]headthemomenttheirlipsbrokethesurface.Theyareunstoppableandinsatiable.”)

7 Thedraftlegislationhasalreadybeenthesubjectofanextensivedescriptiveliterature.Foragoodreviewofthedraftlegislation,includinganalysesofvariouslegislativepressurepoints,seeCorradoCardarelli,“IncomeTrustandMutualFundTrustDevelopments,”inReport of Proceedings of the Fifty-Eighth Tax Conference,2006ConferenceReport(Toronto:CanadianTaxFoundation,2007),10:1-19.

8 Theimperativetofindtax-effectivesubstitutesforincometruststructuresthataresubjecttothedraftlegislationmaybemutedsomewhatbythegeneroustransitionalrelief.Inparticular,applicationoftheproposeddistributionstaxisdeferreduntil2011fortargetedentitiesthatwerepubliclytradedasofOctober31,2006.Moreover,thedepartmenthasexpandedthescopeofthefour-yearsunsetclausetoaccommodatethe“normalgrowth”ofgrandfatheredentities.Thedepartmenthasproposedadefinitionofsuchgrowthasnewequityissuesequaltothegreaterof(1)$50millionand(2)100percentofthemarketcapitalizationofanentityattheendoftradingonOctober31,2006.The100percentsafeharbouristobespreadona40/20/20/20basisfor2007throughto2010.SeeCanada,DepartmentofFinance,News Release2006-082,December15,2006.TheseproposalswerecarriedforwardintheMarch2007noticeofwaysandmeansmotion.Curiously,theywerenotbroughtforwardinlegislativeform.Instead,thegeneralwordingoftheguidelinesinthepressreleaseisincorporatedbyreference.


incrementalresponsesthattargetparticulartaxpayersonthedemandsideofthein-cometrustmarketinthehopethatdoingsowilltakesufficientairoutofthemarket.9Theseresponseshaveinvariablybeenunderinclusiveandhaveallowedtheincometrustmarkettocontinuetogrowattheexpenseofthecorporateincometaxbase.Underlyingbothofthesefeaturesisasubstantialpoliticaldimension,reflectedpartlybytherepresentationsofvocalandpersistent“paperentrepreneurs”(investmentbankers,accountants,andlawyers)and“thegreypowerset.”10Theformerhaveen-joyed a presumably profitable role in creating and marketing the income truststructureaswhathasbeenperceivedtobeanecessaryelementintheinvestmentportfoliosofthelatter,whetherhelddirectlyorthroughRPPsorRRSPs.

Thisarticlehighlightsthepossibleuseofstapledsecuritystructuresasatechniquetoavoidtheapplicationofthedraftlegislation.Thefirstpartofthediscussionde-scribesthedevelopmentofthegeneralfeaturesoftheincometruststructureasanexampleoftax-drivenfinancialinnovationinvolvingthesubstitutionofalower-taxedtransactionalformforahigher-taxedtransactionalform.Thesecondpartreviewsthedraftlegislationasanattempttoequatethetaxonincometruststructuresandconventionalcorporatestructuresbyraisingthetaxontheformer.Thefailureofthelegislationtoapplytothefullrangeofpotentialtransactionalsubstitutesisem-phasized;inparticular,thedraftlegislationleavesthedooropentotheuseofstapledsecuritiesasatax-effectivesubstituteforanincometruststructure.Stapledsecuritiesaresecuritiesoftwoormoreformallyseparateentitiesthatarecontractuallystapledtogethersothattheymaynotbeowned,held,sold,orpurchasedseparately.

ThethirdpartofthearticledescribestheUSexperiencewithstapledsharesin-cluding,inparticular,thelegislationintroducedbyCongresstopreventtheiruseastax-effectivetransactionalsubstitutesinboththedomesticandinternationalcontexts.ThefourthpartconsidershowtheUSlegislativeresponsetostapledsharestruc-turesmightbeincorporatedinthedraftlegislationinanefforttoimproveitstargeteffectiveness.Wenotethatextensionofthedraft legislationtostapledsecurities

9 Theincometrustsagaisnotthefirsttimethatthedepartment’spolicy-makingeffortsinresponsetotax-drivenfinancialinnovationhavebeenmarkedbythesetwofeatures.Apastexamplewithalltoomanyparallelsisthepreferredsharesaga,whichunfoldedfrom1974to1987.Thisperiodsawaseriesofunderinclusive,incrementalresponsestotheuseofpreferredsharesastax-effectivedebtsubstitutes.Demandwasnotshutdownuntil1987,withtheintroductionofacomprehensivedistributionstaxapplicabletodividendspaidontaxablepreferredshares(broadlydefinedasanyshareotherthanafullyparticipatingcommonshare).SeeTimEdgar,“TheClassificationofCorporateSecuritiesforIncomeTaxPurposes”(1990)vol.38,no.5Canadian Tax Journal1141-88,at1149-57.

10 MuchoftheorganizedrepresentationefforthasbeenspearheadedbytheCanadianAssociationofIncomeFunds.However,therehasbeennoshortageofcommentarygeneratedbyindividualsactingindependentlyofthisloosecoalition(thoughalsoapparentlymotivatedbyself-interest).ThelobbyistsfoundawelcomingaudienceamongpoliticiansduringparliamentaryhearingsontheDecemberdraftlegislation.Thehearingsculminatedinananalyticallythinreport:Canada,HouseofCommons,Taxing Income Trusts: Reconcilable or Irreconcilable Differences?ReportoftheStandingCommitteeonFinance,39thParl.,1stsess.,February2007.


wouldstillleavethedirectholdingofhigh-yieldjunkdebtasapossibletax-effectivesubstitute.Intheabsenceofanysignificantnon-taxconstraintsontheuseofsuchdebt,afurtherlegislativeresponsemayberequired.Butthisresponsewouldhavetobemuchdifferent,bothconceptuallyandinitsdesignfeatures,fromthedraftlegis-lation,evenifthelegislationweresupplementedwithadditionalprovisionsaddressingtheuseofstapledsecurities.Inparticular,anextensionofthedraftlegislationtostapledsecuritieswouldsomehowhavetobesupplementedwithafurtherextensiontosecuritiesthatareheldproportionallybyinvestors,butarenotformallystapledtogether.

Thefourthpartofthearticlealsoincludesabriefdiscussionoftheexceptioninthedraftlegislationforrealestateinvestmenttrusts(REITs),11whichthesuggestedmodificationstoaddresstheuseofstapledsecuritystructureswouldleaveinplace.ThesemodificationswouldbelimitedtoadenialoftheavailabilityofexemptREITstatusinthecontextofstapledsecuritiesusedtoavoiddividendtaxtreatment.

income trus t s truc t ure s A s A n e x A mPle of tA x-driven tr AnsAc tionAl substitution

Thecommonfeatureofincometruststructuresistheelimination(orsubstantialreduction)oftheunintegratedportionofthecorporateincometaxbysubstitutinghigh-yield, subordinated junkdebt foradirect share investment inanoperatingcorporation. In addition, the vast majority of income trust structures include apooledinvestmenttrusttoholdthedebtandanyremainingequity.Thesubstitu-tionisthatofa lower-taxedtransactionforahigher-taxedtransactionalongtwodifferentboundaries,oneithersideofwhichisadifferenttaxtreatmentundertheIncomeTaxAct.12

Thesubstitutionofhigh-yieldacquisitionindebtednessforsharesofanoperatingcorporationfocusesonadiscontinuityalongthedebt-equityboundary.Inparticular,thepatternofcashflowsassociatedwiththerelevantsharesisalteredbysubstitut-ingafixedpaymentintheformofinterestontheacquisitionindebtedness.Withbusinessesthatrequirelittleornoretentionofearningsforcapitalexpenditures,thesacrificeinthedesiredpatternofcashflowsissmall,yetthedebt-for-equitysubstitu-tionresultsinasignificantanddisproportionatechangeintaxtreatment(deductibleinterestexpenseatthecorporatelevelversusnon-deductibledividendpayments).Thesubstitutionofatrustforaholdingcorporationasavehicletopoolthecapitalofinvestorsacquiringthesharesoftheoperatingcorporationfocusesonaninconsistencyinthetaxtreatmentofthecashflowsdistributedfromthesetwoorganizationalforms.Withoutanysacrificeinthedesiredpatternofcashflows,distributionsfromthe

11 ThechangestothedraftlegislationproposedintheMarch2007noticeofwaysandmeansmotionprimarilyaddressthescopeofthisexception.Seeinfranotes41and42and110to119andtheaccompanyingtext;andAlanBowman,JonNorthup,andJarrettFreeman,“GovernmentReleasesRevisedIncomeTrust/REITRules”(2007)vol.46,no.2Tax Notes International143-45.

12 RSC1985,c.1(5thSupp.),asamended(hereinreferredtoas“theAct”).Unlessotherwisestated,statutoryreferencesinthisarticlearetotheAct.


trustaredeductibleandarenotsubjecttoanyentity-leveltax,whiledistributionsfromacorporationarenon-deductibleandsubjecttothecorporateincometax.

Atabroadconceptuallevel,theincometruststructureisanexampleofaparticulartypeofbehaviouraladjustmenttotaxesthatissometimesreferredtointheliteratureas“transactionalsubstitution.”13Asoneparticularcategoryofsuchanadjustment,transactional substitution involves the substitutionof a lower-taxed transactionalformforahigher-taxedformininstancesofperfect(ornear-perfect)substitutabilityorinstancesofimperfectsubstitutability.14Theprincipaldifferencebetweenthesetwotypesofsubstitutionliesinthesacrificeofdesirablenon-taxattributesassociatedwithahigher-taxedtransactionthatmustbemadeinordertoaccessthetaxsavingassociatedwithalower-taxedsubstitute.Thisdifferenceinnon-taxattributesrep-resentstheefficiencyloss(referredtointheeconomicsliteratureas“excessburden”or“deadweightloss”)associatedwiththebehaviouraladjustmenttotheparticulardifference in tax treatment. In both instances, the substitution of a lower-taxedtransactionresultsinrevenuelossequaltothetotaloftheexplicittaxessaved.Be-causethesubstitutabletransactionshavedifferentnon-taxfeaturesininstancesofimperfectsubstitutability,efficiencylossesarisedirectlyfromthesubstitution.15

Thedevelopmentoftheincometruststructureis,inlargepart,thestoryoftheattempttorefinethesestructurestomorecloselyreplicatethenon-taxattributesofthehigher-taxedholdingofsharesofacorporationinbothintermediatedanddis-intermediatedforms.Theincometrustsagabeganinnocentlyenoughwithataxrulingin1986thatblessedaroyaltytruststructurecreatedinCalgaryfortheacqui-sitionofoilandgasassetsinAlberta.16Thestructurestrippedtheprofitsfromthe

13 See,forexample,TimEdgar,“DesigningandImplementingaTarget-EffectiveGeneralAnti-AvoidanceRule,”inDavidG.DuffandHarryErlichman,eds.,Tax Avoidance in Canada After Canada Trustco and Mathew(Toronto:IrwinLaw,2007),221-58(categorizingtax-avoidancetransactionsastax-attributecreationtransactions,tax-attributetradingtransactions,andtransactionalsubstitutions);andMichaelBrooksandJohnHead,“TaxAvoidance:InEconomics,LawandPublicChoice,”inGraemeS.Cooper,ed.,Tax Avoidance and the Rule of Law(Amsterdam:IBFDPublicationsBV,1997),53-91(cataloguingthedifferenttypesoftax-avoidancebehaviourthatarethefocusofeconomicsandlaw).

14 SeeBrooksandHead,supranote13(describingsimilarconsequentialattributessharedbythedifferenttypesoftax-avoidancebehaviour).

15 Themostobviousconsequentialattributeofinstancesofperfect(ornear-perfect)substitutabilityistherevenuelossattributabletothesubstitutionofthelower-taxedforthehigher-taxedasset,item,ortransactionalformwithequivalentnon-taxfeatures.Becausethealternativeshaveequivalentnon-taxfeatures,noefficiencyeffectsresultdirectlyfromthesubstitution.Buttheremaybeindirectefficiencyeffectswherethegovernmentoperatesunderabudgetconstraint.Underthosecircumstances,therevenuelosscausedbythesubstitutionmayhavetobemadeupwithothertaxesthatcanhaveefficiencyeffectsassociatedwiththebehaviouraladjustmentstosuchtaxes.Alternatively,therevenuelosscanresultinexpenditurecuts,withincomeandwealthdistributioneffects(andevenefficiencylosseswheretherelevantspendingprogramsaddressmarketfailures).SeeJamesM.Buchanan,“ExternalityinTaxResponses”(1966)vol.33,no.1Southern Economic Journal35-42.

16 JacquieMcNishandBeppiCrosariol,“ATaxingWeek,”Globe and Mail,November8,2006.


propertiesbypayingtax-deductibleroyaltiestoamutualfundtrust,whichdistributedtheroyaltiestotheunitholdersonatax-deductiblebasis.Thecombinationofthetax-deductionfortheroyaltypaymentsandtheflowthroughtreatmentoftheincomedistributedbythetrustavoidedtheunintegratedportionofthecorporate-leveltax,whichwouldhavebeenpayableiftheassetshadbeenacquiredbytheinvestorsincorporateform.Forseveralyears,erosionofthecorporate-leveltaxthroughtheuseoftheroyaltytruststructureremainedconfinedtotheoilandgassector;however,intheearlytomid-1990s,thisstructurewasmodifiedtosubstitutehigh-yield,sub-ordinatedjunkdebtforaroyaltyagreementinwhatcametobecalledan“incometrust”structure.

Developmentoftheincometruststructureasamodificationoftheroyaltytrustismarkedbythreegeneralphasesortypesofstructures.17Thefirststageofdevelopmentproducedthestandardincometruststructure(seefigure1),whichwasinitiallyusedinshareacquisitionsanddebt-for-equityrecapitalizationsofcorporationscarryingonmaturebusinesseswithstablecashflowsandlittleinthewayofcapitalinvest-mentrequirements.Thecommonfeatureofthisfirstgenerationofincometruststructureswastheelimination(orsubstantialreduction)oftheunintegratedportionofthecorporateincometaxbysubstitutingjunkdebtforashareinvestmentinanoperatingcorporation.18Inaddition,thisbasicstructureincludedapooledinvest-menttrusttoholdthedebtandanyremainingshares.

Thesecondgenerationofincometruststructures(seefigure2)combinedthetax-deductiblepreferred share featureof the junkdebt in the standard structurewiththeuseofapartnershiptorealizeasimilarlytax-efficientstructuringofthedistributionofthatportionoftheearningsofabusinessthatrepresenttheriskier

17 Thistaxonomyofincometruststructuresisanadmittedoversimplificationofthetransactionaldetails.Thereisawiderangeofstructuresdifferingincertainrespects.Forexample,intheUScontext(discussedlaterinthisarticle)differentstructuraldetailsareinvolvedwithUSlimitedliabilitycompaniesandUSCcorporationstructuresusedintheacquisitionofaUSbusinessinanassetsaleorasharesale.Anothervariationinvolvestheuseofaroyaltytruststructuretoacquirecertainoperatingbusinesses,ratherthanresourceproperties.Thesestructurescannonethelessbeclassifiedwithinoneofthethreegeneralcategoriesdescribedhere(aswellastheroyaltytruststructure)forthepurposesofillustratingthetargetingissuestheypresent.See,inthisrespect,SimonRomanoandJeffreySinger,“CanadianIncomeTrustsComeofAge”[March2005]International Financial Law Review53-56(characterizingincometruststructuresasvariationsononeoftwothemes:(1)theuseofacorporationtoowntheunderlyingbusinessassets;and(2)theuseofalimitedpartnershiptoholdtheunderlyingbusinessassets).

18 Insomeearlyadvanceincometaxrulings,therewerequestionscentredonthereasonablenessoftheamountoftheinterestexpensefordeductionpurposesunderparagraph20(1)(c).Forareviewoftheformalisticcharacterizationapproachofjunkdebtinthecontextofincometruststructures,seeDouglasA.Cannon,“IncomeTrusts:TheInterest(Deduction)Continues—AReviewofWestshoreTerminalsIncomeFundandSuperiorPropaneIncomeFund,”inCurrent Issues in Corporate Finance,1997CorporateManagementTaxConference(Toronto:CanadianTaxFoundation,1998),4:1-28,at4:8-13.SeealsoPaulD.Hayward,“IncomeTrusts:A‘Tax-Efficient’ProductortheProductofTaxInefficiency?”(2002)vol.50,no.5Canadian Tax Journal1529-69,at1551-53.


growthelementand/ortheassociatedretentionofearningsforcapitalexpenditures.Moreparticularly,these“incometrustwithapartnership”structurescontinuedtoinvolvetheissuanceofhigh-yieldjunkdebttostripouttheexpectedreturnonassetsheldindirectlyinapartnershipthroughanoperatingtrustandanupper-tiermutualfundtrust.Inthestandardpartnershipstructure,thehigh-yielddebtisissuedattheleveloftheoperatingtrust,whiletheunexpectedreturnispassedonbydistributingthereturnonthepartnershipinterestheldbytheoperatingtrusttotheupper-tier

FIGURE 1 Standard Income Trust Structure

Opco

Mutual fund trust

Investors

1. Common shares2. Subordinated debt

Business assets

FIGURE 2 Income Trust with a Partnership Structure

Sellco

Mutual fund trust

Operating trust

1. Trust units2. Subordinated debt

Business assets

Partnership

Investors


mutualfundtrustandontotheholdersofinterestsinthattrust.19Thus,throughthecombinationofanincometrustandapartnershipstructure,themarketdevel-opedameanstostripoutfromthecorporateincometaxbaseboththecompetitivereturnandanyeconomicrentsofabusiness,aswellasthereturnontheassumptionofrisk.Inshort,thewholeoftheunintegratedportionofthecorporateincometaxoneitherofthesereturnscouldbeeliminated.

Thethirdgenerationofincometruststructureseliminatedtheuseofatrustasapoolingmechanism,with investorsholdingdirectly a combinationofhigh-yieldjunkdebtandaspecifiednumberofsharesoftheissuer,referredtoas“incomede-positsecurities”(IDS)20(seefigure3)or“incomeparticipatingsecurities”(IPS)21(seefigure4).Untiltheeliminationofthetax-lawconstraintprovidedbytheforeignpropertyrules(discussedbelow),thesejunkbondstructureswereusedprimarilyinacross-bordercontextforinvestmentintotheUnitedStatesinordertoavoidtheUScorporateincometax.22Thesetransactionsrealizedthesametaxbenefitassoci-atedwiththestandardincometruststructurebysubstitutingfortheintermediarytrustadirectholdingbyinvestorsofacombinationofthehigh-yieldjunkdebtandthesharesoftheoperatingcorporation,whichwouldotherwisebeheldproportion-allybythetrust.

Asmentionedabove,the2005budgetproposaltorepealtheforeignpropertyholdingrestrictionsfordeferredincomeplans23openeduptherangeofsubstitutable

19 TheoperatingtrustwasinterposedbetweenthepartnershipandthemutualfundtrustinordertoensurethatthetrustunitsacquiredbyRPPsandRRSPswerenotforeignpropertyforthepurposesofthelimitationsontheamountofsuchpropertythatthesedeferredincomeplanscouldhold.Seeinfranote23andtheaccompanyingtext.

20 See,forexample,JackBernsteinandBarbaraJ.Worndl,“Cross-BorderAcquisitions:TheEvolutionfromCanadianIncomeTruststoIncomeDepositSecurities”(2003)vol.31,no.2Tax Notes International143-45;KenSnider,“TheEvolvingMarketofCanadianIncomeTrustsandIncomeDepositSecurities”(2004)vol.17,no.6Journal of Taxation and Regulation of Financial Institutions5-12;ChristopherJ.Steeves,“IncomeDepositSecurities—ANewHybrid”(2003)vol.8,no.4Corporate Structures and Groups450-53;andIanKarleff,“Canadian-StyleTrustsHeadSouth,”National Post,July23,2003.

21 IPSsaresimilartoIDSsandhavebeenusedasasubstituteforthestandardIDSstructure.SeeJackBernsteinandBarbaraWorndl,“Canadian-U.S.Cross-BorderIncomeTrusts:NewVariations”(2004)vol.34,no.3Tax Notes International281-84;andSandraRubin,“IncomeTrusts’NextBigThing,”National Post,May5,2004.

22 AversionoftheIDS/IPSstructurewasusedinadomesticcontextbyTimberWestForestCorp.SeeSinclairStewartandAndrewWillis,“BayStreetEyesPlanB,”Globe and Mail,November8,2006.

23 Canada,DepartmentofFinance,2005Budget,BudgetPlan,NoticeofWaysandMeansMotionToAmendtheIncomeTaxAct,resolution(5),February23,2005,effectiveJanuary2005.RPPsremainsubjecttoinvestmentrestrictionsundertherelevantnon-taxregulatoryregime.RRSPsandotherdeferredincomeplansremainsubjecttoatax-lawrequirementthattheirinvestmentsbe“qualifiedinvestments.”Mostimportantly,sharesordebtofanon-residentcorporateissuerarequalifiedinvestmentsonlyiflistedonaprescribedexchange.Interestsinnon-residentpartnershipsandtrustsarenotgenerallyqualifiedinvestments.


structuresbymakingavailabletotheseinvestorsdirectholdingstructureslikeIDSandIPS.Infact, theeliminationof theforeignpropertyholdingrestrictionsalsoopenedupthepossibilityofthedirectsubstitutionofthelimitedpartnershipformforthecorporateform,exposingyetanotherboundaryinthetaxlaw.Ineffect,adir-ectsubstitutionofaflowthroughentityforthecorporateformcouldbeusedforabroadrangeofinvestorstorealizetheresultotherwiseavailablewiththeuseofeitherhigh-yieldjunkdebtinastandardincometruststructureorthecombinationofdebtandapartnershipinterestintheincometrustwithapartnershipstructure.

Eachoftheseiterationsoftheincometruststructureisaccuratelycharacterizedastax-driven;eachinvolvesthedevelopmentofredundantsecuritiesororganizational

1. Common shares 2. Subordinated debt to create IDS

FIGURE 3 IDS Structure

Issuer Corp

Opco

Business assets

Investors

2. Subordinated debt to create IPS

1. Common shares

FIGURE 4 IPS Structure

Canco

Investors

US Limited Liability Company

Business assets

Partnership


formsthatareusedpredominantlyforthetaxsavingthattheyaccess.24Indeed,thedevelopmentoftheincometruststructurefollowsacommonpatternoftax-drivenfinancialinnovation,wherebyalatentinconsistencyordiscontinuityinthetaxlawbecomesthefocusofstructuredfinancetransactionsdesignedtocapitalizeontheparticularinconsistencyordiscontinuity.Theimpetusfortheinnovationisoftenfoundinaparticularmarketdevelopmentorenvironment;forexample,alow-yieldorlow-interestenvironmentissaidtohavebeentheimpetusforthegrowthofin-cometrusts(andtheirolderroyaltytrustcousins).Nonetheless,thefocusoftheseredundantsecurities(ororganizationalforms)remainsthetaxbenefitthattheyaredesignedtoaccess.25

Intermsofthebroaddesignfeaturesofalegislativeresponsethatistarget-effective,incometrustspresentaclassiccaseoftheproblemoflinedrawinginthetaxlaw—thatis,thedifficultyofdrawingaboundarybetweentwodifferenttaxtreatmentswheretheprecisedetailsoftheboundaryatanygivenpointlackmuchinthewayofnormativecontent.Giventhelackofsuchcontent,theprecisedimensionsoftheboundarywillnecessarilybesomewhatarbitrary.Ontheassumption,however,thatthesekindsofboundariesarenottobeeliminatedintheshorttothemediumterm,certainoftheliteraturedrawsontheinsightsofoptimaltaxtheoryasthebasisforanapproachtolinedrawingthatenhancesefficiency.26Verygenerally,thisliterature

24 Atagenerallevel,however,someoftheliteraturesuggeststhatincometrustscanbecharacterizedasefficiency-enhancingbecauseoftheeliminationoftheunintegratedportionofthecorporateincometax;ineffect,theyareseenasaformof“self-help,”or“homemade”integrationofthecorporateandshareholder-leveltaxes.Theyarecharacterizedasefficiency-enhancingbecausetheyeliminatewelfarelossesconventionallyattributedtothreestandardbiasesassociatedwithanunintegratedcorporateincometax:(1)abiasinfavouroftheunincorporatedsector;(2)abiasinfavourofdebtoverequityinvestment;and(3)abiasinfavouroftheretentionofearningsratherthantheircurrentdistributiontoshareholders.Welfarelossesarisetotheextentthatinvestorswouldpreferthecorporateform,equityinvestment,orcurrentdistributionofearnings,butthetaxsystemaltersthatchoicebecauseofapreferencefortheunincorporatedsector,debtinvestment,andtheretentionofearnings.Aswiththeuseofhigh-yieldjunkdebtinleveragedbuyouts(LBOs)anddebt-for-equityrecapitalizations,themoreparticularized(andmoreprominent)versionofthisefficiencycaseforincometrustsistheargumentthattheyreduceagencycostsbyimposingoncorporatemanagementthedisciplineofrequiredcashflowdistributions.Inshort,managementispreventedfromwastingor“burning”excesscashflows,whichmustinsteadbedistributedtoinvestors.See,forexample,PaulHalpernandOyvindNorli,“CanadianBusinessTrusts:ANewOrganizationalStructure”(2006)vol.18,no.3Journal of Applied Corporate Finance66-75,at71.

25 AnexcellentaccountofthisdevelopmentprocessintheUnitedStatesmaybefoundinMarkP.GergenandPaulaSchmitz,“TheInfluenceofTaxLawonSecuritiesInnovationintheUnitedStates:1981-1997”(1997)vol.52,no.2Tax Law Review119-97.Otherpastexamplesofthispatternofdevelopmentoftax-drivenfinancialinnovationinCanadaare(1)theuseofpreferredsharesasasubstituteforloantransactionsand(2)theuseoffinanceleasesasasubstituteforleveragedassetpurchases.

26 See,forexample,DavidA.Weisbach,“LineDrawing,Doctrine,andEfficiencyintheTaxLaw”(1999)vol.84,no.6Cornell Law Review1627-81;andDavidA.Weisbach,“AnEfficiencyAnalysisofLineDrawingintheTaxLaw”(2000)vol.29,no.1Journal of Legal Studies71-97.


suggeststhatdeadweightlossesassociatedwiththemaintenanceofboundariesinthetaxlawcanbeminimizedbytaxingclosesubstitutesconsistentlyinanefforttorealize a level of “transactional neutrality.” This general approach addresses therevenuelossattributabletothesubstitutionoflower-taxedforhigher-taxedformsoftransactions,whileeliminatingthetransactioncostsofsuchsubstitutions.More-over,totheextentthatthesubstitutioninvolvessacrificesinnon-taxfactors,increasingthetaxonthelower-taxedsubstituteeliminatestheefficiencylossesassociatedwiththesesacrifices.

Fortaxpolicymakers,drawingthetax-lawboundarylinesforsubstitutabletrans-actionsisespeciallyproblematicifthereisarangeofalternativetransactionsthatincludesbothcloseand imperfect substitutes.Wheresuch transactionsexist, in-creasingthetaxonalower-taxedsubstitutetoequalthatonahigher-taxedformmayonlyinducethesubstitutionofalternativetransactionsthatarelightlytaxedbuthaveassociatedefficiencylossesattributabletotheirimperfectsubstitutabilityfrom a non-tax perspective. Tax policy makers must therefore first identify therangeofclosesubstitutesthatcandefensiblybetaxedsimilarly.Inaddition,taxpol-icymakersmustidentifytherangeofalternativetransactionsthatprovideimperfectsubstitutes.Thesetransactionsshouldbetaxeddifferentlyonly if thesacrifice innon-taxfactorsissignificantenoughtoconstrainthesubstitutabilityofsuchtrans-actions.Inshort,tax-lawboundariesshouldbedrawnwheretaxpolicymakerscanhavesomeconfidencethatidentifiednon-taxfactorsserveasarobustconstraintonsubstitutability.27Otherwise,thelegislativeresponseexecutingtheline-drawingexer-cisewillbeunderinclusive.

Althoughtheremaybesomecostsassociatedwiththeundesirabilityoftheprivate-lawattributesofincometruststructures,itisclearthattheyhavenotoperatedasanespeciallyrobustconstraintonthetax-drivenadoptionofsuchstructures.28During

27 Foradiscussionofthesignificanceofnon-taxconstraintsor“frictions”generallyfortax-planningpurposes,seeMyronS.Scholes,MarkA.Wolfson,MerleErickson,EdwardL.Maydew,andTerryShevlin,Taxes and Business Strategy: A Planning Approach,3ded.(UpperSaddleRiver,NJ:PrenticeHall,2003),chapter6.Foradiscussionofthesignificanceofsuchconstraintsfromapolicyperspective,seeDavidM.Schizer,“FrictionsasaConstraintonTaxPlanning”(2001)vol.101,no.6Columbia Law Review1312-1409.

28 Muchofthenon-taxlegalliteratureemphasizesthedifferencesingovernancestructures,includingtheliabilityissueforbeneficiariesinanincometruststructure.Inthisrespect,oneofthemoresignificantdevelopmentsfortheincometrustmarketwastheadoptionbytheAlbertaandOntariogovernmentsoflegislationprovidinglimitedliabilityprotectionforincometrustunitholders.SeetheIncomeTrustsLiabilityAct,2004,tabledintheAlbertalegislatureonMay6,2004;andtheTrustBeneficiariesAct2003,tabledbytheOntariogovernmentwiththeMarch27,2003budget.Theliabilityissueapparentlyservedasabarrierfortheacquisitionoftrustunitsbycertainregisteredpensionfundsandpreventedlistingoftrustunitsinstockindexes.Thislatterbarriermayhaveexacerbatedliquidityriskassociatedwiththinsecondarymarketsfortrustunits,whichmayhaveservedtoconstrain,tosomeextent,theuseofincometrusts.Byclarifyingtheliabilityissueandopeningthewaytostockindexlisting,thistypeofprivate-lawlegislationapparentlydeepenedthetax-clienteledemandforincometruststructures,withanincreaseinsupplyandassociatedrevenueloss.


thefirstgenerationoftheincometruststructure,themostsignificantnon-taxcon-straintontheiradoptionwasanapparentmarketperceptionthatthecashdistributionrequirementslimitedtheirusetothosebusinessesthathaverelativelystablecashflows,facelimitedcompetition,andhaveverylittleinthewayofcapitalexpendi-turesthatrequiretheretentionofaportionofthecashflowsofthebusiness.Intheabsenceofanyappreciabletax-lawuncertaintyandanysignificantcostsattributabletotheprivate-lawattributesoftheincometruststructure,anumberofthesebusi-nesseseffectively“checkedthebox”toeliminatetheunintegratedportionofthecorporate income tax.This effective electionwasmadeby adopting the incometruststructure,withthecostbeingtheassociatedtransactioncostsandanyefficiencylossesattributabletotheprivate-lawattributesofthestructure.

The initial perception that the income trust structure was suitable only forbusinesseswithstablecashflowswasbasedonthepremisethatthereturnontheacquisitionindebtednesscouldbeusedtostripoutthecompetitiveornormalreturnontheunderlyingassets(thatis,thestablecashflow).Asnotedabove,thesecondgenerationofincometruststructurescombinedthetax-deductiblepreferredsharefeatureofthestandardstructurewithasimilarlytax-efficientstructuringofthedis-tributionofthatportionoftheearningsofabusinessthatrepresentedtheriskiergrowthelementandtheassociatedretentionofearningsforcapitalexpenditures.Thedevelopmentofthesepartnershipstructuresunderlaythespreadoftheincometruststructuretobusinesseswithgrowthpotential.Thepreciseparametersofanymarketconstraintonthisformoftheincometruststructurewereexceedinglyun-clear. Indeed, thesubsequentdeepeningof the incometrustmarketwasentirelyconsistentwithapatternofincrementaldevelopmentoftax-drivenfinancialinnov-ationgenerally,suggestingthat,intheabsenceoftheintroductionofanytax-lawconstraint,marketswillcontinuetomassageavailabletax-effectivestructuresinanefforttoextendtheiradoption.

Asdescribedinthenextsection,thedraftlegislation,asanexampleofanefficiency-basedexerciseinlinedrawing,isflawedinitsfailuretoapplytostapledsecuritystructures.Inparticular,thefailureofthedraftlegislationtoextendtostapledsecur-ities leavesopen theiruse as tax-effective substitutes for income trust structuressubjecttothelegislation.Giventhatthereappeartobenoobviousnon-taxconstraintsonsuchsubstitution,thisunderinclusivenessispotentiallyfatal,andthedepartmentcouldbeforcedtolegislateretroactively,unlessthethreatintheOctober2006pro-posalstodojustthatservesitsostensiblepurpose.

using s tA Pled securitie s to Avo id the APPlic Ation of the dr Af t legisl Ation

Asaresponseintendedtoshutdowndemandfromtax-exemptandnon-residentinvestors,thedraftlegislationattemptstoraisethetaxonarangeofincometruststructuresconsistentwiththetaxondividenddistributionsinacorporatecontext.Incontrast,theNovember2005proposalattemptedtorestoreameasureofconsist-encyinthetaxtreatmentofcorporatestructuresandincometruststructuresby


reducingthedividendtaxontheformer.Inadditiontothedifferentrevenueconse-quences,thedraftlegislationandtheNovember2005proposaldifferimportantlyintheirrespectivetargetingdimensions.Enhancingthetaxcreditfordividenddistribu-tionsinvolvessometargetingissuesassociatedwiththeneedtoensurethatunderlyingcorporateincomeissubjecttoastatutorytaxrateconsistentwiththegross-upandcreditrateattheshareholderlevel.29Muchmoreproblematictargetingissuesarguablyarisewiththeattempttoensurethatthetaxonincometruststructuresfortax-exemptandnon-residentinvestorsisincreasedtoalevelconsistentwithdividenddistributions.Mostimportantly,anysuchlegislativeresponsemustensurethatitappliestothefullrangeofpossiblesubstitutes.Inthisrespect,theavailabilityofawiderangeofclosesubstitutesforthestandardincometruststructuremeansthatatarget-effectivere-sponsewillinevitablybesomewhatinelegant.Butgivenanacceptanceofarevenueconstraintthatprecludesalowertaxondividenddistributionsfortax-exemptandnon-residentinvestors,theneedforsuchlegislationisunavoidable.

Indeed,inthepresenceofahighdegreeofsubstitutabilityoftheincometruststructureforthepubliccorporation,theNovember2005proposaltoenhancethedividendtaxcreditwasafalsestep:itsacrificedrevenuewithoutstoppingfurtherbleeding fromagrowing income trustmarket.Witha significantportionof thecorporaterevenuebaseremainingatrisk,thedraftlegislationproposestoraisethetaxonincometruststructuresusedassubstitutesforthecorporateforminapub-liclytradedcontext.Thisresultisrealizedbyapplyingdividendtreatmenttodistri-butions of income of a “specified investment flow-through” (SIFT) trust orpartnershipfromits“non-portfolioproperties.”30

Asitsprincipaltargetingmechanism,thedraftlegislationdefinesaSIFTtrustorpartnershipasaresidententitythatholdsanynon-portfoliopropertywhereinvest-mentsintheentityarelistedfortradeonastockexchangeorotherpublicmarket.31“Non-portfolioproperty”isdefined32as

n theholdingbyasingleinvestorofmorethan10percentoftherelativefairmarketvalueofallissuedsecuritiesofasubjectentity;

n theholdingofsecuritiesofasubjectentity(andaffiliatedentities)wherethesecuritiesconstitutemorethan50percentoftheequityvalueoftheinvestoritself;

29 Thisresultisrealizedthroughthedefinitionsinsubsection89(1)ofthe“generalrateincomepool”ofaCanadian-controlledprivatecorporation(CCPC)andthe“lowrateincomepool”ofanon-CCPC,added(withrelatedamendments)bySC2007,c.2,section47(1).

30 Distributionsofincomefromnon-portfoliopropertiesaretreatedasnon-deductibledividends,subjectingtheunderlyingincometotaxattheentitylevelatarateof31.5percent.Thisrateisintendedtoapproximatethecombinedfederal-provincialtaxonthetaxableincomeofapubliccorporation.

31 Draftlegislation,proposedsection122.1,definitionof“specifiedinvestmentflow-throughtrust,”andproposedsubsection197(1),definitionof“specifiedinvestmentflow-throughpartnership.”

32 Ibid.,proposedsection122.1,definitionof“non-portfolioproperty.”


n Canadianimmovableorresourcepropertywheresuchpropertyconstitutesmorethan50percentoftheequityvalueoftheentity;and

n propertyusedinthecourseofcarryingonabusinessinCanada.

An“investment”includesa“security”ofthetrustorpartnership,33whichisdefinedtoinclude(1)anincomeorcapitalinterestinatrust,(2)apartnershipinterest,(3)arighttoacquiresuchaninterest,or(4)aliabilityofatrustorpartnership.34Theconceptofaninvestmentisalsoextendedtoincludearightthatmayreasonablybeconsideredtoreplicateareturnon,orthevalueof,asecurityofatrustorpartner-ship.35Investmentsareconsideredtobelistedonapublicmarketiftheyarelistedonastockexchangeoranover-the-countermarket,definedasatradingsystemorotherorganizedfacilitythroughwhichsecuritiesthatarequalifiedfordistributionmaybeexchanged.36

WiththeseconceptsofaSIFTtrustandaSIFTpartnership,thedepartmentessentiallychosetouseanentity-level“dividendtrap”ratherthananequityrechar-acterizationrule37forthejunkdebtheldproportionallywithsharesofanissuerinanincometruststructure.Asexecutedinthedraftlegislation,thisdifferentconcep-tualapproachaddressestheuseofbothroyaltytrustsubstitutesanddirectentityplays inwhichapublicly tradedtrustorpartnership is substituted forapubliclytradedcorporation.Thedraftlegislationalsomanagestoaddresstheuseofhigh-yieldjunkdebtheldinanintermediarySIFTtrustortheuseofapartnershipinterestthatissimilarlyheld.Morespecifically,theconceptofaSIFTtrustoraSIFTpartner-shipaccurately targetsboth the standard income trust structureand the incometrustwithapartnershipstructure.Undertheproposedprovisions,forbothstruc-tures,thereturnonhigh-yieldjunkdebtwillbetreatedasadividendasitpassesthroughapubliclytradedtrustbeforebeingdistributedtoinvestors.Thereturnonpartnershipinterestswillalsobesubjecttothesametreatment,usuallyasitpassesthroughapubliclytradedtrustholdingtheinterest.Whereinterestsinthepartner-shiparethemselvespubliclytraded,thereturnwillbesubjecttodividendtreatmentasitisearnedanddistributedbythepartnership.Infact,thereturnonbusinessescarriedondirectlybypubliclytradedtrustsandpartnershipswillbesubjecttodivi-dendtreatmenttoensurethattheseentitiescannotbesubstituteddirectlyforthepubliclytradedcorporateform.

The draft legislation does not, however, obviously extend to stapled securitystructures,whichcouldpotentiallybeusedtostreamoffbusinessincomeofanen-titydirectlytotheinvestors.Providedthattheincomestreamisdeductibletothe

33 Ibid.,paragraph(a)ofthedefinitionof“investment.”

34 Ibid.,definitionof“security.”

35 Ibid.,paragraph(b)ofthedefinitionof“investment.”

36 Draftlegislation,proposedsection122.1,definitionof“publicmarket.”

37 ThedesignfeaturesofanequityrecharacterizationruleareexploredinTimEdgar,“TheTroublewithIncomeTrusts”(2004)vol.52,no.3Canadian Tax Journal819-52,at843-52.


operatingentity,astapledsecuritystructurewouldavoidthedividenddistributionstaxforanintermediarySIFTtrustorpartnershipbutwouldmaintainthenon-taxattributesofanintermediatedinvestmentbystaplingsecuritiesheldbyinvestorsdirectlywiththeirinterestsinthetrustorpartnership.Staplingtheinterestswouldensure proportional holdings without the use of an intermediary pooling entity(whichwouldcreatetheintendeddividendtrapunderthedraftlegislation).Securitieshelddirectlybyinvestorswouldnormallyhavetobedebtsecuritiesthatgiverisetoaninterestdeductionfortheoperatingentity.SubstitutestructurescouldalsouserentalpaymentswherethelessorisanintermediaryREIT.Dividendtreatmentattheleveloftheoperatingentitycouldbeavoidedprovidedthattheissuerisacorpora-tion.Inthatcase,itdoesnotmatterthatitssecuritiesarepubliclytraded,sincethedraftlegislationappliesSIFTstatustopubliclytradedtrustsorpartnerships.More-over, dividend treatment is limited to income from non-portfolio properties oftheseentities.Wheretheoperatingentityisitselfatrustorpartnership,interestsorliabilitiesoftheentitycouldnotbepubliclytradedwithoutattractingSIFTstatus.

Asoneillustrativeexampleofatax-effectivestapledsecuritystructure,thestandardincometruststructurecouldbemodifiedusinganIDSorIPSstructure(figures3and4),asshowninfigure5.38Themodificationwouldinvolvetheissuanceofhigh-yieldjunkdebtbyacorporationdirectlytoinvestors,whowouldotherwiseacquirethe debt of the corporate issuer indirectly through interests in an intermediarytrust.Incomefromthebusinesscouldbestrippedoutofthecorporationasdeduct-ibleinterestexpensepayabletotheinvestors.Thedebtwouldbestapledtounitsofthetrustacquiredbytheinvestors,withtheamountadvancedfortheseunitsbeingusedbythetrusttoacquiresharesoftheoperatingcorporation.Thestaplingofthehigh-yieldjunkdebtandthetrustunitswouldensurethatthecashflows,aswellasmostoftheothernon-taxattributes,ofthestapledstructurewouldreplicatethoseassociatedwithastandardincometruststructure.Becauseinterestonthejunkdebtwouldbepaiddirectlytotheinvestors,andnotthroughtheintermediarytrust,thedraftlegislationwouldnotapplytotreattheincomestreamasadividenddistribu-tionfromthetrust.

Muchthesameresultcouldberealizedbymodifyingtheincometrustwithapartnershipstructure.Forexample,high-yieldjunkdebtcouldbeissuedbyapart-nershipdirectlytoinvestorsratherthanthroughanintermediarytrust.39Aswiththeabove-describedmodificationofthestandardincometruststructure,thedebtcouldbestapledtotrustunitsacquiredbytheinvestors.Thisstructure,however,wouldreplicatetheincometrustwithapartnershipstructureonlytotheextentoftheexpectedreturnonthejunkdebt.Amoretax-effectivesubstitute,showninfigure6,would distribute economic rents and/or unexpected returns associated with the

38 StewartandWillis,supranote22.SeealsoAndrewWillis,“WillBayStreetOutfoxGoodale?Don’tBetonIt,”Globe and Mail,October26,2005.

39 However,thedebtwouldhavetobeunlisted.Ifitwaslistedfortrade,theissuerwouldbeconsideredaSIFTpartnership,andincomefromthebusinessassets,distributedasinterestonthedebt,wouldbetreatedasnon-deductibledividendpayments.


growthelementoftheunderlyingbusinessthroughpartnershipintereststhatareissueddirectly to the investors.These interests couldnotbe stapled topubliclytradedjunkdebtofthepartnershipand/ortrustunitsinanintermediarystructure;inthatinstance,thepartnershipintereststhemselveswouldbeconsideredpubliclytradedandthepartnershipwouldbeaccordedSIFTstatus,withdividendtreatmentapplyingtoincomeonitsbusinessassets.Instead,aholdingcorporationcouldbeinterposedbetweentheinvestorsandbusinessassetsheldinapartnership.Investorscouldacquirepartnershipintereststhatarenotlistedfortrade,alongwithpubliclytradeddebtoftheholdingcorporation,whichwouldbestapledtounitsinatrust.Thesameeffectaslistingfortradecouldbeachievedbyprovidingthatthepartner-shipinterestsofinvestorscouldbeexchangedforfurthertrustunitsoracombinationof trustunitsand junkdebtof thecorporate issuer.Providedthat theexchangefeaturewouldnotleadtoacharacterizationofthepartnershipinterestsaspubliclytraded,40thedraftlegislationwouldnotapplytothereturnonthepartnershipinter-estsacquireddirectlybytheinvestors,oranyjunkdebtissuedbytheintermediarycorporation.OnlythereturnthatisdistributedthroughtheintermediarySIFTtrustwouldbesubjecttodividendtreatment.

AthirdillustrativeavoidancetechniqueusingstapledsecuritieswouldinvolveanassetsalewithaleasebackstructureusinganintermediaryREIT,showninfigure7.Moreparticularly,therealestateassetsusedincarryingonabusinesscouldbesold

FIGURE 5 Stapled Version of a Standard Income Trust Structure

Trust

1. Common shares

2. Subordinated debt stapled to trust units

Stapleco

Business assets

Investors

40 Paragraph(e)ofthedefinitionofasecurity,supranote34,includesarighttoacquireanyoftheintereststhatarewithinthedefinition.Itisunclearwhetherthiselementofthedefinitionwouldextendtoarightthatisembeddedinasecurity.Moreover,thereisnothinginthedefinitionofapublicmarket,supranote36,thatwouldextendapubliclytradedcharacterizationtoarighttoacquireasecuritywheretherightisnotitselfpubliclytradedbutthesecuritythatcanbeacquiredispubliclytraded.


toaREITandleasedback,withdeductiblerentalpaymentsmadebythepubliclytradedoperatingcorporationtotheREIT.ThedraftlegislationwouldnotapplytotreattherentalpaymentsreceivedbytheREITasdividenddistributionstoinvestorsholdingunitsintheREIT,sincethelegislationspecificallyexcludestheseentitiesfromSIFTstatus.Forthepurposeofthisexception,aREITisdefined41asapubliclytradedresidenttrustthat

n holdsonly“qualifiedREITproperty”42throughoutataxationyear;n earns95percentormoreofitsrevenuefrominterest,royalties,andrentfrom

realproperty,aswellasgainsfromthedispositionofsuchproperty;

FIGURE 6 Stapled Version of an Income Trust with Partnership Structure

Trust

1. Unlisted/exchangeable partnership interests

Holdco

Investors

2. Subordinated debt stapled to trust units

Partnership

Common shares

Business assets

41 Draftlegislation,proposedsection122.1,definitionof“realestateinvestmenttrust.”

42 “QualifiedREITproperty”isdefinedinproposedsection122.1as(1)Canadianrealproperty;(2)securitiesofanentitythatperformsapropertymanagementfunctioninrespectofpropertyofthetrustoritselfsatisfiestheconditionsforREITstatus;and(3)propertythatisancillarytotheearningofrentfromimmovablesandcapitalgainsonthedispositionofimmovables.Forthispurpose,“rentfromrealorimmovableproperties”isdefinedinproposedsection122.1toincludepaymentsforservicesancillarytotherentalfunctionandtoexcludepropertymanagementfees,hotelservicefees,andrentsbasedonprofits.ThesedefinitionswereintroducedintheMarch2007noticeofwaysandmeans.TheDecemberdraftlegislationlimitedqualifiedREITpropertytoCanadianrealproperty.TheexemptstatusofREITs,aswellastheextensionofqualifyingREITactivitiestoincludeapropertymanagementfunctionandservicesancillarytopropertyrental,isdiscussedinfranotes110-119andtheaccompanyingtext.


n earns75percentormoreofitsrevenuefromrentsfrom,mortgageson,orgainsfromthedispositionofCanadianrealproperty;and

n derives75percentormoreofitsequityvaluefromCanadianrealproperty,cash,andCanadiangovernmentdebtthroughoutataxationyear.

NothinginthesequalifyingconditionswouldpreventanassetsaleandleasebackstructureusinganintermediaryREITtostreamoffmuchoftheexpectedreturnthatwouldotherwisebepaidoutunderastandardincometruststructureasinterestonhigh-yieldjunkdebt.

Thethreestructuralalternativesdiscussedabovearerefinementsofeitherthestandardincometruststructureortheincometrustwithapartnershipstructure;theyattempttomorecloselyreplicatethenon-taxattributesofthepubliclytradedcorporateformininstancesofperfect(ornear-perfect)substitutability.Eachpresentsmuchthesamerevenueandefficiencyeffectsasexistingincometruststructures.Sincethedraftlegislationisintendedtoeliminatethoseeffects,bytaxingallinvest-orsinsuchstructuresconsistentlywithinvestorsinpubliclytradedcorporations,atarget-effectivelegislativeresponseshouldextendthesametaxtreatmenttostapledsecuritystructures.

Inthisrespect,asstatedabove,thedefinitionofaninvestmentinatrustorpart-nershipextendstoarightthatmayreasonablybeconsideredtoreplicateareturnon,orthevalueof,asecurityinthetrustorpartnership.Thisextensionappearstocontemplatepubliclytradedderivativefinancialinstruments,suchasstructurednotes,swaps,orothersyntheticinstruments,whichreplicatethereturnonaunitinatrustoraninterestinapartnershipthatisnototherwisepubliclytraded.Thederivativeinstrument may be issued by the trust or partnership itself or by a third party,

FIGURE 7 Stapled REIT

REIT

Common shares stapled to trust units

Stapleco

Investors

Lease of real estate

Rental paymentsBusiness assets


whetherrelatedorunrelatedtothetrustorpartnership.ExtendingthedefinitionofaninvestmenttopubliclytradedderivativeswouldresultinSIFTstatusfortherel-evanttrustorpartnership;however,itisunclearwhethertheextensionwouldapplytostapledsecuritystructures.Moreover,extensiontoderivativefinancialinstrumentsissuedbyunrelatedthirdpartiescouldwellbeoverinclusivewheresuchinstrumentsareissued,notforthetax-avoidancepurposetargetedbythedraftlegislation,butforlegitimatenon-taxpurposes,suchashedgingtheriskassociatedwithaninvestment.43

Infact,itisunclearwhetherthedepartmenthasstapledsecuritystructuresinmindwiththeextensionofthedefinitionofaninvestmentinatrustorpartnershiptoincludederivativefinancialinstruments.ItismorelikelythattheproductlabelwarningintheOctober2006proposalsregardingsubstitutestructurescontemplatesstapledsecuritystructures,inwhichcasethedepartmenthasmadeitclearthatitiswillingtolegislateretroactivelytoaddresstheiruse.Inourview,theUSlegislativeresponsetostapledsharesisanobviousmodelthatcouldbeusedtotargetstapledsecuritystructuresastax-effectivesubstitutesforincometruststructuressubjecttothedraftlegislation.Inotherwords,extensionofthedraftlegislationbasedontheUSlegislativemodelcouldimprovethetargeteffectivenessoftheproposedmeasuresbyensuringthattheywillapply,explicitlyandmoreprecisely,tostapledsecuritystructures.

us e x Perience with s tA Pled sh A re s

Untilthemid-1980s,stapledshareswereusedintheUnitedStatesforvariousplan-ningpurposesinboththedomesticandinternationalcontexts.Congress,however,effectivelyshutdownthistypeoftax-driven,transactionalsubstitutionin1984withtheintroductionofsection269BoftheInternalRevenueCode.44ThislegislativeresponseshouldserveasacautionarytaleforanyCanadiantaxplannerswhoperceivestapledsecuritiesasanopportunitytoavoidtheapplicationofthedraftlegislation.Indeed,IRCsection269Bprovidesaready-madetemplateforthekindofretroactivelegislativeresponsethreatenedbythedepartmentintheOctober2006proposals.

Stapled REIT Structures

Untilrecently,thecorporateincometaxintheUnitedStateswasaclassicalsystem.Evennow,thecorporateincometaxisonlypartiallyintegratedthroughareducedpersonalincometaxrateondividends.Generally,adomesticcorporation(referred

43 Aproblemofoverinclusivenessalsoseemstoarisebecauseofthebroadbundleofrightsdescribedinthedefinitionofasecurityandthespecificinclusionofliabilitiesofanentity(supranote34andtheaccompanyingtext).Thedefinitionappearstoincludederivativefinancialinstrumentsacquiredbyatrustorpartnershipforhedgingpurposes.Wheretheseinstrumentsareacquiredthroughanexchangeoranover-the-countermarket,theywouldbeinvestmentsinthetrustorpartnershiplistedonapublicmarketandwouldmakethetrustorpartnershipaSIFTtrustorSIFTpartnershipevenwhereunitsinthetrustorinterestsinthepartnershiparenotlistedfortrade.

44 NowcontainedintheInternalRevenueCodeof1986,asamended(hereinreferredtoas“IRC”).


toasa“USCcorporation”)issubject,asaseparatelegalentity,totaxonitsincomeatamaximumgraduatedrateof35percent.Unlikesalaryandinterestexpense,dividendspaidbythecorporationoutofitsearningsandprofitsarenotdeductibleincomputingtaxableincomeandarealsoconsideredtaxableincometotheshareholders.Corporateincomeistherebytaxedtwice,firstatthecorporatelevelandthenattheshareholderlevel.However,corporateshareholdersareaffordedadividends-receiveddeduction(DRD)inrespectofdividendsreceivedfromaUScorporation.TherateoftheDRDvariesdependingontheshareholdingpercentageinthedistributingcorporation.45

Someentities,suchas“Scorporations,”46partnerships,47andcertaintrusts,48aretreatedasflowthroughentities,withincometaxedonlytotheshareholders,part-nersorbeneficiariesasallocatedordistributedtothem.Othercorporations,suchas regulated investment companies (RICs) investing in securities (that is, mutualfunds)arerelievedfromcorporatetaxondividendsandcapitalgainsdistributedtotheirshareholders.49SimilartreatmentisprovidedforREITs50andrealestatemort-gageinvestmentconduits(REMICs).51

LikeRICsandREMICs,theREITisacreatureoftheIRC.TherearethreebasictypesofREITs:“(1)equityREITs,whichownrealestate,andderiveincomefrompropertyrentals;(2)mortgageREITs,whichinvestinrealestatemortgagesandde-riveincomefromfeesandinterestonloans;and(3)hybridREITs,whichholdbothmortgageandrealestateassets.”52TheREITwascreatedin1960withtwoapparentrationales.53TheprincipalrationalewastheextensiontorealestateinvestorsoftheflowthroughtreatmentaffordedtoRICs,toallowthemtosimilarlypooltheirre-sourceswithouttheimpositionofcorporateorentity-leveltaxation.Ineffect,REITsareintendedtoprovideforsmallrealestateinvestorsthesameadvantagesusuallyavailableforinstitutionalandwealthyinvestors.54AccordingtoCongress,

[t]heseadvantagesincludethespreadingoftheriskoflossbythegreaterdiversificationofinvestmentwhichcanbesecuredthroughthepoolingarrangements;theopportunitytosecurebenefitsofexpertinvestmentcounsel;andthemeansofcollectivelyfinancingprojectswhichtheinvestorscouldnotundertakesingly.55

45 IRCsection243. 46 IRCsections1361to1379. 47 IRCsections701to761. 48 IRCsections641to679. 49 IRCsections851to855. 50 IRCsections856to859. 51 IRCsections860Ato860G. 52 RussellJ.Singer,“UnderstandingREITs,UPREITs,andDown-REITs,andtheTaxandBusiness

DecisionsSurroundingThem”(1996)vol.16,no.2Virginia Tax Review329-45,at330-31. 53 CharlesE.WernIII,“TheStapledREITonIce:Congress’1998FreezeoftheGrandfather

ExceptionforStapledStock”(2000)vol.28,no.3Capital University Law Review717-44,at719. 54 Seeibid. 55 HRrep.no.86-2020,(1960),3-4,citedinWern,supranote53,at719-20.


Asecondaryrationalewastheprovisionofinvestorprotectionfromthebusinessrisksassociatedwithrealestateinvestments.ThisgoalisrealizedbylimitingREITstopassiveinvestmentinrealestate.56InprohibitingREITsfromengaginginactivebusinesses,Congressintendedtopreventtheiruseasatax-effectivesubstituteforthecorporateform.57Inthisrespect,Congressstated:

Thisbill[thatis,thelegislationcreatingtheREIT]restrictsthis“passthrough”oftheincomefortaxpurposestowhatisclearlypassiveincomefromrealestateinvestments,ascontrasted to income fromactiveoperationofbusiness involvingrealestate....[A]nyrealestatetrustengaginginactivebusinessoperationsshouldcontinuetobesubjecttothecorporatetaxinthesamemannerasistrueinthecaseofsimilaroper-ationscarriedonbyothercomparableenterprises.58

AREITistaxedasacorporation,butisaffordedadeductionfordividendspaidinataxableyear.59Thedeductionensuresthatdistributedincomeissubjectonlytoinvestor-leveltaxation.REITsaresubjecttoentity-leveltaxation,asregularCcor-porations,onundistributedincome.ToqualifyforREITstatus,acorporation,trust,orassociationmustelecttodosoandmustmeetthefollowingconditions,amongothers:60

n atleast95percentofgrossincomemustbederivedfromdividends,interest,rentsfromrealproperty,gainfromthesaleorotherdispositionofshares,securities,andrealpropertynotheldasinventory,andgainfromthesaleorotherdispositionofanon-prohibitedrealestateasset;61

n atleast75percentofgrossincomemustbederivedfrom“realpropertyrentals,loans,gainsfromthesaleorotherdispositionofrealpropertyorrealestate

56 SeeWern,supranote53,at720.

57 Ibid.

58 HRrep.no.86-2020(1960),3-4,citedinWern,supranote53,at720.TheTaxReformActof1986,Pub.L.no.99-514,enactedonOctober22,1986,allowedREITstodirectlyfurnish“servicescustomarilyfurnishedorrenderedinconnectionwiththerentalofrealproperty,whetherornot...charges[forsuchservices]areseparatelystated”(IRCsection856(d)(1)(B)).REITswerethusabletoprovidesuchservicestotheirtenantswithoutviolatingtheeligibilityconditions,thuseliminatingtheneedtouseindependentcontractors.SeeWern,supranote53,at721.TheMarch2007noticeofwaysandmeansmotionsimilarlyexpandedtherangeofpermissibleservicesforthepurposesoftheREITexemptionunderthedraftlegislation.Seesupranote42andtheaccompanyingtext.

59 IRCsection857.

60 IRCsection856.Inaddition,theentitymust(1)bemanagedbyoneormoretrusteesordirectors(IRCsection856(a)(1));(2)havefullytransferablesharesorcertificates(IRCsection856(a)(2));(3)notbeafinancialinstitutionoraninsurancecorporation(IRCsection856(a)(4));(4)have100ormoreshareholders(IRCsection856(a)(5));and(5)notbecloselyheld(IRCsection856(a)(6)).

61 IRCsection856(c)(2).


assets,abatementsandrefundsontaxes,andincomeandgainderivedfromforeclosureproperty;62

n atleast75percentoftheassetsmustberealestateassets,cashandcashitems(includingreceivables),andgovernmentsecurities;63

n notmorethan20percentofthevalueofthetotalassetsmaybesecuritiesofoneormoretaxableREITsubsidiaries(TRSs);64and

n exceptforsecuritiesofTRSsandgovernmentsecurities,notmorethan5per-centofassetsmaybesecuritiesofanyoneissuer,andtheentitycannotholdsecuritieswithmorethan10percentofthetotalvotingpowerorvalueoftheoutstandingsecuritiesofanyoneissuer.65

(These conditions are similar to those set out for REIT status under the draftlegislation.)66

In theearly1980s, stapled share structuresweredeveloped toallowREITs tocarryonanactivebusinesswhilecomplyingwiththeprohibitiononsuchactivity,therebymaintainingtheirstatusasREITswiththeassociatedflowthroughtreatment.67As illustratedinfigure7,aREITwouldformastapledentity—that is,a formallyseparatecorporationthesharesofwhichwereheldbytheshareholdersoftheREITandwerecontractuallystapledtothesharesoftheREITsothattheinterestsineachentitycouldnotbetradedseparately.TheREITandthestapledcorporationwereconsideredtwoseparateentitiesinform,butwiththesameshareholdersandman-agement.TheREITwouldownandholdonlyrealestateassets,whichwouldbeleasedtothestapledentitycarryingonaparticularbusiness.Bypayingall,ormost,ofitsincometotheREITasrent,thestapledcorporationwouldgenerateadeductionthateliminated,orsubstantiallyreduced, its taxable income.Theactivebusinessincomeontheunderlyingassetsofthestapledcorporationwouldarguablybecon-vertedintoqualifyingpassiveincome(rent)throughthisstructure,therebyavoidingcorporate-level taxation on the business income distributed by the REIT to theinvestors.

62 IRCsection856(c)(3),andseeSinger,supranote52,at331.

63 IRCsection856(c)(4)(A).

64 IRCsection856(c)(4)(B)(ii).TheconceptofaTRSisdiscussedinfraatnotes110to119andtheaccompanyingtext.

65 IRCsection856(c)(4)(B)(iii).

66 Seesupranote41andtheaccompanyingtext.Additionalconditionssimilartothoselistedinnote60,supra,inrespectofUSREITsmustbemetbyCanadianREITsinordertoqualifyforclosed-endmutualfundtruststatusundertheAct.Seethedefinitionof“mutualfundtrust”insubsection132(6)andregulation4801.

67 SeeWern,supranote53,at725-26.


Stapled Foreign Corporation Structures

Avoiding Subpart FUScitizens,residents,anddomesticcorporations(“UStaxpayers”)aresubjecttoUStaxontheirworldwideincome,68withacreditfortaxespaidtothesourcecountry.69Foreign-sourceincomeearnedbyaforeigncorporationisgenerallynotsubjecttoUStaxuntilrepatriatedtoaUStaxpayer.70Since1913,sixanti-deferralregimeshavebeenenactedtolimittheavailabilityofthisdeferral(thoughsomeoftheseprovi-sionsnolongerapply).71OfrelevancetothediscussionhereissubpartFoftheIRC(sections951to964),enactedin1962toeliminatethebenefitofdeferralforcertainoffshorestructures thatCongressconsidered tobeartificial“taxhaven”devicesdesignedtoexploitlowforeigntaxes.SubpartFappliesto“controlledforeigncor-porations”(CFCs)earning“SubpartFincome.”Each“UnitedStatesshareholder”ofaCFCisgenerallyallocatedaproratashareoftheCFC’ssubpartFincome,whetheror not a corresponding distribution is made by the CFC, and must include this

68 IRCsections1,11,and61.

69 IRCsection901.Theforeigntaxcreditissubjecttotwolimitations:thegenerallimitationandthe“baskets”limitation.ThegenerallimitationlimitstheforeigntaxcredittotheUStaxrateontherelevantincome(IRCsection904(a)).Thebasketslimitationappliesthegenerallimitationseparatelytoeachcategoryofincome(basket)(IRCsection904(d)).StartingJanuary2007,therearetwobaskets,thepassiveincomebasketandthegeneralbasket.

70 Adomesticcorporationisacorporationformed,organized,andregisteredintheUnitedStates,regardlessofthelocationofitsmanagementandcontrol,placeofbusiness,etc.Aforeigncorporationisanycorporationthatisnotadomesticcorporation(IRCsections7701(a)(4)and(5)).Thus,thedeterminationofwhetheracorporationisdomesticorforeigndependsonaformalrule:adomesticcorporationisonethatwasincorporatedintheUnitedStates.Astotheclassificationofforeignentities,thecheck-the-boxregulationsundertheIRCgenerallyallowtheshareholdersofsuchentitiestochoosewhethertheentityistreatedforUStaxpurposesasaforeigncorporationorasaforeignpartnership(Treas.reg.sections301.7701-1,2,and3).However,certainspecificforeignbusinessentitiesarenotsubjecttothecheck-the-boxregulations;instead,theyarealwaystreatedasforeigncorporationsforUStaxpurposes.TheseformalrulesmakedeferralofUStaxationarelativelyeasytask,subjecttotheanti-deferralrulesdiscussedormentionedbelow.UStaxpayerscarryingonbusinessoutsidetheUnitedStatesmayincorporateacorporationinaforeignjurisdictionanddeferUStaxationoftheincomefromthebusinessuntilrepatriationasdividendsorliquidationdistributions.Similarly,aUScorporationconductingbusinessthroughabranchinaforeigncountrymaychecktheboxtohavethebranchtreatedasaforeigncorporationforUStaxpurposes,providingthesamedeferralbenefitotherwiseavailabletotheparent-subsidiaryformoforganization.

71 Theaccumulatedearningstax(AET),whichwasenactedin1913(IRCsections531to537)andisrarelyapplied;thepersonalholdingcorporation(PHC)regimeof1937(IRCsections541to547),which,since2001,nolongerappliestoforeigncorporations;theforeignpersonalholdingcorporation(FPHC)regimeof1937(IRCsections551to558),whichwasabolished;theforeigninvestmentcompany(FIC)regimeof1962(IRCsections1246and1247),whichwasabolishedaswell;thesubpartFregime,whichwasenactedin1962(IRCsections951to964);andthepassiveforeigninvestmentcompany(PFIC)regime,whichwasenactedin1986(IRCsections1291to1298).


amountasordinary income.72SubpartF incomeconsistsprimarilyofpassive in-come73andsalesorservicesincomefromcertainrelated-partytransactionswherethe location of the underlying business activity (that is, where services are per-formed,orwhereproductsaremanufacturedorsoldforuse)isoutsidetheCFC’scountryofincorporation.74

ACFCisdefinedasanyforeigncorporationmorethan50percentofthetotalcombinedvotingpower,orthetotalvalue,ofwhichisowned,orisconsideredtobeowned,byUSshareholdersonanydayduringthetaxableyearoftheforeigncor-poration.75AUSshareholder isaUSpersonwhoowns,or isconsidered toown,10percentormoreofthetotalcombinedvotingpowerofaforeigncorporation.76Thus,thesubpartFrulesapplytotheUSshareholderofaforeigncorporationonlyifmorethan50percentofthetotalcombinedvotingpowerorvalueofthecorporation’ssharesisowned,directlyorindirectly,byUSshareholders,eachofwhomownsatleast10percentofthesharesoftheforeigncorporation.

Stapledsharestructuresweresometimesusedtoavoidtheapplicationofsub-partFbyavoidingCFCstatusforaforeigncorporationcontrolledbyawidelyheldUScorporation.InsteadofformingaforeignsubsidiaryearningsubpartFincome,awidelyheldUScorporationwouldformaforeigncorporationthesharesofwhichwouldbestapledtothesharesof theUScorporation(figure8).SubpartFwouldarguablybeavoided,providedthatno10percentUSshareholderstogetherownedmorethan50percentofthetotalcombinedvotingpoweroftheforeigncorpora-tion,whichwouldbewidelyheldinform.

Avoiding Withholding Tax and Retaining the Benefit of the DRDA foreign person’s “fixed or determinable, annual or periodic” income from aUSsourcethatisnotconnectedwiththeforeignperson’sUSbusinessissubjectto

72 IRCsection951(a).

73 IRCsections952(a)and954(c).SubpartFincomedoesnotincluderoyaltiesandrentsfromactivebusiness(IRCsection954(c)(2)(A))andcertaindividendsandinterestfromcorporationswithinthesamecountryastheCFC(IRCsection954(c)(3)(A)(i)).Fortaxableyearsbeginningin2006,2007,and2008,dividends,interest,rents,androyaltiesreceivedoraccruedfromarelatedCFCarenottreatedassubpartFincometotheextentthattheyareattributabletoincomeoftherelatedCFCthatisneithersubpartFincomenorincomeeffectivelyconnectedwithaUSbusiness(IRCsection954(c)(6)).SubpartFdoesnotapply(1)ifthesubpartFincomedoesnotexceedthelesserofUS$1millionor5percentoftheCFC’sincome(IRCsection954(b)(3)(A));(2)ifthetaxpayercanestablishthattheincomewassubjecttoaneffectiveforeigntaxratethatis90percentormoreoftheUStaxrate(IRCsection954(b)(4));or(3)withrespecttoactiveincomefromabanking,finance,orinsurancebusiness(IRCsections954(h)and(i)).

74 IRCsections952(a)and954(d)and(e).

75 IRCsection957(a).

76 IRCsection951(b).


UStaxationonagrossbasisatarelativelyhighwithholdingrateof30percent.77How-ever,“acombinationofsourcerules,statutoryexemptions,andtaxtreatiesresultsin[interest]incomebeinggenerallytaxedonlywhenearnedbyforeignbusinessesaspartoftheiractivebusinessoperations—suchincomegenerallyisnottaxedwhenearnedbyportfolioinvestors.”78

Forforeigndirectinvestors,stapledstockstructurescouldbeusedtoavoidtheapplicationofthisnon-residentwithholdingtaxandretainthebenefitoftheDRDfor US corporate shareholders. For example, assume that a foreign corporation(Forco)andaUScorporation(USco)haveagreedtomergeonashare-for-sharebasis.IfForcoweretoacquireUScoinexchangeforitsshares,dividendsorinterestpaidbyUScotoForco(thenewforeignparent),andprobablysuchpaymentsbyForcotoitsnewUSshareholders,wouldbesubjecttowithholdingtaxes.Moreover,theUScorporateshareholdersofUScoreceivingsharesofForcowouldlosethebenefitoftheDRD.

ToavoidwithholdingtaxandretainthebenefitoftheDRD,thetransactioncouldbestructuredasshowninfigure9.UScowouldfirstissuetoitsshareholders,onaproratabasis,preferredshareswithvotingpowerrepresentinglessthan20percentof thevotingpower inUSco.79Forcowould thenacquire thecommonsharesof

FIGURE 8 Stapled Structure To Avoid Subpart F

Stapled shares of USco and Forco

Forco

USco

Shareholders(public)

Subpart F income

77 IRCsections871(a)and881(a).

78 ReuvenS.Avi-Yonah,“TheStructureofInternationalTaxation:AProposalforSimplification”(1996)vol.74,no.6Texas Law Review1301-59,at1318.SeeIRCsections871(h)and881(c).

79 Thelessthan20percentvotingpowerlimitationisneededinordertoqualifyforaUStax-freereorganizationunderIRCsection368(a)(1)(B),whichrequiresthattheacquiringcorporationhavecontroloftheacquiredcorporationimmediatelyaftertheacquisition.“Control”forthispurposemeans“theownershipofstockpossessingatleast80percentofthetotalcombinedvotingpowerofallclassesofstockentitledtovoteandatleast80percentofthetotalnumberofsharesofallotherclassesofstockofthecorporation”(IRCsection368(c)).However,anumberofotherUStaxissuescouldarise.See,forexample,IRCsections306and367(a).


USco in exchange for classB common shares of Forco, and the USco preferredshareswouldbestapledtotheForcoclassBcommonshares.Thestapledsharear-rangementwouldprovidethetermsandamountsofthedistributionsoneachclassofshares.Inamergerbetweenequals,theobjectivewouldbetorequireForcoandUScotomakeequaldistributionsthroughtheForcocommonsharesandtheUScopreferredshares,respectively.Theremightalsobeaneedforanequalizationagree-ment between the two corporations that would control the required degree ofidentityordiversityof interestbetweenthetwotypesofshares.80ThisstructurewouldallowtheUScorporateshareholderstocontinuetoreceivedividendsthroughUScoandtheforeignshareholderstocontinuetoreceivedividendsthroughForco.Withholdingtaxondividendswouldbeavoided,andtheUScorporateshareholderswouldretainthebenefitoftheDRD.81

US Congressional Reaction to Stapled Share Structures

Case Law Preceding the Enactment of IRC Section 269BBeforetheenactmentofIRCsection269B,somecaselawconsideredthecharacter-izationofstapledsharearrangements.Theissueinthesefewcaseswaswhethertheformallyseparatenatureofthesharesshouldberespected,andthesharestreatedasinterestsineachoftherelevantentities,orwhetherthesharesshouldbeconsideredasingleinterestinasingleentity.Althoughthedecisionsdidnotaddresstheissue

FIGURE 9 Stapled Structure To Avoid Withholding Tax and Retain the DRD

Class B common shares stapled to USco preferred shares

USco

Forco

USshareholders

Common shares

Preferred shares

80 SeePeterC.Canellos,“CombiningUnitedStatesandUnitedKingdomCorporations”(1988)vol.42,no.4The Tax Lawyer935-60,at956-60.

81 Thereissomesuggestionintheliterature(seeCanellos,ibid.,at958-59)thattheInternalRevenueServicecouldhavechallengedthisstructure.Itissuggestedthatthestructuremightbesubjecttorecharacterization,withdistributionsfromUScotoitsUSpreferredshareholdersbeingdeemedtobedistributedfirsttoForco,andthenfromForcototheUSshareholders.(ThestapledstockissuesofthisstructurerelatedtoIRCsection269Barediscussedbelow.)


inatax-avoidancecontext,theapproachtakentothecharacterizationissuewasrel-evanttotheuseofstapledsharestructuresforplanningpurposes.Inthisrespect,thecaselawappearedtoarticulatethesamegeneralprinciple:thatis,thereisnosubstantive difference between a parent-subsidiary structure and a stapled sharestructurethatwouldsuggestthattheyshouldbetreatedinconsistently.Accordingly,astapledsharestructureshouldbeconsideredasingleinterestinasingleentity.

Twocases,inparticular,articulatedthisproposition,albeitnotinastructuredfi-nancecontext.InDe Coppet v. Helvering,82sinceitwasunlawfulforabanktoengageincertaindealingswithsecurities,thedirectorsofthebankheld,astrusteesforthebankshareholders,theoutstandingsharesofaninvestmentcompanythatdealtwithsuchsecurities.Thesharesoftheinvestmentcompanywerestapledtothesharesofthebank.Theinvestmentcompanywaswoundupwithoutassets,andthetaxpayerattemptedtodeductlossesontheshares.Thecourtdisallowedthededuction,hold-ingthat

itwouldcertainlyhavemadeagreatdifferencehowtheinvestmentshareswereheld,if theywerenot lockedtothebankshares.Buttheywere; itwas impossibletosellthemwithoutsellingthebankshares,ortosellthebankshareswithoutsellingthem.Wedonotsaythatnodifferencescanbeconjuredupbetweenthelegalformchosenandtheusualshareholdingofasubsidiary;buttheyareimmaterialtothesubjectathand.Thebeneficialinterestwasasmuchanappurtenanceofthebanksharesasaneasementisoftheservienttenements;itmerelygavethemanaddedvalue,preciselyasitwouldhavedone,hadtheBankbeentheshareholder.Collectivelythesamepersonsmust always be equitable owners of the investment shares and shareholders of theBank, and in the same proportion; there never could be one group holding bankshares,andanotherholdinginvestmentshares.Sofarasacorporationistheaggregateofitsshareholdersinrespectoftheircollectiverightsandobligations,therewasbutonecorporation....

Theimportantmatterisnotwhatformallegaldifferencestherewerebetweenthemodeladoptedandtheordinarycaseofacorporatesubsidiary;butwhethertheinvest-mentwassingle.Itwasiftheinvestorcouldnothavedealtwiththepartsseparately;andtheseinvestorscouldnot.Whenwespeakofaninvestment,wedonotthinkofthevariousventuresinwhichthecompanymaybeengaged,orofthevariouspropertiesitmayhold.Wethinkoftheunitywhichwemustdealwithassuch,regardlessoftheparticularlegalparaphernaliainwhichitisclad.83

In1954,relyingonthefactthatthesubsidiaryshareswerestapledtothebanksharesinDe Coppet v. Helveringandwerenotsubjecttothebank’screditors,depositors,and other third parties, the Internal Revenue Service (IRS) issued the followingruling:

82 108F.2d787(2dCir.1940);aff ’g.38BTA1381(1938):cert.denied,310US646(1940);reh’g.denied,311US725(1940).

83 Ibid.,at788-89(2dCir.).SeealsoMoore v. Hoey,31F.Supp.478(NYDist.Ct.1940);andCommissioner of Internal Revenue v. Hagerman,102F.2d281(3dCir.1939);aff ’g.34BTA1158(1936).


Thedistributionbyanationalbankofthestockofawholly-ownedsubsidiarycorpor-ationtoatrustcreatedforthepurposeofholdingthestockfortheproratabenefitofshareholders of the bank with control vested in the majority of such shareholdersconstitutes a taxabledividend... to the extentof earnings andprofitsof thebankavailablefordividendseventhoughthedispositionofthestockistiedtoexistingstockownershipinthebank.84

Butin1957,theTaxCourtinEarl R. Wilkinson85heldthatthetransferbyabankofthesharesofitssubsidiarytotrustees,withthebeneficialinterestsoftheshare-holdersofthebankbeingstapledtothebankshares,didnotconstituteataxabledividendpaidtotheshareholders.Thecourtreasonedasfollows:

TheplanintheinstantcasewasadoptedtomeettherequirementsoftheComptrolleroftheCurrency.ItwasaplanwherebytheBankwouldriditselfofSecurities,itswhollyownedsubsidiary,andstill retain for its stockholders thebenefits thathadresultedfromitsbeingaBanksubsidiary.EvidentlysuchatransfersatisfiedtherequirementsoftheComptrollerbutarealisticlookatthetransactionshowsthattoallintentsandpurposesSecuritieswasretainedbytheBankasanavailablemediumtoperformthesameauxiliarybusinessfunctionsaswereperformedbyitbeforethetransfer.

FromtheBankstockholders’position,itisdifficulttoseehowanychangeresultedfromthetransferthatgaverisetotherealizationofgain.Petitioner’sinvestmentwas,insubstance,exactlythesameafterthetransactionasbefore.Beforethetransaction,petitioner’sinvestmentandtheinvestmentofalltheBankshareholdersmightbesaidtobedirectownershipofthestockoftheBankandsolelybyreasonofsuchownership,indirectownershipofthestockofSecurities.Afterthetransfer,petitionerandtheotherBankshareholdershadthesameinvestment,namely,directownershipoftheBankstockandsolelybyreasonofsuchownership,indirectorbeneficialownershipofthestockofSecurities.WhileinformtherewasaseveranceofSecuritiesstockfromtheBankassets,thepetitionerandtheotherstockholdersintheBankreceivednothingtheydidnothavebefore,asaresultofthetransaction.ThebeneficialownershipofthestockofSecurit-ies,afterthetransaction,wasstilllockedintoownershipoftheBankstock.ItwasstillaproratainterestdependinguponownershipoftheBankstock.ThatbeneficialinterestcouldnotbetransferredwithouttransferoftheBankstock.If,thedayafterthetransfer,petitionerhadsoldhisBankstock,hewouldhavetransferredsubstantiallythesameinvestmentastoSecuritiesstockasifthetransferhadbeenmadethedaybefore.86

IRC Section 269BIRCsection269Bcontainsthreeseparaterules,eachofwhichaddressestheuseofastapledsharestructureinaparticularcontext.87Therulesapplyinrespectofa“stapledentity”and“stapledinterests”inanentity.“Stapledentities”aredefinedas

84 Rev.rul.54-140,1954-1CB116.

85 29TC421(1957).

86 Ibid.,at425-26.

87 Thetextoftheprovisionisreproducedasanappendixtothisarticle.


anygroupoftwoormoreentitiesifmorethan50percentinvalueofthebeneficialownershipineachconsistsof“stapledinterests.”An“entity”meansanycorporation,partnership,trust,association,estate,orotherformofcarryingonabusiness.

StapledREIT(andRIC)structuresareaddressedbytreatingtheREITandthestapledentityasasingleentity.TheactivitiesofthestapledentityarethusimputedtotheREIT,disqualifyingitfromREITstatuswherethestapledentityengagesinbusinessactivitiesproducingactiveincome.

TheuseofstapledsharestructurestoavoidtheapplicationofthesubpartFregimeisaddressedbyprovidingthat,insuchstructures,astapledforeigncorporationistreatedasadomesticcorporation,therebysubjectingthecorporationtoUSincometaxonitsworldwideincome.However,IRCsection269B(e)excludesfromthisrulethosesituationsinwhichthedomesticandforeignstapledcorporationsarebothforeignowned.Forthispurpose,acorporationis“foreignowned”iflessthan50per-centofitsvotingpowerandvalueisowned(ortreatedasowned)byUSpersons.TherationaleforthisexceptionisthatsubpartFwouldnotapplyinanyevent,be-causeneithercorporationwouldbeaCFC.

AthirdruleaddressestheuseofstapledsharesinthecontextofthedefinitioninIRCsection1563ofa“controlledgroupofcorporations,”whichisrelevanttovariousprovisions. Ingeneral, IRC section1563defines a “controlledgroupof corpora-tions”aseitheraparent-subsidiarycontrolledgroupofcorporations,abrother-sistercontrolledgroup,or a combination thereof (combinedgroup), all subject to theconditionssetoutintheprovision.ForthepurposesofIRCsection1563,astapledcorporationisconsideredasubsidiaryoftheothercorporationtowhichitisstapled.ThisdeemingrulecodifiesthecaselawprecedingtheenactmentofIRCsection269Bdescribedabove.

BecauseaforeigncorporationthatisstapledtoadomesticcorporationwillbetreatedasadomesticcorporationunderIRCsection269B(a)(1),theforeigncorpora-tionwillbedeemedtoconverttoadomesticcorporationinatax-freereorganizationunder IRCsection368(a)(1)(F).88This treatmentcouldallowtheuseofa stapledforeigncorporation’slossestooffsetincomeofothermembersoftheUSaffiliatedgroup.89Topreventsucharesult,theIRSannouncedin1989thatregulationswould

88 SeeRev.rul.89-103,1989-2CB65;seealsoTreas.reg.section1.269B-1(c).UnderUSlaw,corporatereorganizationsgenerallyaretax-freetothecorporationanditsshareholders,butwherethereorganizationhascross-borderaspects,IRCsection367mayrequirethecorporationand/oritsshareholderstoincludecertainamountsingrossincomeortomakecertainotheradjustments.SeeTreas.reg.sections1.269B-1(c),1.367(a)-1T(e)and(f ),and1.367(b)-2(f ).

89 Ingeneral,IRCsection1504definesan“affiliatedgroup”asoneormorechainsof“includiblecorporations”connectedthrough80percentstockownershipinvotingpowerandvaluewithacommonparentcorporationthatisanincludiblecorporation(definedinIRCsection1504(b)).Affiliatedgroupsareaffordedspecialincometaxtreatmentbyfilingoneconsolidatedincometaxreturn(IRCsection1501),withalltheimplicationsthereof.Alossofoneincludiblecorporation,forexample,maybeusedtooffsetlossesofotherincludiblecorporationsintheaffiliatedgroup.


beissuedunderIRCsection269Bwithrespecttostapleddomesticandforeigncor-porations.90Undertheseregulations,astapledforeigncorporation(whichwouldotherwisebetreatedasadomesticcorporationaccordingtoIRCsection269B(a)(1))istreatedasaforeigncorporationforpurposesofthedefinitionofanincludiblecorporationunderIRCsection1504(b).Thus,unlessaspecialelectionismadeunderIRCsection1504(d),lossesofastapledforeigncorporationthataredeemedtobelossesofadomesticcorporationunderIRCsection269B(a)(1)willnotbeallowedtooffsetincomeofanymemberofanaffiliatedgroup.91

However,thisprovisionfacilitatedaplanningstructurewherebyaUScorpora-tioncouldgainataxadvantagebyformingastapledforeigncorporationtoholdthesharesofitsforeignsubsidiariesand/oritsotherforeignassets.Sincethestapledfor-eignholdingcorporationwasnotanincludiblecorporation,itwasnotconsideredtobepartof theconsolidatedgroup,andthusnoconsolidated interestexpenseswouldbeallocatedtoit.Theresultwasanincreaseintheforeign-sourceincomeofthestapledforeignholdingcorporationandthusintheamountofitsforeigntaxcreditlimitation.92In2003,Treas.reg.section1.269B-1(d)(2)wasaddedtoaddressthisplanningtechnique.Theregulationprovidesthat“aforeigncorporationthatisstapledtoadomesticcorporationwillbetreatedasadomesticcorporationforthepurposesofthedefinitionofanincludiblecorporationundersection1504(b)whenapplying§§1.904(i)-1and1.861-11T(d)(6).”93Thatis,forthelimitedpurposeofdeterminingtheforeigntaxcreditlimitationofaconsolidatedgroup,thestapledcorporationistreatedasanincludiblecorporation.

UnderTreas.reg.section1.269B-1(b)(2),thecommissionermaytreataninterestthatwouldotherwisebeastapledinterestasnotbeingstaplediftheprincipalpur-poseofthestaplingistheavoidanceofUSincometaxation.TheIRShadpreviouslysuggestedinFSA20023301694thatitmaybeabletodisregardareorganizationin-volvingstapledinterestsunderthegeneralshamtransactiondoctrine(alsoknownastheeconomicsubstancedoctrine),accordingtowhichatransactionwillbedis-regardedfortaxpurposeswhenithasnosignificanteconomiceffectsotherthanthecreationoftaxbenefits.ItwasalsosuggestedthattheIRSmaychallengeastapledstructureinotherways:first,bytheapplicationofIRCsection48295toallowthere-allocationofincomeandexpensesbetweenaUScorporategroupandastapledforeign

90 Notice89-94,1989-2CB416.

91 Ibid.SeealsoTreas.reg.section1.269B-1(d)(1).

92 Seesupranote69.

93 SeeNotice2003-50,2003-2CB295.

94 InternalRevenueService,FieldServiceAdvice(FSA)200233016,May9,2002.

95 UnderIRCsection482,theIRSmayexerciseitsauthoritytoreallocateincome,expenses,deductions,credits,orallowancesbetweentwoormoretrades,businesses,ororganizationsthatareownedorcontrolledbythesameinterestsifsuchallocationisnecessarytopreventtaxevasionortoreflectthetrueeconomicallocationofincome.


entity;second,bytheapplicationofIRCsection26996todisallowdeductions,credits,orotherallowancesiftheprincipalpurposeofthestapledstructureistosecuretaxbenefits; and third, through thedisqualificationofa transactionasa tax-free re-organizationwhereassetsaretransferredtoastapledentity.

e x tending the dr A f t legisl Atio n to A ddre ss the use o f s tA Pled securitie s

Addressing Stapled Securities in Intermediated and Disintermediated Structures

WithIRCsection269Bavailableasatemplate,itshouldberelativelyeasytodeveloplegislativeprovisionsthatwillblocktheuseofstapledsecuritystructurestoavoidtheapplicationofthedraftlegislation.Forexample,stapledREITstructurescouldbeaddressedbydeemingstapledentitiestobeasingleentityforthepurposesoftheeligibilityconditionsforREITstatus.AprovisionsimilartoIRCsection269B(a)(3)wouldattributethebusinessactivitiesofastapledentitytothestapledREIT,disquali-fyingitfromREITstatus.Otherstapledsecuritystructures,suchasthoseillustratedinfigures5and6,couldbeaddressedusingIRCsection269B(a)(2)asamodel.Inparticular,modificationsof incometruststructuresthatusestapledsecurities tobypassaSIFTtrustorpartnershipandstreamincomedirectlytoinvestorscouldbesubjecttoarulethatdeemsthestapledsecuritiestobeownedbythetrustorpart-nership. Income earned on indebtedness or through a partnership interest heldoutsideaSIFTentitywouldthusbechannelledthroughthatentity,ensuringdeemeddividendtreatment.97

Forthepurposesofthedraftlegislation,thedefinitionsof“stapledentities”and“stapledinterests”setoutinIRCsection269B(c)couldbeused.Somefurthercon-siderationmightbegiven,however,tothearticulationofabrightlinethatwouldresultintheapplicationoftherelevantdeemingrules.Asdescribedabove,IRCsec-tion269Busesa50percenttest:anentityisconsideredastapledentityifmorethan50percentofthevalueofownershipinterests isattributabletostapledinterests.Thisparticularthresholdleavesroomfortheuseofstapledsecurities,apparentlyundertheassumptionthattheymaybeusedinsomeinstancesfornon-taxreasons.This50percentbrightlineessentiallyfunctionsasaprimarypurposetestunderwhichtherelevantdeemingruleswillbeappliedwherestapledinterestscanreason-ablybeconsideredtobeusedprimarilytoobtainataxbenefit.The50percentbright

96 IRCsection269authorizestheIRStodisallowdeductions,credits,orotherallowancesiftheprincipalpurposeoftheacquisitionofcontrolofacorporation,ortheacquisitionbyacorporationofpropertyofanon-controlledcorporationwiththepropertyhavingacarryoverbasisfromthetransferorcorporation,istoevadeoravoidUSincometaxbysecuringthebenefitofadeduction,credit,orotherallowancethatwouldnototherwisebeavailable.

97 Assuggestedbythestructureinfigure6,theconceptof“publictrading”ortheconceptofa“stapledinterest”wouldprobablyhavetobeextendedspecificallytoinvestmentsthatcanbeexchangedforpubliclytradedsecuritiesand/orstapledsecurities.


linemaybeusedasaproxyforthiskindofpurposetestinanefforttominimizethecomplianceandadministrativecostsassociatedwithamorequalitativeassessment.Absentevidenceoftheuseofstapledsecuritiesgenerallyfornon-taxpurposes,thereseemstobenocompellingcaseforalessrestrictivebrightline,suchasa75percentormoretest.Ontheotherhand,theUSexperiencedoesnotsuggestaneedforalowerthresholdtoextendtheapplicationofIRCsection269Btoarangeoftransactionsinwhichstapledsecuritystructureshavebeenusedastax-effectivesubstitutes.

Changestothedraftlegislationalongthelinesofthosesuggestedimmediatelyabovewouldstillleaveopen,asanavoidancetechnique,thedisintermediatedholdingofjunkdebtinIDSandIPSstructures(figures3and4).Becausethesestructuresdonotinvolvetheintermediatedholdingofdebt,theywouldavoidtheSIFTdividendtrapandcouldcontinuetobeusedasameanstoavoidtheunintegratedcorporateincometax,whethersuchdebtisstapledtosharesoftheissuerorisotherwiseheldproportionallywithitsshares.Indeed,theeliminationoftheforeignpropertyholdingrestrictionsfortax-exemptdeferredincomeplans,suchasRPPsandRRSPs,98meansthatthereisverylittleinthewayofatax-lawconstraintontheacquisitionofdirectjunkbondsubstitutesbythisclassofinvestors.99Webelieve,nonetheless,thattherearedefensiblepolicyreasonsforacceptanceofthisparticularsubstitutestructure,butonlywherethejunkdebtisnotheldproportionallywithsharesoftheissuer.

Acomprehensivelegislativeresponsetothetransactionalsubstitutionscharacteris-ticoftheincometrustphenomenoncannotavoidtheneedtoaddresstwofundamentaldefinitionalissuesthatareendemictoacorporateincometaxsystemthattreatsthereturnondebtandequityinconsistentlyandleavesarangeofentities,suchaspart-nershipsandtrusts,outsidethatsystem.Thedraftlegislationaddressesonlyoneoftheseissuesexplicitly:theconceptofacorporation,theequityinterestsofwhicharesubjecttodividendtaxation.Inthecontextofpubliclytradedentities,thisdefinitionalissueiseffectivelyresolvedbytreatingallpubliclytradedtrustsandpartnershipsascorporationstotheextentofthereturnrealizedfromcarryingonabusiness,eitherdirectlybytheparticularentityorindirectlythroughtheacquisitionofindebted-nessandsharesofahighlyleveragedcorporation.Theotherdefinitionalissue—thedistinctionbetweencorporatedebtandequity—isaddressedonlyasasecondaryeffectofthedefinitionofacorporationinthepubliclytradedcontext.

Asemphasizedinanearlierarticle,100anequityrecharacterizationruleisrequiredtoaddresstheessenceofincometruststructures—namely,thesubstitutionofun-secured,high-yield,andsubordinatedjunkdebtforshares,inanattempttomassagethetax-lawboundarybetweendebtandequityandtakeadvantageofthedifferencesintheirtaxtreatment.ThepopularityofincometrustsinCanadaisreminiscentofthe

98 Seesupranote23.

99 Fornon-residentinvestors,thethincapitalizationrulesinsubsections18(4)to(6)limittheamountofdeductibleinterestonindebtednessheldbycertainnon-residentshareholders(thatis,“specifiedshareholders,”definedgenerallyinsubsection18(5)as25percentormoreshareholdersonavotesandvaluebasis).

100 Edgar,supranote37.


leveragedbuyout(LBO)crazeintheUnitedStatesinthe1980s.AsinthecaseofUSLBOs,theundesirableconsequentialattributesofincometrustscanbecompletelyeliminated(assuminganunintegratedcorporateincometax)onlythroughatargetedlegislativeresponsethatrecharacterizesasequitythehigh-yieldjunkdebtcharac-teristicofstandardincometruststructures.However,sucharesponsemustalsobesupportedwithtwoadditionalrules.Onerulewouldaddresstheuseofdebtsubsti-tutes,suchasroyaltyandleasearrangements.Theotherrulewouldaddresstheuseofflowthroughentities,suchastrustsandlimitedpartnerships,asdirectsubstitutesforthecorporateform.Afailuretotreatarangeofroyaltyandleasearrangementscon-sistentwithrecharacterizeddebt,orafailuretotreatarangeoftrustsandlimitedpartnershipsascorporations,wouldmeanthatsucharrangementsorflowthroughentitiescouldbeusedtorealizethesameresultasastandardincometruststructure.

Takentogether,theseelementsofasuggestedlegislativeagendawouldeffectivelykilltheincometruststructure(aswellasitsclosesubstitutes,includingitsolderroyaltytrustcousin)andrestorethecorporateincometaxstatusquoante.Thisparticularlegislativeagendawouldobviouslydifferfromthedraftlegislationinitsuseofanequityrecharacterizationrule.Infact,thedraftlegislation,evenifmodifiedtoad-dressstapledsecuritystructures,remainsnothingmorethanthekindofsupportinglegislation,focusedonentitysubstitution,thatwouldbenecessaryinconjunctionwithanequityrecharacterizationruletoaddressthepossibleuseofsubstitutestruc-turesthatdonotincorporatehigh-yieldjunkdebt.Butasnotedalready,extensionofthedraftlegislationtoaddressstapledsecuritieswouldaddresstheentirerangeofincometruststructuresusinghigh-yieldjunkdebtinanintermediatedinvestmentstructure,aswellasthedirectsubstitutionofthetrustorpartnershipformforthecorporate form in apublicly traded context.Given thisbroad application, therewouldbenoneedforageneralizedequityrecharacterizationrule.TargetingincometruststructuresandtheirclosesubstitutesmayevenbeaneasierlegislativeexerciseusingtheconceptsofaSIFTtrustoraSIFTpartnershipasadividendtrapforincomefromnon-portfolioproperties.101However,therewouldremainaneedforalimitedequityrecharacterizationruleasasupportingruletoaddressthedisintermediatedholdingofjunkdebtasatax-effectivesubstitute.

Thecaseforalimitedequityrecharacterizationruleisbasedonarecognitionthatincometrustspresentatax-drivensubstitutionofadebtinstrumentforshares,

101 Seesupranote43andtheaccompanyingtextforthetargetingdifficultiespresentedbytheuseofderivativefinancialinstruments.Anothertargetingissueariseswithtrustcapitalsecurities,whicharecapitalinterestsofatrusttheproceedsofwhichareusedtoacquiresubordinateddebtofabankorapoolofsecuritizedassetssuchasresidentialmortgages.Thesestructureshavebeenusedprimarilyforregulatorypurposes,withbanksimprovingtheircapitaladequacyratioseitherthroughthequalificationofthesubordinateddebtastier1capitalortheremovaloftherisk-weightedassetsfromthebalancesheet.Withoutanyspecificamendmentstothedraftlegislation,thesetrustswouldbetreatedasSIFTtrustswheretheinterestsarepubliclytraded.Incomeontheunderlyingdebtofthebankorthesecuritizedassetswouldbesubjecttodividendtaxtreatment.Applicationofthedraftlegislationinthesecircumstancesisarguablyoverinclusive,atleasttotheextentthatthestructuresarenottax-drivensubstitutes.


whichdifferssignificantlyfromthesubstitutionofdebtforequitygenerally.102Thedifferenceisthehigh-yield,subordinatednatureoftheindebtednessusedinincometruststructures,which,whenheldbythetrustinproportiontoanyremainingsharesoftheoperatingentity,mimicscloselythecashflowpatternotherwiseassociatedwithapreferredshareorincomebond.Thereplicationissimplymuchcloserthanthatassociatedwithadebtinstrumentthatisnotheldproportionallywiththeequityofacorporateissuer.Inthelatterinstance,thetaxbenefitotherwiseassociatedwiththecorporateinterestexpensedeductionisaccessedonlyatthecostofsomesacrificeinthecashflowpatternassociatedwithanequityinstrument.Althoughthedifferenceisoneofdegreeandnotofkind,thedifferenceincashflowpatternsofarm’s-lengthdebtandthehigh-yield,subordinatedjunkdebtusedinincometruststructuresmeansthatthelattercandefensiblybecharacterizedas“equityindrag,”103consistentwithmarketperceptions.Nosuchcharacterizationextendstoarm’s-lengthindebtednessgenerally,becauseoftheabsenceofaproportionalholdingofthedebtandsharesoftheissuer.Thedebt-equitysubstitutionassociatedwithincometrustsisthereforequalitativelydifferentfromthatassociatedwiththechoicebetweendebtandequitygenerallyinthecorporatecapitalstructure.

Ifsupplementedwithsomespecificprovisionsaddressingtheuseofstapledse-curitiesinintermediatedstructures,thedraftlegislationwouldapplydividendtaxtreatmenttoalmosttheentirerangeofindebtednessthatcoulddefensiblybechar-acterized as disguised equity because of its proportional holding. Targeting thedisintermediatedholdingofhigh-yieldjunkdebtbyinvestorsand,inparticular,dis-tinguishingitfromdisintermediatedholdingsthatcanberespectedasindebtednesswouldremain,nonetheless,adifficultexercise.Asemphasizedhere,thedistinguish-ingfeatureistheproportionalholdingofdebtandsharesofaparticularcorporateissuer.Moreparticularly,whentherelevantsecuritiesarenotheldproportionally,atsomepointdifferencesinthenon-taxattributesofdebtandequityconstraintax-drivensubstitution.Whendebtandsharesofthesameissuerareheldproportionallybyaninvestor,thesedifferencesareentirelyformalistic.Ineffect,aproportionalhold-ingraisesapresumptionthattheinvestorwillnotexercisetherightsofacreditor,withtheproportionalholdingindicatingatax-drivensubstitutionofdebtforequity.

However,exceptinthecaseofaformalstaplingofsecurities,orapooledholdinginanintermediatedinvestment,itisdifficulttodesignatarget-effectiverequire-mentthatwouldlimitanequityrecharacterizationruletoindebtednessthatisheld

102 Butsee,forexample,AveryShenfeld,“TheEconomicBenefitsofIncomeTrusts,”Economic Perspectives(CIBCWorldMarkets,March7,2003)(arguingthatincometrustsdonotrepresentspecialtreatmentintheabilityofthesestructurestoshelterincomefromcorporate-leveltaxusingtheinterestexpensededuction).Muchthesameargumentwasmadeintheliteratureindefenceoftheuseofhigh-yielddebtinLBOsintheUnitedStates.SeeMichaelC.Jensen,“EclipseofthePublicCorporation”(1989)vol.67,no.5Harvard Business Review61-74.

103 Thischaracterizationofthehigh-yieldjunkdebtusedinLBOsisfoundinJeremyI.Bulow,LawrenceH.Summers,andVictoriaP.Summers,“DistinguishingDebtfromEquityintheJunkBondEra,”inJohnB.ShovenandJoelWaldgogel,eds.,Debt, Taxes and Corporate Restructuring(Washington,DC:BrookingsInstitution,1990),135-66,at152.


proportionallywithsharesofanissuer.Toavoidproblemsofunderinclusiveness,therequirementshouldprobablynotbeexpressedintermsofaquantitativebrightline.104Indeed,itisnotevenclearwhatsuchabrightlinemightlooklikeasalegislativestartingpoint.Toconstrainplanningfocusedonaproportionalityrequirement,thelegislativeexpressionofthisrequirementwouldprobablyhavetobecastingeneralterms,suchasarequirementthattheaffecteddebtbestapledwithsharesoftheissuerorotherwiseissuedoracquiredincircumstancesthatmakeitreasonabletoexpectthatitwillbeheldinroughproportionwithsharesoftheissuer.105Applicationofaproportionalityrequirementinthelattercontextwouldbeanadmittedlyindeter-minateexercise.

Thiskindofexpandedlegislativeresponsetoincometruststructureswouldex-plicitlyaddressthedebt-equitydefinitionalissuebyextendingdividendtreatmenttothereturnondebtthatisheldproportionallywiththeequityofanissuer,wheth-erornotstapledtogether.Itwouldlimittheunintegratedcorporateincometaxtopubliclytradedentities,ontheassumptionthatpublictrading,asadefiningfeatureof the tax-lawboundarybetweenflowthrough and separate-entity status, canbeusedbecauseitprovidesarobustnon-taxconstraintonatax-drivensubstitution.Thisassumptionhasbeenchallenged,however,byarecentwaveofleveragedacquisi-tionsofpubliccorporationsbyprivateequityfunds.106Assumingagainthatthereareimportantnormativeargumentsandrevenueconstraintsthatdictatemaintenanceofacorporateincometaxthatistosomeextentunintegrated,107thiswaveofgoing-privatetakeovertransactionsraisestheissueofevenmorefundamentalreform.Given

104 Forexample,theUScourtsappeartohaveadoptedaquantitativelyimpreciseapproachtothearticulationofthecontentoftheproportionalityrequirementintheirapplicationofamultifactordebt-equityanalysis.Thesameapproachisapparentinthedescriptionoftheproportionalityfactortobetakenintoaccountinadebt-equityanalysisunderIRCsection385.

105 Wherehigh-yieldjunkdebtisstapledtoaspecifiednumberofsharesoftheissuerandcannotbeseparatelytraded,arequirementofproportionalholdingisnotespeciallyproblematic.Forexample,theIDSandIPSstructureswerespecificallydevelopedtoavoidtheapplicationofthissamefactorofproportionalholdingarticulatedintheUSdebt-equitycaselaw.Inparticular,thecommonsharescanbeseparatelytraded,ascanthestapledsecurities.Thesubordinateddebtcannot,however,beseparatelytraded,arestrictionthatsignificantlylimits,inpractice,theabilitytoseparatethecomponentpartsoftheIDSorIPS.Intheoryatleast,theabilitytotradethecomponentpartsseparatelymeansthatthehigh-yieldjunkdebtcomponentmaynotnecessarilybeconsideredtobeheldproportionatelywiththesharesoftheissuer.(Snider,supranote20,at10-11,reportsthatinonesuchstructure,amajoraccountingfirmresignedasauditoroftheissuerbecauseofconcernovertheclassificationoftheparticularsubordinateddebt.)

106 See,forexample,LeeA.Sheppard,“MonetizingOldEurope”(2006)vol.44,no.8Tax Notes International587-90.TheacquisitionofCanadianpubliclytradedbusinesses(bothincometrustandcorporatestructures)byforeign-controlledprivateequityfundswasthesubjectofevidencegivenbeforetheHouseofCommonsFinanceCommitteehearingsonincometrusts.SeeTaxing Income Trusts,supranote10,at15-16.

107 ThesenormativeargumentsarecomprehensivelycanvassedinKimBrooks,“LearningToLivewithanImperfectTax:ADefenceoftheCorporateTax”(2003)vol.36,no.3UBC Law Review621-72.


theseassumptions,amorecomprehensiveequityrecharacterizationrulethanthatsuggestedherewouldberequired,108alongwithexpansionoftheconceptofacor-poration to includea rangeofbusiness trusts andpartnerships, especially in thecontextofinboundforeigndirectinvestment.109

Maintaining the Exception for REITs

OursuggestedmodificationsofthedraftlegislationtoaddresstheuseofstapledsecuritystructureswouldmaintaintheREITexceptionfromSIFTstatus,butonlyoutsidesuchstructures.Thetax-lawboundarythatisimplicatedinthecaseofREITsistheboundarybetweentrustsandcorporationsand,inparticular,theflowthroughtreatmentoftheformerversustheseparate-entitytreatmentofthelatter.Incometrusts (andtheirolderroyaltytrustcousins)substituteatax-deductibleformofsecurity(high-yieldacquisitionindebtednessoraroyaltyinterest)forwhatwouldotherwisebeashareinvestmentintheunderlyingassets.Theunintegratedportionofthecorporateincometaxisavoidedthroughtheconversionofthecashflowsas-sociatedwiththeassetsfromanon-deductibledividenddistributiontoadeductibleinterestexpenseorroyaltydistribution.Fortax-exemptentitiesatleast,thesubsti-tutionisrequiredbecauseofthetax-lawlimitationthatpreventssuchentitiesfromcarryingonabusinessandtherebyholdingtheassetsdirectly.Ineffect,thehigher-taxedcorporateformmustbeused,whichrequiresthesubstitutionofhigh-yieldacquisitionindebtednessoraroyaltyinteresttoavoidtheunintegratedportionofthecorporatetaxonincomefromtheunderlyingassetorassets.Butrealestateisgener-allyaneligibleinvestmentfortax-exemptentitiesandcanbehelddirectlyaspassiveinvestmentsbysuchentities.Thetrustformissubstitutedforthecorporateformtorealizetheeconomiesofscaleandmanagementexpertiseavailablewiththelatterform,whileensuringonlyoneleveloftaxontheearningsoftheunderlyingassets.

Atabroadconceptuallevel,thisdifferentmarginofsubstitutionimplicatedbyREITsdoesnotmeanthat theassociatedpolicy issuesareentirelydifferent fromthoseimplicatedbyincometrustsandroyaltytrusts.110Infact,asasubstituteforthe

108 Asaresponsetoleveragedprivateequitytakeovers,broadlimitationsonthedeductionofcorporateinterestexpensehavebeenproposedinGermanyandDenmark.SeeArneMøllinOttosenandMichaelNørremark,“PrivateEquityFunds—AmendmentstoDenmark’sAnti-AvoidanceLegislation”(2006)vol.60,no.10Bulletin for International Taxation402-10;andMartinA.Sullivan,“Denmark,GermanyToCutInterestDeductions”(2007)vol.114,no.8Tax Notes820-22.

109 Applyingthecorporateincometaxtothereturnoninboundforeigndirectinvestmentwouldrequireextensionofacorporatedeemingruletoalldomesticentitiesthatarecontrolledbynon-residentinvestors.Foradiscussionofthedimensionsofsucharuleanditsassociatedrationale,seeTimEdgar,“CorporateTaxCoordinationasaResponsetoInternationalTaxCompetitionandInternationalTaxArbitrage”(2003)vol.51,no.3Canadian Tax Journal1079-1158.Asdiscussedinthecontextofincometrusts,maintenanceofanunintegratedcorporateincometaxwouldrequireanequityrecharacterizationruleforinterest,rent,androyaltypaymentsmadeinthecontextofinboundforeigndirectinvestment.

110 SeeMartinA.Sullivan,“PassiveActivityorActivePassivity?RisingREITsRocktheCorporateTax”(2003)vol.99,no.9Tax Notes1298-1302.


corporateform,REITsresultinthesameavoidanceofanunintegratedcorporatein-cometax,withtheassociatedrevenueloss.REITsmayalsopresentmanyofthesameefficiencyeffectsasincometrustsandroyaltytrusts.111Thesectorbenefitingfromtheallocativeconsequencesoftheiruseisobviouslytherealestatesector,ratherthanbusinesseswithstablecashflowsandmatureproducingassets,whichareperceivedtobeespeciallysuitableforincometrustsandroyaltytrusts,respectively.Butunlikethelattertransactionalforms,itisnotclearthattheuseofREITsimposesefficiencycoststhatwarrantthemovementofthetax-lawboundarybetweenflowthroughandseparate-entitytaxation.Inotherwords,itisnotclearthattheline-drawingexerciseproposedintheOctober2006proposals,andimplementedinthedraftlegislation,shouldbemodifiedinanefforttorealizeameasureofefficiencygains.TheprospectoftheuseofstapledsecuritystructuresusingtheREITexceptionfromSIFTstatusdoesnotalterthisproposition.Becausethesestructurescouldbeusedastax-effectivesubstitutesforincometruststructures,theyshouldbetaxedconsistentlybyextendingtheap-plication of the draft legislation to explicitly include stapled securities using theREITexception.Theneedtoaddresstheuseofstapledsecuritystructuresdoesnot,however,requireeliminationofthegeneralexceptionfromSIFTstatusforREITs.

AssuggestedintheUScontext,thepolicyunderlyingtheflowthroughtreatmentofREITs,112aswellasmutualfundinvestmentsgenerally,appearstobeadesiretoavoidthetaxwedgeandassociateddistortionsotherwiseimposedbyanunintegratedcorporate income tax.Flowthrough treatmentpermits the realizationofcertainefficienciesassociatedwiththepoolingofportfolioinvestmentwhilemaintainingconsistencyoftaxtreatmentwithadirectholdingoftheunderlyingassetsinun-incorporatedform.Inthisrespect,statusasamutualfundtrust(andtheflowthroughtreatmentfollowingfromsuchstatus)islimited,inparticular,byasetofdefinedconditionsthatcanbeseenasanattempttoensurethatthecashflowsfortheholderofatrustunitlargelymimicthosethatwouldbeassociatedwithadirectportfolioholdingofaninterestintheunderlyingassets.SimilareligibilityconditionsinthedraftlegislationforREITstatusperformmuchthesamefunction.113Theuseofstapled

111 Ibid.,at1299-1300.

112 Seesupranotes41and42andtheaccompanyingtext.SeealsotheOctober2006proposals,whichstateonlythattheflowthroughexceptionforREITs“recognizestheuniquehistoryandroleofcollectiverealestateinvestmentvehicles.”EvidencegivenbeforetheHouseofCommonsFinanceCommitteeontherationalefortheREITexceptioninthedraftlegislationwasunenlightening,amountingtonomorethanthepropositionthattheexceptionwasrequiredbecauseothercountries,particularlytheUnitedStates,provideflowthroughtreatment.SeeTaxing Income Trusts,supranote10,at11-12.

113 Themostsignificantconditionsarethelimitationsontheassetsthatcanbeheldbytheentity.Seesupranotes41and42andtheaccompanyingtext.Thelimitationseffectivelydrawaboundarybetweenpassiverealestateinvestmentandthecarryingonofabusiness,withtheformerservingasaproxyfordisintermediatedinvestmentinrealestate.Asindicatedinnote42,theMarch2007noticeofwaysandmeansmotionshiftedthepreviousboundarybyextendingtheclassofeligibleassetstoincludesecuritiesofanentitycarryingonapropertymanagementfunctiononbehalfofaREIT.


securitystructures,however,requiresamodificationoftheseeligibilityconditionstoensurethatREITstatuscannotbeaccessedtoavoidtheunintegratedcorporatetaxbysubstitutingdeductiblerentalpaymentsforhigh-yieldjunkdebtofacorporateissuer.

Giventheseeligibilityconditions,itissimplynotclear,outsidethecontextofincometrustsandroyaltytrusts,thatmutualfundtrustsingeneral,orREITsinpar-ticular, have involved massaging of the relevant tax-law boundary betweenflowthroughandseparate-entitytreatmentinawaythatattemptstosubstitutethecashflowpatternassociatedwithadirectinvestmentinunderlyingcorporateassetsforthecashflowpatternotherwiseassociatedwithsharesofacorporation.Inshort,apartfromthepossibleuseofstapledsecuritystructures,thereisnoevidencethatREITscanbe,orare,usedassubstitutesgenerallyforthecorporateformofcarryingonabusiness.Noristhereanyevidencethatmutualfundtrusts,withtheexceptionofincometrustsandroyaltytrusts,areusedforanythingotherthantheholdingofwhatwouldotherwisebedisintermediatedportfolioinvestment.

Bywayofcomparison,ithasbeensuggestedthatUSlegislativeamendmentsex-tending the assetbaseof REITs to include securitiesof their taxable subsidiaries(TRSs)couldallowtheexpansionoftheREITstructuretoavoidthecorporatein-cometaxbeyondtherealestatesector.114Apparently,aTRSwouldpermittheuseoftransfer-pricingtechniquessuchasthepaymentofdeductiblerenttotheREITonrealestatepropertiesformerlyownedbytheTRS,aswellasinterestpaymentsondebtof theTRS. Indeed, this structuremimics, toa largeextent, thatof incometrustsandroyaltytrustsandpotentiallypresentsasimilarthreattothecorporateincometaxgenerally.115AnysuchexpansionoftheREITstructureasasubstituteforthecorporateformshouldbeconstrainedinCanadabytheconditionsforqualifica-tionasaclosed-endmutual fund trust,116aswellas theeligibilityconditions forREITstatusunderthedraftlegislation,whichtogetherappeartolimitsubstitutabil-itylargelytotherealestatesector.117

114 Sullivan,supranote110.

115 ButseeSullivan,ibid.,at1300:“Toourknowledge,noMcREITorWalREIThasyettobeformed.Althoughthetaxadvantagescouldbelarge,therearemanycountervailingbusinessreasonsforcorporationstomaintaincontroloftheirrealestate.”

116 ForREITs,themoresignificantconditionsarethoserelatingto(1)thecompositionofeligiblefundassets,whichincluderealestate;(2)therequirementthattrustunitsbelistedonaprescribedshareexchangeinCanada;and(3)thelimitationontheholdingofsecuritiesofasingleissuer(notmorethan10percentoffundproperty).

117 Thispropositionisaccurateprovidedthatapropertymanagementfunctionandservicesancillarytotherentalfunctionareproperlycharacterizedaspartoftherealestatesector.TheextensionofeligibleassetsforREITsintheUnitedStatestoincludesharesofaTRSprovidesforamuchmoreexpansiveconceptoftherealestateinvestmentfunction.Butsee,inthisrespect,TonyM.Edwards,“REITAnalysisWasWrongonManyCounts”(2003)vol.99,no.12Tax Notes1851-52.Inalettertotheeditor,EdwardschallengedSullivan’scontentionregardingtheconversionofUScorporationstoREITs,onthebasisofthefollowingthreeconditionsthatconstrainsuchconversions:(1)nomorethan20percentoftotalassetsofaREITcanbeTRSsecurities;(2)paymentsfromacorporationowned10percentormorebyaREITdonotqualifyas“good”


Intheabsenceofanyevidenceof thetax-drivensubstitutionof trusts for thepubliclytradedcorporateformgenerally,itisdifficulttodefendtheapplicationofseparate-entitytreatmenttoREITswiththeassociatedtaxwedgeintheformoftheunintegratedcorporateincometaxfortax-exemptinvestors.118Apolicydecisionwouldhavetobemadethatconsistencyoftreatmentofbusinesstrustsandthecorporateformgenerallyisdesirable,asopposedtoconsistencyoftreatmentofdisintermediatedandintermediatedinvestmentsinthelimitedcircumstancessetoutbytheeligibilityconditionsforREITstatus.119ForREITs,thiskindofmovementoftheboundarybe-tweenflowthroughandseparate-entitytreatmentwouldpresumablycauseashiftofinvestmentoutoftherealestatesector.However,itisnotclearthatanysuchshiftwouldoffsetexistingtaxprovisionsthatinduceaflowofcapitalintotherealestatesector,therebycorrectingexistingdistortions.Intheabsenceofanysuchoffset,itappearsthatmovingthetax-lawboundarybetweenflowthroughandseparate-entitytreatmentinthismannerwouldproducefew,ifany,efficiencygains.

ThebroadertaxtreatmentofREITsbringsusbacktotheissueoffundamentalincometaxreformasanalternativetomorenarrowlyfocusedmeasures.Thelattermerelyattempttoadjustthetax-lawboundariesbetweenthereturnondebtandequitysecuritiesand/orbetweenflowthroughandseparate-entitytaxationoftrusts,partnerships,andcorporations.Thegoalofamorefundamentaltaxreformwouldbetoachieveconsistencyoftaxtreatmentbyeliminatingtheboundariesaltogether.Thereareanumberofapproachesthatcouldbeadoptedtorealizethisbroadpolicygoal.Theseapproacheshavebeenthoroughlyreviewedintheliteratureandarenotdiscussedhere.Inthecontextofthisarticle,theprincipalpointtobeemphasizedisthatthepolicyargumentssupportingfundamentalreformareentirelyindependentofthenarrowerissuespresentedbyincometrustsandroyaltytrusts(andevenREITs).Theallocative,distributional,andrevenueeffectsofbroaderreformmeasuresshouldbeassessedindependentlyofthenarrowersubstitutioneffectsassociatedwiththeproblempresentedbytheseparticularbusinesstrusts.

rentalincome;and(3)a100percentexcisetaxisimposedwhenaREITandaTRSenterintoanon-arm’s-lengthtransaction.Inresponse,SullivanappearedtoacceptthatEdwardswascorrectinhisanalysisoftheeffectofthecurrentREITlegislation,butwarnedthatfurtherlegislativepressuretolooseneligibilityconditionsforREITscouldhavetheeffectofasubstantialdisincorporationofwidelyheld,non-real-estatebusinessesthatwouldotherwisebelimitedtocorporatestatusunderthecheck-the-boxregulations.SeeMartinA.Sullivan,“MartySullivanConvincedButWorried”(2003)vol.99,no.12Tax Notes1852.

118 SeeEdwards,supranote117(arguingthattherealestatesectorispredominantlyorganizedinunincorporatedform,andthatREITsrealizeconsistencyoftreatmentwiththisorganizationalformwhileallowingaccesstoeconomiesofscalethroughpooling).

119 NewZealand,forexample,hasmadeapolicydecisiontorealizeconsistencyoftreatmentofbusinesstrustsandcorporationsgenerally.Inparticular,apolicychoicewasmadetotreatbusinesstrustsascorporationstoensureconsistencyoftreatmentofrealizedcapitalgainsdistributedtoinvestors.However,itisalsorecognizedthatthispolicychoicecreatesabiasfordisintermediatedinvestment,withassociatedinefficiencies.SeeRobinOliver,“CapitalGainsTax—TheNewZealandCase,”paperpreparedfortheFraserInstitute2000SymposiumonCapitalGainsTaxation,September15-17,2000,16.


A PPendi x irc sec tio n 269 b(a) GENERALRULE.—Exceptasotherwiseprovidedbyregulations,forpurposes

ofthistitle—(1) ifadomesticcorporationandaforeigncorporationarestapledentities,the

foreigncorporationshallbetreatedasadomesticcorporation,(2) inapplyingsection1563,stockinasecondcorporationwhichconstitutesa

stapledinterestwithrespecttostockofafirstcorporationshallbetreatedasownedbysuchfirstcorporation,and

(3) inapplyingsubchapterMforpurposesofdeterminingwhetheranystapledentityisaregulatedinvestmentcompanyorarealestateinvestmenttrust,allentitieswhicharestapledentitieswithrespecttoeachothershallbetreatedas1entity.(b) SECRETARY TO PRESCRIBE REGULATIONS.—The Secretary shall prescribe

suchregulationsasmaybenecessarytopreventavoidanceorevasionofFederalincometaxthroughtheuseofstapledentities.Suchregulationsmayinclude(butshallnotbelimitedto)regulationsprovidingtheextenttowhich1ofsuchentitiesshallbetreatedasowningtheotherentity(totheextentofthestapledinterest)andregulationspro-vidingthatanytaximposedontheforeigncorporationreferredtoinsubsection(a)(1)may,ifnotpaidbysuchcorporation,becollectedfromthedomesticcorporationre-ferredtoinsuchsubsectionortheshareholdersofsuchforeigncorporation.

(c) DEFINITIONS.—Forpurposesofthissection—(1) ENTITY.—The term “entity” means any corporation, partnership, trust,

association,estate,orotherformofcarryingonabusinessoractivity.(2) STAPLEDENTITIES.—Theterm“stapledentities”meansanygroupof2or

moreentitiesifmorethan50percentinvalueofthebeneficialownershipineachofsuchentitiesconsistsofstapledinterests.

(3) STAPLEDINTERESTS.—Twoormore interestsarestapled interests if,byreasonofformofownership,restrictionsontransfer,orothertermsorconditions,inconnectionwiththetransferof1ofsuchintereststheothersuchinterestsarealsotransferredorrequiredtobetransferred.(d) SPECIALRULEFORTREATIES.—Nothinginsection894or7852(d)orinany

otherprovisionoflawshallbeconstruedaspermittinganexemption,byreasonofanytreatyobligationoftheUnitedStatesheretoforeorhereafterenteredinto,fromtheprovisionsofthissection.

(e) SUBSECTION(a)(1)NOTTOAPPLYINCERTAINCASES.—(1) INGENERAL.—Subsection(a)(1)shallnotapplyif it isestablishedtothe

satisfactionoftheSecretarythatthedomesticcorporationandtheforeigncorpor-ationreferredtoinsuchsubsectionareforeignowned.

(2) FOREIGNOWNED.—Forpurposesofparagraph(1),acorporationisforeignownediflessthan50percentof—

(A) thetotalcombinedvotingpowerofallclassesofstockofsuchcorpora-tionentitledtovote,and

(B) thetotalvalueofthestockofthecorporation,ishelddirectly(orindirectlythroughapplyingparagraphs(2)and(3)ofsection

958(a)andparagraph(4)ofsection318(a))byUnitedStatespersons(asdefinedinsection7701(a)(30)).

stapled securities—“the next big thing” for income trusts ... · investment flowthrough n...

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