Mirroring worldwide activity, Canadian private equity has experienced substantial growth in recent years, both in fund formation and investment activity.
On the fund side, there has been a redirection of institutional capital from public markets to private equity, leading to significant capital commitments being made to new funds by institutional investors. The Canadian government’s elimination in 2005 of limits on institutional holdings of non-Canadian property has significantly increased capital allocated to foreign investment.
On the investment side, Canada’s strong economic fundamentals, combined with restructuring to reflect the pressures of an integrated North American economy and active and developed capital markets, have led to increased investment activity (incoming and outgoing) from both Canadian and foreign capital sources.
When PE sponsors take a position in private companies, the investments are most commonly made through convertible preferred stock, although investors will use subordinated debt that is convertible into common stock or accompanied by warrants to acquire common stock. Convertible preferred stock offers numerous advantages including priority on liquidation or sale, preferred return, preferential voting or consent rights on material matters and convertibility that facilitates liquidation transactions.
Subordinated debt convertible into common stock or accompanied by warrants also offers these advantages, with the additional benefit of security on the assets of the investees. Securities legislation generally requires the issue or transfer of securities to be affected through a prospectus or made in reliance on a specific prospectus exemption.
Private equity-backed acquisitions of public companies have become more popular in recent years for a variety of reasons, including the high costs of compliance with new corporate governance rules and the occasional instances of limited liquidity of the Canadian public markets. The public-to-private buyouts are typically completed through either a one-step amalgamation or plan of arrangement transaction where the target is merged with a wholly owned subsidiary of the buyer or a two-step process involving a takeover bid followed by an amalgamation or other squeeze-out transaction. Under Canadian corporate law, amalgamations, arrangements and other forms of going-private transactions typically require shareholder approval of 66% of the votes cast at a shareholders’ meeting.
Canadian corporate laws provide safeguards for minority shareholders in a taking-private buyout, including the right for shareholders to dissent from fundamental corporate changes (such as an amalgamation) and to have their shares purchased at “fair value” as determined by a court. In addition to corporate legislation, Ontario and Québec securities rules attempt to ensure fair dealing for minority shareholders in going-private and insider transactions. If applicable, the most important requirements imposed by these rules are to prepare and disclose a valuation of the target; obtain “majority of the minority” approval of each class of equity shareholder; and provide certain prescribed disclosure to shareholders.
For non-Canadian investors, there area certain ownership restrictions sponsors need to take into account.
Investments by non-Canadians to acquire control of existing Canadian businesses or to establish new ones are either reviewable or notifiable under the Investment Canada Act, depending on the value of the assets being acquired and the status of the investor. The rules relating to acquisition of control and whether an investor is “Canadian” are complex and comprehensive. An investment will also be reviewable, regardless of asset value, if it falls within a prescribed business activity related to Canada’s cultural heritage or national identity.
A reviewable transaction may not be completed unless the federal government is satisfied that the investment is likely to be of “net benefit to Canada.” Other laws limit foreign ownership in sensitive industries such as airlines, financial services, broadcasting and telecommunications.
On top of ownership restrictions, there are also certain tax implications that U.S. investors need to keep in mind as well. In addition to Canadian taxation of capital gains, dividends, interest, royalties and certain other payments paid by a Canadian resident to non-residents are subject to 25% withholding tax on the gross amount, subject to certain exemptions under Canada’s Income Tax Act or rate reduction under the Canada-U.S. Tax Convention. Of particular note for U.S. private equity investors, the Canada Revenue Agency (“CRA”) does not consider an LLC to be a U.S. resident for the purposes of the Canada-U.S. Tax Convention and it, therefore, is not eligible for benefits under the Convention including the reduction in withholding tax rates. There are structural solutions which may be implemented at the outset of an investment to avoid these adverse effects.
Private Equity Exits
The most common form of exit from Canadian portfolio investments remains a trade sale. While value may be less than could be received on an IPO, the generally shorter time frame, limited securities regulatory compliance and greater deal certainty frequently favor a trade sale.
IPOs through Canadian income trusts have also been an extremely successful exit strategy for private equity investors. Thirty two initial public offerings of income trusts were completed in Canada in 2005, bringing the market to 229 issuers with total market capitalization of C$190 billion. The main reason for this success is straightforward. In addition to the higher valuations placed on public companies by virtue of their inherent liquidity, income trusts are structured to minimize or eliminate corporate tax, resulting in higher earnings and, therefore, a higher valuation.
Income trusts achieve their tax efficiency by either using partnerships to own their assets or employing a significant amount of internal corporate debt, which results in deductions for interest expense that minimize the taxable income of any taxable subsidiaries within the structure. Provided that all the income receivable by the income trust (including dividends and interest), is paid or payable by year end to unitholders, the trust will not be required to pay tax on its income and the unitholders will be taxable.
To respond to increasing investor demand, the Canadian income trust market expanded to include trusts established to acquire U.S. businesses. As with an income trust that owns a Canadian business, a key feature of many of these trusts involves the distribution by the operating business of a significant amount of its cash flow as interest on internal debt, thereby enabling the operating company to reduce its taxable income in the U.S. These trusts have also been structured to take advantage of the U.S. portfolio interest exemption in respect of U.S. withholding tax and to not be subject to the U.S. “earnings stripping” rules.
As these structures proliferated, concerns arose that the debt of the U.S. business was not sufficiently separate from the equity to support the debt characterization. As the deductibility of interest on internal debt is critical to tax structuring, these concerns created uncertainty about the U.S. tax treatment of cross-border trusts. The result was an effective standstill in the creation and marketing of trusts holding U.S. businesses.
A noteworthy development in May 2006 was the “conversion” of Cinram International Inc., a public Canadian corporation, into an income trust with the objective of enhancing shareholder value. A unique feature of this conversion, which may have broader implications for cross-border income trusts, is Cinram’s substantial U.S. source of revenue.
Tax Considerations for U.S. Residents
Just as there are tax implications to be considered when buying a company in Canada, U.S. investors need to keep in mind certain tax considerations when unloading an investment. The principal Canadian tax considerations under the ITA applicable to U.S. private equity investors are the Canadian taxation of capital gains and compliance obligations.
Non-residents of Canada are taxable on capital gains resulting from the sale of “taxable Canadian property,” subject to tax treaty protection. The Canada-U.S. Tax Convention provides that a U.S. resident will not generally be taxable under the ITA on a capital gain on shares unless the shares are of a corporation resident in Canada, the value of which is derived principally from Canadian real property. As mentioned above, an LLC is not recognized by the CRA as a U.S. resident under the Convention.
There are two important tax compliance obligations for non-residents. First, a non-resident disposing of a taxable Canadian property must generally provide a clearance certificate to a purchaser regardless of whether there is a gain; if no certificate is provided, the purchaser must withhold and remit 25% of the purchase price to the Canada Revenue Agency. If a clearance certificate is not issued and the purchaser remits, the seller will have to file a Canadian tax return and claim a refund of the withheld amount based on the Convention, if applicable.
Where the taxable Canadian property is sold by a partnership, the partnership is required to obtain a clearance certificate for each of its non-resident partners as they are treated as realizing the capital gain directly. There are structural solutions that may be implemented at the outset of the investment to avoid filings by each non-resident partner where to do so would be unduly onerous.
Secondly, any person disposing of a taxable Canadian property including all partners, must file a Canadian tax return even if Convention protection is claimed and a clearance certificate is obtained.
Although important structural and legal differences remain between raising and investing private capital in Canada and the United States, steps taken by the Canadian federal government to reduce restrictions on the use of institutional capital, the continued growth of domestic private equity markets, continued positive experiences of U.S. sponsors with Canadian businesses and the resilience and demand for yield securities by Canadian capital markets all point to an increasing flow of cross-border private equity transactions for the foreseeable future. There is no question that Canada will remain an important source of private equity capital and investment opportunities as the industry expands and evolves around the world.
Michael Gans is a partner in the New York office Blake, Cassels & Graydon LLP, where he focuses on cross-border transactions between the U.S. and Canada. Rob Collins and Ken Snider, partners in Blake’s Toronto office, also contributed to the article.