Private Equity e-COMMUNIQUÉ - April 2017
By Jason (Jake) Bullen, Nicola Geary, Andrew M. Reback, Ken Snider, Kristin Taylor, Xi Chen, Jacquie Richards
In This Issue
- Legal Due Diligence Trends in the Private Equity Industry
- How to Say What You Mean: The Importance of Contractual Bonus Language
- Managing Disclosure Risk in M&A Transactions
- Canadian Federal Income Tax Considerations Applicable in Respect of “Secondary” Transactions
- Non-Resident Private Equity Investors and Management Fees - Some Canadian Tax Considerations
A look at today's private equity landscape from Cassels Brock,
a leader in Canadian mid-market private equity
Legal Due Diligence Trends in the Private Equity Industry
By Nicola Geary, Jacquie Richards
While the nature and extent of due diligence in a private equity transaction is deal-specific, increasing globalization and use of electronic data storage and dissemination practices have created new liabilities including:
- foreign corruption and bribery issues,
- cybersecurity risks, and
- privacy law practices,
all of which are being considered with increasing frequency when performing due diligence on a potential investment or acquisition target.
Anti-Corruption Due Diligence
Recent years have seen an increase in the enforcement of anti-corruption legislation. As such, acquirers must pay increasing attention to whether a target company is in compliance with the Corruption of Foreign Public Officials Act (Canada) (CFPOA)1, Foreign Corrupt Practices Act (US)2 and similar anti-corruption legislation in other jurisdictions. An acquirer must determine whether a target’s activities are acceptable in the home country’s legislation, as home legislation may cover the activities of local companies, citizens and permanent residents even when operating abroad. For example, the CFPOA provides that the Canadian government may assert jurisdiction where a transaction has a “real and substantial” connection to Canada, and over Canadian companies, citizens and residents, regardless of where actions take place. An acquirer must also consider whether the target is in compliance with anti-corruption legislation in the target’s jurisdiction.
Anti-corruption due diligence is by its nature challenging, as violations are often hidden from view. Companies wishing to conduct adequate anti-corruption due diligence need to be creative in looking for red flags. Companies should review the target’s anti-corruption and anti-bribery policies and procedures and assess the robustness of compliance controls to prevent and detect corrupt foreign practices. In addition, it may be necessary to engage local third-party advisors, to review information relating to the approval, recording and monitoring of gifts, travel and entertainment of agents and consultants, to interview key personnel, to contact local government agencies and to review internal/external reviews, audits and examinations.
With the number of high-profile cyber attacks (Target, Ashley Madison, Bell) increasing, regulators, boards of directors and purchasers alike are turning their focus to cybersecurity issues. Cyberattacks can create significant liability for any target, including smaller targets and targets in industries not typically associated with technology. Most companies store records of customers, payment records, employment records, private correspondence - and often much more - electronically, and any of this material can be compromised by malicious third party attackers, which can lead to private suits, regulatory fines (including under the relatively new Digital Privacy Act (Canada) and valuation issues. An acquirer will typically acquire all such records (and attack risks) when acquiring a target.
While it is impossible to expect zero cybersecurity risk during a PE acquisition, this risk can be better understood through thorough due diligence, and mitigated through purchase price adjustments, representations and warranties and/or indemnities. When conducting cyber due diligence, an acquirer should review any previous breaches or cyberattacks to determine how and whether these breaches were addressed or resolved, what additional security measures have been implemented and how the target reacted to the breach. The acquirer should determine whether the target’s data security systems, cybersecurity governance and cyber risk protocols meet with industry standards and whether a target has cyber incident response and monitoring systems in place. It should also determine the target’s exposure based on current security protocols. Where the exposure is large, an acquirer may also wish to review cyber insurance policy coverage and engage experts to assess the extent of liabilities in more detail.
Privacy Law Diligence
In addition to conducting focussed due diligence to assess the target’s protection of its data, both the target and the potential buyer will want to ensure that the due diligence itself does not cause the target to be in breach of its obligations. The Personal Information Protection and Electronic Documents Act, (PIPEDA)3 applies to the collection, use and disclosure of personal information, meaning “information about an identifiable individual” for federal businesses across provincial and national borders as well as for businesses in provinces without substantially similar privacy legislation. PIPEDA applies to commercial activity, meaning it previously applied to personal information collected, used or disclosed during the due diligence process. However, in 2015 the Digital Privacy Act4 amended PIPEDA to include a business transactions exemption. Organizations are now permitted to use and disclose personal information without consent in the context of a business transaction, where necessary, to determine whether to proceed with a transaction, however there are a number of requirements on both the target and the buyer. Both parties must agree in writing to limit use and disclosure to that required for purposes related to the proposed transaction, to protect the personal information with appropriate security safeguards and to return or destroy personal information if a transaction does not proceed. In the event that the transaction does proceed, notice must be provided to the owners of the personal information.
1 SC 1998, c 34.
2 15 USC § 78dd-1, et seq.
How to Say What You Mean: The Importance of Contractual Bonus Language
By Kristin Taylor
In the last several months, Canadian appellate courts have considered employer’s bonus plans three times. Having discussed the implications of these decisions with many clients, the common reaction seems to be: But that isn’t what we meant when we drafted our plan! Rather than debate how language can be misinterpreted, the more constructive approach simply is to fix it. When these appellate decisions are considered carefully, the take-away message for employers is that incentive plan language will be carefully scrutinized and entitlement only excluded where the language clearly supports that result. Accordingly, now is the time for employers to review their existing plans and policies and update them, where appropriate, to ensure that they will be interpreted as they intended.
In our e-Lert “Top 10 Employment & Labour Law Cases and Trends in 2016,” we noted two of these appellate court decisions: Paquette v. TeraGo Networks, 2016 ONCA 618 (Paquette) and Lin v. Ontario Teachers’ Pension Plan, 2016 ONCA 619 (Lin). Both decisions were released by the same panel of the Ontario Court of Appeal in August 2016. One of the issues common to both decisions was entitlement to bonus payments following dismissal.
In Paquette, the bonus program required the employee to be “actively employed” on the date of payout to be eligible. In prior years, the employee had been awarded between $7,800 and $31,800 in annual bonus. The Court of Appeal found that the “active employment” pre-condition for the payment of bonus did not limit his common law right to the inclusion of bonus in his damages for wrongful dismissal. Rather, the Court of Appeal found that a term requiring active employment when the bonus is paid, without more, is not sufficient to defeat a claim for compensation for stub bonus through the date of termination as well as the inclusion of bonus on top of salary during the period of pay in lieu of notice.
In Lin, the employer sought to rely on a Long-Term Incentive Plan (LTIP) definition of Termination Date that “for greater certainty, does not include any period following the date on which a Participant is notified that his or her employment or services are terminated (whether such termination is lawful or unlawful) during which the Participant is eligible to receive any statutory, contractual or common law notice or compensation in lieu thereof or severance payments.” The Plan provided that on the Termination Date, a Participant would forfeit any and all rights to be paid a bonus under the plan. This definition, however, was introduced in a LTIP amendment that employees, including Lin, refused to accept. Accordingly, the Court of Appeal found that the employer could not rely on it. This meant the employer was left relying on earlier plan wording that simply provided if a Participant resigned or was terminated, grants not yet vested at the time of termination would be forfeited without any right to compensation. The Court of Appeal again found this wording to be insufficient to unambiguously alter or remove the employee’s common law right to damages for bonus he would have received during the reasonable notice period. The Court of Appeal did not comment on the effectiveness of the LTIP amendment; however, it appears to address the concern identified with the earlier wording. It specifically removed the common law right to damages for lost bonus following the date on which employment terminates. One caution though: The language purports to contract out of section 60(a)(a) of the Employment Standards Act, 2000 which prohibits employers from altering any term or condition of employment during the statutory notice period.
More recently, in January 2017, in Styles v. Alberta Investment Management Corporation, 2017 ABCA 1 (Styles), the Alberta Court of Appeal overturned a Court of Queen’s Bench decision that held an employee with less than four years of service was entitled to a bonus under his employer’s LTIP that expressly required four years of service for the bonus to vest. The basis upon which the Court of Queen’s Bench concluded the employee’s grant should not have automatically forfeited was the stated requirement that the employer exercise its discretion in administering the LTIP fairly and reasonably relying on the Supreme Court of Canada’s decision in Bhasin v. Hrynew, 2014 SCC 71 (Bhasin). The Alberta Court of Appeal unequivocally rejected the analysis of the Court of Queen’s Bench.
The contractual language of the LTIP, as always, is critical. In this case, the Court of Appeal found that, on a plain reading of the LTIP bonus was only paid when they vest under a four year cycle, a participant must be actively employed on the vesting date which did not include a period of notice or payment in lieu, and the employee was terminated before he completed four years of employment. The employee argued that there was a discretion involved in the forfeiture because the LTIP provided that “entitlement to an LTIP grant, vested or unvested, may be forfeited upon the Date of Termination of Active Employment...”. The Court of Appeal disagreed and determined that “may” merely indicated that upon certain events the right to a bonus would be lost. “May” was found to operate as a warning or caution, not a signal of discretion.
The employee also argued that the employer was required to exercise its discretion to only terminate his employment with a justifiable reason. The Court of Appeal rejected this argument as well. In so doing, the Court of Appeal also set out important, fundamental employment law principles of interpretation worth repeating in view of the uncertainty created by Bhasin:
- Reasons are not needed for termination without cause, not because the employer does not have reasons, but simply because fundamental incompatibility between the employee and the employer, or the work, or other employees, is difficult to express in words. [para.37]
- The general duty of good faith in contract law did not “...extend to the employer’s reasons for terminating the contract of employment because this would undermine the right of an employer to determine the composition of its workforce.” [para.46]
- The Bhasin principle relates to the performance of the contract; it does not relate to the negotiation or terms of the contract. In particular, it does not invite the court to examine the terms of the contract to assess whether they are fair and reasonable. [para. 51]
- Bhasin does not make it dishonest, in bad faith or arbitrary to require performance of a contract in accordance with its terms. [para. 52]
- Refusing to pay a bonus that is not payable is not dishonest. [para. 52]
- Acting in one’s self-interest in a commercial contractual context is neither dishonest, capricious, nor arbitrary. [para. 57]
- Whatever the reasons, if one party to a contract is given a discretion, it should be allowed to exercise that discretion without being second-guessed by the courts with the benefit of hindsight. [para. 60]
Of particular note is the Court of Appeal’s conclusion that the employer’s point of view that it was unreasonable for the employee to claim a bonus to which he agreed he would not be entitled, is just as worthy of consideration as the employee’s claim that it was unreasonable for him not to have received a bonus. According to the Court of Appeal, the fairness and reasonableness analysis require a consideration of the positions of both sides, remembering that each party is entitled to promote its own interests.
When reviewed collectively, three take-aways from these decisions are:
- Bonus plan language should acknowledge that it is a reward for past performance as well as an incentive for future performance.
- Bonus plan language, like pension language and stock option language, must expressly and precisely contract out of any period of notice or severance required under statute or contract and reasonable notice under common law. There is an exception for Ontario employers who should acknowledge that the notice period required by the ESA extends the date following which forfeiture can occur.
- Requiring “active employment” as a condition of bonus payment will not effectively eliminate an employee’s entitlement on termination, except where – as in Styles – it is a pre-condition to even participating in a plan. The key in Styles is that a lengthy (four year) period of employment was required to be eligible to participate in the plan.
As with the trend we are seeing for courts to enforce unambiguous termination provisions, we expect to see courts enforce properly drafted incentive plan language as well. It is definitely incumbent upon employers though to review their existing language to ensure that it says what you mean considering the case law above.
Managing Disclosure Risk in M&A Transactions
By Jason (Jake) Bullen, Xi Chen
The disclosure of confidential information during the negotiation and due diligence phases of an M&A transaction can expose the disclosing party to various risks. For example, competitors can initiate M&A discussions as a strategic tactic to gain access to sensitive proprietary information and to exploit that information at the expense of the disclosing party. In a hyper-competitive and technology-focused business environment, the protection of confidential information (and other intellectual property) should be a priority for all businesses – particularly during a merger or acquisition.
An example of the inherent risks in M&A disclosure is found in the ongoing US litigation between Stingray Digital Group (Stingray) and Music Choice. On June 6, 2016, Stingray, a publicly-traded Canadian media and entertainment company, was accused in the courts of the Eastern District of Texas of infringing on patents owned by Music Choice, a US provider of digital music. Stingray allegedly gained access to the patents during a failed attempt to acquire Music Choice in 2013. Since June 2016, Stingray has filed a countersuit alleging that Music Choice is engaged in a “smear campaign” designed to damage Stingray’s reputation through the dissemination of misinformation.
In the M&A context, a company should consider both legal and logistical methods to minimize disclosure risk. In particular, a company should not disclose any confidential information to a third party without first negotiating and executing an appropriate non-disclosure agreement (or, NDA).
A strong NDA (or confidentiality agreement) includes a comprehensive and relevant definition of confidential information, a clear definition of the permitted use of such information and covenants addressing the appropriate standard of care to protect the confidential information. An NDA should also prohibit any reverse engineering, decompiling or disassembling of the information.
The importance of the definition of “confidential information” is evidenced by the judgment in Visagie v TVX Gold Inc1. The facts relate to the aftermath of a failed joint venture attempt to purchase a mine, where one party (TVX) made an independent (and successful) bid for the intended target of the proposed joint venture a few months later. At trial, TVX argued that it was free to use the information provided by the disclosing party because the information was not “confidential” and therefore was not protected by the provisions of the NDA. The Ontario Court of Appeal, as part of its analysis on the breach of confidentiality, determined that the information provided by Visagie to TVX “had the necessary quality of confidentiality to be worthy of protection in law.” The Court found that “Mr. Visagie developed new information, new theories and new presentations on existing data so that he created new information which was confidential information to him until he disclosed it to others”. Further, the court determined that TVX first became interested in acquiring the mine because of the information provided to it by Visagie and that it used this information as a springboard in the ultimate acquisition. Consequently, the Court upheld the trial judge’s decision and recognized the existence of a constructive trust over the mine. In drafting NDAs, it is therefore important to define specific types – and forms (including verbal disclosure) - of information that are considered to be confidential.
Similarly, settling a precisely crafted definition of “permitted use” is also essential to an NDA. In Certicom Corp v Research in Motion Ltd2, an NDA was signed in contemplation of a friendly acquisition. However, when Research in Motion (RIM) initiated a hostile takeover after failed negotiations, Certicom asked the Ontario Superior Court to prevent RIM from continuing its bid. The signed NDA specifically limited the use by RIM of confidential information only for certain permitted “purposes,” which was defined to mean “some form of business combination between the Parties.” The Court found that RIM’s hostile takeover bid could not be interpreted to fall within the permitted “purposes” contemplated by the agreement, as a hostile takeover bid could not be understood as a business combination “between” the parties as the word “between” connotes each party’s consent and agreement. In reaching this conclusion, the Court placed considerable emphasis on the intention of the parties as determined through the wording of the NDA.
Significant consideration should also be given – particularly in a cross-border deal – to the governing law and forum clauses in an NDA, which should clearly indicate the jurisdiction that governs the agreement and the relevant forum for dispute resolution. Well-drafted governing law and forum clauses will reduce (if not eliminate) the ability of the receiving party to argue that conflict of law principles provide that another jurisdiction and/or forum (more beneficial to such party) should apply. Where the two parties are situated in different countries, litigation concerning applicable laws and forums can quickly become complex and expensive, so disclosing parties should take the time to confirm the desired jurisdiction and forum, as well as any exceptions to the governing forum (such as injunctive relief where the recipient is breaching the NDA in another jurisdiction).
Where the confidential information pertains to formulae, code, processes or methodologies, it is prudent to include a provision prohibiting the reverse engineering, decompiling or disassembling of the disclosed information. Further, one or both parties may choose to prohibit the other from soliciting its existing employees, customers and suppliers through restrictive covenants in the NDA.
Finally, an NDA should provide for specific performance and injunctive relief in the event of a breach by the recipient, including the actual or threatened disclosure of the confidential information.
Common Law Remedy
In many circumstances, a written NDA will not exist between the parties. For example, most venture capital funds refuse to sign NDAs.3 This is a risky situation for the disclosing party, but where an NDA is not in place, the Supreme Court of Canada has clarified that a common law remedy of “breach of confidence” can be established under certain criteria. However, the threshold is high and this is not a suggested strategy. The leading case (International Corona Resources Ltd. v LAC Minerals Ltd)4 provides that in the absence of a signed NDA, LAC’s misuse of confidential information obtained from Corona constituted a breach of confidence. However, in order to establish breach of confidence, Corona had to prove that:
a) the information conveyed was confidential5;
b) the confidential information was conveyed in confidence; and
c) the confidential information was used in an unauthorized manner by the party to whom it was communicated.
This three part analysis requires proof of subjective knowledge and requires an assessment of whether the third party knew or ought to have known that the information is confidential. In order to circumvent this complex and subjective analysis, it is much more efficient to establish through an NDA that specific obligations of confidentiality apply.
The disclosure of highly sensitive information such as trade secrets6 must be accompanied by contractual protection; otherwise the value of the information disclosed may be significantly compromised. Unlike patents, which are protected by statute upon disclosure to the relevant regulatory body, trade secrets do not enjoy legislative protection. Instead, in order for a trade secret to hold common law rights of exclusivity, it must maintain its status by being kept confidential (for example, being safeguarded by employees). Disclosure without the proper contractual framework may result in the information losing its “trade secret” status and thereby expose the information to reverse engineering and replication with no legal remedy.
The Oculus Decision
The recent (and highly publicized) February 1, 2017, decision (Texas Northern District Court) in ZeniMax Media, Inc. v. Oculus VR, LLC7 highlights the difficulty of establishing the misappropriation of trade secrets versus a breach of an NDA. In a claim filed after Facebook offered US$2.3 billion to acquire Oculus, ZeniMax alleged (in a US$6 billion claim) that Oculus and the other defendants8 misappropriated trade secrets, breached an NDA between ZeniMax and Oculus and infringed copyright and trademarks. The jury ultimately found Oculus guilty of copyright and trademark infringement, as well as breach of the NDA. For its infringement and breach, Oculus was found liable for US$250 million and other defendants were found liable for another US$250 million for false designation.
Although ZeniMax’s primary claim was for misappropriation of trade secrets (including the following technologies: (1) distortion correction technology; (2) chromatic aberration correction method; (3) gravity orientation and sensor drift correction technology; (4) head and neck modeling technology; (5) HMD view bypass technology; (6) predictive tracking technology; and (7) time warping methodology), the jury did not find in favour of ZeniMax on this point. Instead, after hearing the evidence, the jury determined that while Oculus had infringed both ZeniMax’s copyright in code and trademarks, ZeniMax failed to establish by a preponderance of evidence that:
(1) any trade secrets existed;
(2) the defendants acquired the trade secrets through breach of a confidential relationship or by improper means;
(3) the defendants made commercial use of the trade secrets in their business without authorization; and
(4) ZeniMax suffered damages as a result.9
Without the benefit of legislative protection, NDAs and other steps designed to preserve confidentiality are paramount to the effective protection of sensitive information constituting a trade secret. This case is ongoing as ZeniMax filed a motion dated February 23, 2017 seeking a permanent injunction to stop Oculus from using and distributing products that infringe ZeniMax’s copyrights.
Practical Tips – What and When to Disclose
Whether or not a written NDA exists, a number of practical steps are recommended for disclosing parties in the M&A context. It should be noted that courts will assess the precautions that a disclosing party took to ensure the secrecy of confidential information. Accordingly, consider the following suggestions:
- Internal controls and risk management. Vendors should implement internal controls to ensure that a robust framework is in place to effectively identify and mitigate the threat of disclosure from within the company, including:
o implementing policies addressing the management of confidential information (both in tangible and electronic forms) (e.g., require password protection for documents);
o fragmenting confidential information and restricting access; and
o entering into appropriate NDAs with employees and independent contractors, and conducting entry and exit interviews with these individuals to ensure compliance with obligations of confidentiality.
- Clean Teams. Where transacting parties are competing firms, competition law considerations become relevant to the due diligence process. In order to facilitate the safe transmission of confidential competitively sensitive information, parties should assemble “Clean Teams” to a) exchange and retain information without disclosing it to others within the organization and b) filter and sanitize information for targeted consumption. Clean Teams can consist of both external advisors and internal business people and the composition of the team should evolve as the transaction progresses.
- Staged disclosure. As important as contractual provisions are for the protection of confidential information, once the information is disclosed, the proverbial genie is out of the bottle and the recipient will have knowledge of the contents. It may be difficult to prove that the recipient used the information in an unauthorized manner (for example, in learning of the disclosing party’s business strategy, the recipient may simply alter its own strategy) so it is crucial to consider staggering the disclosure of information. The vendor should first assess the information that purchasers will want and need to know. Critical information should be separated from the balance, and the most sensitive information (for example, information that could be patentable or is considered a trade secret, or customer lists and customer contracts that show pricing details) should not be disclosed until as late as possible in the deal process. As noted above, a trade secret should never be disclosed without an NDA in place.
- Personal Information. The Personal Information Protection and Electronic Documents Act10 (or PIPEDA) restricts the collection, use and disclosure of an individual’s personal information (as defined under the Act) in the context of “commercial activity” without the consent of the individual. PIPEDA was amended in June of 2015 and now permits organizations to use and disclose personal information without consent in the context of a business transaction (inclusive of due diligence in M&A, a partial sale of assets or transfer upon insolvency). The exemption only applies, however, if the parties enter into an agreement to: a) only use and disclose personal information for purposes related to the proposed transaction, b) protect the information with appropriate security safeguards and c) return or destroy the information if the transaction does not proceed. Once the transaction is complete, Section 7.2(2) of PIPEDA requires either party to a transaction to notify affected individuals, within a reasonable amount of time after closing, that the transaction is complete and that their personal information was disclosed pursuant to the exemption.11 In order to comply with PIPEDA requirements and in keeping with the objectives of preserving confidentiality and minimizing unintentional disclosure, it is advisable for vendors to anonymize any personal information (at least in the early stages of disclosure).
- Initial due diligence on the bidder. Performing due diligence to understand a bidder’s business profile, transaction strategy and litigation history can be an effective way to filter out companies seeking access to information for misuse.
- Security precautions. Where highly sensitive information is to be disclosed, the vendor may consider further security precautions, such as only providing hard copies with watermarks and possibly a hidden mark and/or individually numbering each copy provided and restricting copies from being made.
- Cybersecurity. Given that most documents are shared and exchanged electronically through virtual data rooms (VDRs), vendors should carefully evaluate data room providers to utilize only secure services. Competitive VDRs should offer data encryption upon upload and deploy effective firewalls to keep the information safe once uploaded. Desirable features include the automatic watermarking of documents and selective print/ save functionalities to restrict document dissemination. Beyond the data room, parties should also negotiate and build into the deal documents risk allocation provisions in the form of representations and warranties, indemnities and holdbacks that will allocate the costs of cyberbreaches, whether discovered before or after closing.
1 Visagie v. TVX Gold Inc.,  OJ No. 1992, 49 OR (3d) 198 (Ont CA). (“Visagieb v TVX”)
2 Certicom Corp. v. Research In Motion Limited,  OJ No. 252, 94 OR (3d) 511 (Ontario Superior Court).
3 Indeed, some funds and technology companies require companies that intend to disclose information to sign “Non-confidentiality Agreements” that make it clear the recipient can use the information received - since it is likely that similar information is being generated within the recipient’s business.
4 Lac Minerals Ltd. v. International Corona Resources Ltd.,  2 SCR 574 (SCC).
5 For a discussion on the nature of “confidential information”, see Visagie v TVX at para. 42-46.
6 A formula, process, device, or other business information that is kept confidential to maintain an advantage over competitors; information — including a formula, pattern, compilation, program, device, method, technique, or process — that (1) derives independent economic value, actual or potential, from not being generally known or readily ascertainable by others who can obtain economic value from its disclosure or use, and (2) is the subject of reasonable efforts, under the circumstances, to maintain its secrecy. Black’s Law Dictionary, 10th ed, sub verbo “trade secret”.
7 Zenimax Media Inc et al v. Oculus VR Inc et al, 166 F.Supp.3d 697 (N.D. Tex.).
8 Defendants included Facebook, Inc., Palmer Luckey and Samsung Electronics America, Inc.
9 Max Hooper and Brian Sommer, Verdict Analysis: Why the Jury Awarded ZeniMax $500 Million in Oculus Lawsuit, Online: Road To VR (February 2, 2017) <http://www.roadtovr.com/verdict-analysis-why-jury-awarded-zenimax-500-million-oculus-vr-lawsuit-facebook-id-software/>
10 Personal Information Protection and Electronic Documents Act, S.C. 2000, c. 5.
Canadian Federal Income Tax Considerations Applicable in Respect of “Secondary” Transactions
By Ken Snider
This article summarizes the principal Canadian federal income tax considerations generally applicable in respect of a “secondary” sale of an interest in a limited partnership (LP Interest). A secondary sale is considered to be a sale by a limited partner of its LP Interests, to another or new limited partner, in contrast to an issuance of an LP Interest by a limited partnership (an LP).
As a preliminary matter, the applicable LP Agreement must be reviewed to address various tax related matters such as income allocation provisions, and the conditions of transferability of the LP Interests, as there may be restrictions relating to the tax status of the purchaser, such as requiring the purchaser being a resident of Canada for purposes of the Income Tax Act (Canada) (the ITA). It is very important to identify multi-jurisdictional considerations as early as possible. These would include determining the jurisdiction(s) in which the seller or purchaser may have tax filing obligations or potential tax liability.
Seller Tax Considerations
A seller will realize a capital gain (or capital loss) equal to the amount by which the proceeds of disposition exceeds the Canadian tax cost of the LP Interest, plus reasonable costs of disposition. The Canadian tax cost will require a computation commencing with the original cost to acquire the LP Interest and various ongoing additions or deductions. Partnership income (or loss) will be allocated to the former partner for the fiscal year in which the taxpayer ceases to be a member. The income (or loss) allocated will increase (or decrease) the tax cost of the LP Interest.
The seller should ascertain the Canadian tax status of the purchaser of the LP Interest as soon as possible, and obtain tax advice whether a special rule in the ITA could apply to increase the proceeds of disposition (and taxable capital gain). In summary, this can occur if the LP Interest sold to a certain type of person, and certain tests are satisfied.
If the seller is a non-resident of Canada for purposes of the ITA, and LP Interest is “taxable Canadian property”, the seller must comply with certain tax clearance requirements, tax return filing requirements, and potential tax liability subject to whether the gain is protected from Canadian tax under a tax treaty.
Purchaser Tax Considerations
If the prospective purchaser of the LP Interest is a non-resident of Canada for purposes of the ITA, it must be determined whether (a) it is permitted by the LP Agreement to purchase the LP Interest directly, (b) if so, whether it will be subject to ongoing Canadian tax compliance obligations, or (c) whether it should use a Canadian corporation to acquire the LP Interest. There will be many additional Canadian tax considerations if a Canadian subsidiary is used.
A prospective purchaser who is subject to tax in Canada in respect of its share of future gains realized by the LP will wish to investigate whether there is any inherent gain in property of the LP Interest at the time acquisition. Generally, the tax cost of any partnership property will not be written up to fair market value. Consequently, if the property is sold by the LP in the future, the purchaser will be allocated some gain that was inherent at the time they became a partner.
Another due diligence consideration for the purchaser is to investigate how the income of the LP will be allocated to it for the year of a purchase and how this relates to cash distributed. The purchaser will want to be aware of whether there will be an “inappropriate” amount of income allocated to it.
Another consideration that can arise LP Interest, in certain instances, is where the “at risk” rules in the ITA apply. These rules can limit the amount of a loss that can be deducted by a limited partner from a business. These rules, in effect restrict the amount of the loss to not exceed the taxpayer’s “at risk amount” at the end of the relevant fiscal year. The at risk amount in respect of a LP Interest includes the Canadian tax cost of the LP Interest to the purchaser, computed in accordance with a very specific rule relevant to secondary acquisitions. Where a taxpayer has acquired the LP Interest at any time from a transferor, other than the partnership, there is a deeming rule that in effect will deem the at-risk amount of the purchaser to be nil (subject to exceptions) unless the Canadian tax cost of the seller can be determined by the purchaser.
Non-Resident Private Equity Investors and Management Fees - Some Canadian Tax Considerations
By Andrew M. Reback
Typically in the case where a non-resident private equity group (Non-Resident Group) acquires a Canadian target (Canco), the Non-Resident Group provides management services to Canco in exchange for an annual fee. Such management services would include consulting, financial, accounting and/or administrative type services. Non-Resident Groups should be aware that such fees may be subject to Canadian withholding tax which would be withheld and remitted by Canco to the Canada Revenue Agency (CRA).
Paragraph 212(1)(a) of the Income Tax Act (Canada) provides that a 25% withholding tax shall be payable on “a management or administration fee or charge” that is paid by a Canadian resident to a non-resident, subject to certain exemptions. Management fees paid under management services agreements in the context of private equity transactions would typically fall under this provision. However, if the management services provided by the Non-Resident Group were performed in the ordinary course of its business and Canco and the Non-Resident Group were dealing with each other at arm’s length (i.e., non-resident does not control Canco such as in a minority deal) the withholding tax should not apply.
If the management fees are not exempted from the withholding tax as provided above, the withholding tax may often be exempted under an applicable tax treaty. For example, in the case of the Canada-US tax convention, management fees are treated as business profits and as long as the business is not carried on by the US private equity group through a permanent establishment in Canada, any management fees paid to the US private equity group by Canco will generally be exempt from Canadian tax.
In addition to the management fee withholding tax mentioned above, regulation 105 of the Act provides for a 15% withholding tax to be withheld by Canco on any fee, commission or other amount paid to a non-resident person in respect of services rendered in Canada. If services are rendered in Quebec, an additional 9% withholding tax may be applicable. Accordingly, this withholding tax does not apply if no services are rendered in Canada (i.e., all services are rendered from the US).
In the event that the services are rendered in Canada, the Non-Resident Group could apply to CRA for a waiver of this withholding tax if it can demonstrate that it does not have a permanent establishment in Canada pursuant to the applicable treaty or the 15% withholding tax exceeds its Canadian tax liability after taking into account expenses to render the services. Until a waiver is obtained, Canco must withhold the tax.
To summarize, non-resident private equity groups should be aware of the Canadian tax implications regarding management fees that they charge to their Canadian portfolio companies, however this tax should not apply if a tax treaty is applicable, the non-resident private equity group does not have a permanent establishment in Canada and all services are rendered by the non-resident from outside Canada.