In This Issue
A look at some important tax aspects of today's private equity landscape from Cassels brock, a leader in canadian mid-market private equity.
Non-Resident Private Equity Investors and Management Fees - Some Canadian Tax Considerations
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 Canada Revenue Agency (CRA).
Paragraph 212(1)(a) of the Income Tax Act (Canada) (the Act) 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.
The Tax Implications of Rep and Warranty Insurance
In purchase and sale transactions, the parties can obtain insurance to compensate them for financial loss arising from inaccuracies in the representations and warranties made in the purchase agreement. Popular in the USA, “R&W” insurance for Canadian purchase transactions is still somewhat novel. As a result, the tax implications of such insurance have remained largely unexplored.
To understand the tax implications of R&W insurance, it is important to understand how R&W insurance works. The party that pays for the R&W insurance is negotiated as part of the transaction and largely depends on which party requires the insurance. In some cases, the seller prefers to obtain R&W insurance, rather than a holdback or escrow of a portion of the purchase price. In other instances, the buyer requires the insurance to satisfy its lenders.
The premiums for the policy typically range from 4-8% of the insured amount, payable in one instalment, for the entire term of the policy. There is a flat underwriting fee payable to the insurer for undertaking the due diligence process required to insure the transaction, regardless of whether or not the policy is written. The term of the policy is normally the applicable limitation period of the insured R&W.
The tax treatment of the premium as well as any payout under the policy is dependent upon on who is paying the premium and receiving the payment. Different alternatives are discussed below.
Seller Pays Premium
Typically in a seller-side policy, the seller is the beneficiary and the party making a claim under the policy. If a seller R&W is breached, the seller makes a claim under the policy and insurance proceeds are paid to the seller, who then makes a payment to the buyer in the form of an indemnity payment. If the seller pays the R&W premium, it is likely that the premium will be considered to be a cost incurred to implement the sale of the transaction property. This cost will be deducted in calculating any capital gain (or loss) realized by the seller on the sale of the transaction property.
Buyer Pays Premium
In a buyer-side policy, the buyer is the beneficiary under the policy and the party making a claim under the policy. Any payout under the policy is paid directly to the buyer. If the buyer purchases the policy, the premium paid will likely be added to the cost amount to the buyer of the transaction property.
Payment Received Under the Policy
A purchase agreement generally specifies that indemnification payments received or paid are treated as adjustments to the purchase price of the transaction property.
If the seller receives insurance proceeds and makes an indemnity payment to the buyer, as a result of the surrogatum principle, the insurance proceeds will be taxed in the same manner as the payments they are intended to replace; in this case, the purchase price. Since the purchase agreement will reduce the purchase price by the amount of any indemnity payment made by the seller, and the insurance proceeds replace the reduced purchase price, it is likely that the payments will offset each other for tax purposes.
However if a buyer receives insurance proceeds directly, that is not an indemnity payment under the purchase agreement and therefore not an adjustment to the purchase price paid. As with proceeds received by the seller, insurance proceeds received by the purchaser will be taxed in the same manner as the payments they are intended to replace. If the parties intend to have any insurance proceeds received by the purchaser to be an adjustment to the purchase price, this should be clearly stated in the purchase agreement.
As the tax implications of R&W insurance depend on who pays for the premium and who is insured under the policy, these implications should be considered when negotiating the terms of the purchase agreement and prior to the purchase of the policy.
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 to be 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 generally realize a capital gain (or capital loss) equal to the amount by which the proceeds of disposition exceed 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 limited 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 special rules in subsection 100(1) of the ITA could apply to increase the taxable capital gain. In summary, this can occur if the LP Interest was sold to a certain type of person, and certain other tests are satisfied. These rules are very broad and should be carefully reviewed in order to identify any potential unanticipated tax consequences.
If the seller is a non-resident of Canada for purposes of the ITA, and the 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, such as how it is financed.
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 at the time of acquisition. Generally, the tax cost of any partnership property will not be written up to fair market value at the time of the secondary transaction. Consequently, if the property is sold by the LP in the future, the purchaser may 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 with respect to the 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.