Tax changes not likely to impede deal flow

Recent federal tax changes may bring a measure of pain mixed with a smaller amount of pleasure to Canadian mergers and acquisitions, but none are likely to impede the flow of deals, say some of the country’s top tax lawyers.

“The tax changes will not dramatically affect M&A activity, but those carrying out mergers and acquisitions have to be careful they structure future deals according to the new rules,” says Elinore Richardson, a senior tax partner at Borden Ladner Gervais LLP in Toronto.

“Some former structures have been disallowed, while some rules on lending have been improved.”

The recent rules primarily affect two areas, explains Corrado Cardarelli, a partner at Torys LLP in Toronto. The first effectively ends certain tax advantages enjoyed by income trusts, while the second helps open up international arm’s length borrowing by eliminating withholding taxes on interest paid to foreign lenders by Canadians.

The downside first: On October 31, 2006, the federal government announced income trusts would be subject to tax on income starting in 2011. Previously, the trust structures were able to pass through income on a tax efficient basis to unit holders. Returns to investors often reached into the double digits a year.

Income trusts became a useful exit strategy for private equity investors and business owners, but as more companies converted to income trusts, the government began to fear the trend would lead to a serious erosion of its corporate tax base.

“On the income trust side, the move has been a mixed blessing for M&A activity,” Mr. Cardarelli says. “The first nine months after it was announced, there was a flurry of activity as income trusts were sold to a range of buyers. They were largely faced with the choice of selling or converting to some other structure by 2011.”

The irony was that many were sold either to foreign interests or tax exempt Canadian buyers. A federal initiative intended to preserve the tax base actually saw those income trust sales reduce it. “The government probably lost some of the revenue it was seeking to reclaim,” says Mr. Cardarelli.

The plus side is the beneficial impact on Canadian corporations looking for debt financing, says Ms. Richardson. The removal of withholding taxes on interest paid by Canadians on foreign loans to unrelated foreign lenders then – once the Canada-U.S. tax treaty is ratified by the U.S. Senate – on loans between related Canadian and U.S. persons will “encourage the free flow of lending and borrowing across borders,” says Ms. Richardson.