This discussion focuses first on the most recent developments in tax, competition law, foreign investment review and securities law. Then we consider a number of topics that have traditionally been of importance to private equity investors, including tax structuring, investments in public companies, investments in private companies, shareholder agreements, exit strategies and employment/executive compensation issues.
Distinctive characteristics of private equity investments
While similar in many respects to “classic” M&A transactions, private equity investments tend to raise some special legal and practical issues. These are largely derived from the traditional characteristics of these transactions:
- They are often motivated by financial considerations rather than strategic/synergetic considerations;
- They are often undertaken with a finite time-frame in mind (although private equity is generally “patient money”);
- They are often leveraged with debt and therefore usually require consistent cash flows to service high debt loads;
- They sometimes involve the acquisition of a minority interest; and
- As private equity players typically do not intend to manage the businesses they acquire with internal expertise, they typically require the retention of competent incumbent management.
Tax law developments
Recent years have seen a number of amendments to Canadian tax laws that could affect private equity investors, particularly U.S. private equity investors, looking to acquire an interest in Canada.
Amendment to the definition of “Taxable Canadian Property”
Non‐residents of Canada are subject to Canadian tax on employment income earned in Canada, income from a business carried on in Canada, and capital gains from the disposition of “taxable Canadian property” (“TCP”) except (in all cases) to the extent exempted by an applicable tax treaty.
Effective March 4, 2010, the definition of TCP was amended to exclude the shares of a corporation, interests in a partnership and interests in a trust that do not directly or indirectly derive and have not directly or indirectly derived at any particular time in the 60-month period ending at the time of measurement (i.e., the time of disposition) their value principally from one or more of:
- Real or immovable property situated in Canada,
- Canadian resource property, or
- Timber resource property.
As a consequence, this amendment substantially mitigates clearance certificate obligations (subject to a prospective purchaser’s satisfaction that the subject property is not TCP), reduces the need for tax reporting and exempts a host of non-resident persons who would otherwise have been taxable in Canada on the disposition of shares of Canadian corporations and other interests which did not qualify for exemptive relief under an existing Canadian income tax treaty or convention (“tax treaty”).
TCP was previously defined to include shares of a corporation resident in Canada that were not listed on a designated stock exchange, significant interests in listed shares of a corporation resident in Canada, and other interests the value of which were, or had been within the 60-month period ending at the relevant time, derived principally from real or immovable property (including Canadian resource property and timber resource property).
Elimination of withholding tax on interest payments
Under the ITA, there is now no Canadian non‐resident withholding tax on interest paid or deemed to be paid by a Canadian resident person to a non‐resident person with which the payor deals at arm’s length and where the interest is not considered to be “participating debt interest”. This elimination of Canadian withholding tax on interest paid to arm’s length non-residents, regardless of their country of residence, has greatly facilitated direct, cross-border acquisition financing by foreign lenders.
In addition, under the Canada‐US Income Tax Convention (“US Treaty”), Canadian withholding tax on arm’s length and non-arm’s length payments of non‐participating debt interest to U.S. persons is now generally eliminated. As a result, U.S. originated internal financing structures have become significantly more tax efficient.
U.S. LLCs eligible for Treaty benefits
Many U.S. investors are structured as limited liability companies (“LLCs”) and, as such, are flow-through vehicles that do not pay income taxes in the U.S. In a cross-border context, this historically raised taxation issues because the Canada Revenue Agency did not consider LLCs to be eligible for exemption under the US Treaty.
However, the US Treaty now provides that an amount of income, profit or gain will be considered to be derived by a member of an LLC where that member is resident in the U.S. for purposes of the US Treaty. Accordingly, income that the residents of the U.S. earn through an LLC is in certain cases treated by Canada as having been earned by a resident of the U.S. Accordingly, where U.S. investors use an LLC to invest in Canada, provided the U.S. investors are taxed in the U.S. on the income in the same way as they would be if they had earned it directly, Canada treats the income as having been paid to a U.S. resident. The reduced withholding tax rates provided in the US Treaty, therefore, apply to the extent that the U.S. resident is entitled to benefits under the US Treaty.
Budget 2012 Measures
The Canadian federal budget released on March 29, 2012 (“Budget 2012”) introduced a number of proposed changes which, once enacted, may have an impact on private equity investors looking to acquire an interest in Canada. It should be noted that many of the proposed Budget 2012 measures will be effective as of the date of the budget (with some measures having grandfathering provisions), regardless of the date such measures get enacted into law. A summary of the relevant budget measures follows:
- Amendments to the Bump. The “88(1)(d) bump” is one of the more important tools in the arsenal of the Canadian corporate tax planner. The bump allows an acquiring corporation to remove assets from a target corporation following the acquisition of the target on a tax‐free basis. It can be used to distribute foreign subsidiaries held by a target corporation to avoid “sandwich” structures in which a foreign acquisition company acquires a Canadian target corporation with foreign subsidiaries. Budget 2012 proposes to deny the 88(1)(d) bump in respect of a partnership interest to the extent that the accrued gain on the partnership interest is reasonably attributable to the amount by which the fair market value of assets which would not themselves be eligible for the bump exceed their cost amount. The purpose of such rule is to prevent what had become a very common planning technique whereby the target corporation would transfer its assets which were not eligible for the bump to a partnership immediately before the acquisition of the target (as a partnership interest itself could be eligible for the bump despite the fact that some or all of its underlying assets were not).
- Sale of Partnership Interest to Non-Residents. A related proposal deals with the sale of a partnership interest to a non‐resident. Under current law, only one-half of a capital gain is included in income. However, the full amount of a capital gain realized on the sale of a partnership interest to a person that is exempt from tax is included in income to the extent that the gain is attributable to increases in the value of property of the partnership other than non‐depreciable capital property. Budget 2012 proposes to extend this rule to the sale of a partnership interest to a non‐resident unless, immediately before and immediately after the sale, the partnership uses all of its property in carrying on business through a permanent establishment in Canada.
- Foreign Affiliate Dumping. Budget 2012 proposes a measure to curtail what the Department of Finance refers to as “foreign affiliate dumping transactions”. Generally, “foreign affiliate dumping” occurs when a Canadian corporation uses borrowed or internal funds to acquire the shares of a foreign affiliate from its non‐resident parent corporation. There are two aspects to the measure that will apply to an investment in a non‐resident corporation (the “subject corporation”) by a corporation resident in Canada (“CRIC”) if, after the investment, the non‐resident corporation is a foreign affiliate of the CRIC and the CRIC is controlled by another non‐resident corporation (the “parent”). First, the CRIC will be deemed to have paid a dividend to the parent equal to the fair market value of any property (other than shares of the CRIC) transferred, or obligation assumed or incurred, by the CRIC in respect of the investment. Second, no amount is to be added to the paid‐up capital of the shares of the CRIC in respect of the investment and no amount is to be added to the contributed surplus of the CRIC for purposes of determining its capital under the thin capitalization rules. As a result, assuming that the CRIC had a debt to equity ratio prior to the investment equal to the maximum allowed under the thin capitalization rules, those rules would prohibit the deduction of any interest payable by the CRIC on any debt issued by it in respect of the investment. The measure will not apply to an investment made by the CRIC in the subject corporation if the investment may not reasonably be considered to have been made by the CRIC, instead of being made or retained by the parent, primarily for bona fide purposes other than to obtain a tax benefit.
- Amendments to the Thin Capitalization Rules.Budget 2012 proposes a number of amendments to Canada’s thin-capitalization rules including:
- lowering the current debt‐to‐equity ratio “cap” from 2:1 to 1.5:1;
- extending the application of the thin capitalization rules to partnerships that have a CRIC as a member; and
- re‐characterizing interest expense that is denied under the thin capitalization rules as a dividend for Canadian withholding tax purposes.
Developments in competition/antitrust and foreign investment legislation
In 2009, the Parliament of Canada enacted amendments to Canada’s antitrust and foreign investment laws, known respectively as the Competition Act and the Investment Canada Act. These changes constitute the most significant overhaul of legislation in this area in more than 20 years. Also discussed in Chapter A of M&A Activity in Canada, these changes can be summarized as follows:
The 2009 amendments to the Competition Act create a U.S.-style Hart-Scott-Rodino merger notification process, with an initial 30 day “waiting period” and the possibility of a “second request” for additional information. While familiar in the U.S., the second request process and the level of documentary assembly and production that it typically involves, are new to Canada. Through mid-2012, Canadian second requests had been issued in approximately 19 transactions (over a 3-year period), which represents a very small percentage of the total number of transactions reviewed by the Competition Bureau in that period. To date, therefore, the “second request” process has not imposed undue burdens on merging parties in Canada, and it is certainly the case that the scope and breadth of Canadian “second requests” is, generally speaking, considerably less than is the case in the U.S. Furthermore, the Competition Bureau engages in pre-issuance dialogue, including providing a draft “second request” to the parties, and has published “Merger Review Process Guidelines” intended to further explain the “second request” process. Nevertheless, when a second request does come, complying with it can be a time-consuming and resource-intensive undertaking.
Other points to note about the 2009 legislation include:
- The “transaction size” test increased from C$50 to C$70 million (indexed annually for inflation – the threshold for 2012 is C$77 million). However, the “size of parties” test (which includes affiliates of the parties to a transaction) remains at C$400 million. These financial tests are used to determine whether advance notification of a proposed merger is required.
- Retention of the “advance ruling certificate” (ARC) and “no-action letter” processes, which offer an alternative means to satisfy a pre-merger notification obligation.
- The Commissioner of Competition can challenge a non-notifiable transaction that has closed in the absence of an ARC or no-action letter for only one year after closing (previously three years).
- Significant amendments to aspects of the Competition Act of less pressing concern to private equity players (e.g. pricing practices, conspiracy, misleading advertising) were also implemented.
Investment Canada Act
In the event of an acquisition of control by a U.S. or other foreign private equity investor of a Canadian business, the acquisition will be subject to federal government review or notification under the Investment Canada Act. Changes in recent years to the Investment Canada Act are of interest to private equity investors in a number of respects. As noted, the review process under the Act is triggered by an “acquisition of control” by a “non-Canadian” of a “Canadian business”. One of the most positive developments is that the review threshold for a World Trade Organization (WTO) investor acquiring control of a Canadian business will increase from C$330 million for 2012 (based on book value of assets) to C$600 million in “enterprise value” when regulations implementing the increase are enacted, and then increased to $1 billion over a 4-year period, after which the threshold will be indexed to inflation. These changes are expected to be implemented in 2012.
As background, note that the “acquisition of control” by a “non-Canadian” (which would include the Canadian subsidiary of a foreign investor) of a “Canadian business” is either notifiable or reviewable under the Act (absent the availability of an exemption under the ICA). An acquisition of a majority of the voting interests attaching to all shares of a corporation is deemed to be an acquisition of control, while an acquisition of at least one-third (but less than a majority) of the voting interests is subject to a rebuttable presumption that it is an acquisition of control. An acquisition of control is reviewable where the thresholds discussed above are exceeded.