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Ottawa tightens tax rules on hybrid investment product

Finance Minister Jim Flaherty

CHRISTINNE MUSCHI/REUTERS

Ottawa has moved to tighten tax regulations in response to investment entities that it says are designed to circumvent its income trust policy.

Several businesses listed on the Toronto Stock Exchange took a hit on Wednesday as a result, with units of InnVest REIT tumbling 15 per cent, units of Westshore Terminals Investment falling 7 per cent and the units of Labrador Iron Ore Royalty dropping more than 4 per cent.

In October 2006, the federal government announced that it would impose a tax on cash distributions to unitholders of income trusts as a means to level the playing field between trusts and regular companies. It called the new policy the Tax Fairness Plan.

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Since the changes took place at the beginning of this year, investors hungry for high-yield returns have scrambled to find alternative products. One type of investment that has proved popular is stapled securities, which involves two separate products that trade together.

Stapled securities can tie together equity and debt instruments, a structure which until now could offer tax advantages similar to those of earlier income trusts. Because interest payments on business debt are deductible for income tax purposes, an entity could use the interest on the note to shelter part of the income of the company. Under the new rules, a company or trust will no longer be able to deduct the interest paid on the debt portion of the stapled security.

"These proposed measures will ensure that the policy objectives of the Tax Fairness Plan continue to be met," Finance Minister Jim Flaherty said in a news release. "They also reflect our government's ongoing commitment to address structures that frustrate those policy objectives."

The government is also targeting some REITs with the amendments.

To qualify as a REIT, a business can only have passive income from its properties and not operating income. That means a REIT can own the land and buildings of a hotel but cannot operate the hotels itself. One way REITs have got around this rule is by putting operations into another company which leases the hotels from the REIT. The shares of the new operating firm can then be "stapled" to the units of the REIT. The new rules will remove the advantage of this structure.

There are only a handful of businesses that will be affected by the government's clamp down, says Stephen Pincus, a senior partner at Goodmans LLP specializing in corporate finance and M&As, but Ottawa is clearly moving to prevent a bigger trend. "The government made these changes because they had a concern that there might be other entities that might want to use this sort of structure," he said.

While the government is trying to make the rules "as pure as possible," it is making them narrower than they are in other countries, which is unfair to Canadian investors, Mr. Pincus said.

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He thinks the proposals go too far in respect of REITs, pointing out that other countries allow real estate businesses to separate their operations and still deduct rent payments. As a result, more Canadian investors will be attracted to more favourable investment conditions in the United States, Australia and other countries, he said.

The government's move was not surprising, said Sheryl Purdy, vice-president and investment advisor with Leede Financial Markets Inc. in Calgary. "The original legislation left the door open, saying that if something comes up that they perceived frustrates the policy objectives then they will tweak it. In this case that's what the government is doing, they are tweaking the legislation."

Ms. Purdy says she kept clients away from the hybrid products, turning instead to Canadian high-yield bonds. "You can push the envelop if you want, but the reality is your clients may pay for it later on if the government acts retroactively," she said.

The government is imposing varying transition periods. For example, a business that issued stapled securities prior to Oct. 31, 2006 will have until Jan. 1, 2016 to fix their structures. Those who issued stapled securities after October 2006 will have one year to change their structures.

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