Leave it to income trust executives and their high-priced legal and financial advisors to find a way around Ottawa's despised new tax on income trusts.
Some have resorted to merging with companies that have huge losses on their books. It's a move that could lose Ottawa hundreds of millions of dollars of tax revenue and possibly lead to a dust-up between tax regulators and converting trusts when they try to claim the losses in future tax filings.
As many as 10 trusts have converted to corporate status through a complex series of transactions that essentially amount to a reverse takeover using a firm with tax-hefty losses and a series of corporate manoeuvres involving such things as redeemable shares, new firms, subsidiaries, mergers and income-tax rollovers available to trusts to effect the transaction.
The result is that trust unit-holders become shareholders in a company that carries on the trust's business and the tax losses shield it from income tax. The company can keep paying shareholders a high yield and shareholders can access the favourable dividend tax credit.
At a tax conference in November, lawyers say a top Canada Revenue Agency official said CRA was aware of, and concerned about, the moves. A CRA spokesman said "... the confidentiality provisions of the acts administered by the CRA prevent me from discussing the details of specific cases."
Using a loss company (lossco) to convert is controversial, because trading in tax losses is frowned upon by tax regulators and limited to situations involving companies conducting the same type of business.
However, some of the business and energy trusts doing the deals are using biotechs and technology companies, such as Vasogen Inc., Conjuchem Biotechnologies Inc. and Ballard Power Systems Inc. Even a former airline has been part of the mix.
There may be more to come.
A survey earlier this month found that 83% of income trust executives would consider doing a tax-loss acquisition transaction as part of their conversion strategy. Most of the remaining 165 trusts must convert to corporations and pay corporate tax by 2011 or face paying a tax under the new rules.
A company attempting a similar transaction is prohibited from using the losses under the acquiring control provisions of the Income Tax Act. However, those sections apply only to corporations and not trusts and the government hasn't amended the law to close the apparent loophole.
There's also a debate in tax circles whether a lossco conversion runs afoul of the general anti-avoidance rule (known as GAAR), a catch-all provision in the Income Tax Act that regulators have used to attack schemes designed to reduce tax. The Supreme Court of Canada has only begun to explore the boundaries of the rule.
The tax-loss numbers involved appear to be substantial and converting trusts look to be paying about 4¢ to 5¢ on the dollar to access the losses. If the remaining 165 or so trusts convert using a lossco method, the hit to tax revenues could be in the hundreds of millions, if not billions of dollars.
In October 2008, Superior Plus Income Fund paid Ballard $46-million to buy the $800-million in tax losses the fuel-cell company built up.
In March 2009, Total Energy Services Trust announced a conversion arrangement using Biomerge Industries Ltd. Under the arrangement, Biomerge shareholders were paid $3.9-million and Total became a corporation holding $80-million of undepreciated capital-cost allowances, and $74-million in non-capital losses and scientific research and development tax pools.
In June 2009, Exchange Industry Income Fund announced an arrangement with HMY Airways and its sole shareholder David Ho. The deal provided an estimated "aggregate tax shield in excess of $275-million."
That same month, Premium Brands Income Fund announced a conversion using Thallion Pharmaceuticals Inc. and said the deal provided a tax shield in excess of $260-million.
Also in June, Algonquin Power Income Fund entered an arrangement with Hydrogenics Corp. allowing it to tap $192-million in "tax attributes that exist within this corporation."
In July 2009, Colabor Income Fund paid Conjuchem Biotechnologies $5-million to acquire as much as $100-milllion in tax losses.
In August, Cervus LP, a limited partnership caught by the new rules, announced a $7.45-million deal with Vasogen Inc. that Cervus said will leave it with "an estimated aggregate tax shield in excess of $225-million following the conversion."
Calls to top tax lawyers for comment were met with silence, with one noting it's a "sensitive" matter.
One of those willing to talk, John Brussa, a lawyer with Burnet Duckworth & Palmer, in Calgary, said it is possible the CRA could reject the structure and deny the losses, noting "any time you find a transaction that has some uncertainty, you take on some risk."
However, he said, "if you are gong to do a conversion, you have to consider it and consider the risks and rewards like everything else."
As for the GAAR concern, Mr. Brussa added there's a "lot of uncertainty as to the scope of the GAAR."
Robert Kopstein, a lawyer at Blake Cassels & Graydon in Vancouver, says the conversions should pass muster under Canada's tax laws.
From a "technical analysis," the conversions are in line with tax rules, Mr. Kopstein said. The "lynchpin as to why this structure works is there is no such [tax] rule that deems all the unitholders of a trust to be one unit-holder, in the same way there is that treats all shareholders of a corporation to be one shareholder. There's no comparable rule."
He added that in terms of tax policy, the Department of Finance has been silent on the structures. "There hasn't been any noise that we've heard."
At least not yet. With a budget on the horizon, there could be an indication if Finance Minister Jim Flaherty wants to shut down the loophole or whether he's had enough of the whole income trust tax issue.
From the income trusts' perspective, what do they have to lose? For a few million dollars, they can do a lossco conversion, assuming they can find an appropriate target. At worst, the use of the losses will be rejected and they'll pay tax like any other company. But if the conversions stand, and CRA accepts the losses, then shareholders benefit and taxpayers lose.
Mr. Kopstein said it's been a "very bad situation for a lot of these trusts" since the new tax rules were announced. He's not sure "how politically viable it is for Ottawa to come in and start smacking them down again."