Private equity funds, family offices and strategic investors impacted


On March 19, 2019, Minister of Finance, the Honourable William (Bill) Morneau tabled the government’s final Budget prior to the federal election, which will take place later this year. While private equity investors may feel the impact of the Budget proposals to varying degrees, the overall tone of the Budget for businesses from a tax perspective was muted. Although highly anticipated, there were no broad-based proposals to address international competitiveness such as lowering of the corporate tax rates, nor did the Budget address the increasing complexity of, and interpretive challenges with, Canada’s income tax system through a plan for a comprehensive review. Rather, the government maintained its course with business measures targeted to support innovation, skills improvement and protect the fairness and integrity of Canada’s tax system both domestically and in an international context.

While the Budget did not contain substantive measures for businesses from a tax perspective, we note a few items of interest to private equity firms and their portfolio companies. Continue reading below and watch our summary:

  1. Expansion of Canada’s foreign affiliate dumping (FAD) rules
  2. Limiting stock option benefits
  3. International tax planning
  4. Promoting innovation through Scientific Research and Experimental Development (SR&ED)
  5. Expansion of character conversion rules

1. Expansion of Canada’s foreign affiliate dumping (FAD) rules 

The FAD rules are in place to prevent the erosion of Canada’s tax base resulting from the distribution of Canadian surplus to a foreign owner without the appropriate application of withholding tax. Budget 2019 proposes to extend these rules to Canadian companies that are controlled by a non-resident individual, a non-resident trust, or a group of persons that do not deal at arm’s length and are comprised of non-resident corporations, non-resident individuals, or non-resident trusts. The extended rules apply to transactions occurring on or after March 19, 2019. Non-resident private equity investors should continue to consider the application of these rules as they may pertain to their investment structures. These measures may be applicable to non-resident investors such as family offices or funds that invest in Canada through JVs, partnerships or trusts.

2. Limiting stock option benefits

An increasing number of private companies utilize stock options or similar equity-based compensation to incentivize key employees or portfolio company management. The current Canadian taxation regime provides for a preferential deduction in certain circumstances of any benefit realized from an exercise of options, effectively taxing only half of the benefit to the employee. The Budget announced its intention to limit the available stock option deduction to employees of “large, long-established, mature firms” where the fair market value of the shares is greater than $200,000 at the time of grant for a particular year. This change is a result of the government’s view that the policy intent behind the stock option deduction was to benefit employees of start-ups and rapidly growing businesses. Accordingly, the Budget proposes that there would continue to be no cap on the deduction for employees of such enterprises. Many questions arise from the proposals, however, no guidance was provided as to what may be considered a “larger, long-established, mature firm” or how early stage/growing portfolio companies may be impacted as they relate to the overall fund structure. Further details will be released in the summer of 2019 and any changes to the treatment of stock options would apply on a go-forward basis at that time. Although no details have been provided yet, private equity firms and their portfolio companies should begin to assess the potential impact to employees and possibly consider accelerating option grants.

3. International tax planning

The government continues to be concerned with international tax planning which results in inappropriate shifting of profits earned in Canada to other jurisdictions. The Budget reaffirms the government’s commitment to ongoing international initiatives to address these concerns. In addition, the government will continue focusing on enforcement actions to ensure appropriate reporting of profits and payment of withholding taxes. It will be important for portfolio companies operating internationally to ensure that appropriate transfer pricing documentation is in place and that non-resident tax compliance is adequately addressed from a Canadian perspective.

4. Promoting innovation through Scientific Research and Experimental Development (SR&ED)

The SR&ED program is critical for supporting middle market innovation in Canada by providing tax credits for businesses of all sizes and sectors for qualifying SR&ED expenditures. A 35 per cent refundable tax credit is available to Canadian-controlled private corporations and a 15 per cent non-refundable credit generally available to all other businesses. The 35 per cent refundable credit may be reduced based on the size/capital or the profits of the business and associated businesses. The Budget proposes to eliminate the profits test that would reduce the refundable tax credit, thereby allowing more private businesses to access the 35 per cent refundable credit. However, as the associated business test with respect to the size/capital of the business is still applicable, most portfolio companies may still be subject to the lower, non-refundable rate depending on the size of the fund and other associated portfolio companies. The rules will apply to taxation years that end on or after March 19, 2019.

5. Expansion of character conversion rules

In the past, certain taxpayers entered into financial arrangements (character conversion transactions) that sought to reduce tax by converting, with the use of derivative contracts, the returns on an investment that would have the character of ordinary income to capital gains, only 50 per cent of which are included in income. Where the prescribed conditions are satisfied, the rules currently treat any gain arising from these “derivative forward agreements” as ordinary income rather than as a capital gain. An exception exists that would carve out certain commercial transactions (e.g., merger and acquisition transactions) from the scope of the derivative forward agreement rules.

In response to planning that could circumvent the current rules, Budget 2019 proposes an amendment that introduces an additional qualification for the commercial transaction exception. In general terms, this amendment will provide that the commercial transaction exception is unavailable if one of the main purposes of the series of transactions is for a taxpayer to convert an amount paid on a security into a capital gain during the period that the security is subject to a forward purchase agreement or similar arrangement.

This measure will apply to transactions entered into on or after Budget Day. It will also apply after December 2019 to transactions that were entered into before Budget Day including those that extended or renewed the terms of the agreement on or after Budget Day.

To prevent inadvertent treatment of capital gains as fully taxable ordinary income, private equity entities and their portfolio holdings should re-evaluate the applicability of the newly expanded derivative forward agreement rules to any outstanding financial instruments that contain a forward obligation. The grandfathering provisions may additionally capture certain post-Budget Day amendments made to such financial instruments originating prior to Budget Day.

Given that the impacts of the Federal Budget are dependent on the investment profile and portfolio of a private equity firm, private equity investors should work with their tax advisors to identify areas of risks and opportunities.


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Maria Severino

National Tax Leader

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