Cascading opportunities, Expanding markets

Sponsors

Goodman and Carr LLPLaSalle Business Credit, LLC

Associate SponsorTorys LLP

The 2005 Report on

Canadian Private Equity

The conventional acquisition structureused by US investors to acquire Canadiancompanies is depicted in Figure 1.

Non-residents have acquired Canadiancorporations by incorporating a Canadianacquisition corporation (CanAcquireco) ina Canadian jurisdiction and funding it byway of interest-bearing debt and equity ona 2:1 basis to comply with Canadian thincapital rules. CanAcquireco purchases allthe shares of the Canadian target corpora-tion (CanTarget). CanAcquireco and Can-Target typically then amalgamate (formingCanAmalco). The “internal” debt used inthis structure and the other structuresdescribed in this article normally takes theform of subordinated unsecured debt car-rying a higher rate of interest than seniorsecured debt.

Some of the advantages of this acquisitionstructure are as follows:

u Interest on the debt owing by theamalgamated company to the non-residentowner is deductible against the earnings of

the acquired business; thiscomes at a cost of Canadianwithholding tax on the interest(when paid) of 10 percent.

u The non-resident ownercan extract cash from CanA-malco without attracting Cana-dian withholding tax by havingthe principal of the debt owingto it repaid and by having thepaid-up capital of CanAmalco’sshares returned to it (and theamount of that paid-up capital

will, in general, equal the amount the non-resident owner originally invested in theshares of CanAcquireco).

u Depending on the application of atax treaty between the non-resident’s coun-try and Canada, the non-resident investorcan generally sell the shares of CanAmalcoand not be subject to Canadian tax on anycapital gain realized, provided CanAmal-co’s shares do not derive their value prima-rily from Canadian real property.

Use of hybrids to acquire Canadianbusinesses: businesses in flow-through form

A US-based investor may consider themethod depicted in Figure 2 (see next page)

for acquiring a Canadian business that isowned in a flow-through form (such as apartnership).A Nova Scotia unlimited lia-bility company (NSULC) is a corporationincorporated in the province of Nova Sco-tia,but unlike a regular corporation, it hasan unlimited liability feature for whichprotection steps are required. For US taxpurposes, an NSULC can be a disregard-ed entity (if it is wholly owned) or treatedas a partnership (if it has more than oneshareholder).Under this structure, the US-based investor invests in a newly estab-lished NSULC by way of interest-bearingdebt and equity on a 2:1 basis to complywith Canadian thin capital rules. AnNSULC is a corporation for Canadian taxpurposes but is disregarded for US taxpurposes. The NSULC incorporates GPInc. in a Canadian jurisdiction and maywholly own it. The NSULC, GP Inc. andother investors (potentially includingmanagement) establish a limited partner-ship (the Partnership) that acquires theassets of the business from the vendor.ThePartnership is a partnership for Canadiantax purposes, but will “check the box” tobe treated as a corporation for US tax pur-poses.

Some of the advantages of this structureare as follows:

u Income of the Partnership is allo-cated to the partners for Canadian taxpurposes. The NSULC can deduct itsinterest expense on its debt owing to theUS investor against its share of the Part-nership’s income; again this comes at acost of Canadian withholding tax on theinterest (when paid) at 10 percent.

Effective structuring: notjust for billion-dollar dealsThe use of ‘hybrid entities’ to acquire Canadiancompanies can have significant benefits for USinvestors in the appropriate circumstances. ByCorrado Cardarelli and Stephen Donovan*

2005 Report on Canadian Private Equity 27

E x pe rt Comm e nta ry

Non-resident investor

Canadian Acquireco

Canadian target

SubsequentAmalgamation

figure 1

u The US investor can extract cashfrom the NSULC without Canadian with-holding tax by having the principal of thedebt owing to it repaid and by having thepaid-up capital of the NSULC’s sharesreturned to it.

u Under the Canada-US tax treaty,the US investor can generally sell theshares of the NSULC and not be subjectto Canadian tax on any capital gainrealised, provided NSULC’s shares do notderive their value primarily from Canadi-an real property.

u The structure is also efficient froma US tax perspective, depending on thenature of the US investors (certain tax-exempt investors may need to consider theimplications of unrelated business taxableincome [UBTI] of this structure). TheNSULC is disregarded,as is the subordinat-ed loan owed by the NSULC. The U.S.investor is taxed on distributions from thePartnership,which are regarded as distribu-tions from a corporation, to the extent of“earnings and profits”for US tax purposes.Where distributions from the Partnershipare limited to cover only the taxes of itspartners, the income for U.S. tax purposeson that distribution will be much less thanthe NSULC’s share of the Partnership’s

income for Canadian tax purpos-es.The major benefit of this struc-ture is to permit interest expenseon the internal debt (i.e., the 2:1debt) to be deductible for Canadi-an tax purposes against the busi-ness income generated, but nottaxable in the United States.Onlythe U.S. recognizable income inrespect of distributions from thePartnership is taxable in the Unit-ed States. The Canadian taxespayable by the NSULC in respectof its earnings may be eligible forforeign tax credit relief to the U.S.investor in computing the U.S.investor’s income for U.S.tax pur-poses. The Canadian tax savings

generated from the interest deduction in theNSULC can be used to further pay downdebt incurred to make the acquisition.

The use of NSULCs as the acquisition vehi-cle does raise questions of liability protec-tion for its shareholders. Shareholders ofthe NSULC (US investors) have no directrelationship with creditors and cannot besued during corporate existence. However,on a winding-up, shareholders are jointlyand severally liable for the NSULC’s obli-gations. To reduce the potential for liabili-ty, the U.S. investor may find the use of aDelaware LP or other liability blockerappropriate in structuring the acquisition.

Use of hybrids to acquire Canadianbusinesses: businesses in corporate form

A variation of the foregoing structure canbe used where the Canadian business to beacquired is in a Canadian corporation(Canco) and the US investor is required tobuy shares of the Canco. The variationrequires the owner of Canco to “continue”Canco as an NSULC (NSULC Opco) priorto its acquisition by the U.S.investor (a con-tinuance of this kind is a tax-free event forCanadian tax purposes).The final structurewould be as depicted in Figure 3.

Under the structure shown in Figure 3, theUS-based investor invests the “equity”por-tion of the acquisition price in a newlyestablished NSULC by way of interest-bearing debt and equity on a 2:1 basis tocomply with Canadian thin capital rules.The NSULC is a corporation for Canadiantax purposes,but is disregarded for U.S.taxpurposes. The NSULC incorporates GPInc. in a Canadian jurisdiction and maywholly own it. The NSULC, GP Inc. andother investors (potentially including man-agement) establish a limited partnership(Finco). Finco is a partnership for Canadi-an tax purposes, but will check the box tobe treated as a corporation for US tax pur-poses. The NSULC invests all of its fundsin equity of Finco. Finco borrows the debtportion of the acquisition price from third-party lenders.Finco then sets up a transito-ry acquisition NSULC, onlends the third-party debt proceeds to it and invests in sub-ordinated debt and equity of that NSULCin the same way as the top NSULC wascapitalized (on the 2:1 basis). The acquisi-tion NSULC then buys the target NSULCOpco and amalgamates with it, leavingNSULC Opco with the same capital struc-ture as the acquisition NSULC.

Some of the advantages of this structure areas follows:

u For Canadian income tax pur-poses, NSULC Opco can deduct the inter-est expense on the subordinated debt(which originated with the US investor)and also on the onloan of the third-partydebt in computing its income; again thiscomes at a cost of Canadian withholdingtax on the interest payable by the topNSULC (when paid) at 10%.

u Finco will have interest incomeon the onloan of the third-party debt,which will be matched by the interestexpense on the third-party debt; Finco willalso have net interest income in respect ofthe subordinated loan to NSULC Opco;for Canadian income tax purposes, this

28 Private Equity international

E x pe rt Comm e nta ry

TToorryyss LLLLPP

GP Inc.

3rd Party debt

BusinessAssets

Otherinvestors

U.S.Resident

LP

NSULC

2 1

figure 2

interest will be allocated to the NSULCpartner, which will have an offsettinginterest expense on the matching subordi-nated loan from the US investor.

u For US income tax purposes,NSULC Opco is disregarded so that Finco(a foreign corporation for US tax purpos-es) will be considered to have acquiredassets at fair market value, creating a hightax basis for US tax purposes; this basiswill be available to create shelter in com-puting the “earnings and profits”of Fincofor US tax purposes.

u For US income tax purposes, thetop NSULC is also disregarded, as is thesubordinated loan owed by the topNSULC; the “interest” on that loan willnot be interest for U.S.income tax purposes butwill instead be regarded asa distribution from Finco,which will be taxable inthe US only to the extent ofthe “earnings and profits”of Finco (which will beminimized for the reasonsmentioned above).

u The US investorcan ultimately extract cashfrom the structure andfrom the top NSULC with-out attracting Canadianwithholding tax by havingthe principal of the debtowing to it repaid and byhaving the paid-up capitalof NSULC’s sharesreturned to it.

u Under the Cana-da-US tax treaty, the USinvestor can generally sellthe shares of the NSULCand not be subject toCanadian tax on any capi-tal gain realized, providedNSULC’s shares do not

derive their value primarily from Canadi-an real property.

u As described above, the structure isalso efficient from a US tax perspective (ingeneral, UBTI issues are not a concern inthis case). The major benefit of this struc-ture is to permit the interest expense on theinternal debt (i.e., the 2:1 debt that origi-nates with the U.S. investor) to bedeductible for Canadian tax purposesagainst the business income generated inNSULC Opco, but not taxable as interestin the United States. As is the case in theflow-through structure, the Canadian taxsavings generated from the interest deduc-tion in NSULC Opco can be used to fur-ther pay down debt incurred to make theacquisition.

GP Inc.

3rd Party debt

BusinessAssets

Otherinvestors

U.S.Resident

Finco I.P.

NSULC

NSULCOPCO

Equity1 + 2

2 1

figure 3

2005 Report on Canadian Private Equity 29

E x pe rt comm e nta ry

Torys LLP is an international business

law firm with more than 330 New York

and Toronto lawyers. Our strength lies

in working with clients on mergers and

acquisitions, corporate finance, and

major litigation matters. As an integrat-

ed international law firm, Torys’ private

equity group can draw upon our exten-

sive resources and expertise on both

sides of the US-Canada border. Transac-

tion structures must often accommodate

various competing objectives, including

leverage, managing risk and valuations.

As a result, a wide variety of instru-

ments, including equity, convertible or

subordinated debt, bridge loans,

options, warrants and exchangeable

instruments are frequently used in what

are often multi-tiered financings.

AAbboouutt TToorryyss LLLLPP

*Corrado Cardarelli is a partner in the TaxDepartment of Torys LLP in Toronto. Hispractice largely involves corporate taxation,including reorganizations, mergers, divesti-tures, joint ventures, acquisitions, restruc-turings of financially troubled corporationsand corporate finance. He can be reached byphone at 416.865.7386 or by email at ccar-darelli@torys.com.Stephen Donovan, co-head of the firm’s Pri-vate Equity Group, is a corporate/commer-cial lawyer whose practice includes mergersand acquisitions work and has acted in sev-eral management buyouts and leveragedbuyouts of private and public companies.