Canada’s private equity industry, whose sluggish growth has trailed that of its U.S. counterpart, will be revitalized by the federal budget’s pledge to eliminate the 34-year-old foreign property rule for pension plans and RRSPs, say industry players.

At least some of the growth is expected to come at the expense of the $135-billion income trust sector, an asset class bolstered by its structural efficacy relative to limited partnerships, which were previously hampered by their classification as foreign property, says Jack Mintz, CEO of the C.D.
Howe Institute and Deloitte & Touche LLP professor of taxation at the University of Toronto’s Rotman School of Management.

In a paper published last month, Mintz theorized that “the elimination of the foreign property rule encourages a portfolio shift away from domestic securities such as income trust units” and toward limited partnerships, now that they are on a level playing field with income trusts, which have not been considered foreign property.

Recently added to the S&P/TSX composite index, income trusts were poised to capture as much as 7% of Canada’s huge pension fund pie before the budget rescinded the foreign-content rules.

“Now pension plans and RRSP investors will have a new interest in limited partnerships,” Mintz writes, although, he acknowledges in an interview, income trusts are so entrenched in the market that there is no danger they will disappear.

Limited partnerships, like income trusts, offer a way around what he calls “excessive” double taxation of dividend income — 35% at the corporate level and 32% for individuals, after factoring in the dividend tax credit — leaving a combined tax rate on dividend income as high as 56%.

In contrast, income trusts flow through all earnings to investors, where they are taxed only at the investor’s personal income tax level. A limited partnership levies only personal taxes on income to partners, who, therefore, pay no more than the maximum income tax rate of 46%.

Despite their tax efficiency, the use of limited partnerships for corporate financing in Canada has been dampened by their classification as foreign property, making them subject to the 30% ceiling on foreign property holdings within pensions and RRSPs.

With foreign-content restrictions no longer an issue, says Mintz, limited partnerships may emerge as a superior structure for many businesses vs income trusts, which pay a tax penalty on undistributed taxable profit and are, therefore, suitable only for businesses that have reached their growth potential.

Lawyers who specialize in income trust structures are also considering the potential effect of the changes, says David Ehrlich, a lawyer with Stikeman Elliott LLP in Toronto.
“The foreign property leaving has enormous structural implications. And whether partnerships become vehicles of choice because of greater flexibility, in terms of rolling and so forth, when foreign property restrictions have gone, will be an interesting
story.”

“We are trying to figure this out ourselves. It may be a year before this legislation is passed, and the devil is in the details,” he adds. “There may be more demand because pension funds will be buying more income trusts. Who knows?”

However, colleague Jeffrey Singer, also with Stikeman Elliott in Toronto, says there are other highly technical reasons why limited partnerships may face other shortcomings relative to income trusts — at least, in the short term. “The effect of the budget isn’t going to be enough to drive issuers to the limited partnership structure [and] away from a trust partnership structure,” says Singer.
“In the fullness of time, when the wrinkles are ironed out, I suspect we’ll see more limited public partnerships because some of these difficulties or inequities between pure limited partnerships and pure income trust structures will fall away.”

Whatever its effect on the national asset mix, the budget’s proposal will provide a much needed boost to Canada’s private equity markets, say industry players.

“The removal of foreign property restrictions is a huge plus for us,” says Kevin McKenna, managing director of McKenna Gale Capital Inc., a Toronto-based mid-market mezzanine lender that was “shackled” by the need to structure as a qualified limited partnership to get around the foreign property designation.

“We have easily lost $100-million worth of business because of restrictions imposed by virtue of qualified limited partnerships. So the proposal to remove or repeal foreign property restrictions is something we’ve applauded,” he says. “We’ll be in a much better competitive position relative to other [global] private equity players.”