Canadian pension plan investors face a wide variety of tax considerations whenever they make investments globally. While investing in Canada carries its own requirements, investing abroad is more complex, with each jurisdiction governed by its own detailed set of tax rules especially as it relates to returns on investments being repatriated back to Canada.
The U.S. is a special case, given the geographic proximity between the two countries, their intertwined economies, and the favourable tax rules between them, including the benefits that exist under the Canada-U.S. tax treaty. There are certain tax exemptions that exist between Canada and the U.S. which are rarely seen in other tax treaties. In this sense, investing in the U.S. could be more advantageous than Europe or Asia from a tax structuring and leakage perspective.
Despite providing favourable exemptions for Canadian pension plan investors, the U.S. still wants to tax business activity taking place within its borders. In fact, the U.S. tax system is particularly complex due to the interaction between the federal government and the governments of each of the 50 states. Investing in the U.S. is akin to investing in 51 different countries. The additional administrative burden alone can be significant for some Canadian pension plans.
Foreign Tax Effects
When investing in an asset in the U.S., it is imperative that foreign tax implications are considered as part of the due diligence. This is to ensure the foreign tax effects can be managed, or at least tolerated, while still delivering the targeted rate of return. While it is rare that tax considerations alone would kill a deal outright, they must be scoped, weighed, and managed as early as possible in the due diligence process so that issues can be identified and appropriately mitigated, or factored into the underwriting.
Foreign tax implications include withholding tax on income being returned to Canada and federal, state, and local income taxes, especially in those jurisdictions where the state or local authority does not recognize the Canada-U.S. tax treaty. Because each state has its own set of tax laws that may differ materially from the federal rules, important nuances may be missed if a thorough tax analysis is not completed before making an investment.
Designing an efficient ownership structure is critically important. For example, to invest in an asset in the U.S. through a holding entity set up in Canada, it is important to have a clear understanding of the tax relationships in place. Income taxes, withholding taxes, and other state and local taxes all have to be clearly understood.
Ownership Chain
A simple way to accomplish this is to model out the flow of cash and the associated tax implications at each level, starting at the business level of the asset all the way up the ownership chain to the pension plan investor. Doing this will enable investors to understand the potential tax leakage at each level in the structure.
Once a transaction is closed, your tax team is responsible for making sure the tax underwriting assumptions that have been modelled during due diligence are actually coming to fruition. The right documentation, such as tax returns and tax elections, need to be submitted in a timely manner and investment returns need to be categorized correctly for tax purposes. The cashflow produced by the investment must be monitored very closely for tax leakage, which directly impacts returns.
This is, of course, in addition to all the other tax impacts investors have to watch for when underwriting a U.S. asset, including monitoring income, and any changes to tax law or the business climate that could impact the underlying assumptions with respect to the ongoing operations or exit strategy.
With all of these considerations, investors need to ensure they have appropriate tax support. Despite being tax-exempt, larger pension plans will likely have a sizable tax team. On the other hand, smaller pension plans may not have that level of in-house tax expertise, so it’s important to either hire experienced tax professionals or leverage advisers.
Debt Interest
Pension plans are cautioned to stay disciplined when it comes to complying with tax rules. But sometimes things can go wrong. One example pertains to U.S.-Canada financing structures. Certain tax strategies involve pushing down debt to the target company being acquired, which can yield a bigger interest deduction thereby reducing taxable income in the target jurisdiction and correspondingly reducing the amount of tax paid.
However, in order for this to work in certain structures, the debt interest must actually be paid pursuant to the loan agreements. The interest deductions will not be allowed if the interest isn’t paid in cash and is only recorded in journal entries for accounting purposes.
When hearing about these structures, investors often become excited by the ability to maximize interest deductions and agree to make interest payments as instructed by their advisers. The problem arises if the cash interest isn’t paid after the structure is implemented because no one has followed up operationally. The interest deduction is denied in the target country, resulting in increased taxable income, which means more tax has to be paid. In addition, there can be interest applied on tax amounts owing and penalties on the late payment of taxes. The result is a big hit to returns that could have been managed with the right advice and disciplined adherence to the agreed financing structure from an operational perspective.
Less Costly
While the above considerations are more cautionary in nature, tax policy can also create significant opportunity. A recent favourable change to the U.S. tax code for foreign (i.e., non-U.S.) pension fund investors is the exemption from the Foreign Investment in Real Property Tax Act, or FIRPTA.
In the past, investing in U.S. real property – such as land, office buildings, or toll roads – meant that FIRPTA withholding tax was applicable upon the exit of the investment and it applied to all non-U.S. sellers of real property situated in the United States. That had implications on expected rates of return, deal structuring, and financing.
Now, with the FIRPTA exemption in place for foreign pension funds, it is simpler and less costly from a tax perspective to invest in U.S. real property. That’s created a significant opportunity for foreign pension funds, including Canadian pension plans, interested in investing in infrastructure and real estate in the U.S.
As a global private markets investment firm based in Canada, Northleaf is focused on the same issues impacting Canadian investors seeking to invest internationally. We have years of experience investing in private market transactions outside Canada, across private equity, private credit, and infrastructure. We are a global manager with significant experience with Canada-specific tax considerations and can help pension fund investors with many of these complex taxation issues. This, combined with our global expertise, makes us uniquely positioned as the investment partner of choice for Canadian pension funds.
Derek participates in all aspects of Northleaf's private markets investment activities and is responsible for international tax planning and strategy, compliance and investment transaction support for Northleaf’s investment funds, management company and related corporate entities.