Canada: ILP, SLFI, HST – Tax Acronyms Every Fund Should Know

When we structure private equity funds, whether through a mutual fund trust, limited partnership or certain other entities, considerable time is spent on the income tax issues. We examine the deductibility of the management fees. We consider strategies for delivering the carried interest to employees in a tax-efficient way. We take steps to keep the flow-through nature of the mutual fund trust and prevent it from being a SIFT trust. We draft detailed securities tax disclosure dealing with allocation and distribution of earnings to unitholders, the resulting impact on adjusted cost base and the tax consequences of redemption of units, among other issues.

What we often don't do, however, is consider the GST/HST implications. At first glance, this makes sense, as the only sales private equity funds usually make are sales of trust or partnership units (or shares of a corporation). The fund's income is generally derived from interest or dividends. All of these are exempt from GST/HST, as supplies of financial instruments and services (respectively). Accordingly, much less thought is given as to whether one needs to register, file returns and collect and remit any GST/HST.

However, because the supplies of financial instruments or services are exempt from GST/HST, this also means that input tax credits cannot be claimed to get a refund of GST/HST expenditures. These expenditures include the GST/HST paid on legal fees, filing fees, and accounting and administrative costs, among certain other day-to-day costs. This means that GST/HST is a real cost to private equity funds and other financial institutions, such as banks, credit unions and insurance companies (as opposed to a cash flow issue for most businesses, where GST/HST is paid and then refunded). Accordingly, when real costs are involved, there is naturally an impetus to go where they are lowest – making purchases in Alberta, where GST applies at a rate of 5%, makes much more sense than the Ontario HST rate of 13%.

For this reason, the "selected listed financial institution" or "SLFI" rules were introduced in 1997. Starting in 2010, certain "investment plans", such as mutual fund trusts and unit trusts (among certain other investment entities), were also included in the SLFI regime. The SLFI rules, while nightmarishly complex, essentially impose HST based on where the particular entity's offices, operations, unitholders or beneficiaries are located, depending on the type of entity (as opposed to where the actual expenditure is made, as under the regular calculation of "net tax" under the Excise Tax Act). A complex array of regulations needs to be consulted in order to determine the HST payable. Further, various provincial percentages and numerous elections need to be considered (particularly by more complex structures). The compliance burden is serious and the costs potentially significant.

In order to be an "SLFI", an entity needs to be both a "financial institution", such as a bank or mutual fund trust, and a "prescribed financial institution": a financial institution that has a permanent establishment in more than one province (including an HST province). Permanent establishment for "investment plans", such as mutual fund trusts, is defined to include any place where unitholders have a residence or where the fund is qualified to sell or distribute units pursuant to provincial securities laws. Accordingly, the SLFI rules apply quite broadly and likely capture the majority of private equity funds. The consequences can be significant.

To use a very simplified example, suppose 90% of the unitholders of a mutual fund trust are resident in Ontario and the remaining 10% in Alberta. The trust has made all of its GST/HST exigible purchases in Alberta in a particular taxation year and paid 5% GST. However, as the trust would qualify as an SLFI under the tests above, it would owe an additional 8% as HST on 90% of those purchases (plus interest and penalties). Further, unless the SLFI registers for GST/HST and elects to file returns annually, it will have to file GST/HST returns on a monthly basis (as well as a special annual return). Failing to file these returns will yield a penalty of $100 per failure, as well as additional penalties and interest on any amounts owing under any such returns. In certain circumstances, other penalties will apply as well. Multiply this by numerous entities and several years and you have a serious expense.

Additionally, beginning in January 2019, "investment limited partnerships" or "ILPs" will also be included in the definition of "investment plans". The SLFI rules will apply to them in much the same manner as they apply to mutual fund trusts, unit trusts and certain other entities. ILPs were introduced in late 2017 and are defined as limited partnerships with the primary purpose of investing in property consisting primarily of financial instruments, if such partnerships are controlled by financial institutions or are otherwise represented as collective investment vehicles. The initial impact of introducing ILPs was to make management and administrative services GST/HST exigible, when provided by a general partner to a partnership. Now, starting in January 2019, ILPs will have the additional compliance requirements of the SLFI rules. This means that they will both have to file GST/HST returns and calculate their HST owing pursuant to the special SLFI method mentioned above.

The SLFI rules are often overlooked and as a result, can catch an unsuspecting fund by surprise. Failing to comply with the SLFI rules can result in considerable HST payabl, interest and penalties, as well as the reputational risk of neglecting tax obligations. Accordingly, the next time you are structuring a private equity fund, it is advised that you consult with tax lawyer with respect to whether the SLFI rules apply.

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