The traditional income fund structure is generally a trust, structured as a flowthrough entity for US tax purposes, that holds the debt and equity of an operating business and provides a steady investment return to unitholders in the form of dividends and interest. Such structures have been used to fund the acquisition of US-based operating businesses in the last couple of years. Income participating securities (IPSs) in Canada or income deposit securities (IDSs) in the United States are essentially that same structure, but without the trust: instead of holding trust units, the investor directly holds Canco's underlying debt and equity in one security, the IPS. The following overview of some US tax issues focuses on IPSs but is also relevant to income funds and their unitholders.

Debt versus equity. It is critical that the IRS respect the IPS's debt component and not recharacterize it as equity. If the debt is not respected, the interest paid from the US Opco to the IPS holders is not exempt from US withholding tax under the portfolio interest exemption, and a 15 percent withholding tax generally applies to the amounts as US-source dividends. Furthermore, US-source interest paid on corporate debt is deductible from the US Opco's taxable income, but dividends are not. The classification of a corporate security as debt rather than equity is a question of fact, but numerous factors are well-accepted indicators of debt. Although the IRS has not yet examined an IPS or IDS structure in which a company's debt and equity are clipped, it recently examined the debt-versus-equity issue in connection with the increasingly popular US hybrid securities. Revenue ruling 2003-97 blessed the use of Merrill Lynch's "feline PRIDE" products, which are investment units comprising a three-year forward contract to buy the corporation's stock and a five-year note; each unit is referred to as a single purchase-contract/note unit. The unit's note portion is pledged to secure the holder's obligation to pay the settlement price under the purchase contract, but the holder has the legal right to separate the note from the unit by putting up new collateral for the purchase contract; the facts in the ruling state that the holder is thus not under economic compulsion to keep the unit components together. The issuer also promises to remarket the notes at specified intervals; the issuer's agent sells the note on the public market, so that the proceeds of the remarketing (not the note itself) are used to satisfy the holder's obligation under the purchase contract. The facts in the ruling assume that remarketing is "substantially certain" to succeed.

The IRS ruled that the note and the purchase contract were separable instruments when issued, so that the interest accruing on the unit's note was deductible under Code section 163(a), and the deduction was not disallowed under the interest-stripping rules. The IRS identified four critical characteristics that led to the note's being treated as debt for federal income tax purposes: (1) the holder has an unrestricted legal right to separate the unit into its purchase contract and note components and was not economically compelled to keep the unit together; (2) the purchase contract terminates on the issuer's bankruptcy, when the note is released to the holder, a creditor in bankruptcy; (3) the note remains outstanding for a significant period after the remarketing, and on the maturity date the issuer must pay the note's principal amount; and (4) a remarketing of the note is substantially certain to succeed.

New US inversion legislation. The increasing use of Canadian income fund and IPS structures to acquire and invest in US Opcos mandates a focus on the corporate inversion rules enacted as part of the American Jobs Creation Act in October 2004, retroactive to transactions occurring after March 4, 2003. The rules target certain transactions in which a non-US corporation acquires "substantially all" the assets of a US corporation or partnership whose former equity owners receive a certain percentage interest in the acquiror. In determining that percentage ownership, securities are disregarded if they are issued in a public offering of the non-US entity (in the context of income funds and IPSs, to partially fund the acquisition of the US operating business).

The IRS has yet to issue regulations on the rules' interpretation, including what is meant by the acquisition of "substantially all" the assets. For example, if a new income fund is the top tier in a structure involving a Canadian Holdco and a wholly owned US Opco, were substantially all of the US Opco's assets acquired by a foreign entity, triggering the inversion rules? Moreover, if the US Opco's existing owners exchange their interests for fund units or IPSs in conjunction with the issuer's Canadian public offering, are they deemed to own 100 percent of the foreign entity after the offering for purposes of the inversion rules?

The tax consequences of the inversion rules turn on whether the US entity's former equity holders hold between 60 and 80 percent or over 80 percent of the new foreign parent. If the over-80-percent threshold is met, the foreign acquiror is treated as a US corporation for all US federal tax purposes, including taxability on its worldwide income and classification of its equity as US-situs assets for US estate tax.