EY’s annual Financial Reporting Developments series | ASPE Reporting

Morgan Silverberg (01:56):

Hello, everyone. Thanks for joining us today. I'd like to welcome you to our webcast on financial reporting developments for private companies that are using accounting standards for private enterprises, or ASPE.

My name is Morgan Silverberg. I'm a manager at EY and I'll be moderating today's session. We have a full agenda with EY presenters joining us from across Canada. Our audience is also national in scope, so we've curated some timely topics for Canadian private businesses, which include the latest on accounting standards for private entities or enterprises, and a Canadian capital markets briefing, followed by a Canadian tax update on recent and relevant changes for private businesses. We then have a transaction real estate update on how private companies can take advantage of the trends we are seeing. And, for those who are in Quebec, or who have subsidiaries operating in Quebec, we have a Quebec-only provincial tax update.

Before I hand it over to our speakers, I want to go through some of the standard housekeeping notes and some questions that you might have. The session is being recorded, and I want to go through some of the details around that. In the coming weeks, we will be sending along a copy of the presentation as well as the recording, so look out for that in your emails.

We want to hear from you during the session. However, we have a packed schedule with a two-and-a-half-hour session ahead of us, so we may not get to all of the questions, but please use the Q&A function. I'm going to be monitoring that, and I'll make sure that if we have time at the end of each module, our presenters will take some questions. If not, don't worry; we plan to follow up one-on-one to all the questions that come in if we don't get to them today.

The session is eligible for CPE credits and the certificates will be sent out automatically to anyone who is registered and attended the session today. Those will come out in the coming days, so no need to follow up or request them; they will be in your inbox.

To kick off, I'd like to introduce Adam Rybinski and Andrew Coates. Adam leads our EY Private professional practice nationally, and Andrew is an Audit Senior Manager in our London office. Over to you both to take us through some of the more notable changes in the ASPE reporting requirements.

Adam Rybinski (2:28):

Thank you very much for the introduction, Morgan, and hello everyone. My name is Adam Rybinski and I'll be kicking things off. For the next 30 minutes or so, I and Andrew will be taking you through a number of recent ASPE updates.

As you can see on the current slide, we've got a packed agenda for today. It's a longer list than normal because we've already discussed some of these topics in the 2019 FRD, but given the impact of COVID, many of the topics were delayed by a year and are only now becoming effective in 2021 and 2022.

Let's kick things off and get moving with the first topic, which is leases and COVID-19-related lease concessions on slide 7. This standard for leases is probably well known to many of you because it's already in effect for 2020 year-ends. It was introduced at the end of last year and introduces a simplistic model for dealing with COVID-19-related lease modifications. That is similar to what we had under IFRS, and under the current 3065 guidance or the previous guidance, you have to treat for all lease modifications as a new lease. But what this practical expedient did was provide for simplified accounting methods. To go through those methods and the conditions that need to be met to apply it, there are three conditions that need to be met.

Firstly, the rent concession needed to occur as a direct consequence of the COVID-19 pandemic. So, any changes that resulted factors that were discussed prior to the start of the pandemic would not meet that criteria.

Secondly, the total payments resulting from the rent concession were the same or less than the total payments that were required by the original lease contracts. However, there is an exception made for a small increase in fees in line with time value of money for that rent deferral.

Thirdly, any reduction in lease payments affected only those payments that were originally due on or before December 31. So, it allows for deferred payments to be repaid after December 31, 2021.

If you meet those three criteria, then you're eligible to use the practical expedient simplified accounting, where the lease expense and revenue for the lease contract is recorded in accordance with the terms of the original lease. But then any lease deferral, your lease payable receivable, is booked related to that amount of the deferral. And if there's a rent concession and a rent decrease, that amount is booked as an income or an expense, depending on whether you're the lessee or lessor in the period in which you're providing that lease concession and that decrease in rent.

The key change this year, though, is that it was in effect until December 31, 2021, but the Accounting Standards Board issued an exposure draft earlier this summer to extend that optional relief for rent concessions provided up until December 31, 2022. So, it's currently in deliberation, but we expect that those amendments will be passed before the end of the year.

Moving on to the next slide, slide 8. Entities that avail themselves of the practical expedient are required to include certain additional disclosure requirements. We've listed those requirements on this slide for reference. That was just a quick summary of standards that are in effect now. Next, we'll talk about amendments that are effective for periods beginning on or after June 1, 2021.

The first topic we're going to talk about, which is one of our meatier ones, is amendments to 3856, Financial Instruments for ROMRS, or Retractable or Mandatorily Redeemable Shares issued in a tax planning arrangement.

Moving on to slide 11. These amendments were previously effective for reporting periods beginning on or after January 1, 2020, but because of the impact of COVID, they delayed it a year to 2021. So, if you had attended the 2019 FRD session, a lot of what we're going to discuss here may be a refresher for you since we've covered a lot of these topics.

This slide covers a summary of the major features under the revised standard, which we're going to walk through in more detail over the next few slides. But fundamentally, the Accounting Standards Board considers these ROMRS that are issued in a tax planning arrangement to be liabilities in substance, rather than equity, which is generally in line with what IFRS requires. There are exceptions, however, to this liability classification.

On slide 12, we have the new ROMRS decision tree, and under these approved amendments, the classification of ROMRS is based on the following three conditions, which all must be met.

Firstly, the shareholder receiving the ROMRS needs to have control of the enterprise both before and after those ROMRS are issued.

Secondly, no consideration is involved other than shares. So, it must be a share-for-share exchange only. This is because the AcSB considers non-share consideration to be a form of a financing arrangement that changes future cash flows and, therefore, the related ROMRS would be considered a liability. However, the standard and further interpretations allow nominal cash consideration to be issued. For example, if you're issuing these ROMRS, but need to have a par value of $1 or $10 per share in order to legally affect the share issuance, that's allowed because it's such a nominal amount that it wouldn't be considered a financing arrangement.

Thirdly, there can be no fixed or determinable repayment schedule other than it being due on demand. So, provided you meet all three criteria, you have a choice of classification where you can either continue to classify those ROMRS as equity, if they were previously; or you still have a policy choice to classify as a financial liability, which should be measured at the redemption amounts. As soon as you don't meet all three criteria, if you breach one of the three, you automatically move to having to classify as a financial liability and measure out the redemption amount.

The last thing to highlight is that this assessment is done on a transaction-by-transaction basis. So, if you had two different classes of ROMRS, you would go through this tree for each ROMRS and could theoretically get to two different conclusions. It's not necessarily a policy choice for all your ROMRS.

Moving on to slide 13, we've got an example of control. And the thing to highlight is that the definition of control per Section 3051 subsidiaries essentially narrows down control to a maximum of one party. That's because of the last part of the definition, which says it must be control without the cooperation of others. On this example, we've got Corporation X, which is controlled by five shareholders who each have 20% of the common shares. But because none of the five shareholders have more than 50% of the shares, the entity is not actually controlled by any individual party without the cooperation of others. So, if Corporation X issued ROMRS here, they would have to be classified as a liability, given that they wouldn't meet the control criteria.

Another example would be a joint-control scenario where, let's say, a husband and wife jointly control an entity with 50% each of the shares. They only control the entity jointly, but not individually because they each have an equal 50% share. That would be another situation where you would not meet the control and any ROMRS would be classified as liabilities.

Moving on to the next slide and looking forward and thinking about reassessment. You could have future transactions or events that could occur, which result in those conditions for equity classification to no longer be met. This means that entities need to continue to monitor for these ROMRS and assess whether these facts and circumstances change. And if they do, we have to consider and review it, to determine whether a reclassification is required.

The standard provides some examples of events or transactions that could trigger this reclassification. A few of them are a death of the holder of the shares, repayment terms that are subsequently being added or a change in the ownership of the enterprise. Paragraph 23F of 3856 provides a number of additional standards, but if any of these things happen, we need to reassess it. The last point on this slide highlights that as soon as any ROMRS are classified as financial liabilities, they're effectively tainted for life and can never be reclassified back to equity.

So, on to slide 15, talking about transition. Again, the standard is in effect for fiscal periods beginning on or after June 1, 2021. So, if you're a December 31, 2021 year-end, this is effective for you this year. There is some transitional relief where there's an option not to restate comparative periods for these ROMRS. That might be helpful for entities that have rolling covenants calculations. And if you made adjustments to the prior period, it would affect those banking covenants. So, something to think about in terms of who the users are of the statements, and whether it would make sense to restate the comparative financial information for this.

There is note that retrospective adjustments are not required for ROMRS that were extinguished prior to the beginning of the fiscal year in which we apply the amendments. So, that date is going to depend on whether we're applying the amendments at the beginning of the current year or the prior year.

Moving on to slide 16, what we have is a decision tree to follow the transition date. On the middle of this slide, the key thing to highlight is that we have to understand when the ROMRS were initially issued. If they were issued prior to January 1, 2018, then the condition that no consideration other than shares was issued is actually not assessed for those older ROMRS. Because by the time this revised guidance came out, it would have been too late for an entity to avoid the breach in that condition. So, you only have the two conditions on the left side of the screen if the ROMRS were issued prior to January 1, 2018, whereas if it was issued after that date, we have to consider all three criteria.

Next, we'll highlight on the right side of the screen that when we're recording the impact of applying amendments, entities have a policy choice to recognize the impact of any adjustment to reclassify these equities to liabilities, either directly in retained earnings or in a separate component of equity.

On the next slide, we'll walk through an example that looks through that different classification. In this example, we've got ROMRS with a carrying amount of $100, a redemption amount of $200,000 and during the year they issued $80,000 in dividends. If any of the three conditions that we just discussed are not met, this equity ROMRS under the old standards is going to be reclassified as a liability, and you're going to have to book that adjustment to equity.

at we see on the next slide are two columns, and the left column is showing that if you're taking that adjustment between the $100 carrying value and the $200,000 redemption value, the adjustment is being booked directly into the retained earnings line. So, it's decreased on the left-hand column from the $249,000, down to $49,900. The other alternative on the right side is that you could present it as a separate line item. Our retained earnings stay at $249,000, and then you've booked that $199,000 adjustment as an additional equity line item, or a separate component of equity.

What we see on the next slide are two columns, and the left column is showing that if you're taking that adjustment between the $100 carrying value and the $200,000 redemption value, the adjustment is being booked directly into the retained earnings line. So, it's decreased on the left-hand column from the $249,000, down to $49,900. The other alternative on the right side is that you could present it as a separate line item. Our retained earnings stay at $249,000, and then you've booked that $199,000 adjustment as an additional equity line item, or a separate component of equity.

On the next slide, again showing the difference between your equity classification or your pre-amendments versus your liability classification after the amendments, is the impact of the dividends paid. So, when you've declared these dividends of $80,000 with an equity classified ROMRS, those dividends are treated like any other dividends. They're just included as a reduction of retained earnings, but they don't impact your net income. Whereas, if we now have a liability classified ROMRS, the dividends declared are actually treated akin to interest. As you can see on the right-hand side of the screen, your operating income of $150,000 is being reduced by the interest of $80,000. And you've got a net income of $70,000, so it’s still the same ending retained earnings, but you've now introduced some P&L volatility that we didn't have prior to these amendments coming in place.

Moving on to slide 20 and looking at the potential impact, there is a significant impact both to the balance sheet and the income statement of your enterprise. If your entity is subject to covenants or other conditions related to financial ratios, like a debt-to-equity ratio or an interest coverage ratio, we really need to consider whether you need to be renegotiating those terms of those arrangements or agreements with those other stakeholders or lenders. Or at least make them aware that there are going to be changes to the composition of your balance sheet.

Similarly, on the P&L side, profit sharing arrangements could be impacted by those dividends issued on ROMRS. So, whether it's a profit-sharing arrangement, or a bonus calculation, there is going to be that P&L volatility.

On slide 21, we have our key action items. And to highlight these changes coming into place, you definitely need to begin planning for this transition if you haven't already and really need to understand, based on the users and the stakeholders involved, which transition options and election options work best for you.

The next topic we're going to cover is another amendment to 3856; this one relating to related-party financial instruments. Slide 23 highlights the key features of these amendments, and really, they were intended to address diversity in practice in accounting for related-party financial instruments. We'll spend some time on slide 24, which is an important decision tree when it comes to initial recognition. Under these amendments, the guidance for initial measurement is now included in 3856, rather than under the old standard 3840, where there really wasn't much guidance on how to deal with related-party financial instruments. In particular, there's new guidance for the determination of cost, which is going to be influenced by whether or not the related-party financial instruments have repayment terms.

On this slide, you can see that the initial measurement is going to be based on the nature of the financial instrument. And based on that nature, you're going to record it at fair value based on the cash flows of that instrument itself, or potentially at carrying amount or exchange amounts. And it really depends on the nature of those instruments. So, in terms of fair value, what we have listed on the slide are your investments in equity instruments or debt instruments that are quoted in an active market. Debt instruments with significant observable inputs and derivative contracts are initially measured at fair value, and if you're not one of those instruments, then we have to look at whether the instrument itself has repayment terms.

If it does have repayment terms, where it's straight down to the middle orange box here, we're determining the cost using the undiscounted cash flows, excluding interest and dividend payments. Whereas if the financial instrument does not have repayment terms, we then look at the consideration transferred in exchange for that instrument, and if the consideration transferred has repayment terms or not. If it does have repayment terms, and we again go down to the middle box and look at the undiscounted cash flows, vs. if it doesn't have repayment terms, then we're looking at your standard 3840 guidance in terms of whether you meet the criteria to recognize based on exchange amount, or whether we have to recognize at the carrying amount.

On the next slide, we've got a couple of other initial recognition considerations. With respect to compound financial instruments, the guidance is the same now for related-party instruments as it is for non-related-party instruments. You can recognize the equity portion at zero or, alternatively, you measure the liability portion first and attribute the residual amounts to a liability. Secondly, if there's any variable or contingent portion of a related-party instrument, we would not include that, and we would measure it at zero with the exception for index liabilities.

For the last bullet point, any gain or loss on initial recognition is going to be booked in the P&L when the criteria for exchange amount is met. If you don't meet that exchange amount criteria, then we book it to equity.

Moving on to the next slide for subsequent measurements, the subsequent measurement of the related-party instrument follows the initial measurements. So, if you have investments in equity instruments that are quoted in an active market or derivative contracts, those were initially measured at fair value, continue to be measured at fair value. Whereas with debt instruments quoted in an active market or debt instruments with significant observable input, you have a policy choice. You could record them at fair value through that election, otherwise it would be at amortized costs and then all other financial instruments would be recorded at their cost, less any reduction for impairment.

Moving on to impairments, there's not much to highlight here other than the only key difference between related-party instruments and non-related-party instruments is that the cash flows considered for related-party instruments are undiscounted, as in the italicized text here. So, we go through the same process of understanding cash flows, but with related-party instruments, it's more simplistic and we don't have to deal with coming up with discount rates.

For the next slide on forgiveness, once we've gone through the process of assessing for impairments, we consider whether an enterprise may then recognize forgiveness. And the classification of that forgiveness, whether it's through the P&L or not, depends on the original nature of the transaction that gave rise to the financial asset. That is, whether the original transaction was in the normal course of business or was not.

There are two exceptions on the last bullet point here. If it was impracticable to determine whether an amount forgiven originated outside the normal course of operations, or if it's a financial asset due to a counterparty that's acting in a capacity of management such that it's really considered a compensation, those are two exceptions where you would still recognize any forgiveness in the P&L as an expense, as opposed to an adjustment to equity.

For the last topic on modification and extinguishment, the key thing to highlight is that we don't go through the assessment for related-party instruments of whether it's just a modification versus an extinguishment like you would do for a non-related-party instrument. For related-party instruments, by default, it's considered an extinguishment, so we're going to derecognize the original liability and then recognize a new financial liability. What this means is that, again, it's simplistic. You no longer have to go through that assessment and determining a present value of cash flows to make that assessment.

Onto transition requirements. It is a retrospective application when it comes to transition requirements here. So, if you're a December 31, 2021 year-end, we have to adjust for related-party instruments as at the beginning of the prior period. So, we're talking January 1, 2020, and we're making that assessment for a December 31, 2021 year-end. However, there is some relief provided in that any related-party instruments that were either settled or extinguished before that January 1, 2020 date are not remeasured.

Moving on to key action items on slide 31. Each of these bullet points on this slide highlights differences in how we're going to initially measure and subsequently measure those instruments. So, whether or not you have repayment terms is going to impact what that initial measurement is, variable and contingent repayments. If it was previously measured in the instrument, it’s no longer going to be measured in there. If it's not an index liability, we have to consider whether there are observable inputs to those related-party debt instruments, because that determines whether the initial measurement is at fair value or not. And we also have elections in terms of whether you're going to elect certain related-party debt instruments at fair value or amortized cost.

Last, here on the nature of transactions that created the related-party instruments, that's relevant because whether a transaction is in the normal course of operations or not dictates whether that forgiveness and debt modifications are recognized in the P&L or recognized inequity.

So, that's everything for those topics, and now we can turn things over to Andrew, who will take us through the remaining topics.

 

Andrew Coates (24:22)

Thanks very much, Adam. I'll now turn attention to Section 3051 and discuss the amendments related to investments.

The amendment to Section 3051 was made to clarify certain wording related to the guidance on the application of the cost method for interest in joining the controlled enterprises. In accordance with this amendment, cost is measured as the fair value of consideration transferred in exchange for the investment at the acquisition date. It's also worth noting that the acquisition-related costs are expensed in the period incurred except for costs related to the issuance of debt and equity securities. In practice, we don't expect significant impacts from this amendment as the purpose of this amendment was really just to clarify guidance, with many enterprises already adhering to this approach and practice.

Continuing on, we'll look at the amendment to Section 3465 for income taxes. The key amendment to Section 3465 relates to the presentation of future income tax assets and liabilities. The Accounting Standards Board decided to remove the requirement to split out the current portion of future income taxes and liabilities, and replace this with additional disclosure requirements. So, going forward, all future income tax assets and liabilities are classified as non-current, and there will be additional disclosure regarding the nature of the temporary differences that give rise to the future tax amounts.

Next, we'll look at the recent accounting standard changes that have been improved for annual periods ending on or after January 1, 2022. So, for your calendar year-ends, that's this upcoming fiscal year.

First, we'll look at revenue Section 3400. The amendments to Section 3400 seek to clarify the principles already contained within the standard and were largely made through the addition of an appendix, rather than changes to the body of the standard itself. You can see there are a number of topics affected here. However, we’ll only be touching on a few in detail. That said, please take note of all items on this list for topics that could be pertinent to your organization.

The first item we'll look at is identifying units of account in a revenue transaction. Almost all companies should keep this amendment in mind as the first step in applying Section 3400 is to determine the unit or units of account in a revenue transaction. Generally speaking, the revenue recognition criteria are applied separately to each unit of account identified in a transaction. However, that may not be appropriate in all circumstances. This could include a single transaction with separately identifiable components, where there may be more than one contractor deliverable with a single transaction. In this case, each contract or deliverable would require a separate revenue recognition assessment. It could also include two or more transactions that are linked such that the commercial effect of each transaction cannot be understood without reference to the series of transactions as a whole. In other words, both transactions are considered to be a single transaction and should be considered in assess for revenue recognition on a combined basis.

Continuing on, when it comes to evaluating units of account in a revenue arrangement, an enterprise evaluates all deliverables in the revenue arrangement at its inception to determine whether they represent separate units of accounts. The revenue recognition criteria in Section 3400 are then applied separately to each unit or account that is determined to exist in the arrangement. This slide highlights our considerations when determining whether it's a segment or combined revenue contracts. The slide also highlights our considerations in determining whether a single contract or group of combined contracts contains more than one deliverable. Fortunately, there's a handy decision tree to help clarify this on the next slide.

This decision tree can be found in the appendix of Section 3400. We start out with identifying the contracts that form the arrangement and determine if the arrangement has separately identifiable deliverables. If the answer is no, then the arrangement is one unit of account. If the answer is yes, then each separately identifiable component is deemed to be a unit of account and we're to allocate revenue to multiple elements to each unit of account.

The other two topics we'll touch on include multiple-element arrangements, and the percentage of completion method. For multiple-element arrangements, note that consideration is allocated at the inception of the arrangement to all deliverables on a relative standalone selling-price basis. With respect to percentage of completion, the updates include guidance for determining the percentage of completion, computation of income earned under the percentage of completion, revised estimates, contract costs and expected losses. There's a good amount of content to dig into on this topic, so if it is applicable to your organization, I encourage you to review the standard in detail and reach out to your EY advisor to discuss as needed.

Lastly, on revenue with respect to disclosure, most additional disclosure requirements are specific to the percentage of completion amendments that I just went through. That said, organizations should consider their revenue recognition policy in the context of the new standard and modify accordingly. With respect to transition, as mentioned earlier, this additional guidance is effective for fiscal periods beginning on or after January 1, 2022; however, early adoption is permitted.

Next, we'll look at Section 3462, which deals with employer future benefits. The amendments to employee future benefits are the results of a diversity of practice in the application of Section 3462. The main area of diversity relates to the use of a funding valuation measurement of the defined benefit obligation, or DBO, and how the requirements of the section interact with recent changes to pension legislation. This includes changes in Ontario and Quebec, where new components were introduced to fund evaluations, such as the provision for adverse deviation, or PFAD, in Ontario and the stabilization provision, or SP, in Quebec.

There are two key changes made to the standard as a result. For defined benefit plans that have no legislative regulatory or contractual requirements to prepare a funding valuation, the amendments remove the policy choice currently available to all defined benefit plans to measure DBOs using either a funding valuation or accounting valuation, which means that an enterprise can only use accounting valuations for such defined benefit plans.

Secondly, when an enterprise elects to use a funding valuation for DB plans with the funding valuation requirement to measure the DBO, DBO is measured at the amount that is required to be funded by contributions in accordance with legislative regulatory or contractual requirements and includes all underlying components thereof since such components are required to be funded by contributions to the plan. More specifically, the funding evaluation include items such as Ontario's PfAD or Quebec’s SP.

Entities with defined benefit plans, such as individual pension plans, or IPPs, for owner managers should take note of these changes because their counting may be impacted. Affected entities should consult with their actuaries to determine the impact of these amendments on the financial statements. This can include, for example, needing to prepare an accounting valuation for a defined benefit plan without a funding valuation requirement, or needing to include PfADs or SPs in the measurement of a DBO for a defined benefit plan with funding valuation requirement.

Just a reminder that you'll need to ensure compliance with the amended standard for fiscal years beginning on or after January 1, 2022, with early adoption being permitted, but only if applied to all DB plans. As you can see on the next slide, there's also some transitional relief available as indicated here, which includes being able to defer obtaining a new funding valuation report until it is required.

Next, we'll take a brief look at the new agriculture standard, which is Section 3041. The introduction of Section 3041 is a big deal, as today, there's really no specific guidance on agriculture, which has led to significant diversity in practice regarding the accounting for biological assets. There's lots to digest in Section 3041; however, for the purpose of today's discussion, our focus will be on helping to identify entities that are in scope for this new standard.

At a high level, an entity must be an agricultural producer as defined in Section 3041 in order to apply the guidance. More specifically, only the transactions or events specific to agricultural production are in the scope of this section. Generally, this is limited to producers, agricultural inventories and biological assets, and includes harvested products or biological assets that have been purchased by a producer. Assets from secondary production are not in the scope of Section 3041. For example, if we think about a dairy operation, a dairy farmer would consider their herd and milk products under Section 3041. However, the production of cheese or another secondary product would not be in the scope of Section 3041; rather, that would be covered by Section 3031 inventories.

Lastly, we'll look at one active project with the ACSV right now, which deals with financial instruments. In light of IBOR and similar benchmarks being phased out this past September, an exposure draft was issued on the topic of IBOR reform. And that's given that many jurisdictions are placing the existing IBOR benchmarks with alternative benchmarks. The exposure draft proposes optional expedience, which would allow for an enterprise to choose to account for debt modifications related to IBOR reform as a continuation of existing contract, and not as an extinguishment. For hedge accounting, changes to the critical terms that are directly related to IBOR form would not result in the discontinuation of a hedging relationship, either.

That's everything for the accounting updates, and I'll pass it back to Morgan.

 

Morgan Silverberg (33:21)

Thank you both. We had some questions come in but are tight for time to go on to our next session, but don't worry—we will get to your questions. We're going to have one-on-one follow-ups afterwards. Both Adam and Andrew will be reaching out, so apologies for not getting to them, but you will have an answer in the coming days.

Next up, we have Bill Wu. Bill leads our Capital Markets Advisory practice and has over 23 years of experience in the financial market for both public and private companies. Bill, over to you to share the latest on what you're seeing in the Canadian Capital Market sector.

 

Bill Wu (34:10)

Thanks, Morgan. Let’s go to the next slide.

So, what's happening in capital markets? Well, right now we're definitely seeing a lot of strong liquidity, and liquidity continues. It started off relatively strong in the beginning of this year and that strong liquidity position continues to be pretty evident in the third quarter, and also going into our fourth quarter.

When I talk about the amount of liquidity and capital that's available, not counting the banks for now, just the amount of private capital that's out there, there's over $1.6 trillion of undeployed capital just in North America alone, not counting what bank capital is available. So, we're definitely seeing a lot of liquidity and a strong capital position. What does that all mean? It means that if there are businesses that are looking to strengthen their balance sheet, adding some additional liquidity, it's probably a great time to think about that.

With a lot of strong liquidity, what we're also seeing is that there are a lot of competing credit terms. As we slowly move away from the COVID era, we see a lot of bank covenants on a lot of capital structures, being moved away to almost covenant-like structures. We're seeing a lot of bank proposals and term sheets, and a lot of financings that we are looking at as well. What we're also seeing is that the credit spreads are compressing, definitely being lower, and the overall leverage position of the acceptable amount of debt that banks were willing to lend for businesses is definitely increasing. I'll show a bit of that in the next few slides.

What we're also seeing, was feeling a the strong liquidity market, is really around the entrance of non-bank lenders or alternative lenders. These guys have been around for well over 20 years in Canada, but we're seeing a lot of traction and a lot of popularity in these non-traditional lenders. If you take a look at today, about 40% of all transactions has some form of what we would view as alternative or non-bank lenders. And of course, cost of capital continues to remain relatively low.

What we're seeing right now, in terms of what a lot of businesses are doing, is that our businesses are looking at recapitalizing their balance sheet and also taking advantage of the low interest rates. During 2020, with the beginning of COVID, we noticed that the banking industry scaled back in terms of their committed capital; how much they're willing to do. And, of course, what we're seeing is that as each of these deals are coming up for maturity, a lot of businesses out there are looking at refinancing a lot of their capital structure, to be able to get longer maturities and, of course, renegotiate better terms, etc. Another part is that a lot of businesses these days are looking at recapitalizing their balance sheet to deal with a lot of pent-up demand or strategic directions; what the company was supposed to be, but obviously couldn't execute at a time because of COVID, and are now looking at the right capital to help them do that.

In terms of the interest rates, I'm sure there's no surprise that we see it continues to be at an all-time low. The chart at the top-right is what we call the Canadian benchmark yields. These are Bank of Canada two-year to 10-year tenure notes. And what you see is that, during the COVID era, interest rates dropped relatively low. But in the beginning of 2021 and the later part of 2021, with the fear of inflation and the overall economy recovery, we have been noticing that the interest rates for these benchmark deals began to creep up. It went as low as almost sub-1% at the beginning of this year, to almost about 2% for the 10 years.

Overall, even though the interest rate has gone up, 2% is still a relatively low rate. We take a look at the short-term interest rates, which are on the bottom-right chart, called the CDOR, and CDOR is an acronym for Canadian deposit overnight to lending rates. These are the rates that Bank of Canada sets for Canadian lenders when they borrow the money. In return, they reflect that to businesses, which they borrowed by the form of either CDOR notes or banker's acceptance notes.

But overall, this is what we call short-term borrowing facilities, or borrowing rates, typically 30 days. And we see it at almost an all-time low. I would say the CDOR rates since last year to this year have held pretty steady, around 40 to 43 basis points. So, relatively overall low interest rates. Are low interest rates continuing? Well, we’re probably going to see some hiking in terms of interest rates, which both the central bank in Canada and also in the United States have indicated they may take a look at, but probably in the second quarter or the third quarter of 2022. Of course, that's dependent on how well the economy is performing and overall inflation from that perspective. The long-term Canadian benchmark deals have already factored those in, which is one of the drivers and the reason why we see the interest rates in terms of long-term notes being relatively high.

In terms of the overall debt issuance and so forth, there are four different charts here, but I'll try to keep it simple. At the top-left is the Canadian loan issuance, and this just gives you an idea as to how active the debt capital market is. This is as of September 30 for year-to-date 2021. What we're seeing is that the number of loan issuances and also the amount of debt have almost surpassed 2019 and 2020 levels. When you take a look at it on a quarter-by-quarter basis, and this is the chart at the bottom-left, what we're seeing is a lot of Canadian loan issuance being relatively steady in the fourth quarter of 2020, and then slowly increasing in 2021. Then, an almost explosion of debt issuance or loan issuance in the second quarter of 2021. And of course, the third quarter tapering off to what we see as more normalized levels. But overall, from a year-to-date perspective, 2021 has been what we would view as almost a record year in terms of the amount of loan issuance.

When you're asking the question, “That's definitely a lot of loans and a lot of loan issuances; what is -company doing with all that money?” Well, we take a look at the pie chart at the top right-hand corner. You'll see that the two biggest uses of this type of money are really mergers and acquisitions and leveraged buyouts. And I'm going to combine those two; it's pretty much change of ownership. We have seen a very active and a very busy M&A market. When you combine that with a leveraged buyout market, it represents 48% overall the use of money. Coming in as a third or strong contender is obviously the refinance. And this goes to my earlier point about the fact that companies today are taking a look at the low interest rates and thinking, “Why don't I take a look at refinancing that interest rate, locking myself in for another three- or five-year tenure, and getting myself the capital capacity to do what I need over the next two to three or even five years, depending on the outlook?” And of course, followed up by dividend recaps and other miscellaneous. But, overall, M&A, leveraged buyout and refinance would capture about 80% of the overall total uses of money.

The chart at the bottom-right, not going to go into too much detail, but this shows you a bit of the flow of funds. As in 2020, we saw a disciplined approach that loans were shrinking; loans were being paid down. A lot of companies were looking at shoring up their balance sheet, but as we entered into 2021, we saw $25.9 billion of new loan issuance or capital that's being deployed, with an average of about $496 million of loans being deployed on a weekly basis. So, overall, a relatively strong debt market.

When we talk about debt, we definitely talk about leverage, and I'll start off with the top-right chart around leverage multiples. When we take a look at leverage multiples, and leverage multiples here as measured as a function, as a multiple of EBITDA, the typical rule of thumb is that if any company leverages, three-and-a-half to one or less, you're in what we would view as a healthy leverage position. What we've seen over the last 10 years, in fact, I would say in 2021, is that from a large corporate perspective, a leverage position of all our large corporate has remained relatively steady Eddie around 5.2. But the middle market, which is really private businesses, has taken advantage of the low interest rate environment, and has also taken advantage of the amount of liquidity and the more flexible terms. And we've seen almost an increase in overall leverage multiples, of almost six times cash flow.

Now, this is not a chart to tell everybody to go out and leverage your balance sheet up to six times, but it does give you a bit of indication as to the amount of leverage that is available out there; the comfort levels that lenders are willing to provide. A six-times multiple is a lot higher even before the pre-financial crisis of 2007-2008. When we take a look at the chart that's at the top-left, and when I talk about low interest rates, what I did was pull some data on single B, double B, non-investment grade—or a better way of saying it, junk bonds—that are in the market. What we’ve seen was that back in 2020, where there was a bit of disciplined framework about risk versus return, a higher-risk type of loan product typically will attract 12 to 14% interest rates. What we're seeing right now is that the same amount of risk, the single B and the double B, are now commanding low yields of 4.2% or 5.2%, depending on the rating. This is pricing above LIBOR, which is the US equivalent of their 30-day underlying borrowing rate. And the LIBOR rate as of this morning, just to give everybody some reference, was around seven to eight basis points for 30-day LIBOR. So, when you take a look at issuing a high-leverage bond or high-leverage debt that is not investment grade, but at interest rates that are sub 5%, and clearing market, we're definitely seeing the amount of capital and liquidity that's out there. What we're seeing is a lot of this undeployed capital, just really chasing yields and has really driven down the lending market. So, what that means for businesses such as yours is that the interest rate is at an all-time low, and the leverage position a bit of an all-time high.

At the bottom-left is what we call the default rate, and what we've noticed is that the default rate given the amount of government stimulus and the number of banks willing to restructure existing debt as businesses, somewhat exit out of that COVID environment; that the default rate has gone to an all-time low of just 50 basis points. As a rule of thumb, when you're above 7%, it's when an alarm bell rings and where we are at as of September 30, around 50 basis points, it is at an all-time low.

For the bottom-right chart, not going to go too much in detail. It's the bond index, and it's telling the same story that I mentioned earlier: yields are coming down in comparison to the last 10 years. But even though it has most recently spiked about 40 to 60 basis points, overall, the long-term bond index is still relatively low. What we're seeing here is that the difference between sovereign, which is government-issued bonds, as well as investment-grade bonds and high-yield bonds, are relatively converging and are almost sub-5%.

I mentioned earlier about the private debt market, and this is really what we call the alternative lenders and why that has gained a lot of traction. Some of you guys may be familiar with it, some may not. But private debt or alternative lenders are companies that have well-capitalized balance sheets, typically by a pension fund, a PE or family office money that has committed capital, sometimes 10, 15 or 20 years. They go out and compete with the banks to provide debt solutions. Typically, the play in a space that traditional Canadian banks don't play because it is outside their comfort level. What we've seen, and this is a chart at the top-right corner, is really around the private debt boom. As of 2020, it's a bit shy of $900 billion of capital that's available to be used and to be deployed. It is estimated that by the end of 2021, it will hit the $1 trillion capital market cap.

So, why are a lot of businesses seeking private debt versus their Canadian traditional lenders? Well, the biggest and most obvious one is that as Canadian banks become more and more regulated, that means more covenants, tougher lending structures, and it does put a challenge for businesses as they're looking at growth. And the best way of growth is through cheap capital and debt instruments as one of them. What we're finding is that a lot of alternative lenders for private debt lenders are willing to provide more favorable terms, especially at a time where banks are still somewhat cautiously optimistic from that perspective. We're also finding that their credit structuring is a lot more flexible and creative versus what the banks are willing to do, which facilitates growth. And the view that the private debt lenders, less handcuffs, less regulations and shackles, have more of a long-term vision, which is tied in alignment with a lot of entrepreneurs.

The last part is that with most of these private debt lenders, it's a very flat organization where you could have turnaround and approvals done within a couple of weeks, versus traditional lenders, which sometimes may take three to four weeks, or maybe longer, depending on approval and turnaround. And if you're a business that need capital fairly quickly because there's a transaction that needs to be done, we need to be quick at the trigger. An alternative lender could be a solution for those needs, as an example.

In summary, what are we seeing and how can companies take advantage of favourable capital market conditions? Number one, if you haven't had a chance to look at your balance sheet or your lending agreement, it's probably a great time to take a look at it from that perspective and see if there's an opportunity there for you guys to refinance it, to get some additional financing. Traditionally, banks look at historical financial statements and not future forecast as they take a look at lending. And as the business grows, businesses are looking for capital structures. So, it's not a bad time to take a look at refinancing some of that debt and being able to maybe get a three- or a five-year tenured facility at today's overall low interest rates.

The second part is to take a look at improving your balance sheet or optimizing your balance sheet, and going out and getting the right capital structure, but you don't have to spend it all away. Knowing that you have the authorization, the limit and the capacity to be able to borrow is not a bad thing because as your business grows, you're going to need capital to do so. So, it's a good time to a look at optimizing the balance sheet.

The last two parts is that it's a great time to take a look at renegotiating your covenants, your terms and all that. Covenants do restrict and if you want to slow down a bit of growth from that perspective, but in today's market where there are lots of lenders competing for business waiting to deploy capital, it's probably a great time to take a look at renegotiating your lending agreement to be someone less restrictive, and more to facilitate growth from that perspective. And of course, as always, take advantage of the favourable market conditions, because it doesn't happen all the time. We're in a unique situation where there's lots of capital right there. The interest rates are relatively low, and banks are in favour of deploying their capital as quickly as possible. And this is not just banks, but also alternative lenders.

With that being said, Morgan, I'll pass it back to you. I'm not sure if we have any time for some questions, but I’m happy to answer if there are any.

 

Morgan Silverberg (52:45):

You've recovered some time beautifully, so thank you, Bill. We do have some questions that came in, so I'm going to read those to you, and hopefully we can answer all three. The first one is sector-related, so not sure if you're able to speak to it. In recent years, there was a strong move by Canadian and other banks away from the Canadian junior energy space. Do you know if this situation is improving at all?

 

Bill Wu (53:00):

I think that's a great question. I would say most banks haven’t reduced their overall exposure in terms of the energy space. I would say they probably held their internal whole limits within that industry, relatively the same. I speak with a lot of Canadian banks almost daily and I’ve asked that question myself. And I talk to a lot of senior folks within the bank. These are the key decision-makers or credit risk managers and executives. I haven't seen them increase their exposure or cap into the energy space, but I also haven't seen them reduce it. I think, if anything, they know that it is still a part of the Canadian economy, and I think they're just being probably a bit more selective with how they're going to be lending within that industry. With that being said, what we're noticing is that alternative lenders are stepping up where the banks were falling short, from that perspective. Which is also one of the reasons why we see the alternative lending space has increased its overall market share. I hope that answers your question.

 

Morgan Silverberg (56:45):

Next question, bit of a hot topic. What would be the best strategy to preserve your funds during inflation?

 

Bill Wu (56:46):

Preserve your funds … I think that's an investment question, right?

 

Morgan Silverberg (56:57):

Giving any free advice today, Bill? I don't know.

 

Bill Wu (57:10):

I think it's hard to say. If it's for a business that needs short-term liquidity to fund its working capital needs and so forth, my idea would be that you could either invest that into something like a GIC, which isn't paying very good right now. But a lot of banks right now offer treasury accounts, which are prime minus 90 or 100 basis points, as other ways of mitigating some of that higher inflation right now, from that perspective. Inflation, if I recall properly as of October, was around 4.7. There are not any safe instruments out there that's paying that; even the best dividend stocks, such as banks and so forth, yielding five-and-a half to six at best; even those I would say will be more long-term. But I think right now, if you have the liquidity and you want to keep it, keep it maybe short-term and put it in some form of a treasury account that the banks were willing to offer, because you want to preserve that capital versus risking it from that point of view.

And I'm just giving you as an example as to what we're seeing a lot of businesses doing, because right now, given the government stimulus and Canadians, we're quite disciplined with keeping a strong balance sheet. We're noticing there's quite a bit of cash on their balance sheet. And the question is, “What do I do with it?” Well, you could pay down debt, which is one option, but debt interest rates are low too, right? Two-and-a-half, three-and-a-half percent is relatively low. So, maybe some treasury accounts are probably the best that I can think of to mitigate or partially mitigate some of that inflation risk.

 

Morgan Silverberg (58:00):

Thank you. One last question before we hand it off to the next speaker. I think this is a very timely question and probably on lots of people's minds right now. For the alternative lenders, are deals being written using the 2019 financial results, given that 2020-2021 might be skewed by the pandemic, or does it depend on the sector? How does that alternative lending market work?

 

Bill Wu (58:00):

Great question. What we're seeing, and it's not just the alternative lenders, but I would say the alternative lenders were probably the first to lead off with that thinking. They understand that 2020 is a blip here. What they do to qualify companies is look at how you have performed leading up to COVID or leading up to 2020. And what have you done afterwards to repivot the business and so forth. So, I would say more weight is placed on historical performance and forecast. And I will say that what amazes me every single day is that when you talk to the alternative lenders, they're more interested with businesses figuring out what you plan to do differently. How do you plan to repivot yourself and 2021-2022 and 2023 to get back to where you used to be from that perspective? So, it's more of a forward-looking conversation versus a backward-looking conversation, because I think all businesses have been affected negatively by COVID. Some did benefit, but I would say the majority did get affected negatively by COVID, and I think lenders, especially the alternative ones, are more proactive, progressive thinkers than reactive.

 

Morgan Silverberg (58:25):

Thank you so much.

 

Bill Wu (58:27):

Thank you everyone.

 

Morgan Silverberg (58:28):

Moving on to our next module here, I'd like to welcome Gabriel Baron. Gabe is a partner in our EY Private Tax practice. Today, he will be providing us with an update on the latest Canadian tax changes, affecting private entities and their owners. So, Gabe, over to you.

 

Gabriel Baron (59:00):

Thanks very much, Morgan, and good afternoon everybody.

 

It's fair to say that we're heading into probably the most unprecedented and uncertain time with respect to tax planning for both corporations and family affairs. It really doesn't take much to guess that tax rates and tax policy are probably going to be trending higher rather than lower as both the Canadian government and governments around the world are looking at ways of funding what's been a massive investment in stimulus programs.

The big question that we're getting asked is, “How much, and when?” I wanted to start this tax update with just a reminder and a refresh of the past, perhaps to give us a sense of direction as to where things might go based on previous expressions of what is really the current Liberal government. Now, none of these that we're presenting on putting up here on the slides are proposals today, but they could be indicative of what we might yet see. You might recall an update similar to this where four years ago, there was a sweeping program of anti-private company tax reform. Ultimately, most of that didn't get enacted or passed in any form, but again, when we're trying to make some form of predictions or educated guesses about what might be coming, this is a pretty good place to start.

Some of these proposals included, number one, restricting the number of lifetime capital gains exemptions that were available through family trusts. Now, many people are aware that a sale of a qualifying private Canadian company will allow a shareholder the first $900,000 to be received, or the first $900,000 of gain—almost, it's $892,000, but we'll round up—can be received tax-free. One common tax planning structure is to use the discretionary family trust; which allows multiple family members to not necessarily to be direct shareholders in a private company, but indirect shareholders in a private company at the discretion of the controlling trustees on a sale of that company; to parcel out and give multiple family members up to $900,000 of allocable gains without paying any tax. And that was going to be shut down.

The second material tax planning change that had been on the table was up to, as an approximate, 73% effective tax rate, on the distribution of investment income that was earned within a corporate system where the principal money to be invested was taxed at business rates. And what we mean by that is that businesses today pay relatively low taxes compared to individuals, ranging as low as about 10% to, we'll call it, the mid-to-high twenties; 26 and a half percent, for example, in the province of Ontario.

Two people, one who earns their business income through a corporation versus somebody who earns it as an individual, not a corporation, having that initial lower tax rate would give people a substantially higher amount of capital to be invested, notwithstanding that the investment rates a company pays on its passive investments (the tax rate is about 50%), is comparable to what you pay as an individual. So, the government wanted to increase the tax rates on those investment incomes to "level the playing field."

The third one that really caught everyone's attention at the time, and I think this will lend itself quite nicely to the rest of this discussion, is that they wanted to increase the tax rate applicable to corporations that realized capital gains, and then made distributions of those gains to the shareholders instead of making distributions at highly taxed dividend rates. The only piece of legislation that made it through and became effective January 1, 2018 was the expanded program of income splitting legislation, or TOSI, which was an acronym for tax on split income.

Now, if the 2017 proposals are perhaps too distant to give us any form of guidance, we only need to look at the most recent 2021 election, where the NDP and Liberal governments in their platforms put out tax proposals as part of their overall election platform. And again, this is going to give us hopefully some indication of what we might see. Of all the proposals that we've listed there, I think the two that struck us the most were the Wealth Tax and the Potential Increase to Capital Gains Tax rates. I'd have to say that both concepts have spurred more phone calls in the past three to four months than anything we've seen in about 10 years of practice, specifically on people wanting to do two things: (a) engage in speculative tax planning, which to me is really making a legally binding committed tax planning maneuver, reorganization, or event, despite not having any draft legislation on the table. So again, making binding actions today, surely on the speculation of what might come. And then (b) we usually see the odd phone call once every six months, but the number of times the phone rang within a week where someone was asking, “How do I depart Canada for tax purposes? What can I do to extricate myself from the tax system?” Again, not necessarily based on any particular piece of legislation, but concerns that something was on the horizon.

Now, while nothing is known tangibly about what a wealth tax might look like, we can try and draw certain parallels from other countries around the world. A couple of the European countries have current, during-life wealth taxes, but in capital gains taxation it is far more graspable by the everyday taxpayer. And today, only one-half of capital gains are subject to tax. If the inclusion rate, or what we call the capital gains inclusion rate (the amount in which you improve in your tax income), was moved from a one-half inclusion with 75% inclusion as was floated during the election, that would move tax rates from the mid-to-high twenties, depending on what part of the country you live in, to the high thirties. Some edging is close to 40%. And what you'll also notice is that higher rate edging on 40 also happens to be what the eligible dividend tax rate is in many parts of the country. Again, for example in Ontario, it's approximately 40%. While this might be only conjecture, one of the dialogues at the time in 2017 was there was a general discomfort by the government at the tax planning, which was being engaged in which individuals through their corporations were structuring distributions.

Again, instead of taking funds out in the form of a dividend, which would be taxed at about 40%, people were structuring their affairs to be taxed at capital gains rates through tax planning maneuvers. So, one of the possible options at the time of 2017, targeted legislation had been introduced, but there was chatter in the media that an alternative way to address this would be to just increase the capital gains rates to near 40%, thereby neutralizing the arbitrage and advantage that corporate capital gains rates lend themselves.

Now today, we don't want to be alarmist and we really don't know what will happen with future tax rates. However, what we do know is that there are certain individuals or companies that might find tax planning for a potential increase in capital gains rates to be a prudent course of action. This type of planning is not for everyone, and it's not appropriate for assets that are going to be held for a substantial amount of time.

One phone call we took from a client really strikes to mind saying, “Excuse me Gabe, you had talked to us about managing and in some ways, protecting against a capital gains rate increase. We'd like to do that.” And I had asked, “On which asset would you like to do it?” And he said, “The family cottage. We'll be selling it in 60 years.” So, the most important thing to realize that when we talk about tax planning for capital gains rates, in one shape or form or another, it really does involve an actual prepayment of tax and realization of that capital gain today versus at some point in the future.

So, what do I mean by protecting against a capital gains tax increase? That tax planning, as I mentioned, really involves some form of prepayment of tax where you sell the asset in a manner that increases the cost of the asset. So that—and here's the interesting part where you'll get into financial planning—when you go to ultimately monetize that asset, if you've already reported tax on that and increased its tax cost, there's very little gain, if maybe none at all, left to be realized because you've already paid tax on that. The variation in the plans, which range from simple to complex, lends itself to how much you can control the timing of when you're paying the tax and the possibility to unwind or undo your arrangement, economically speaking, and not pay the tax. This might be useful, for instance, if rates don't go up, because again, short of having a political connection, we just don't know whether rates will or will not go up.

So, let me give you some examples of what, anecdotally, people are doing in the market in some of the dialogues that we're having with many of our clients. The capital gains protection transaction, and we typically see this with stocks and the publicly traded market, is that you execute a trade to sell the stock and you immediately repurchase it. Most people choose to immediately repurchase it if they particularly like the position that they're in, and they're not interested in being out of the market from an exposure perspective. What this does is trigger a tax and a gain to be reported, now, say, in November of 2021, and that would be until such time as the law has changed, tax at current capital gains rates. What ends up happening is that you now inherit, or you rebalance, your portfolio. This is no different than churning the stocks that you might have in your portfolio, but you rebalance, and you reset the tax cost or adjusted cost base, or ACB. You'll hear all sorts of different acronyms out there, but you reset the tax cost to what is now the trading market price.

Ultimately, when you go to sell, assuming that there's no material movement in the price of the stock, you wouldn't have any major gain or loss. If the stock continues to move up, perhaps you'll have a small gain in the future. If the stock trends lower, you'd have a loss. But if, for example, the rates were to become a higher amount effective in 2022, in 2022 when you go to sell, you wouldn't have that much gain left over. However, the issue with this type of planning while it's simple, doesn't lead yourself to have much control over whether you might want to undo it and not prepaid the tax. Because come next April, you'd be showing a sizeable bill.

A variation to the extent that you're married or have a common law spouse, is that you can modify this transaction to transfer the investments to your spouse. What that's going to do is that transfer of assets between spouses normally doesn't trigger tax. In fact, you can transfer assets all day long back and forth between spouses and that transaction happens automatically at the low ACB or tax cost of the asset. However, when it comes time to tax filing, again, next April if you're an individual—and this is the case where we're talking about human individuals—you have the choice in a spousal transfer situation to elect or choose to pay tax. You can choose to make that gain happen at whatever was the market value of the transaction.

So again, what some people are considering doing is that if they're concerned and want to lock in a higher tax cost and give themselves the opportunity to prepay some tax on that game at today's low rates, but they'd like a chance to, for lack of a better phrase, see into the future, they transfer it to a spouse and they don't have to make the decision as to whether they will or won't elect to pay tax at the full fair market value of that asset. You don't have to make that choice until you go to file your tax during April. So, in essence, you're giving yourself the ability to look about five and a half months into the future between now and next April, at which time again, the government’s going back to business today; the first day back for the house of commons in Ottawa.

Typically, we'll have a mini-budget in the fall and a full budget in March or April. So, this might be an appropriate maneuver for a position that you might be thinking of liquidating, maybe in the next six to nine months, maybe one year from now. This would give you the ability to at least have until April to be able to decide whether you're going to prepay tax. I will point out there are complexities when we transfer assets back and forth amongst spouses, in that any income or gains realized by that asset, if it continues to be held, attribute back to you the transferring spouse. But that complexity might be worthwhile if you're concerned about a higher increase in taxes.

What I would say is the ultimate in tax planning is for individuals or corporations. So, in this case, not requiring a spouse, in which you create new entities, typically corporations or partnerships, and you can sell an asset to those newly formed entities, which will give you the ability to control both. How much of a gain you might report? Whether you report it all and based on typical time of when corporations are realizing these gains in their fiscal period, you might find that you don't have to make a decision for as much as 12 to 18 months as to whether you're going to pay tax on that transaction.

Certainly, it's more complicated in that you're forming the new entities, involves a tax reorganization, but it gives you the ultimate in scalability and flexibility. And again, it's all hinged on the concept of trying to realize a transaction today, to protect for a capital gains rate increase on a monetization of an asset that will happen in the future. I keep coming back to that idea of trying to make sure that you're thinking about financial planning and financial math when thinking about this, because as much as tax rates might go up, and again, high degree of uncertainty as to whether they do, this is only appropriate I would say for assets that are going to be sold in the next six months to maybe two-and-a-half to three years out. Because after that point, if I had the decision whether to prepay tax at 27%, would be subject to tax at 40%, that then defines my ROI and say, “Okay, if the tax rates do go up to 40, my current tax rate is 27. I can save 13 points by prepaying my tax.” But at some point the opportunity costs of pre-payment of tax, or said another way, the present value of the future tax rate increase really doesn't make good financial sense anymore, particularly if you're deploying capital away from the business that can be earning a higher ROI. At some point, a prepayment tax just no longer makes good financial sense.

What I would say for those of you on the webcast today who we haven't already spoken to about the benefit of these transactions, certainly anyone here at EY would be happy to look at your situation and see if there's a way to identify whether this planning would be appropriate for you.

In the vein of talking about capital gains tax plan, our update would not be complete without addressing Bill C-208. And you might not realize this, but until Bill C-208 came out, which was a piece of legislation passed in the summertime, the Canadian tax system disincentivized family companies being sold to other related family members or being transitioned generation to generation. And the reason for this is as follows. Most people know, as we talked about in the family trust capital gains splitting context, the first $900,000 of capital gains on qualifying private Canadian company sales can be realized tax-free. But what most people were not aware of was that most typical M&A transactions are the most typical ways in which companies are sold. Typically, company assets, whether cash on hand or leverage that you'd put on the company, both cash inside the company, leverage within the company, are used to facilitate a purchase of one buyer to the next. Very common tax planning technique, because it's efficient to use corporate assets to be able to facilitate the purchase of shares from another shareholder.

The problem was that if a family member wanted to sell the shares to the next family member, and the expectation was that either cash inside the company or leverage inside the company, was going to be used to facilitate that purchase. Instead of having a tax-free sale of shares for the first $900,000—or even let's dispense for a second with tax-free money—even if someone was going to sell to a family member and just enjoy or realize an ordinary half-tax capital gain, the proceeds of disposition would be converted from capital gains, either at zero tax or at the half inclusion rate, to highly taxed dividends. And this was a punitive outcome. So, in a rare form of parliamentary drama, a private member's Bill, being Bill C-208, made it to the House of Commons, and then to everyone's surprise, passed and became law in an attempt to fix this decentivization, or this problem, which stops or hurts families from selling their company, generation to generation. If anybody looked in the media at the time, it was referred to as the “intergenerational transfer of a business.”

Unfortunately, Bill C-208 was drafted with what many would consider deep technical flaws that resulted in unintended but lucrative tax planning opportunities. And because of this, the government flip-flopped for a while whether they were going to accept the legislation as drafted. They'd said they were contemplating drafting retroactively applicable legislation to try and neutralize the effect of this technically flawed bill. But, ultimately, they came out and acknowledged and said, “We will accept the law as has been drafted but be forewarned: we're going to be working on new legislation. There are a number of things that we want to see in that new legislation, and these new laws will become effective on the later of November 1, or when that draft legislation is released.”

So, there were some high-profile editorials; a number of open editorials written in the National Post, as an example, where these unintended tax planning opportunities that came out of Bill C-208 were laid bare out in the open media. Particularly that an individual could pre-access their $900,000 capital gains exemption. Instead of just using it to purely sell shares of the business to a family member, that indirectly, we could use that to make a distribution of funds and take money out of a private company in advance of selling it to a third party.

Now, because the government had been clear about their concern, about what was being done with the legislation, what they wanted to see in the new iteration of the legislation, it's too early to tell how aggressive the government is going to be in enforcing or auditing what they might consider inappropriate uses of Bill C-208. When we were drafting the slides for this presentation, we weren't sure if we were going to talk about Bill C-208 because, by everyone's account, looking down at the date, we're 22 days into November, and it was widely anticipated that the shutdown legislation with the revised package would have been released on November 1. There was a lot of tax planning activity that took place before then. We're still waiting to see that draft’s legislation.

So, the best that I can tell anyone who's engaged in dialogue around the use of Bill C-208 for anything other than the true in the spirit of intergenerational business transfers, would just be to exercise some form of caution, to consider the risks that those types of transactions that fall outside of the scope of what the government has put out into the public domain is the intent of it. Which is, again, to facilitate the transfer of business generation to generation. We'd just recommend exercise in some form of caution over what may be enforcement activity in the future.

A bit different now, turning our minds less around tax planning and more so to the stimulus conversation. We've allotted 30 minutes for this tax update, and this could really be the entire focus of a full afternoon’s webcast and tax update. But what we wanted to call to everyone's attention to is that the CEWS, which was Canada's primary labour subsidy program; and the CERS, which was the rent subsidy program; both closed for good for the period that ended October 23, about a month ago. And this would have been the 21st and the 14th claim periods, respectively, for both the wage and the rent programs. So, as far as what was supposed to be a short-term stimulus program, it certainly lived a lot longer than most people had anticipated. So, instead of the CEWS and the CERS, which are the legacy programs, they've been replaced with more targeted, industry-specific programs, for which the legislation has yet to be released. We're told it's forthcoming. Again, the government has reconvened its business and so we expect parliamentary process to start working again. And we're hoping that we're going to get some detailed legislation on the program. But, essentially, these new programs, being the tourist industry the hardest-hit program, are going to combine the wage subsidy and the rent subsidy under a single banner. And, again, some of them being sector-specific, such as directly applicable to restaurants, bars, tourist operations and hotels.

I will also point out that they announced an extension of the third version of the wage subsidy program, which was the Canada Recovery Hiring Program. But maybe more relevant to the individuals that are attending this webcast, it’s only available to CCPC (an acronym for Canadian Controlled Private Corporations), or certain partnerships. So, if you're a part of a closely held foreign controlled company, that form of the wage subsidy will not be applicable.

What we’ve tried to do is condense some of the key hallmarks of these new and extended programs onto a single page (the new programs being on the first three lines of the slide), which show there will be continued government support, but only for businesses that are continuing to suffer material declines in their revenues relative to pre-COVID times as well as, in some cases, the need to have had significance during the early days of the pandemic. So, both impacted businesses right out of the gate from COVID and sustained challenges with the business. I will point out, though, that the Canada Recovery Hiring Program continues to act like the CEWS program, albeit for a more restricted group of applicants.

Prior to this webcast, we had the chance to canvas several EY teams that are involved in working with the CEWS programs, and particularly that had gone through audits with the CRA. We just wanted to give some anecdotal feedback. Again, this is not an official stance of the government, but we thought it would be helpful as we expect we're going to be seeing more and more enforcement activity from the wage programs. The key takeaway—if it’s not the single-largest claim that was made by a Canadian taxpayer, then it's up there in the top five—was that the enforcement by the CRA program is still very new. And the exact words were “Have some patience and empathy with your auditor.” In that the CRA has put forward a very new workforce to address this program, the details of interpretation are still being made and that these early-day audits, particularly if that's something you've experienced, are going to pave the way for future audits.

The key takeaway that I think not everyone realizes is that there is no statute of limitation on the wage subsidy programs. What that means is that with ordinary income tax positions, when you file an income tax return, there's a lot of dialogue saying the government does not have the right apps for  fraud or carelessness. There's no ability for the government to go back and audit an income tax return beyond three and sometimes four years; seven years, where there's a transfer pricing involved. And in the case of these wage subsidy claims, there is no limitation. While it might sound academic, the government could go back four years from now, five years from now, seven years from now. So, you have to consider that to the extent there may be some challenges, friction or concern in the claims that were made historically, it might be worthwhile doing a refresh and looking at what skeletons you might have in the closet around documentation. Was there legal paperwork produced to evidence elections? There are a number of things that can go into it, but I think people need to be prepared that the enforcement of the wage subsidy program is going to be taking a lot longer than most anticipated, and that the government is not running up against a clock. So, it’s better to address any concerns there might be sooner rather than later.

I want to close out the session with just a brief update on the R&D tax credit program. For what it's worth, the R&D Scientific Research and Experimental Development program, also known as SHRED, was really the original wage subsidy program before the term “wage subsidy” became cool. CRA continues to do its technical and financial audits virtually, and this is consistent with other enforcement of CRA programs that goes on. For instance, all income tax and GST audits are still being done virtually. We're not aware of any wholesale changes to the program that are anticipated; nor has the government expressed any interest in changing the form of the actual submissions, being the form T 661, which is filed with the corporate income tax return.

The CRA wants to continue to push and publish guidance and help companies determine what is and is not R&D program eligible, including targeted industry committees, which are in emerging and highly technical industries, such as Cleantech. So, to that end, to help the tax community; really help the business community at large; understand whether they're putting forward good claims that are entitled to the subsidy or to the R&D tax credits, the CRA is launching new tools and services that are going to continue to help companies assess their eligibility for tax incentives, both for financial and technical bases.

I want to put out one anecdotal reminder. Again, this is something that emerged in conversations over the last 12 to 19 months, as we found the pandemic a drag-on and we now have the spill-on effects of finally filing a lot of the tax returns for the period that included both the early and now mid stages of COVID. That is, to the extent you're getting other forms of government stimulus, such as the wage subsidy program, you're not allowed to double up on R&D tax incentives while also getting wage tax incentives. The R&D program always had a reduction in the credits that are payable for some form of government assistance. Traditionally, that government assistance was in the form of grants or other targeted or specific programs, but now you have a much broader population that has been exposed to capital G government stimulus. Therefore, when you're looking at your budgets and your forecast, it's important to realize that you may have to be curtailing or retracting some of your R&D tax incentives, because the qualifying labour base, the actual dollars that go into the mechanical computation of the R&D tax incentives, will be clawed back, associated with the quantum of dollars on which you've gotten the wage subsidy.

We want to thank everyone for their time. I believe we have one or two questions coming in, and I really hope that everyone enjoys the rest of their session. Thank you.

 

Morgan Silverberg (01:29:54):

Thanks, Gabe. I know we have a couple of minutes here before we hand it off, but one question/comment came up a couple of times in various forms. If the federal government increases the capital gains inclusion rate and they are likely to have a valuation day, or V-day, so that paper gains to that date will retain the current 50% inclusion rate and only future gains would have the higher inclusion rate.

 

Gabriel Baron (01:30:24):

If I'm going to interpret that, the question is, “Where do we draw the line in the sand or what's going to happen?” It lends itself to a very interesting point; again, we can use the past and some long-term paths to try and give us an indicator of what will happen. And this would not be the first time that there have been changes in the capital gains inclusion rate during the run-up of the dot-com boom, when you saw the stock market on a heater in the 2000s. There was an increase in the capital gains inclusion rate from 50%, to two-thirds, to 75%. They actually moved it twice and then as the market went the other way, they quickly scaled back and said, “We don't want to give people the benefit of a 75% inclusion rate for losses.” And in that case, and each time there was a date set by the government, the tax legislation inclusion rate literally followed. If the announcement was made at four o'clock on November 22, then that would become the crystallized date on which transactions made before that date were subject to one tax rate, and transactions made afterwards were subject to the hiring.

It's less around a V-day value in which, for instance, when capital gains tax rates were first introduced, all capital properties were valued and that valuation set the cost, or the floor, above which capital gains tax would apply. To our knowledge, there's been no discussion by the government as to whether all capital properties in this country would be blessed or caught by a V-day concept; where everyone would have their properties valued and be told that whatever the value of your property is on November 22, it shall be grandfathered or locked in and blessed to be at the one-half capital gains inclusion rate. That hasn't been discussed. It's a possibility, but I'd say it's an unlikely possibility.

The more likely outcome is that they're going to set a transactional date, saying any gains realized after this date will be subject to the higher tax rate, in which you'll find it’s tantamount to a tax increase on unrealized capital gains. That's why you're seeing so much market activity of individuals who are looking to refresh, or monetize on monetize their gains, because there has been no public discourse around whether the government would set some form of V-day, or valuation day, floor.

I will also point out that I am hoping this is not what we're going to see. I recall that there was a paper produced when they were considering changes to capital gains, tax inclusion rates, back in the 80s I believe, where someone had talked about the idea that you could have a certain inclusion rate on one day, and have another on the next day. But, for instance, for corporations, that you will apply an average or pro-rata rate that averages the two inclusion rates based on how many days you have in your fiscal period. Again, that would be tantamount to a retroactive tax increase because people are engaging in transactions today with the understanding that there is the one-half inclusion rate. And if somehow the tax rate averages up based on a proration, that would be tantamount to a retroactive tax increase. Generally, the government tries to avoid retroactive tax rate increases. They limit that for what they would consider egregious tax planning situations. But again, we're in an unprecedented time. So, there is an element of risk and engaging in these tax planning transactions to protect the gains. And it's important that you engage in conversation with your own advisor to make sure that it's appropriate for you.

Thanks, Morgan.

 

Morgan Silverberg (01:34:18):

Thank you so much. Moving on, I would like to introduce Zach Pendley, who leads the Transaction Real Estate and Valuation practice for EY Canada. He specializes in helping clients make strategic real estate decisions to address their biggest challenges within their corporation, as well as in their personal real estate portfolios. Zach, thanks for joining us. I'm going to hand it over to you.

 

Zach Pendley (01:34:45):

Thanks, Morgan. It's great to be here with you all this afternoon.

We think real estate is a relevant topic for everybody online, because either your companies are big occupiers of real estate, you may have real estate on your balance sheet, or individually you may invest in real estate. So, I think everybody is keenly aware of the changing dynamics of the market coming out of COVID. We thought it would be helpful to cover a bit around the emerging trends we're seeing in the real estate sector, and tie it back to some of what we just went through, both with Gabe on changing tax policy, and how that might be impacting real estate transactions. I’d also like to talk a bit about the capital markets space and what's happening with interest rates and the real estate market.

Starting with some of the trends that we're observing, the first is really a focus shifting towards recovery. A year ago we were talking about pure risk, and we were talking about rent subsidies and other programs. We were talking about lenders extending credit and forgiving defaults. It's really different a year later. It's surprising to many of us in the industry as to how resilient the real estate industry has been over the course of the last year. We've never been through a period of such change in terms of how people are working, shopping and living. So really, it's about renewed optimism and the sector in general.

I think that COVID, in some ways, has accelerated some of the changes that were already happening in this industry. Things like online shopping and hybrid work styles started to happen before COVID, and have really been accelerated as a result of the pandemic. One area that we're having a lot of conversations about, though, is an increased focus on ESG-related initiatives; as we look to build back better.

One of the most common things I get asked is this concept of WELL building certification, or WELL building standard. You are probably familiar with LEED, and LEED platinum was the gold standard for many years in real estate. Now, this WELL certification that is being done by the Green Business Certification and corporation is becoming the new standard. It really incorporates elements of the health, wellbeing, and mental health of occupants of a building, in addition to initiatives around smart building clean technologies. So, you'll start to hear that being referenced more often, both from occupiers of real estate, as well as tenants and landlords. There's also a lot of emerging prop tech companies that are driving change in this industry; “prop tech” meaning property technology. The real estate industry was typically slow to evolve or change, but instead of talking about smart buildings, we're really talking about healthy buildings. Healthy buildings and user experience are top areas of growth. So, any technology that helps to make a building smarter and better understand the needs of end users is really gaining a lot of attraction.

Then, we're talking about the redevelopment and repurposing of certain assets. There are changes in how we live, work and shop, and it's requiring us to reimagine the use of certain assets. There's a lot of demand for different uses that have increased as a result of the pandemic, and some uses have really decreased as a result of the pandemic. But again, that's an acceleration of change that was likely starting before COVID. We're continuously evolving consumer behaviours. Each of us has increased our behaviour of shopping online, and as such, there has been an incredible demand for logistics space. The cost of warehouse space across this country is unbelievable. It's really considered to be the most desired asset class in the real estate industry and asset juicing, record level of price and growth, both on pricing of the assets themselves, and also on the underlying cost of occupying that space. We're talking about double-digit annual rental growth rate for warehouse logistics and distribution space.

Another key trend we're seeing is that a lot of the municipalities and provincial governments are looking for ways to shore up some of the deficits that have been incurred as a result of the pandemic. So, you're starting to see them thinking about offloading certain non-core assets. They're asking questions like, “Do we really need to own the office space that our provincial municipal or federal workers work in, or could that capital be better used elsewhere?”

I think you're also starting to see whispering of increases in interest rates, and this is really building off of what Bill just spoke about. So, what does that mean for real estate? We're going to do a deeper dive on the correlation between real estate values and capitalization rates, which is the standard metric with which we value real estate, to interest rates, and see what a forecasted increase in interest rates really means for the sector. I think that sellers are absolutely taking advantage of renewed optimism and strong pricing for certain assets in real estate. We're seeing transaction activity substantially increase year over year. It's a combination of people believing that perhaps we're at record pricing, that perhaps interest rates are going to increase, and that perhaps tax codes are going to change, which could further incentivize people to crystallize some of those capital gains taxes now. And then, the one question mark in all of this is, “What is happening with inflation?”

We've all heard about supply chain issues, but it is having a dramatic impact on the cost of materials. Anybody who's undertaken a home renovation project during COVID knows the cost of lumber firsthand, and that the availability of contractors is challenging. So, even in an environment in which real estate values are rising significantly, inflation has a material impact on the feasibility of projects. What may have been feasible a year ago may no longer be, given construction costs. And one of the things that we're seeing is that a lot of real estate companies typically like to enter into a fixed-price contract with a contractor to build and develop real estate. It's becoming more and more challenging to shift that risk of inflation to contractors, so there's a lot more pushback on locking and fixed-price contracts. In fact, trades are walking away if developers are not willing to renegotiate some of those key terms.

So, while the market continues to evolve, real estate evolves differently day-by-day by asset class. We'll talk a bit about some of the asset classes that are the most interesting to us. Back to what Bill talked about though on-capital markets, not only is there a record amount of liquidity just in general for businesses, but there's also plenty of dry powder on the sidelines looking to acquire real estate. So, a lot of the pension funds and family offices held tight during 2020. That has dramatically changed, and in fact, there is more capital looking to invest, to partner, to joint venture with businesses related to their real estate than we've ever seen before.

It's really interesting because many of the institutional pension funds are desperate to find opportunities to acquire real estate through joint ventures with operating businesses. So, it's a prime opportunity as a private business that potentially owns real estate to think about real estate in a different way, in terms of attracting capital or investment. We’ll talk a bit about that as well.

We thought, at the peak of COVID, that there would be an opportunity for capital to solve the broken capital stack or provide liquidity and distress situations, but we really haven't seen much of that. Distress funds that were raised for COVID largely sat undeployed. We certainly saw some taking advantage of opportunities in the hospitality space, but beyond that, lenders were patient and with government subsidies, there wasn't a high level of distress situations.

Now, we're going to do a deeper dive into certain asset classes. Obviously, the sector that remains the most at risk is hospitality, tourism-related. You heard Gabe talk about initiatives and programs that the government is looking at to try and spur growth in that sector, but it is a tale of two different sectors. Drive-to, leisure hospitality assets have actually performed really well through COVID. Urban business core hotels, which were the most desired hotels to own pre-COVID, have still struggled. There was a significant amount of patience from the lending and investor community during COVID. At one point, more than 50% of all hotel mortgages were in technical default from non-payment or from a breach of covenants. Travel has resumed, but there still is concern over the long-term shifts in leisure travel, as well as business travel, which means that we are starting to see certain hotels completely coming off market and being repurposed.

We saw it here in Toronto where some of the first movers and hotel owners approached the city and have turned hotels into homeless shelters, affordable housing or accommodations for support staff during the height of the pandemic. And the question that remains is: “Are those going to come back as hotels?” We will see.

Retail was the sector that we were all talking about at the height of the pandemic, as landlords weren't collecting on rent and stores were forced to close from provincial shutdowns. But the retail industry has actually come back fairly strong, and a lot stronger than many thought. Retail anchored with essential service tenants is the flavour of the day. So, as much as some people say retail is dead, no—if you have a shopping centre with a grocery store, a hardware store, a pharmacy, a liquor store with national credit-rated tenants, it's the most desired. There are benefits: both landlords who own these assets, and also tenants understand the impact that they have on the overall attractiveness of a shopping centre. So, if you are one of those essential companies that I just talked about, your ability is significant to negotiate, make lease modifications, seek reductions in rent or receive free rent in exchange for an extension of your lease term.

COVID also accelerated the redevelopment of some of these retail assets. You may have seen in the news, and Oxford announced yesterday, that Yorkdale mall is going to have several apartment towers. That's on top of their plans for Square One and Scarborough Town Centre. We’re just starting to see that increased level of densification and introduction of multi-family assets on any excess density of retail. Senior housing will be an interesting one. There's going to be significantly more government involvement around ensuring quality care and the adequacy of the facilities given what we all saw firsthand at the height of the pandemic. But it's also a sector that's right for disruption and poised for growth. As the demographics are still showing that we need much more and better-quality senior housing in this country, we think that a lot of the hotels may be repurposed as a senior housing product. It's also attracting a lot of interest from US players who are looking at Canada and trying to bring their operating models around senior housing here.

Office is the one that I'm spending a lot of my time on that I wasn't a year ago. A year ago, we didn't think that the majority of us would still be working from home at the end of 2021. But the reality is that the way we work has changed, and it likely has changed for a long time. Now, the return to office looks different for every organization, but there are a few common themes.

We commissioned a physical return-to-work reimagined survey earlier this year, and 75% of all respondents said they're totally rethinking their workplace real estate by either redesigning their offices, reducing the square footage of space, or adopting some level of permanency with remote work. The key is that flexibility is here to say; going to the office is going to be for collaboration, training and brainstorming, rather than simply for getting work done. So, how office space is designed will change to accommodate those activities that happen in person.

But every occupier of office space is rethinking how much space they need, and also where they occupy that space. Does it make more sense for you to have a distributed portfolio where you have smaller offices across a broader geographic area to reduce commute times for individuals? Does it still make sense to have one central nodal location? These are the questions that people are asking, and it means that we're in for a period of significant change. We're already seeing it. Vacancy rates are the highest level they've ever been in the last 20 years in most markets across Canada, and landlords are nervous. They're facing near-term lease expires, and they're trying really hard to persuade tenants to stay, to not reduce too much of their square footage, and they're offering pretty attractive inducements for tenants who are willing to make commitments to stay in their space. As users of office space take a look at and are thinking about how much space they need, they’re asking if this an opportunity to lower some occupancy costs or rethink how much space they actually need, as they adopt a more flexible work environment going forward.

Finally, the retail and industrial. If you take nothing else away from this presentation, remember this: that the phrase of the day is “beds and sheds.” Everybody wants to own beds and sheds; they're the most desired asset classes. It's really a function of an imbalance between supply and demand. There are not enough good multi-family apartments across this country, and there's not enough good industrial space to deal with the rise of e-commerce and the changing way in which we shop. So, you're seeing an incredible amount of investment capital chasing these types of assets. Lenders are willing to lend aggressively to get this type of product built. So, you're just going to continue to see it.

For those companies that are in the manufacturing or production space, and happen to own their warehouse or manufacturing facility, now's a really good time to take a look at how much that might be worth. Is there somebody who may be willing to come in and either joint-venture with you on it, or acquire it in a sale leaseback transaction if you're looking for way to unlock capital? You might be surprised at how much some of these industrial assets are trading. I certainly have been, as I've been watching the market.

Now, I'm going to go a bit more academic on the next slide and tie it back to what Bill was talking about. I'm going to present this slide, which I track quarterly. And I love this slide because it translates cap rates and the risk-free rate for the 10-year bond yields. We look at what happens to cap rates over time, and remember that cap rates are a key measure of how investors value and perceive risk in real estate. You can see that during the peaks of the pandemic, as well as other major times of disruption like the global financial crisis, there was a widening spread between the risk-free rate in Canada bond yields and the corresponding cap rates. And we saw that again in the Q1/Q2 of 2020. What's happened since then is that bond yields have come back significantly, which are effectively lowering the spread between cap rates and risk-free rates.

What that means is that investors perceive there to be quite a bit less risk in the real estate industry. In fact, the spreads are so low that there haven't been many times in the last 20 years where the spreads have been this low. And what that means is that if bond yields continue to increase, it's unlikely that the spreads will continue to compress. Instead, what you'll likely see is cap rates starting to rise. We've already started to see it in some of the asset classes. So, we're at the end of what I believe has been a 21-year downward trend on cap rates with a few minor inflection points over time. That's really a function of rising bond yields and rising interest rates. At the end of the day, real estate is acquired through financial instruments, typically, 70% debt, net. If the cost of debt goes up, or the availability of debt changes, that will have an impact on real estate. And again, I can't paint the industry with one broad brush. I just finished walking you through all of the different sectors and not every sector will be impacted the same way.

But on the next slide, you can see the forecast on increases in interest rates and varying levels of cap rates across the country. I should also point out that it is different by market. Some markets are going to be more exposed, where cap rates have been at historical lows for quite some time, versus others that may have more of a cushion to absorb increases in bond yields and interest rates. But the consensus is that we are going to see interest rates rise here in the 2022 to 2023 timeframe. As such, we anticipate seeing broad levels of cap rate increases. That doesn't necessarily mean that real estate values will come down. But what it does mean is that there's going to be a renewed focus on driving income generated from real estate. So, operating efficiencies, investing in technologies that drive operating efficiencies and trying to grow rents will ultimately be the way to realize real estate value increases, rather than just benefiting from a low cap rate period and horizon.

This gets to my next point on the next slide, which is that now is the perfect time to answer some of the questions that we have on this screen. Do you understand your real estate portfolio? Do you understand it, given where we're at in the cycle today? I just walked through the point that I believe we are at peak asset pricing and that there is still runway for growth in certain asset classes, especially multi-family and industrial. But now might be a compelling time to take advantage of the amazing amount of capital that is available from institutional investors who are looking for strategic acquisitions or partnerships with real estate businesses, or with companies who own real estate. So, you may not be a real estate business, but you may have a portfolio of real estate within your company, and now's an opportune time. Is now a great time to create a REIT; a public and/or private REIT? Is now a great time to look at entering a joint venture where you vent some of your assets into a new holding company, or enter into some kind of financial arrangement with a financial partner to free up capital? And it really begs the questions: Do you need to own your real estate? Is that the best use of your capital? Are there other initiatives that you have undermined where now's an opportune time?

We're seeing companies thinking about spinning their real estate off into a separate holding company. One of the reasons for that is that there may be a significant uptick in the book value or the market value of your asset relative to the book or carrying value. And by spinning it into a separate entity, does that then allow you to do things like attract mortgage financing at historic low interest rates today, or seek third-party investors to become equity investors into that entity? Those are some of the questions that I think people who have exposure to real estate in this market in this country should be thinking about.

And it's something that we do with our clients. What you see on the right-hand side is an example of the fact that real estate shouldn't be held in isolation from your business. So, we ask people why they own their real estate. Is it about controlling their brand? Is it about driving earnings? Is it about their ability to scale their business? We try to understand what's really most critical to your company's strategy, and then tie that back to your real estate to ask: Does it match? Do you need to own this real estate? Do you need to control this real estate, or not? Or is there an opportunity to do something more creative with it to better realize upon the underlying value of those holdings?

One of the most common strategies that we have seen, which I'll walk through on the next slide, is an uptick in both provincial, municipal governments and private sector organizations looking at sale-leaseback strategies. This is for situations where we've decided that we don't need to own our real estate, or we don't need to own 50% or 60% of our real estate, but we want to realize some of the uptick and value that we know has happened, but we still really like the physical space. We like having some control and that control can be still mitigated and a sale leaseback strategy with certain key terms. Essentially, it's an opportunity for companies to shed a core asset like real estate and then, in turn, generate significant capital. And there's a lot of flexibility in how sale leasebacks are structured. If some prefer a very low, ongoing long-term lease where they're locking in a very low cost of occupying space, that's a trade-off instead of maximizing the sales value of that real estate. Others look for restrictive covenants on who else could occupy within that building. For some, it's an opportunity to lower the amount of space that they occupy on their property. Maybe they only need 50% of the space, so they do a sale leaseback and allow a third-party investor landlord to come in and fill the balance of the space.

We're seeing a lot of innovative things where companies retain an ownership interest in the property to still have some level of control or influence on property management. It's a lot different than the old historic sale leaseback where it was simply just a purchase and sale. Instead, it's more creative and a lot more innovative. So again, an opportunity to tie it, to leverage some of the value accretion that has happened as a result of the real estate industry over the course of the last 21-year run.

Before I go to the questions here, I want to run through how we're helping some of our EY Private clients better unlock value on their real estate. It really starts with doing that strategic analysis, helping you think through your holdings, and whether the holdings match your long-term objectives. Is there a better way to structure, to own the real estate, to tap into the capital market space? Is there an ability to better leverage your assets based on market value of those assets as well? Is now the right time to potentially dispose of or acquire more real estate? EY is one of the only professional services firms that has an active real estate brokerage across the country, so many times we will broker a sale at leaseback on behalf of our clients.

The last bit here is that we have an ability to help you understand the value of your assets. So, if you want perspectives on market value, and how an institutional investor would approach your real estate, we can certainly provide an opinion for you on that. Tying back to the work that Bill Wu talked about earlier, we could come up with innovative strategies to help you better think about how to unlock capital that might be tied up in your real estate.

With that, I want to make sure that we have an opportunity to answer any questions that you may have. But I will end by saying that it's been a very interesting time to be in the real estate space. I certainly don't have a crystal ball, but I think that now is the time to think creatively about how to lock in any significant-value appreciation that certainly would have occurred over the balance of the last 20 years for real estate holdings.

Morgan, I'll turn it back to you.

 

Morgan Silverberg (01:58:28):

Thanks, Zach, that was incredible. I think you gave a lot of folks on the line a lot to think about, which is fantastic. We have one question. It speaks a bit to seniors’ residences, or organizations that don't necessarily have government funding from an investor’s perception perspective. I realize that you’re not the content owner but, hopefully, you can answer it. Noted that there may be government policies to redefine operational practices or processes. How does this government policy or involvement impact investors’ perceptions, particularly in seniors’ residences that are private pay (i.e., no government funding)?

 

Zach Pendley (01:59:15):

It's interesting because, historically speaking, a lot of institutional investors would have shied away from any long-term care residences. Because with long-term care, traditionally speaking, you don't have the ability to drive rental growth rate. You're fairly limited in terms of what your per-diem reimbursements are from the government. So, I think that whole model of how long-term care worked in the past is being rethought.

I think there's more of an interest in being able to leverage private sector investment dollars into building high-quality senior housing product. I think you're going to see a change in the way that government money is made available. It may not just simply be on a per-diem basis. It may be about incentivizing the development and construction of new, high-quality products. There could be even ways in which people are incentivized to better manage and better look after the elderly, as opposed to just saying we'll pay you on a per-bed basis. So, I don't think it's been solved. I know there's a lot of time and money being spent on it, but I think that if the government can be more innovative, it'll bring more private sector dollars to this versus the traditional private pay model.

Again, if you look south of the border, the private pay model is much more common. And as a result, I think you've seen more innovation in terms of how senior housing is built and how age and care works, where people can literally move from an apartment where they're entirely self-sufficient, all the way through to when they need advanced Alzheimer's care. You'll start to see more of that creativity come as soon as we can incentivize private sector to really step up. And I know firsthand that many of the large pension funds and others are looking at what they can do to play a role in building high-quality and reasonably affordable senior housing solutions. So, more to come.

 

Morgan Silverberg (02:01:15):

Thank you. Just a quick note before we move on. We're coming to our final topic today. I want to remind everyone that our next session is a Quebec-only briefing on some specific changes that have occurred recently in the province. So, if this does not affect you or your business, feel free to drop off. We thank you for joining us today and hope that you found the previous presenters beneficial.

Coming to us from our Quebec tax practice, we have Jonathan Bicher, who’s a tax partner focusing mainly on corporate and personal tax for private companies and their owners. Jonathan, I'll pass it over to you now for an update on some fairly significant changes that we're seeing for private businesses in Quebec.

 

Jonathan Bicher (02:00:03):

Thanks, Morgan.

The first set of changes involve the corporate tax rates, and as you can see on March 25, 2021, Quebec brought down the corporate tax rate from 4% to 3.2%. So, for a prorated year, you're looking at a combined rate at the low rates of 12.38%. That's before any of the changes that Gabe talked about that may be coming out, so I'm not going to really talk too much about it because everything else is pretty static.

The bulk of my presentation will be discussing the APFF Conference and the roundtable at the APFF Conference. If we slide a bit forward, we'll see that there are two main topics where they spoke to questions at the APFF roundtable. Number one was the C3I credit for investment and innovation. It was introduced in the March 10, 2020 budget and covered in many of our mailings. Essentially, the C3I credit was made to introduce and encourage industries that are in low-vitality sectors to make the investments in innovation. So, any companies that had qualified expenses for manufacturing processing equipment, computer equipment or other software would be eligible to get a credit between 10, 15 and 20%.

Then, in the March 25, 2020 budgets, at the 2021 budget, Revenue Quebec decided to double up on their credit. Now, how did the credit work? The property had to have been acquired after March 10, 2020, and it had to be ready to go by January 1, 2025. The property is not any property if it was acquired before or written obligation entered before March 11, 2020, or if construction began before that period – would not qualify. Also, any property that was finished after January 1, 2025 would not qualify. With the March 25, 2020 budget, they doubled up their credit for any property that was acquired before January 1, 2023. The increase will also be available if the property is delivered April 1, 2023, but based on a written obligation before January 1, 2023, and construction already had begun.

Some of the terminology in terms of the transfer is that the property has been subject to an order (that it) may not be acquired until a few months later, when the construction is completed and the purchaser had to be notified that the property is certain and determined, which it's all a civil law concept. This is easier to show you in a timeline on the slide, which we’ll return to for a couple of discussions.

The first period is before December 31, 2022. So, as I talked about before, anything after March 10, 2020 would be eligible to claim the credit. The period up until December 31, 2022, or January 1, 2023, is one where you would be able to get the increased rates. The period up until December 31, 2024, or January 1, 2025, is the period where the standard rate was applicable. So, if we look at this example, and then we look at all of the different periods, on October 1, a contract was signed. On October 31, a deposit was made by the acquirer. On November 3, they received a notification that production was starting. Over the period, every quarter they would get a report on progress. And as we see, progress is at 90% in October 2024, but production only finished in January 2025.

If we look at this, there are a whole bunch of questions. What rate would apply? What would be eligible? If we look at the first question that was posed to the roundtable, the first question was by Revenue Quebec, they asked the question, when is it “certain and determinant” on, i.e. can you confirm the date of the acquisition of the property described in this scenario above? So, the acquisition takes place and it's considered to be certain and determinant, and the purchaser has been informed of the status as soon as it is possible to clearly identify the property intended for the purchaser at the time that production is completed. What would that mean? That the property was really only a part on January 31, 2025, despite the fact that it wasn't totally completed, and that it would be delivered only in the following months, but it was enough to determine that the property would be usable. However, since the property would not be a specified property because it wasn't in place by December 31, 2024, no credit could be claimed.

The next question that Revenue Quebec was asked on the same fact pattern, was whether expenses need to be incurred within 18 months of the expense being incurred. When you have a very long production process of an assembly line or something like that, and the deposit was made as we saw in October 2022, the question that Revenue Quebec was asked was when the claim could be made. Revenue Quebec confirmed that they should file their claim based on the date that the claim is made, and the rate that they should be using for their claim is based on when it's expected to be delivered.

Although, in our example, January 2025 is the date that the property was ready to go. At the time, the assumption was that it would be December 31, 2024. So, when filing for the 2022 tax year, 18 months after, they would be able to make the claim. The second question was, “At what rate?” Assuming that it would have been in 2024, it would have been at the regular rate, the lower rate doubled-up rate because it was after January 1, 2023. There are a number of different scenarios with different timing. And in this example, because they would've made the claim for 2024 and subsequently they did not since the property came in only in January, they would have to then go back and amend the claim and refund the money. So, in strategy and in planning, when you're dealing with suppliers and you're putting in these lines, please ensure that delivery before December 31, 2024 is specified.

The following questions resolve around some things that are a bit simpler. If we assume that for this purpose, the vendor of the product has it in inventory, if there's no long production process, what normally could happen? Well, on February 15, a purchase order sent to the supplier asking, “Can you please send me the [inaudible, 2:08:34] property?” On March 12, a signature of contract between the corporations and the supplier, sending out the terms of agreement, was signed between the two parties and it was delivered on the 15th. So, we all know that the important date was March 10, 2020. Well, the purchase order came before, but the signature of it only happened after. So, the question then becomes, “When did the exchange of consent take place?”

Now, if there are any lawyers here, they'd get excited about the fact that it's only on the receipt back of the signed contract, when both parties signed the contract, that the change of consent would have taken place. And if we look at this example, and let's look at it a couple of other ways, what would have happened if there was no March 12 stage of contract? What if the purchase order came in, you made a verbal commitment, everybody said it was okay, and on December 15 it was ordered? At that point, Revenue Quebec would probably say, “If the purchase order, and that's when you went into the deal, and February 15 was when you said you would acquire it, and there's no other evidence.”

One of the things that is suggested is if the correspondence is by email, and if you get a reply back from the customer saying, “Yes, we have your vendor. Yes, we have an in-stock. We will be sending it to you on March 15;” those are the kinds of evidence that would dictate when the exchange of consent would take place. And therefore, it would enable you to claim the credit. So, sometimes keeping some old correspondence and emails is really important just to use it as evidence for this purpose.

The other section that dovetails a bit onto some of the stuff that Gabe was talking about, in terms of some of the new disclosure that's required, is that in Quebec, there's a concept of determined transactions and the disclosure for determined transactions. And it was a list of subjects that Revenue Quebec says, “We would like you to come to us and let us tell you what we are doing.” Some of the transactions are, they're trying to (demonstrate is the) substance and the facts are specific to a taxpayer, and they have to be significantly similar to the ones that have already been published in the Gazette Official.

Now, what does that mean? And the kinds of transactions are avoidance and deemed disposition of trust property. I'm not going to get into that one too deeply, but trust property is deemed to be disposed of at the 21st anniversary of the trust. If you go into a transaction where you're avoiding that deemed disposition, then Revenue Quebec would like you to talk about it. Payments to non-treaty countries. Not subject withholding tax. It could fly under the radar little. Sometimes, it's some of the planning around it. Again, Revenue Quebec would like to see. Multiplication of the capital gains deduction is what Gabe had spoken about before, where you have a family trust, and in the trust there are multiple beneficiaries. What Revenue Quebec is saying is that they would like to know when you're doing that, and then tax attribute trading. Acquiring a company that has losses, and I'll get into that in a couple of minutes.

The mandatory disclosure applies to the taxpayers, and it also applies to the advisors and promoters. The consequences of not disclosing could be rather severe for the taxpayer. It could be $10,000 plus $1,000 a day to a maximum of a hundred thousand dollars, and 50% of the tax benefit. For advisors and promoters, the same $10,000 plus $1,000 a day, maximum of $100,000, and 100% of the fees charged. Something a bit more worrisome is when your GAAR period gets extended another three additional years, and listing on the Le Registre des entreprises non admissibles aux contrats du government, which means that you will no longer be able to do any government transactions, or any government contracts. So, anyone who is selling to any governments, subsidiaries of government, municipalities, if the transactions are coming under GAAR or a sham, you'd be listed on an ineligible list and would not be able to provide any of those services.

I'm going to just get a bit into Transaction 3 and Transaction 4. For targeted transactions, as we've talked about before, were the capital gains deduction and how many people have been using family trusts to multiply capital gains on deduction. There was a court case Laplante v. the Queen in 2017, which was the basis of the capital gains deduction using multiplication through the trust.

A second one was bringing a spouse into a business in order to claim a capital gain deduction by manipulating the attribution rules, which was Gervais v. Queen in 2018. Those two court cases were the ones that drove Revenue Quebec to push for publication in the Gazette Officiale. A situation where non-taxable amounts would be excluded is if non-capital taxable amounts are excluded in the trust. A situation where non-taxable person is allocated by distress and is loaned gifts by an individual to a non-arm’s-length person, or a person to have a capital gain after the individual has claimed their capital gains deduction. That would mean somebody would, after they received it, give the money back to a related person to reinvest the gain they realize on the sale of a corporation in another corporation that they have formed. So, essentially what Revenue Quebec is looking at is whether they want to understand the transactions and they want to make sure that you're not plowing back money to the original shareholder.

The second targeted transaction is tax attribute trading. Some of the examples of tax attribute trading would be operating losses, tax credits that can be carried over from one taxpayer to another and shred expenses that we had talked about before. Essentially, if their expenses or their tax attributes that were from somebody who was not affiliated before the acquisition of a company for its losses. Those would be the transactions that Revenue Quebec would like to see. Some of the time, if these transactions occurred within a reorganization of related parties within a related group, then those would be excluded transactions, and that would not be subject to the disclosure rules.

Thank you very much. If anybody has any questions?

 

Morgan Silverberg (02:19:28):

Hi, Jonathan. I don't have any questions at this time. If any come in after we close, I will definitely send them to you directly so you can answer them.

That brings us to the end of the session. We are finishing a bit early today, which is fantastic. Give people a couple minutes back. I would like to thank our speakers today—Adam, Andrew, Gabe, Bill, Zach and Jonathan. Thank you so much for sharing your insights and expertise with us; there was a lot to cover. You did a great job summarizing all the key takeaways, and thank you all for joining the conversation. We hope to see you back in person soon, and we appreciate your patience over the last few years, where we've had to shift to this virtual environment, which is not always ideal and tough for the two-way communication that we often enjoy during these events.

When you close out this webcast, there'll be a survey that comes up and we’d really appreciate you taking a moment to respond. We'd love to hear from you and appreciate the feedback. We'd also like to hear about topics that are top of mind for you, that keep you up at night, that we can address. So please use that form to type in those types of comments.

As I mentioned at the beginning, and if you missed it, please look out for an email from us in the next few days with the recording of the session and our speaker’s contact information, as well as the deck that you can download. Please reach out to one of your local EY advisors, or to me, with any additional questions. As I mentioned, if you submitted a question and we weren't able to get to it today, we're going to have our presenters follow up with you one-on-one, and maybe have a discussion around some of those questions. So, thank you for those. Again, thanks for taking the time to join us today, and I hope you have a great rest of your day. Take care.