UPDATE ON CANADA-U.S. M&A

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1 Page 1 of 5 UPDATE ON CANADA-U.S. M&A by Jack Bernstein and Francesco Gucciardo Aird & Berlis LLP Toronto To be submitted for publication in Tax Notes International, was a boom year for M&A. On January 2, 2015, the New York Times reported that U.S. M&A activity rocketed with over 40,000 transactions reaching nearly $3.5 trillion in deal value for 2014, making it one of the best years for M&A since the financial crisis. Canadian M&A activity has been robust with the following dynamic businesses at the forefront farming, real estate, financial services, food and beverage, healthcare, hospitality, manufacturing, mining, professional services, retail, transportation and technology. Cross-border M&A has also been robust. In this short article, we provide a high-level overview of certain fundamental tax considerations that are relevant when a U.S. enterprise seeks to expand into Canada, whether through organic growth or by way of an acquisition. The fundamental considerations will depend on the following variables, among others: Is the target a public or private company? Is the purchaser a private equity or a strategic purchaser? Are there any regulatory considerations? Is there an auction process? Will leverage be used? Further transaction specific considerations include securities law, environmental, labour/employment, and a consideration of Investment Canada Act and Competition Act obligations and hurdles. Industry specific considerations, especially for regulated industries (i.e., insurance, energy, banking), also become pertinent.

2 Page 2 of 5 Tax Considerations The difference between the Canadian and U.S. tax regimes is quite substantial and a great deal of structuring and planning revolves around such differences. By no means exhaustive, the following list of four key differences drives a considerable amount of cross-border structuring and planning: 1. Form Governs in Canada - Absent sham, the form of a legal instrument governs how it will be treated for Canadian tax purposes. Contrast this with the U.S. Internal Revenue Code 385 whereunder the Internal Revenue Service can determine whether an instrument is to be treated as debt or equity 2. A Corporation is a Corporation - Canada does not have any entity characterization or check-the-box rules a corporation is a corporation and a partnership is a partnership. An unlimited liability company (ULC) or a partnership might be characterized as something other than a corporation or a partnership for domestic U.S. tax purposes, but that characterization does not alter its treatment for Canadian tax purposes. 3. PUC reigns supreme - Very generally, paid-up capital or PUC, represents the amount originally paid to subscribe for shares of a corporation from treasury (except where property is contributed to the corporation on a tax-deferred basis, in which case the elected amount, and not the value of the property, generally governs). PUC is valuable because it represents the amount that can be returned to a shareholder as a tax-free return of capital (no withholding tax, only reduces cost in share) regardless of whether the distributing Canadian corporation has undistributed earnings and profits. However, a non-resident must be mindful that a return of capital distribution could trigger a gain if the cost in the share goes negative; that gain could be taxable in Canada if the share is a taxable Canadian property (generally, that of a real property holding company) and the gain is not otherwise exempt from taxation in Canada under the terms of a treaty, such as the Canada-United States Tax Convention (1980) (e.g., treaty protected). 4. No Consolidated Reporting - There is no consolidated tax reporting in Canada. Canadian entities report their income and file tax returns on a standalone basis. Positive steps and planning

3 Page 3 of 5 must be implemented in order for a profitable affiliate to access the losses or other attributes of another. A significant component of Canadian cross-border tax planning involves: (i) taking advantage of the differences in how Canada and the United States approach the characterization of legal instruments and entities through hybrid mismatch arrangements, (ii) taking steps to maximize cross-border PUC, and (iii) managing/mitigating the absence of consolidation in Canada. Share Sale vs Asset Sale - Considerations The tax positon of the vendor(s) will generally indicate a bias towards either a share sale or an asset sale. For example, if the vendor is a non-resident and the shares of the target are not taxable Canadian property or are otherwise treaty protected, there is no Canadian tax on a share sale and the vendor will not be amenable to an asset sale. In general, shares will be taxable Canadian property if at any time in the 60-month period before the sale more than 50% of the value of the shares was derived from any combination of Canadian real estate, Canadian resource properties, Canadian timber rights, or rights and interests in any of the foregoing. Another factor is whether the vendor has a high adjusted cost base or tax cost in the shares, as the vendors may have either made a large investment in treasury shares or previously purchased the shares from a third party. Canadian resident individual vendors may each benefit from an $800,000 capital gains exemption on a direct (or indirect through a trust) sale of the shares of certain qualified Canadian small business corporations and, for this reason, would generally prefer to sell shares (gains in excess of the exemption will be taxed at a rate of approximately 25%). If the main asset of the corporation is goodwill, it has been advantageous to sell the assets in circumstances where the ultimate individual shareholders do not require a substantial portion of the proceeds for some time (if ever). One half of the gain on the sale of goodwill is not taxed at the corporate level and can be flowed out to Canadian resident shareholders tax-free as a capital dividend. Also, refundable tax which normally applies to tax passive corporate income and capital gains does not apply to a gain realized on the sale of goodwill. Accordingly, the corporate tax on such sale is limited to approximately 26.5% of one-half of the gain (i.e., 13.25% of the total gain) (Ontario rates). This allows for a significant deferral by allowing the corporation to retain and reinvest the higher after-tax proceeds without the incidence of

4 Page 4 of 5 refundable tax. The 2014 Federal Budget launched a consultation on the current regime with one of the potential changes being to tax the sale of goodwill as a capital gain. If enacted as such and the refundable tax applies, the previous tax deferral of leaving after-tax corporate proceeds in corporate solution for investment purposes would be eliminated. If a corporation has non-capital loss carryforwards from a business that will continue to be carried on, a purchaser in the same business may pay a premium to purchase shares in order to use the loss carryforwards. Alternatively, on a corporate asset sale the vendors may be able to shelter any resulting income with any non-capital loss carryforwards of the target. If the target has been subject to litigation or if the vendor is not selling all of the assets (e.g., may only sell one of several business divisions or may wish to retain the building or other redundant assets) then an asset sale may be the only feasible option. If the target has significant retained earnings, which may be suggestive of safe income, the vendor may prefer to pay a significant intercompany dividend to a Canadian holding company and then have the holding company sell the shares of the target. The intercompany dividend will not be taxed. If the target does not have sufficient cash on hand to pay the dividend, the vendors may institute a series of pre-closing transactions, involving stated capital increases to trigger deemed dividends, in order to convert the target corporation s safe income into outside basis in the shares about to be sold. This is commonly referred to as safe income planning or a safe income strip. Acquisition Company and Bump A purchaser will always wish to use a Canadian acquisition company to complete the acquisition except for the rare occasion in which the PUC in the target company shares exceeds the purchase price. The Canadian acquisition company may be capitalized with shareholder loans and treasury shares so that the non-resident purchaser may later receive a tax-free return of capital (by way of repayment of loans and reduction of paid up capital equal to the amount paid for the treasury shares) without triggering dividend withholding tax (regardless of underlying earnings and profits). If the acquisition company borrows funds from a financial institution or from the shareholders (subject to the thin capitalization restrictions) to fund the share purchase, a subsequent amalgamation or winding up of the acquisition company and the target will push the

5 Page 5 of 5 debt into the target and make the related interest expense deductible against the income of the business. The amalgamation or winding up is necessary in order to push the debt down to the operating level given that Canada does not have consolidated reporting. Subject to the application of targeted anti-avoidance rules, the use of an acquisition company followed by an amalgamation or winding up will also facilitate a bump in the adjusted cost base of any nondepreciable capital properties of the target, including foreign subsidiary company shares, and permit their removal, whether by way of third party sale or spin-out to a foreign parent, after the amalgamation or winding-up free of Canadian corporate tax or withholding tax. Hybrid Acquisition - Canadian Share Sale and U.S. Asset Purchase In the case of a strategic purchase, a U.S. purchaser may prefer to purchase assets, at least for U.S. tax purposes, while the vendor may insist on a share sale. A way to bridge the gap is for the U.S. purchaser to form a ULC. The acquisition would be structured as a qualified stock purchase entitling the purchaser to make an IRC Section 338 election. This election results in a steppedup basis in the Canadian target s assets for U.S. tax purposes and is usually available if the purchaser (for example, Canadian ULC) acquires at least 80% of the shares of the target company by way of purchase. The IRC Section 338 election would be made and then be followed by the continuance of the target as a ULC followed by an amalgamation of the acquisition ULC with the target ULC. The amalgamation is tax-deferred in Canada. The result of the transaction is that the U.S. purchaser may treat the transaction as the acquisition of a branch and may write off goodwill in a U.S. tax return on a straight line basis over 15 years.