Takeover and Tax Issues

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1 Takeover and Tax Issues Federated Press Taxation of Corporate Reorganizations Conference Alan M. Schwartz Mitchell Thaw of Fasken Martineau DuMoulin LLP January 18, 2005 Toronto

2 2 This paper will highlight some of the Canadian income tax issues and planning that are typically dealt with in a takeover bid situation. The planning for the vendor entails determining whether a tax-deferred rollover is available, planning to reduce the gain through accessing safe income and dealing with employee stock options. Planning of the purchaser focuses on financing the acquisition and preparing for post-acquisition dispositions and distributions. Structuring the bid in a tax efficient manner for the vendors could increase the purchaser s chances of a successful bid in multi-bid scenario. 1. Deferral of Capital Gain by Vendor 1 As a general rule, in the context of a takeover bid, the shares sold by the vendor will be capital property such that the disposition will result in the vendor realizing a capital gain or loss. If the shares were held on income account, including as a result of being the subject matter of an adventure or concern in the nature of trade, the gain or loss will be business income or loss. Most taxpayers resident in Canada can elect in prescribed form in the year of a disposition of a Canadian security to deem every Canadian security owned in that year and all subsequent years to be capital property. 2 In the case of a cash takeover bid the vendor cannot defer a gain. If the vendor receives non-cash consideration a reserve or deferral may be available. A reserve will generally be available in respect of debt consideration. 3 A deferral of the vendor s gain may be available in the case of share consideration that consists of the shares of the purchaser if the conditions of section 85 or 85.1 are met. A takeover by way of an amalgamation within the meaning of section 87 may also afford a deferral for the vendor. Section 85 If the conditions of section 85 are complied with the vendor may achieve a partial or full rollover. The main conditions of section 85 are: The taxpayer disposes of property that is eligible property ; The property is disposed of to a taxable Canadian corporation; The taxpayer receives consideration that includes shares of the capital stock of the acquiring corporation; and All statutory references herein are to the Income Tax Act (Canada) ( Tax Act ) The election is provided in subsection 39(4). Subsection 39(5) provides that the election does not apply to a disposition of a Canadian security owned by a trader or dealer in securities, a financial institution, a nonresident or a corporation whose principal business is the lending of money or the purchasing of debt obligations. A mutual fund corporation or trust is not subject to these restrictions. For trader or dealer cases, see Kane v. Canada, [1995] 1 CTC 1 (FCTD) and Vancouver Art Metal Works Ltd. v. Canada, [1993] 1 CTC 346 (FCA). Subparagraph 40(1)(a)(iii) in the case of shares held as capital property and paragraph 20(1)(n) and 20(8) for shares held as inventory.

3 3 An election in prescribed form is filed within the statutory time limits in which the parties agree on the amount that will be the taxpayer s proceeds of disposition for the property and the acquiring corporation s cost of the property. In the context of a takeover bid of a publicly held corporation or a widely held private corporation, the feasibility of preparing and filing a mass quantity of elections may be prohibitive in terms of cost and logistics. For this reason alone, the non-elective rollover provided for in subsection 85.1(1) is often preferred. Section 85.1 A full rollover may also be achieved on a non-elective basis under the narrower provisions of subsection 85.1(1). The main conditions for its application are: The taxpayer ( Vendor ) exchanges shares of a taxable Canadian corporation that are capital property to a Canadian corporation ( Purchaser ) who issues its shares as consideration; The Vendor does not include in computing income any portion of the gain (or loss) that is otherwise determined from the disposition; Immediately before the exchange, the Vendor and Purchaser were dealing with each other at arm s length; Immediately after the exchange, the Vendor or persons with whom the Vendor did not deal at arm s length did not control the Purchaser or beneficially own shares of the capital stock of the Purchaser having a fair market value of more than 50% of the fair market value of all of the outstanding shares of the capital stock of the Purchaser; The Vendor and Purchaser do not file a section 85 election with respect to the exchanged shares; and

4 4 The Vendor did not receive consideration other than shares of the particular class of the capital stock of the Purchaser. If both the Purchaser and target are not resident in Canada a rollover in subsection 85.1(5) may be available. The criteria for subsection 85.1(5) are similar to the criteria for subsection 85.1(1). Comparison of 85 vs Under section 85, a full or partial rollover is possible whereas under section 85.1 there is either a full rollover or no rollover. If non-shares consideration is received by the selling shareholder, a section 85 election is possible and a full rollover may generally be achieved as long as the non-share consideration does not exceed the seller s cost base in the shares being disposed of. Under section 85.1 no rollover is available if consideration other than shares of the purchaser are received. However, if the seller can clearly identify which shares were exchanged for shares and which shares were exchanged for cash (or other non-share consideration), section 85.1 can apply. 4 Cash paid in lieu of issuing fractional shares may also be administratively acceptable. 5 A subsection 85(1) rollover applies to a transfer of shares of a Canadian or a non-resident corporation that are capital property or inventory to the vendor. Subsection 85.1(1) rollover applies only on an exchange of shares of a taxable Canadian corporation that are capital property to the vendor. The cost of the shares of target acquired by the purchaser will usually be higher and more easily determined under section 85. If an election is not filed under subsection 85(1), a purchaser may not always know whether the shares were acquired from a vendor who qualifies for 85.1 especially if the vendor reported a gain on the transaction. 4 5 See IT-450R at paragraph 7. See IT-450R at paragraph 6.

5 5 More of the adjusted cost base is made available to vendors on a section 85 rollover to shelter any non-share consideration received. Under subsection 85.1(1), only a fraction of the vendor s adjusted cost base of their target shares will be available to shelter their nonshare consideration. The purchaser s cost in the target shares acquired will generally be lower under a section 85.1 rollover. Under section 85.1 the purchaser s cost will be the lesser of the fair market value and paid-up capital of the target shares. Under subsection 85(1) the purchaser s cost will be the elected amount which is generally equal to the vendor s adjusted cost base which is generally greater than the shares paid-up capital. A section 85 election could be intentionally avoided by not filing an election. A section 85.1 rollover may be tainted by issuing non-share consideration or multiple classes of shares without any specific allocation of the non-share consideration or multiple classes of shares to the shares of target, respectively. 6 Occasionally, the offeror will provide the selling shareholders with the option of relying on section 85 or 85.1 in which case the selling shareholders will have to analyze their particular situation to select the most beneficial result. Amalgamations A purchaser can effect a takeover through an amalgamation with the target. This method is most effective if the purchaser has a greater fair market value than the target so that the former shareholders of purchaser will have control of the amalgamated corporation. In the case of a non-amalgamation takeover, an amalgamation may subsequently be used to remove minority shareholders. One form of amalgamation squeeze-out entails the target corporation and the purchaser amalgamating with the minority shareholders receiving preferred shares of the amalgamated corporation which are immediately redeemed for cash. On such amalgamation, it is typical to allocate paid-up capital to the preferred shares equal to their fair market value redemption amount so that so that a capital gain, and not a deemed dividend, results on their redemption. This type of planning which may be used for privatizing a public company is accommodated by subsection 87(10) of the Tax Act which provides that such shares, provided they are redeemed within 60 days of the amalgamation, will continue to be considered listed shares postamalgamation which will avoid the requirement for a non-resident to apply for a section As part of the Canadian Pacific spin-off transaction, there was an exchange of Special Shares of CPL for two classes of shares of another corporation. One of the reasons for issuing two classes of shares was to avoid the application of section 85.1.

6 6 clearance certificate on the redemption. 7 However, the shares may still be taxable Canadian property to a non-resident shareholder who holds at least 25% of that class of shares. 8 Earnouts If the amount of the purchase price is determined at least partially by reference to future earnings of the target, the precise amount of the proceeds of disposition cannot be determined at the time of sale and may not be known for several years. 9 At best, one could estimate what the proceeds of disposition will be. Pursuant to paragraph 12(1)(g) a person is required to include in income any amount received in the year that was dependent on the use or production from property whether or not the amount was an instalment of the sale price of the property. This provision arguably applies to a sale of shares subject to an earn-out, although technically the earnout provision would determine the amount to be paid based on the use of the underlying assets of the corporation not the use or production from the shares themselves. The Canada Revenue Agency ( CRA ) states that the application of paragraph 12(1)(g) or estimating the total proceeds on the date of the sale are approaches that produce unsatisfactory results. 10 The CRA accepts the cost recovery method for reporting the gain (or loss) from the sale of shares where the price is subject to an earnout provision. 11 An agreement that merely determines when amounts are to be paid is not considered an earnout agreement for purposes of using the cost recovery method. The method entails the vendor reducing the adjusted cost base of the target shares as the price becomes determinable. Once the amount of the price so determined exceeds the adjusted cost base, the excess is considered to be a capital gain realized at the time the amount became determinable and the adjusted cost base is reduced to nil. When further amounts become determinable, they will be included in the vendor s income as capital gains in the year of the determination. An amount is only determinable when it can be calculated with certainty and the taxpayer has an absolute but not necessarily immediate right to be paid. The minimum amount payable in a typical earnout is determinable on closing and this amount will reduce the adjusted cost base in the year of the disposition (and it will result in a capital gain in the year of disposition to the extent that the minimum amount exceeds the vendor s adjusted cost Paragraph 116(6)(b). This may be the case for a significant minority shareholder who dissents. Any gain on the disposition of taxable Canadian property may be exempt under a treaty, but the non-resident will still be required to file a Canadian tax return reporting the disposition. The normal earnout will provide for a minimum price plus further payments calculated according to a formula agreed by the parties that factors in future earnings. A reverse earnout sets a maximum price which is subject to reduction should future earnings not attain certain levels. Paragraph 12(1)(g) does not apply in the case of a reverse earnout, see paragraphs 9 and 10 of IT-462. Interpretation Bulletin IT-426R. The cost recovery method applies where (i) the vendor and purchaser deal at arm s length, (ii) the gain or loss is on capital account, (iii) the earnout feature does not exceed 5 years, (iv) the earnout relates to goodwill, the amount of which cannot be agreed upon by the parties, (v) the vendor submits with his return of income a copy of the agreement and a request for the application of the cost recovery method; and (vi) the vendor is a person resident in Canada. The last condition was added in the latest version of IT-426 released on September 28, This may reflect a change in the CRA s administrative practice of not applying subparagraph 212(1)(d)(v) in respect of earnout payments made to a non-resident if all of the previous conditions were met; see document number RCT-0537 (April 15, 1980).

7 7 base). The capital gain reserve can apply to amounts that become determinable but are not payable until a subsequent taxation year. 2. Deductibility of Costs of Making or Fighting a Takeover bid Takeover bids are costly undertakings. In addition to the purchase price of acquiring shares of the target, the purchaser and target will typically incur many professional fees, financing expenses and printing and distribution fees. Due to the magnitude of these amounts, their deductibility for tax purposes is of concern to both the purchaser and target. General Discussion of Deduction of Expenses The decision of the Supreme Court of Canada in Symes v. The Queen, 94 D.T.C at 6009, clarifies the appropriate steps to be taken in analyzing whether expenses incurred by a taxpayer are deductible for tax purposes. The Supreme Court confirmed that one s first recourse is to subsection 9(1) of the Tax Act which embodies a form of business test for taxable profit. Mr. Justice Iacobucci, speaking for the majority of the Court, affirmed that, because the determination of profit is a question of law, it is more appropriate in considering the subsection 9(1) business test to consider well-accepted principles of commercial trading rather than generally accepted accounting principles which are motivated by a desire to present an appropriately conservative profitability picture. More recently, in the decisions of Toronto College Park Limited v. The Queen, 98 D.T.C (S.C.C.) and Canderel Limited v. The Queen, 98 D.T.C (S.C.C.), the Supreme Court of Canada clarified their decision in Symes by stating that generally accepted accounting principles will generally form the foundation of the well-accepted business principles applicable in computing profit. However, the two may differ and the courts must apply a legal test. The Court in Canderel set out the following principled approach to the computation of income: (1) The determination of profit is a question of law. (2) The profit of a business for a taxation year is to be determined by setting against the revenues from the business for that year the expenses incurred in earning said income: M.N.R. v. Irwin, supra, Associated Investors, supra. (3) In seeking to ascertain profit, the goal is to obtain an accurate picture of the taxpayer s profit for the given year. (4) In ascertaining profit, the taxpayer is free to adopt any method which is not inconsistent with (a) the provisions of the Income Tax Act ; (b) established case law principles or rules of law; and (c) well-accepted business principles. (5) Well-accepted business principles, which include but are not limited to the formal codification found in G.A.A.P., are not rules of law but interpretive aids. To the extent that they may influence the calculation of income, they will do so

8 8 only on a case-by-case basis, depending on the facts of the taxpayer s financial situation. (6) On reassessment, once the taxpayer has shown that he has provided an accurate picture of income for the year, which is consistent with the Act, the case law, and well-accepted business principles, the onus shifts to the Minister to show either that the figure provided does not represent an accurate picture, or that another method of computation would provide a more accurate picture. Where a fee or expense is deductible under well accepted principles of business practice for purposes of subsection 9(1) and the deduction of the expense is not prohibited by paragraphs 18(1)(a) or otherwise, the deduction of that expense in computing income may nevertheless be denied by virtue of the specific prohibition in paragraph 18(1)(b). Paragraph 18(1)(b) applies to prohibit the deduction of an outlay which is capital in nature. The classic test applied to determine whether an expense is on capital account is whether the payment was made with a view to bringing into existence an advantage for the enduring benefit of the business: Atherton v. British Insulated and Helsby Cables, Ltd. (1925), 10 T.C. 155, and Algoma Central Railway v. M.N.R., 67 D.T.C Deduction of Takeover Bid Expenses Certain expenses of a takeover bid may be deductible under a specific provision of section 20 of the Tax Act which operates notwithstanding paragraph 18(1)(a) and (b). 12 Other expenses, which do not fall within a specific provision in section 20, may be deductible on the basis of the principles discussed above. The first case to address the deduction of certain costs incurred in the context of a take-over bid is Boulangerie St. Augustin, 97 DTC 5012 (FCA). In this case the Court specifically addressed the deduction of costs of a target corporation in preparing a circular to its shareholders outlining the directors positions on three take-over bids as required under Quebec s security legislation. The Federal Court of Appeal did not disturb the Tax Court s findings which allowed the deduction. In its reasons, the Tax Court of Canada stated that: These communications and share transfer costs are part of general administrative expenses which every corporation must incur in order to earn it business income. The decision stands for the proposition that the failure of an expense to come within subparagraph 20(1)(g)(iii) is not fatal to its deductibility under section 9 provided it was not prohibited by paragraph 18(1)(a) or (b). Based on this decision and the general principles enunciated above by the Supreme Court of Canada, reasonable costs incurred in satisfaction of directors fiduciary obligations under corporate and securities laws should also be deductible. Such costs include legal, accounting, investment adviser and other professional fees incurred in the course of preparing directors circulars and obtaining related fairness opinions, as well as printing and mailing costs. 12 See for example paragraph 20(1)(b) [eligible capital expenditure], paragraph 20(1)(c) [interest], paragraph 20(1)(e) [financing expenses], paragraph 20(1)(e.1) [annual fees, such as filing fees], and paragraph 20(1)(g) [share transfer, listing, financial reports].

9 9 In March 2003, the CRA issued a series of technical interpretations setting out their views on the tax treatment of various types of expenses that are typically incurred by a purchaser or a target corporation in the context of a takeover. In summary, the CRA stated that the findings in Boulangerie are only applicable in the case of expenses incurred by a target corporation 13 and that costs incurred by a purchaser in the course of a successful takeover will be capital expenditures (i.e., added to the cost of the acquired sharers or assets) even if the purchaser combines the business of the target with its own business. 14 In the case of an unsuccessful takeover, the expenses incurred by the purchaser will still be treated as capital in nature but may be eligible capital expenditures if the purchaser can demonstrate that it intended to make the business of the target corporation part of a similar business that the purchaser already operated. 15 The CRA specifically stated that break-up fees paid by either the target or purchaser are capital expenditures that are generally not eligible capital expenditures. 16 The CRA also specifically stated that investment banking fees paid by a target corporation in the course of the issuance of shares are generally not deductible and distinguished these expenses from the type discussed in Boulangerie. 17 The CRA takes a narrow interpretation of the deduction provided for in subparagraph 20(1)(e)(i) which permits a deduction of an amount that is an expense incurred by a taxpayer in the course of an issuance or sale of shares of the capital stock of the taxpayer. The CRA is of the view that the reference to sale does not contemplate a sale of shares by the shareholders. 18 The CRA disputed comments made by the Tax Court in International Colin Energy on this point in the following terms: 19 We also comment on the application of subparagraph 20(1)(e)(i), relating to the deduction of expenses of issuing or selling shares, in light of the recent decision of International Colin Energy Corporation v. The Queen, 2002 DTC 2185 (TCC). The issue in this case was whether the taxpayer was entitled to deduct fees paid to its financial advisor in the course of a take-over of the taxpayer by way a plan of arrangement under the Alberta Business Corporations Act. Regarding the application of paragraph 20(1)(e), in dicta, the Court stated that a "sale" in subparagraph 20(1)(e)(i) could only...refer to a sale by the shareholders in the course of a corporate transaction of the type involved here where the interests of the corporation are affected. Ultimately, however, the Court declined to conclude on this point. We do not agree with the Court's interpretation of subparagraph 20(1)(e)(i). In our view, there are other possible interpretations of the word sale. For instance, a sale 13 CRA document number (March 5, 2003). 14 CRA document number (March 5, 2003). 15 CRA document numbers and (March 5, 2003). 16 CRA document number (March 5, 2003). 17 CRA document number (March 4, 2003). The CRA also stated that subparagraph 20(1)(e)(i) will not apply to such investment banking fees in document number (March 4, 2003). 18 CRA document number (March 4, 2003). 19 CRA document number: (March 5, 2003).

10 10 in subparagraph 20(1)(e)(i) could mean a sale of the shares by an underwriter to the public, after the particular corporation has issued such shares to the underwriter. Costs incurred for defensive tactics in the case of a hostile takeover bid may be treated differently. It may be that such expenses are may only be deductible under a specific provision in section 20 because the income-earning purpose test of paragraph 18(1)(a) may not be satisfied. Along these lines, the CRA may view the purpose of defence mechanisms as the maintenance of the status quo of existing management and shareholders and not for the purposes of gaining or producing income from property or business. 20 However, the 2003 decision of the Tax Court of Canada in BJ Services Company Canada held that fees incurred in defending against a hostile takeover bid are deductible. In that case, BJ Services Company Canada acquired the shares of Nowsco Well Service Ltd. ( Nowsco ) in a hostile takeover. In the weeks leading up to that transaction, the directors of Nowsco paid fees for financial and legal advice in dealing with the hostile takeover bid and a competing bid. The parties agreed to the deduction of legal and accounting fees and the Court had to decide whether certain other fees were deductible. These included fees paid to financial advisors to assist in evaluating the proposals and determining a course of action and hello and break-up fees paid to a white knight whose bid was ultimately rejected in favour of an increased bid by BJ Services Company Canada. The issue that the Court addressed was whether expenses incurred in respect of shareholder relations and to maximize shareholder value could be considered as laid out for the purpose of earning income in the same way that expenses more directly connected with the conduct of day to day business are deductible. The former, referred to as ancillary expenses, were found deductible on the basis that shareholder confidence and ability to raise capital are essential to the operation of a business. The Court went on to hold that expenses should be deductible when they satisfy a need of the company, even if ancillary, as long as they are not personal. The Court noted that shareholders provided the taxpayer with funding, and if this was lost or withdrawn, customers would be lost, staff laid off and eventually, event the taxpayer s operations could shut down. Maximizing taxpayer value was tied to the bare bones of gaining or producing income on a daily basis in any corporate environment. On the issue of whether the deduction of the fees was precluded under paragraph 18(1)(b) the Court stated: In light of the Crown s admissions in respect of these expenses [that Nowsco obtained no enduring benefit when it incurred the expenditures] and because no evidence was presented to show that capitalizing these expenses could result in a more accurate portrayal of Nowsco s income either in the present year under appeal or any other year, I do not accept that current deductibility is prohibited by paragraph 18(1)(b). 20 See CRA document number (February 6, 2002) for the CRA s current views on the deductibility of costs incurred in the course of a takeover bid.

11 11 3. Tax Cost of Assets and Structure for the Bump There is often a difference between the tax cost of the shares of the target corporation ( outside basis ) and the tax cost of the assets owned by the target corporation ( inside basis ). The purchase price paid by the purchaser will be reflected in the tax cost of the shares acquired and the tax cost of the assets inside the corporation will remain unaffected and comparatively low (subject to the acquisition of control rules discussed below). 21 To a limited extent, however, steps can be taken to internalize the excess outside basis. The corporate transactions that must be effected to bump the inside basis are relatively straightforward. The purchaser corporation must own 90% or more of the issued shares of each class of the target corporation and then the target corporation can be wound-up in a transaction to which subsection 88(1) applies. 22 Alternatively, if the purchaser corporation wholly owns the target corporation, then the purchaser corporation and target corporation can also be merged by way of a vertical amalgamation to which section 87 will apply. In either transaction, provided the specific provisions of the Tax Act are satisfied, a designation can be filed to step up the adjusted cost base of the non-depreciable capital assets of the target corporation, unless the assets are ineligible property. The aggregate amount of the increase in the adjusted cost bases of the assets of the target corporation generally cannot exceed the excess of the adjusted cost base of the target shares over the sum of the net tax bases of the target corporation s assets plus the amount of money on hand in the target corporation immediately before the merger. Further, the adjusted cost base of any particular non-depreciable capital asset of the target cannot be increased beyond its fair market value at the time the purchaser corporation last acquired control of the target. 23 The definition of ineligible property found in paragraph 88(1)(c) must be carefully reviewed to determine whether there are any transactions that would deny the bump-up in cost base. For example, it will not be possible for a non-resident acquiror that issues share consideration on the acquisition to access the bump. 24 These rules are aimed at attacking attempts to achieve backdoor butterfly transactions. It is possible to convert otherwise ineligible assets into assets eligible for the bump-up. For example, non-eligible assets can be rolled into a new subsidiary of the target corporation prior to the sale. The shares of the subsidiary taken back as consideration for the transfer of the ineligible assets will be non-depreciable assets and will not, by virtue of such a transaction, be ineligible property. The usual concern with this type of package and bump planning is to ensure that the shares of the subsidiary are non-depreciable capital property to the target If the acquisition occurs on a rollover basis (i.e., share exchange transaction) for the vendor, the purchaser will generally have a cost base in the target shares equal to the vendor s aggregate cost base in those shares prior to the takeover. Accordingly, there may be little or no excess of outside cost base over the inside basis. The remaining shares must be owned by arm s length parties. The Act also contains rules that generally decrease the amount of the bump by the amount of dividends paid on the shares of the target (or shares substituted or exchanged therefor) received by the parent corporation or by a corporation with which the parent was not dealing at arm s length: subparagraph 88(1)(d)(i.1) and 88(1.7). The same result is obtained whether the consideration is in the form of shares of the non-resident purchaser or exchangeable shares of a Canadian subsidiary of the non-resident.

12 12 corporation. Section 54.2 provides that where any person has disposed of property that consisted of all or substantially all of the assets used in an active business to a corporation for consideration that includes shares, the shares will be deemed to be capital property. Section 54.2 will not apply if the transferred assets do not represent all or substantially all the assets used in an active business or, in other words, the division is not a separate business. 25 In such circumstances, one would have to rely on the common law principles to support a capital property characterization of the shares. Similarly, since there is no rule similar to section 54.2 in the case of a rollover of property to a partnership, the common law principles would be relied upon to determine whether the partnership interest were capital property and hence eligible for the bump. Due to the intricacies involved in planning for a takeover that involves a bump it may be advisable to seek an advance income tax ruling Tax Planning for Foreign Purchasers A non-resident may acquire shares of a Canadian corporation directly, but usually the acquisition will be made through a Canadian subsidiary that may be incorporated solely for the purpose of the acquisition. 27 The main advantages of using a Canadian acquisition company may be summarized as follows: the ability to return paid-up capital to a shareholder without the distribution being treated as a distribution of accumulated profits; the opportunity to step up the tax cost of eligible non-depreciable capital property upon the winding-up of a wholly-owned subsidiary; and the possibility of maximizing the amount of interest expenses on acquisition debt that can be matched against income from the acquired business. Generally, the stated capital and tax paid-up capital of the target shares are significantly lower than the purchase price. If the non-resident purchaser acquired those shares directly, the adjusted cost base of the shares to the non-resident would be equal to the purchase price but the paid-up capital of those shares would remain unchanged. If the non-resident wished to subsequently For the CRA s views on what constitutes a separate business see IT-206R. The most recent case on the issue is Dupont Canada Inc. v. The Queen, 2001 DTC 5262 (FCA). See for example the rulings in CRA document numbers (April 26, 2000) and (August 29, 2001). In the case of a U.S. acquiror, a Nova Scotia unlimited liability company ( NSULC ) is often the vehicle of choice since it may be treated as either a corporation or disregarded entity. As a disregarded entity, the NSULC may provide opportunities to plan for a more effective use of U.S. foreign tax credits and treat the acquisition of the target shares as an acquisition of assets.

13 13 return (i.e. repatriate) the original value of its investment (i.e. the purchase price) the excess of the amount repatriated over the paid-up capital would be considered a payment of a dividend and subject to withholding tax. 28 If the non-resident acquires the target shares through a Canadian holding company ( Canco ), the entire purchase price may be repatriated free of Canadian tax. The non-resident could incorporate Canco and subscribe for shares with a subscription amount equal to the purchase price of the target shares. Canco would then use the subscription proceeds to purchase the target shares. The adjusted cost base and paid-up capital of the Canco shares would be equal to the purchase price. As the target earned profits, inter-corporate dividends could be paid tax free to Canco which could pay these amounts to the non-resident on capital reductions without attracting Canadian withholding tax. 29 It may also be advantageous to merge Canco and the target corporation either by winding-up the target corporation or amalgamating it with Canco. The paid-up capital of Canco as a result of the merger will remain unchanged at an amount equal to the purchase price. In addition, upon the merger, there may be an opportunity to step-up the cost base of certain assets of the target to their fair market value. 30 There may be other tax benefits to using Canco to acquire the target shares. For example, Canco may be able to deduct more interest on debt issued to its non-resident parent due to the increase in its equity. 31 In very general terms, if the amount of outstanding debts to specified nonresidents exceeds two times the equity of a Canadian subsidiary, a pro-rated portion of the interest paid or payable in the year to such non-residents would not be deductible in computing the income of the subsidiary. For every dollar of the increased paid-up capital through the use of Canco, two dollars of additional debt capacity is created on which interest may be deducted. Another advantage of using Canco would be the ability to maximize the benefit of the interest expense deduction on debt used to acquire the shares of the target. This advantage is also available to Canadian acquirors and is discussed later in the paper. In structuring a takeover bid that involves the issuance of shares of a non-resident acquiror, consideration should be given to structuring an exchangeable share deal. As discussed above, the Tax Act currently does not contain any provision which permits a resident of Canada to The dividend would be subject to a statutory withholding tax at a rate of 25%, but in the case of a Canadian corporation owned by a corporation that is a resident of the U.S. and owns more than 10% of the voting stock of the Canadian corporation the withholding is reduced to a rate of 5% under the Treaty. The Treaty may be amended to reduce this rate to nil. Although returns of capital are generally free of Canadian tax, such returns of capital may be subject to tax under the tax laws that govern the foreign parent shareholder. For Canadian tax purposes, a return of capital reduces the shareholder s cost base in the shares and if the cost base becomes a negative amount, such amount will be deemed to be a gain realized by the shareholder. In the case of a non-resident shareholder, the gain may be exempt under the Tax Act or an applicable tax treaty. As noted earlier, the advantage of the bump will not be possible following a takeover bid in which shares of a non-resident (or exchangeable shares of a Canadian subsidiary of a non-resident purchaser) are issued as consideration. Subsections 18(4) - (8).

14 14 dispose of shares of a Canadian corporation to a non-resident corporation on a rollover basis. 32 The details of an exchangeable share structure and the related tax issues will be dealt with in another paper at this conference. In simple terms, the basic structure of an exchangeable share transaction involves the Canadian resident shareholder exchanging his or her shares for special shares of the target or more often of a Canadian holding corporation that acquires the shares of the target. This exchange is governed by either section 86 or 85 in the former case and section 85 (or less likely 85.1) in the latter to provide the Canadian resident with a tax-deferred rollover. The special shares typically contain provisions, and are subject to arrangements, which provide the Canadian resident with the same economic interest as a shareholder of the non-resident purchaser. Ultimately, the special shares are exchanged for shares of the non-resident purchaser at which time the Canadian shareholder will realize a gain. Among other things, the structure requires detailed attention to the taxable and term preferred share rules, the requirements of the particular rollover provision being relied upon, qualified investment rules, foreign property rules, and the creation of cross-border paid-up capital in the case where a holding corporation is used as the agent with the overriding call right to implement the ultimate exchange of shares. 5. Capital Gains Reduction through Safe Income Distribution Several years ago, individual vendors would structure a sale of shares to convert capital gains into dividends since the tax rate on dividends was lower than the tax rate on capital gains. Now that tax rates are lower on capital gains, planning for individual vendors focuses on avoiding dividend treatment and obtaining a lower or deferred capital gain. On a disposition of shares, the vendor will realize a capital gain to the extent the proceeds of disposition exceed the adjusted cost base of the shares. The gain may be derived from many components. In part, it may arise because the corporation has undistributed retained earnings, representing income upon which taxes were already paid at the corporate level. To the extent that a gain would arise because of such income, the corporate vendor will generally be able to realize such amount without incurring a tax liability. As a general rule, inter-corporate dividends received by a taxable Canadian corporation from a connected corporation are not subject to Canadian income tax. 33 If a corporation receives a dividend before selling the shares it holds in a corporation, generally the proceeds and, therefore, the capital gain realized will be reduced by the amount of the dividend. 34 As a result, a portion of the tax that would otherwise have been paid on the sale will have been avoided since no tax will be paid on the dividend. The Tax Act contains an anti-avoidance provision, subsection 55(2), which limits the amount of tax free inter-corporate dividends which can be received prior to the sale of shares. Where the In an October 18, 2000 economic statement the federal government announced the intention to develop a sharefor-share exchange rollover rule to apply to cross-border share-for-share exchanges where a Canadian resident shareholder receives in exchange for shares of a Canadian corporation only share consideration on the exchange. No draft legislation has been released yet. Subsections 82(1), 112(1) and 186(1). If the corporations are not connected Part IV tax will apply. Accordingly, the planning to access safe income through dividend payments is only beneficial if Part IV tax does not apply. For example, if a company with shares with a fair market value of $100 pays a dividend of $10, then the fair market value of the shares should be reduced to $90 and a purchaser should only be willing to pay $90 for the shares.

15 15 anti-avoidance rule applies, it recharacterizes the dividend as proceeds of disposition thereby increasing the amount of the capital gain. However, the amount of the dividend that is reasonably attributable to the corporation s income earned or realized after 1971 and before the dividend was paid is not subject to this recharacterization. This income is known as the safe income. The Tax Act does not contain an exhaustive code for the calculation and allocation of safe income among different classes of shares of a corporation and there is limited jurisprudence on the issue. In practice, articles and rulings written by the CRA are relied upon in determining the amount of safe income and safe income on hand attributable to any particular share. 35 If the amount of a dividend paid, or deemed to be paid, on a share exceeds the safe income attributable to the share, the whole amount of the dividend will be deemed to be proceeds of disposition or a capital gain under the anti-avoidance rule. Paragraph 55(5)(f) allows a corporation that has received a dividend to make series of designations deeming it to have 35 The starting point for calculating safe income on hand attributable to a share is its share of the net income for tax purposes during the share s holding period. In computing the safe income on hand the following are some of the items which will increase the amount: scientific research allowances deducted under section 37.1, non-taxable portion of capital gains realized and non taxable portion of eligible capital amounts, income tax refunds received, and dividend tax refunds received. The following are some items which will decrease the safe income on hand: non-deductible portion of capital losses, non-deductible portion of meals and entertainment expenses, non-deductible portion of car leases, non-deductible portion of land carrying charges, non-deductible portion of life insurance premiums, unclaimed portion of R&D pool, federal income taxes paid, Ontario income taxes paid (and capital taxes if not deducted), large corporation taxes paid, non-deductible income tax interest and penalties paid, dividends paid, dividends in arrears or dividends declared and unpaid, charitable donations paid, contingent liabilities and certain accounting provisions which are not currently deductible for income tax purposes, any amount which reduced income under any provision of the Tax Act will generally reduce safe income, and any amount included in taxable income that does not represent actual income earned and which is not included as a deduction above will reduce safe income. The following items are ignored when computing safe income on hand: capital dividends paid, and deferred income taxes.

16 16 received separate dividends. 36 If there is insufficient safe income to cover the entire dividend, by making the designations the corporate recipient can obtain the benefit of the safe income through deemed separate dividends up to the amount of the safe income. An alternative to making paragraph 55(5)(f) designations is to actually pay, or be deemed to have paid upon increases in capital, a series of separate dividends. The safe income may be accessed through the declaration and payment of actual dividends or alternatively through increases in the stated capital of the shares subject to the sale which give rise to deemed dividends. 37 If actual dividends are paid, the value of the target corporation will be reduced. 38 If a dividend is deemed to be paid as a result of an increase in the capital of the shares, the value of the corporation will not be reduced but paragraph 53(1)(b) will automatically increase the adjusted cost base of the shareholder s shares by the amount of the dividend deemed by subsection 84(1) to have been received. As a consequence the capital gain realized on the sale will be reduced. 39 In the context of a takeover bid, even of a public corporation, if the vendor is an individual, planning is possible to access the safe income attributable to the vendor s shares of target. The individual may transfer the shares of the target corporation to a holding company ( Holdco 1 ) on a rollover basis. The shares of the holding company would then be rolled into a second holding company ( Holdco 2 ). Holdco 1 would increase the stated capital of its shares to the extent of the safe income attributable to the shares of target held by Holdco 1. The resulting deemed dividend under subsection 84(1) will not subject Holdco 2 to Part I or Part IV tax. 40 The The Court in The Queen v. Nassau Walnut Investments, 97 DTC 5051 (F.C.A.), permitted a late designation under paragraph 55(5)(f). Subsection 84(1). Stated capital is the corporate law term. Subject to the adjustments provided for in the Tax Act, paid-up capital will be equal to stated capital. The increase in stated capital and, therefore, paid-up capital will not result in a deemed dividend if the increase results from one of the exceptions enumerated in paragraphs 84(1)(a) to (c.3). If desired, the amount of these dividends can then be returned to the corporation as a capital contribution and the adjusted cost base of the vendor s shares increased accordingly pursuant to paragraph 53(1)(c). At one time, there was a concern that double tax could result if safe income was being extracted through an increase in the stated capital of a share. If the amount of the capital increase is not covered by safe income, such that subsection 55(2) deems the amount to be a capital gain and not a dividend, the adjusted cost base of the share will not be increased under paragraph 53(1)(b) since this paragraph only provides for the step-up in the adjusted cost base when there is a deemed dividend. Therefore, prima facie the same amount could be realized as a capital gain a second time when the share was sold. However, it is now accepted that subsection 248(28) may be relied upon to avoid the double tax problem. In an advance income tax ruling (Document Number ) the CRA ruled that to the extent that subsection 55(2) applied to a particular deemed dividend arising on the increase in the stated capital of a share such that the deemed dividend was deemed not to be a dividend, neither paragraph 55(2)(b) or (c) would be applied to the deemed dividend to recharacterize it as anything else. If a dividend is actually paid the potential problem is not present. If an actual dividend is paid and it is recharacterized as a capital gain or as proceeds of disposition under subsection 55(2) because of insufficient safe income, the value of the company will nevertheless have been reduced by the payment of the dividend. Therefore, a further gain will not be realized on the disposition of the share. Further, if the dividends were recontributed as capital to the target corporation, the adjusted cost base of the shares would be bumped under paragraph 53(1)(c) and a further gain would not be realized on the sale of the share. As long as the takeover bid does not make the shares of target or Holdco 1 taxable preferred shares or term preferred shares, there will be no concern for Part VI.1 and IV.1 tax. The shares will generally not be taxable preferred shares if the target shares are purchased with 60 days of the agreement to acquire them is made.

17 17 amount of the deemed dividend will increase Holdco 2 s cost base in its shares of Holdco 1. Holdco 2 will tender its shares of Holdco 1 to the acquirer. Of course, concurrence with the acquirer is required as well as a determination whether a collateral benefit under securities law has been conferred on this particular shareholder. This holdco alternative may not be efficient if the purchaser or seller is a financial institution. 41 Proposed amendments to paragraph 88(1)(c.3) will facilitate certain types of safe income crystallizations prior to a takeover. 42 Sometimes an individual holds the shares of the target through a holding company. The holding company may have a low cost base in the shares of target and the individual may have a high cost base in the shares of the holding company. In such circumstances the purchaser may be asked to buy shares of the holding company or the target will agree to enter into a tuck transaction. In a tuck transaction, the individual transfers the shares of the holding company to the target in exchange for shares of the target and a section 85 election is filed. As a result, the individual will hold shares of the target with a high cost base which can be tendered into the bid. Target can amalgamate with its newly acquired wholly-owned subsidiary without the need for shareholder approval. 6. Change of Control Implications A takeover bid will most often give rise to an acquisition of control of the target. An acquisition of control 43 of a corporation by a person or group of persons gives rise to a number of consequences under the Tax Act. There is no general definition in the Tax Act of when control is acquired; however, there are provisions that deem control not to have been acquired for specific provisions 44 and there is provision which deems a corporation to be controlled for purposes of the associated corporation rules. 45 In general, a person or group of persons who acquires more than 50% of the voting stock acquires control of a corporation. 46 Time of the Acquisition of Control In very general terms, a financial institution is required to mark shares it owns to market value if it owns less than 10% of the shares; see subsection 142.5(2) and the definitions of mark-to-market property and significant interest in subsections 142.2(1) and (2) respectively. A mark up is treated as ordinary income as opposed to a capital gain. See Clause 36 of the December 20, 2002 draft technical amendments. A proposed amendment to paragraph 88(1)(c.4) will facilitate participation by a specified shareholder in a takeover bid where shares of the parent are acquired for cash by amending the definition of specified property to include shares of the parent issued for consideration that consists solely of money. The expression controlled, directly or indirectly in any manner whatever is referred to as control in fact and it has a special meaning for the purpose of the Tax Act: subsection 256(5.1). This portion of the paper generally addresses control in its legal or de jure sense. Subsection 256(7). Subsection 256(1.2). Buckerfield s Ltd. v. MNR, 64 DTC 5301 (Ex Ct), MNR v. Consolidated Holdings Company Limited, 72 DTC 6007 (SCC), The Queen v. Imperial General Properties Limited [1985], 2 SCR 288, Oakfield Developments (Toronto) Ltd. v. MNR, 71 DTC 5175 (SCC), The Queen v. Duha Printers (Western) Limited, 98 DTC 6334 (SCC), and The Queen v. W. Ralston & Co. (Canada) Inc., 96 DTC 6988 (FCTD).

18 18 Pursuant to subsection 256(9), for purposes of the Tax Act, an acquisition of control is deemed to occur at the commencement of the day on which the acquisition occurs unless the acquired corporation elects in its return for the year ending immediately before the acquisition of control not to have subsection 256(9) apply. If the election is made, the time at which control was legally acquired, determined under commercial law principles, will determine the time of the acquisition of control for the purposes of the Tax Act. Deemed Year-End An acquisition of control will result in the corporation having a year-end immediately before the time of the acquisition of control and a new taxation will be deemed to have commenced at the time of the acquisition. 47 If the corporation s last real taxation year ended within the seven day period that ended immediately before the acquisition of control then the corporation may elect to have the last taxation year extended to end immediately before the acquisition of control. 48 Ordinarily a corporation requires the concurrence of the Minister to change a fiscal period; however, in the case of an acquisition of control no such concurrence is necessary to establish the first year-end following the acquisition of control. 49 Some of the income tax consequences that may arise from the deemed year-end are as follows: Requirement to file a tax return and pay taxes. Shorter carry-forward or carry-back periods for items such as non-capital losses, donations and investment tax credits. Proration for capital cost allowance deductions. Income inclusion of unpaid amounts: subsection 78(1). Deduction denial for unpaid bonus: subsection 78(4). Income inclusion as a result of shareholder loans: subsection 15(2). Imputed interest on loans to non-residents: subsection 17(1). Recognition of reserves on inventory and capital gains. Inventory write-down: subsection 10(1) Paragraphs 249(4)(a) and (b). Paragraph 249(4)(c). The election is not available if there was another acquisition of control of the corporation within that 7-day period. Paragraph 249(4)(d) and subsection 249.1(7).

19 19 Contributions to plans such as RPP, EPSP, DPSP. Shorter time to acquire replacement properties: subsections 13(4), 14(6) and 44(1). Other Consequences of an Acquisition of Control Many of the significant tax consequences that arise as a result of an acquisition of control are provided for in section Use of Losses - Subsections 111(4) and (5) There are rules that apply on an acquisition of control that significantly limit a corporation s ability to use its non-capital and net-capital losses. Paragraphs 111(4)(a) and (b) provide that capital losses incurred in taxation years ending before the acquisition of control cannot be carried forward and deducted against capital gains realized in years ending after the acquisition of control and that capital losses incurred in taxation years ending after the acquisition of control cannot be carried back and applied in a taxation year that occurred prior to the acquisition of control. In other words, old capital losses are lost and new ones can only be applied against postacquisition gains. The general rule for non-capital losses is the same as for capital losses i.e., old non-capital losses are lost and new ones incurred post-acquisition of control can only be applied against postacquisition income. However, there is an exception for non-capital losses that were incurred in carrying on a business. The exception does not apply to non-capital losses derived from property. The pre-acquisition non-capital losses from a business may be carried forward to taxation years ending after the acquisition of control and deducted in computing taxable income if that same business is carried on by the corporation for profit or with a reasonable expectation of profit throughout a particular year and then only to the extent of the corporation s income from that business. In addition, if the old business was one in which properties were sold, leased, rented or developed or services were rendered in the course of carrying on that business, then the old non-capital losses from that business may be applied against the income of a new business 50 Tax consequences that occur from the acquisition of control, other than those found in section 111 and subsection 249(4), discussed above, include the following: Limitation on unused Part I.3 tax credits: subsection 125.3(3). Limitation on unused surtax credits: subsection 181.1(7). Loss of capital dividend account: subsection 89(1.1). Restrictions on the use of investment tax credits: subsection 127(9.1) and (9.2) Reduction in SR&ED expenses: subsection 37(6.1). Restriction on resource expenses: subsection 66.7(10).

20 20 where substantially all the income of it is derived from the sale, leasing, rental or development of similar properties or the rendering of similar services as the old business. The post-acquisition non-capital losses from a business can be carried back against income from a pre-acquisition business if the criteria mentioned in the preceding paragraph for the carrying forward of non-capital losses have been satisfied. On a vertical amalgamation of a parent and a wholly-owned subsidiary post-amalgamation losses may be carried back against the predecessor parent corporation. 51 Non-Depreciable Capital Property - Paragraph 111(4)(c) If the adjusted cost base of a corporation s non-depreciable capital property exceeds its fair market value immediately before the acquisition of control, then the excess is deducted from the adjusted cost base and treated as a capital loss in the year ending with the acquisition of control. 52 As a result, the inherent capital loss in such properties is crystallized and cannot be realized after the acquisition of control and deducted against capital gains realized in the postacquisition period. If the capital property does not have an inherent loss, the corporation may make a designation which deems such non-depreciable capital property to be disposed of for proceeds equal to the lesser of (i) the fair market value of the property, and (ii) the adjusted cost base of the property, or such greater amount as is designated in respect of the property. 53 The property subject to the designation is deemed to be reacquired for an amount equal to the deemed proceeds. As a result, the adjusted cost base of such property can potentially be increased to its fair market value at the time of the acquisition of control. Generally, a designation triggering a gain would only be made if it can be sheltered with net capital losses that cannot be used post-acquisition of control. Depreciable Property - Subsection 111(5.1) If depreciable property in a prescribed class has an inherent terminal loss, then the corporation is required to deduct in computing its pre-acquisition of control income the excess of the undepreciated capital cost of the class over the aggregate of the fair market value of all of the property of the class and the amount of the capital cost allowance or terminal loss otherwise deductible in computing the corporation s income in respect of that class in the taxation year ending on the acquisition of control. 54 The effect of this rule is to convert unrealized terminal losses into non-capital losses of a taxation year ending prior to the acquisition of control. As a consequence, the limitations on the deduction of such amounts following the acquisition of control are applicable Subsection 87(2.11). This places these types of vertical amalgamations on par with a wind-up under subsection 88(1). On other forms of amalgamations there is no ability to carry back losses. Paragraphs 111(4)(c) and (d). Paragraph 111(4)(e). Subsection 111(5.1).