Canada: Structuring Share Acquisitions – A Basic Primer

This article was originally published in Blakes Bulletin on Mergers & Acquisitions Tax - June 2006

Article by Leslie Morgan, ©2006 Blake, Cassels & Graydon LLP

Section 88(1)(d) of the Canadian Income Tax Act (the Act) provides the ability to "bump up" the cost of non-depreciable capital property (generally shares of subsidiaries, interests in partnerships or land) owned by a Canadian corporation, all of the shares of which are acquired in an arm’s length transaction. Absent the bump, if shares of a corporation are acquired, the tax basis in the shares acquired cannot be "pushed down" to step up the tax basis of the underlying assets. The "bump" provisions are highly technical in nature and contain many potential problems. Any expectation that a bump will be available in any particular situation will need to be carefully reviewed by Canadian tax counsel.

It is often desirable to be able to utilize the bump where a Canadian corporation (Canadian Target) is acquired by a nonresident of Canada (Non-resident Acquireco) and part of the value of the Canadian Target is referable to shares of foreign subsidiaries (Foreign Subsidiaries). If the bump is available, it will facilitate the removal of Foreign Subsidiaries from beneath the Canadian Target without the imposition of Canadian level tax. The remainder of this article considers the bump in the context of this very common structure, although the bump may be utilized in other contexts.

ONE. Non-resident Acquireco incorporates a Canadian company (Canadian Acquireco) and Canadian Acquireco incorporates a Canadian subsidiary (Canadian Sub).

TWO. Canadian Acquireco acquires all of the shares of Canadian Target pursuant to a takeover bid by way of a plan of arrangement, or otherwise, using funds raised by equity from Nonresident Acquireco (to the extent of the fair market value of the Foreign Subsidiaries) and arm’s length debt or related party debt (taking into account Canada’s thin capital requirements).

THREE. Canadian Acquireco transfers the shares of Canadian Target to Canadian Sub for the issuance of common shares and the assumption of the debt.

FOUR. Canadian Target and Canadian Sub amalgamate to form Amalco and the tax cost of Foreign Subsidiaries’ shares is bumped to their fair market value at the time of the acquisition of control. For purposes of this article, it is assumed that the bump will take place on the amalgamation of Canadian Target and Canadian Sub, although the bump is also available on the winding up of Canadian Target into Canadian Sub.

FIVE. Amalco distributes the shares of the Foreign Subsidiaries to Canadian Holdco as a return of capital.

SIX. Canadian Holdco distributes the shares of the Foreign Subsidiaries to Non-resident Acquireco as a return of capital.

Generally speaking, an amalgamation of two or more taxable Canadian corporations gives rise to a flow through of tax accounts and tax values from the predecessor corporations to the amalgamated corporation. In addition, on an amalgamation of a Canadian parent with its wholly-owned subsidiary, the parent is entitled to "bump" the cost of certain property.

This bump should be available in respect of shares of Foreign Subsidiaries, provided all of the following conditions are met:

ONE. The shares of the Foreign Subsidiaries are capital property of Canadian Target at the time Canadian Sub last acquired control of Canadian Target. Generally, the shares of subsidiaries will not be acquired for the purposes of resale in a speculative transaction. On that basis, they should qualify as "capital property" under the Act.

TWO. The shares of the Foreign Subsidiaries were owned by Canadian Target from the time that Canadian Sub acquired control of Canadian Target and thereafter without interruption until the amalgamation with Canadian Sub.

The Act provides that, for the purpose of the foregoing, Canadian Sub is deemed to have last acquired control of Canadian Target at the time that Canadian Acquireco last acquired control of Canadian Target. There must be no change in the shareholdings of Foreign Subsidiaries after the acquisition of control and prior to the proposed transactions.

THREE. The shares of the Foreign Subsidiaries are not "ineligible property".

In the context of the proposed transaction, the shares of the Foreign Subsidiaries will be "ineligible property" if any of the following conditions are met:

ONE. The shares are acquired by Canadian Sub as part of a Canadian spin-off (butterfly) transaction.

TWO. As part of the series of transactions or events that include the proposed transactions, the shares are: (a) acquired by Canadian Target from Canadian Sub or any person who did not deal at arm’s length with Canadian Sub, or (b) substituted for other property described in (a).

The concept of "substituted property" is very broad and includes property acquired through exchanges of property or stock dividends.

THREE. As part of the series of transactions or events that include the proposed transactions, any property of the Canadian Target is acquired by: (a) any person (other than Canadian Acquireco or a person related to Canadian Acquireco) that was a "specified shareholder" (a person owning alone or together with non-arm’s length persons 10% or more of any class or series of shares of Canadian Target or an upstream related corporation) of Canadian Target at any time before the acquisition of control, (b) two or more persons (other than Canadian Acquireco or a person related to Canadian Acquireco) that would, if they were a single person, be a "specified shareholder" of Canadian Target at any time before the acquisition of control, (c) a corporation (other than Canadian Acquireco or a person related to Canadian Acquireco or Canadian Target or its predecessors) (i) of which a person referred to in (a) is a specified shareholder after the acquisition of control, or (ii) of which two or more persons (other than Canadian Acquireco or a person related to Canadian Acquireco) referred to in (b) would, if they were a single person, be a specified shareholder after the acquisition of control.

These requirements may not be met where, as part of the same series of transactions and events that include the proposed transactions, any of Canadian Target’s property is sold or transferred after closing directly or indirectly to any person who was a shareholder of Canadian Target prior to closing. There could be a concern, for example, if any of Canadian Target’s property, including money, is actually distributed on the amalgamation or winding up and is used to repay debt to persons who were also shareholders of Canadian Target prior to closing.

FOUR. As part of the series of transactions or events that include the proposed transactions, any property "substituted for" property of the Canadian Target is acquired by any person or persons referred to in 3 (a) to (d) above. As mentioned above, the concept of "substituted property" is very broad. For the purpose of this test, "substituted property" includes any property owned by any person at any time after the closing, if the fair market value of such property (a) is wholly or partly attributable to any property of the Canadian Target (subject to certain itemized exceptions set out below) or (b) is determinable primarily by reference to the fair market value of the proceeds from the disposition of any property of the Canadian Target.

For purposes of the bump, substituted property does not include money, property that was not owned by the person after the acquisition of control or in the case of property the Canadian Target (that is property described in (a) above), "specified property". In general terms, specified property includes the shares of the capital stock of a Canadian corporation issued as consideration for the Canadian Target, indebtedness issued by a Canadian company in consideration for the acquisition of shares of the Canadian Target and where the Canadian Target is amalgamated with one or more other corporations, at least one of which was a wholly-owned subsidiary of the acquiring company, a share of the capital stock of the subsidiary that was issued on the amalgamation in exchange for a share of the capital stock of a predecessor and that was immediately after the amalgamation redeemed acquired or cancelled for money (this permits an amalgamation squeeze-out transaction which may be utilized to acquire 100% of Canadian Target).

Because of the broad definition of substituted property, in a situation where the consideration includes property other than cash, there are often significant issues with the bump. In particular, if shares of a non-resident corporation or debt of a non-resident corporation are or will be issued as part of the series of transactions that includes the amalgamation, the bump will not be available.

The amount of the bump-up to each asset must be designated in Canadian Sub’s tax return for the year ending on the amalgamation. The total amount available for bump-up is equal to:

ONE. Canadian Sub’s cost of the shares of Canadian Target, less the sum of:

TWO. The tax cost of the Canadian Target’s assets, plus any money in Canadian Target, less any debts or other obligations of the Canadian Target, less certain tax reserves claimed by the Canadian Target for tax purposes, and

THREE. Certain dividends received by Canadian Sub from Canadian Target.

The bump can be applied to the particular eligible assets selected. The amount of the bump-up on each share of the Foreign Subsidiaries cannot exceed the amount by which the fair market value of the share at the time of the acquisition of control of Canadian Target exceeds Canadian Target’s tax cost of the share. Under proposed amendments to the Act, Canadian Target’s tax cost of the shares may be deemed to be increased by any tax-free dividends received by Canadian Target or any predecessor from the foreign subsidiary for purposes of computing the bump available. This would have the effect of decreasing the amount of available bump. It is anticipated that this proposed amendment will be modified so that it only applies to dividends paid after Canadian Acquireco acquires control of Canadian Target, but there can be no assurance of this.

The bump can be extremely useful in the context of corporate acquisitions and reorganizations. It is, however, a highly technical provision and is often not available due to hidden and unexpected problems with the provision in particular fact situations.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.