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Canadian Income Tax Primer on Mergers and Acquisitions

Published: 05/14/2010

By Ken Snider, Janice Vohrah

We have found that there are numerous recurring questions about the Canadian tax considerations applicable to mergers and acquisitions. We have prepared this primer in the hope that many of these questions will be addressed at least in summary form. We would be pleased to answer more specific questions.

INTRODUCTION

This primer is intended as an overview of the principal Canadian federal income tax considerations under the Income Tax Act (Canada) (the "ITA") generally applicable in respect of mergers and acquisitions. This primer is in no way exhaustive and should not be construed as tax advice in respect of any particular transaction. "Mergers and acquisitions" encompasses a very broad range of transactions and will vary depending on a public or private target, tax residency of target, vendors, and purchaser, and share or non-share consideration. Please consult with a tax lawyer at the earliest possible opportunity in respect of your particular transaction. Non-Canadian tax considerations may play a very important part in cross-border transactions with Canadians.

This primer will review the general tax considerations from the perspective of

(a) a vendor of shares,
(b) a purchaser of shares, and
(c) the target.

It is assumed that an asset sale is not the structure of the transaction and therefore the tax considerations applicable to an asset purchase and sale will not be addressed. Similarly, tax representations and warranties will not be addressed in this primer.

Unless otherwise indicated, all statutory references herein are to the ITA.

I. VENDOR INCOME TAX CONSIDERATIONS

A. Tax Residence of Vendor

The tax residency of the vendor is a very important threshold consideration which can affect structuring. If the vendor is a non-resident of Canada, it will have tax considerations applicable in its home jurisdiction. There are also specific rules under the ITA applicable to a non-resident, which are summarized below. Please note that a transaction such as a share-for-share exchange qualifying for tax-free treatment in Canada may not necessarily qualify as a tax-free transaction in the home jurisdiction of the vendor.
A non-resident of Canada will be taxable on any capital gain under the ITA from the disposition of shares that are "taxable Canadian property" ("TCP"). A tax treaty may, however, provide protection against Canadian taxation of the gain. Subject to very important proposed amendments (the "Amendments") to the definition of TCP released in the 2010 Canadian federal budget, TCP currently includes:
1. a share of the capital stock of a corporation resident in Canada that is not listed on a designated stock exchange,
2. a share that is listed on a designated stock exchange if at any time during the 60-month period that ends at the time of sale the taxpayer, persons with whom the taxpayer did not deal at arm’s length, or the taxpayer together with all such persons owned 25% or more of the issued shares of any class of the capital stock of the corporation that issued the share, and
3. shares received on certain tax rollovers that are deemed to be TCP as discussed below.
The Amendments limit the scope of TCP in several critical respects. First, they provide that after March 4, 2010, TCP will no longer include a share of a corporation that is not listed on a designated stock exchange, unless at any particular time during the 60-month period that ends at the time of sale, more than 50% of the fair market value of the share was derived directly or indirectly from one or any combination of
1. real or immovable property situated in Canada,
2. Canadian resource properties,
3. timber resource properties, and
4. options in respect of, or interests in, or for civil law rights in, property described in any of subparagraphs (i) to (iii), whether or not the property exists.
Second, the Amendments provide that a share listed on a designated stock exchange that meets the test in paragraph (2)(b) above will only be TCP if at any particular time during the 60-month period that ends at the time of sale, more than 50% of the fair market value of the share was derived directly or indirectly from one or any combination of properties described in subparagraphs (i) to (iv) above.
If shares of a public corporation are acquired by a non-resident in exchange for shares that are TCP, the shares of the public corporation will be deemed to be TCP if such shares to be acquired are subject to a tax-free rollover (i.e. section 85, 85.1 or 87) based on current law. This was potentially disadvantageous for the non-resident because, absent treaty protection, the non-resident would be taxable in respect of a capital gain on a sale of the public corporation shares which accrues after the purchase. Pursuant to the Amendments in determining after March 4, 2010 whether the shares received on certain tax-deferred transactions are TCP, such shares are deemed to be TCP for a 60 month period, regardless of how the shares derive their value.
There will be tax compliance and withholding obligations under section 116 of the ITA if the target shares are TCP as determined by the Amendments or are not exempted on the basis of being listed on a "recognized stock exchange." The purchaser will be liable for failure to withhold and remit 25% of the purchase price to CRA even if the gain is treaty protected. Accordingly, in any acquisition of shares of a private corporation from a non-resident, consideration should be given as soon as possible as to whether the shares will be TCP and if section 116 compliance is required. This can be particularly important where there are many non-resident vendors and the consideration is shares.
An individual who was resident in Canada throughout the year may be able to claim the lifetime $750,000 capital gains exemption in respect of a "qualified small business corporation share." There are numerous requirements that have to be satisfied and a “purification” reorganization may be required.

B. Tax-Free Rollovers

The ITA provides a variety of provisions that facilitate a vendor having a partial or full tax-free rollover in respect of a share-for-share exchange in different circumstances. Each relevant provision has its own requirements. There are also important considerations applicable to a purchaser in respect of these provisions which will be outlined below. The types of tax-free rollovers are summarized below.
Generally, a non-resident would not need a tax-free rollover for Canadian tax purposes unless its shares are TCP and there is no relief under an applicable tax treaty.
Subject to several conditions, there is an automatic and complete rollover for an exchange of shares of a taxable Canadian corporation held as capital property for shares of a Canadian corporation pursuant to section 85.1, unless the shareholder elects to report any portion of the gain (or loss) otherwise determined. There can be no non-share consideration unless there is a proper allocation of the share and non-share consideration to different portions of each target share. A vendor may receive shares of the purchaser for some of the exchanged shares and cash or other consideration for other exchanged shares. In these cases, the automatic rollover in section 85.1 may be utilized for the exchanged shares for which shares of the purchaser were received, as long as the vendor can clearly identify which shares (or fraction of each share) were exchanged for cash or other consideration and which were exchanged for shares of the purchaser. Where the vendor receives shares and cash or other consideration for each exchanged share, section 85.1 may be utilized for the fraction of each exchanged share for which only share consideration was received, provided that the purchaser's offer clearly indicates that the share consideration will be exchanged for a specified fraction of each share tendered and the non-share consideration will be given for the remaining fraction. In these situations, the cash or other non-share consideration received represents proceeds of disposition of shares or fractions of shares of the target.

An exchange of options or warrants does not qualify for a tax-free rollover under this provision.
There is a complete or partial rollover of shares held as capital property or inventory transferred to a taxable Canadian corporation under subsection 85(1) in consideration of shares of such corporation. A joint election signed by the vendor and purchaser must be filed specifying an elected amount. The amount elected will determine the proceeds of disposition to the vendor, the cost of the purchaser shares received by the vendor, and the cost of the target shares acquired by the purchaser. There can be non-share consideration, but if the fair market value of the non-share consideration exceeds the tax cost of the target shares, a gain will be triggered equal to the excess. In addition, the elected amount cannot be less than the fair market value of the non-share consideration. An exchange of options for options does not qualify for a tax-free rollover under this provision.
There is a complete rollover on the exchange of shares and options of a taxable Canadian corporation held as capital property on a qualifying amalgamation of two or more taxable Canadian corporations pursuant to section 87. The shareholder cannot receive any non-share consideration for the shares and only options in exchange for options.
There is a complete rollover on the exchange of units of a publicly-traded trust that is a "SIFT trust" (e.g. an income trust) for shares of a taxable Canadian corporation pursuant to subsection 85.1(8), provided that the exchange takes place before 2013. The unitholder cannot receive any non-share consideration for the units.
There is a complete rollover for shares and options of a taxable Canadian corporation held as capital property on a qualifying triangular amalgamation of Canadian corporations pursuant to section 87.
Subject to several conditions, there is a complete rollover for the exchange of shares of a foreign corporation held as capital property for shares of another foreign corporation pursuant to subsection 85.1(5).
There is a complete rollover in respect of the exchange of shares and options of a foreign corporation on a qualifying foreign merger, unless the taxpayer elects otherwise.
There is not a tax rollover in respect of the following transactions:
1. The exchange of shares (or options) of a Canadian corporation for shares of a foreign corporation. To address the absence of a rollover in this situation, exchangeable share transactions have developed to provide a tax-deferred transaction under the ITA.
2. A triangular merger of two foreign corporations pursuant to which a shareholder receives shares of a Canadian corporation in exchange for shares of a predecessor foreign corporation.

C. "Safe Income" Dividend

A Canadian corporate shareholder of a target can reduce its capital gain otherwise to be realized on a sale of shares by its share of the "safe income" (i.e. the tax-retained income of the target during the vendor’s holding period), if any, of the target.
This will require the payment of an actual dividend prior to the sale, or creating a deemed dividend for purposes of the ITA not exceeding the holder’s share of the safe income. There are various non-cash ways of creating a deemed dividend.
In the public company context, where it is generally not possible to pay an actual dividend equal to the safe income attributable to each shareholder, a structure has developed called the "holding company alternative" which can achieve the desired tax effect without an actual payment of a dividend. This requires the full cooperation of the target and must be implemented prior to closing.

D. Options Held by Employees

The target may have various types of employee bonus, retirement and equity compensation plans, such as an option plan. It is very important to consider existing plans, necessary changes to these plans and the tax consequences to all parties.
There are rules that allow for the exchange of employee stock options without triggering employment income.

II. PURCHASER INCOME TAX CONSIDERATIONS

The tax considerations applicable to the purchaser will vary depending on a number of variables, some of which are mentioned below.
If the target has foreign subsidiaries, there will not only be potential foreign tax considerations applicable to the purchaser, but also the controlled foreign corporation rules in the ITA will be applicable on a go-forward basis.

A. Financing

The financing of the purchaser is a critical consideration if there is a material amount of cash to be paid as purchase price. The most tax efficient manner of financing the acquisition from internal and external resources must be considered at the earliest stage.
There is presently no consolidation for purposes of the ITA. Generally, a Canadian acquisition corporation would be the borrower and amalgamate with the Canadian target so the interest expense will offset the income of the target. The amalgamation of two or more taxable Canadian corporations can occur on a tax-free basis.
Withholding tax must be considered if there is a non-resident lender.

B. Tax-Free Rollovers

A purchaser will often be required to accommodate a full or partial tax-free rollover where the consideration wholly or partly consists of its shares. The purchaser as client must fully appreciate the tax implications to it of providing a tax-free rollover. It is in this context decisions must be made regarding structuring an automatic share-for-share exchange or a "tainted" section 85.1 exchange, as discussed below.
One potential adverse tax consideration applicable to a purchaser in respect of a tax-free transaction for the vendor is that the purchaser will be treated as acquiring the shares of the target at a tax cost which is below fair market value at the time.
The tax cost of the target shares will be very important in circumstances where the purchaser later wishes to dispose of the shares of the target, or possibly "spin out" non-depreciable capital property (e.g. shares) of the target, as discussed below. If the tax cost is less than fair market value by reason of a rollover, the purchaser will subsequently be taxable on the gain inherent in the target shares at the time of acquisition, even though fair market value consideration was paid.
The tax cost will depend on the applicable rollover provision. In an automatic share-for-share exchange rollover under section 85.1, the tax cost to the purchaser of the shares acquired will be the lesser of the "paid-up capital" and fair market value immediately before the exchange. However, if subsection 85(1) elections are filed, the aggregate tax cost will be the aggregate elected amounts, and, if no elections are filed, the aggregate tax cost will be the fair market value of the shares of the purchaser. Therefore, the tax cost of the target shares will generally be lower in an automatic rollover under section 85.1 than where subsection 85(1) elections are filed.
To reduce this potential disadvantage to the purchaser, the purchaser must decide whether to structure the consideration as follows:
1. "taint" the automatic section 85.1 tax-free rollover by including nominal non-share consideration without allocating such consideration to a specific portion of the target share(s) so the automatic rollover does not apply, and
2. provide for a joint election under subsection 85(1) only with taxable Canadian residents and non-residents of Canada who would otherwise be taxable under the ITA without any treaty relief.
There is an administrative cost to pursuing this strategy in the public company context where hundreds of subsection 85(1) elections may be required. The client must decide whether the incremental cost of processing these elections is justified having regard to the uncertainty that there will be a future tax benefit of “tainting” the section 85.1 rollover.

C. Non-Resident Purchaser

A non-resident purchaser should first consider whether it is entitled to benefits of a tax treaty with Canada (e.g. reduced rates of withholding tax). In particular, US residents will now have to consider whether they satisfy the requirements in the limitation of benefits provision in the Canada-US Tax Convention.
A non-resident purchaser may wish to use a "blocker" corporation in a jurisdiction with both a favourable tax regime and a tax treaty with Canada (e.g. Luxembourg) to make the investment into Canada. As noted above, the Amendments will eliminate the taxation of certain capital gains realized by non-residents. This will eliminate the need for use of a “blocker” corporation in many situations. Their use may, however, continue to be beneficial in certain situations.
It is very important for the non-resident, regardless of whether a "blocker" is used, to set up a Canadian acquisition corporation to effect the acquisition for many reasons. This will generally provide an opportunity to:
1. offset the interest expense incurred in financing the acquisition against the income of the target (subject to the "thin-capitalization rules"), and
2. repatriate more Canadian funds by a return of paid-up capital free of Canadian withholding tax than would be the case if a non-resident corporation were the purchaser.
Please note that a non-resident corporation as a direct purchaser of a Canadian target will prevent the transaction from qualifying for a tax-free rollover if there is share consideration, and achieving a "bump" as discussed below.

D. "Bump" in Tax Cost of Non-Depreciable Capital Property of Target

A purchaser can be interested in reorganizing the ownership of the shares of the subsidiaries of the target with the objective of distributing the shares to a non-resident shareholder or selling such shares after closing. The resulting income tax liability will depend on the fair market value at the time of the spin-out and the tax cost. In the most favourable circumstances, the "bump" rules will permit a spin-out of the shares without triggering a gain. This "bump" will be particularly important if the target has foreign subsidiaries and the shareholder of the Canadian purchaser resides in a foreign jurisdiction. A Canadian corporation interposed between two non-residents could create tax inefficiency in the future.
The "bump" rules permit a step-up in the tax cost of qualified property up to fair market value at the time of acquisition of control. This requires either an amalgamation of the Canadian target and Canadian purchaser or a winding up of the Canadian target into the Canadian purchaser after all the target shares have been acquired. The tax cost of the shares of the target is a crucial variable in computing the "bump," and the amount of the "bump" will be reduced to the extent such tax cost is less than fair market value. Therefore, the maximum "bump" up to fair market value at the time of acquisition of control is not possible where the acquisition of the target shares occurs on a tax rollover basis. This is because the tax cost of the shares of the target to the purchaser will be less than fair market value.
The "bump" rules are very complex, and there are a number of anti-avoidance rules that could disqualify a "bump." The planning must occur well before closing.

E. Tax Due Diligence

It is very important to identify as early as possible who will be responsible for tax due diligence. Generally, in Canada, accounting firms conduct the tax due diligence. Tax lawyers may get involved where there are substantive issues and exposure. Particular regard should be made to tax attributes such as capital cost allowance, resource tax pools, and losses, and the special status of any outstanding shares, such as flow through shares.
In some transactions there may be important post-closing integration and restructuring that will have tax considerations. This is best identified well before closing to identify any potential costs.

III. TARGET INCOME TAX CONSIDERATIONS

The ITA has a comprehensive set of rules that apply where there is an acquisition of control of the corporation. These rules range from tax compliance (e.g. a deemed year end) to more substantive. For example, there are rules which require the recognition of inherent losses for the taxation year ending on the acquisition of control, and restrictions on the carryforward of losses.
The target may have status as a "Canadian-controlled private corporation" prior to the sale and lose its status. This could have material monetary implications to the purchaser as there may be the loss of refundable tax credits, and the small business deduction. These implications should be addressed as part of tax due diligence.

Please do not hesitate to contact the authors should you have any questions.