Republished with permission from Federated Press.
The Federal Court of Appeal's decision in Husky Oil Limited v. The Queen1 sets out in clear terms the purpose of subsection 87(4) of the Income Tax Act2 and offers some clarity to taxpayers contemplating corporate amalgamations to which subsection 87(4) will apply. In addition, this decision provides useful guidance that may assist taxpayers in challenging any tax assessment based largely on the assumptions of fair market value by the Minister of National Revenue (the "Minister").
The Transaction at Issue
The facts in this case are complex and difficult to summarize. Interested readers may refer to paragraphs 13-43 of the Federal Court of Appeal's reasons for judgment for a full summary of the facts leading up to and following the transaction at issue. For purposes of this analysis, only the key facts will be presented.
A predecessor to the Appellant taxpayer ("Old Husky") was a Canadian corporation. Old Husky and another Canadian corporation, Balaclava Enterprises Ltd. ("Balaclava"), wished to take over a Canadian petroleum company – Mohawk Canada Limited ("Mohawk") – in which Balaclava had a minority interest. Neither Balaclava nor any of its subsidiaries were "related" (as defined in the Act) to either Old Husky or Mohawk or any of their subsidiaries.
To facilitate the takeover, the following preliminary steps were taken: (1) Balaclava transferred its minority interest in Mohawk to one of its wholly-owned subsidiaries, BEL Enterprises Inc. ("BEI"), on a tax-deferred basis using subsection 85(1); (2) Old Husky and BEI formed an acquisition corporation – HB Acquisition Inc. ("HB") – in which Old Husky maintained control; and (3) Mohawk transferred certain property to one of its wholly-owned subsidiaries – Mohawk Lubricants Ltd. ("Lubricants") – in exchange for additional shares in Lubricants, such that Mohawk held all shares in Lubricants having an adjusted cost base of $9,891,181.
In a Joint Bid Agreement dated June 1, 1998, it was agreed that HB would make a bid for all Mohawk shares not already owned by Balaclava or its subsidiaries, for $7.25 per share, and that the bid was conditional on 90% of Mohawk shareholders accepting the bid. The Joint Bid Agreement provided that if 90% or more of Mohawk shareholders accepted the bid, Old Husky or a subsidiary would subscribe for $103 million of HB shares, which HB would use to purchase all deposited Mohawk shares. The Joint Bid Agreement further provided that BEI would transfer all its Mohawk shares (valued at $20,693,436) to HB on a tax-deferred basis, using a subsection 85(1) rollover.
Finally, the Joint Bid Agreement provided for an Option and Put Agreement to be entered into if the Mohawk bid was accepted by 90% or more of Mohawk shareholders. Under this Agreement, BEI would be granted an option to buy the Lubricants shares from Mohawk for $15.5 million payable in 2023, without interest. However, due to unforeseen circumstances, the Option and Put Agreement was amended so that rather than selling the Lubricants shares to BEI, Lubricants would be amalgamated with a subsidiary of BEI, 3470750 Canada Inc. ("347"), to form a new corporation ("Amalco"). This amalgamation would effectively result in Mohawk receiving $15.5 million in 2023 by way of redemption of certain shares of Amalco (Class A, Class B and Class C preferred shares). Significantly, 347 was not "related" to Lubricants.
These transactions were completed substantially in accordance with this plan by the end of 1998. It is undisputed that subsection 87(4) of the Act applied to the amalgamation of 347 and Lubricants. Finally, in 1999, Old Husky and Mohawk were amalgamated to form the Appellant, Husky Oil Limited (though this amalgamation is not relevant to the issues under appeal).
Subsection 87(4) Explained
Subsection 87(4) of the Act is a rollover provision that applies upon the amalgamation of two or more Canadian corporations. It generally provides, subject to a number of conditions, a rollover for the shareholder of a predecessor corporation who exchanges shares of the predecessor for shares of the amalgamated corporation. Generally, where two or more corporations are amalgamated, a shareholder of a predecessor corporation who only receives new shares of the amalgamated corporation on the amalgamation is deemed to have disposed of the shares of the predecessor (the "old shares") for proceeds of disposition equal to their adjusted cost base, and to have acquired the shares of the amalgamated corporation (the "new shares") at a cost equal to that same amount.3
However, no rollover is available to a shareholder of a predecessor corporation if the following conditions exist: (1) the fair market value of the old shares immediately before the amalgamation exceeds the fair market value of the new shares immediately after the amalgamation; and (2) it is reasonable to regard all or any portion of the excess (referred to in subsection 87(4) as the "gift portion") as a benefit that the shareholder desired to have conferred on a person related to the shareholder. The Federal Court of Appeal referred to this as the "87(4) Exception."
In such a case, the shareholder generally is treated as having realized a capital gain on the disposition of the old shares. As the Federal Court of Appeal pointed out, the amount of the capital gain is determined by a formula; typically, the amount of the capital gain is equal to the amount of the "gift portion."4
The practical impact of subsection 87(4) is not readily apparent on a simple reading of the legislation. However, Justice Sharlow provided a helpful example of the application of subsection 87(4) at paragraphs 6 through 10 of the reasons for judgment. For purposes of this analysis, it is sufficient to understand that the 87(4) Exception operates as a specific form of anti-avoidance rule that is designed to tax the conferral of a benefit between related persons in the course of an amalgamation.
The Reassessment and Appeal to the Tax Court
In 2004, the Minister reassessed the Appellant, Husky Oil Limited, to include in Mohawk's 1998 income a taxable capital gain of $4,205,615 arising from the disposition of the Lubricants shares for deemed proceeds of disposition of $15.5 million. The Minister contended that the fair market value ("FMV") of the Lubricants shares immediately before the amalgamation was $15.5 million, yet the FMV of the Class A, B and C shares in Amalco issued immediately after the amalgamation was $0. As a result, the 87(4) Exception would apply to deem a $15.5 million benefit to Mohawk. The Minister also relied on subsection 69(4), on the basis that the Lubricants shares were appropriated at less than FMV for the benefit of HB, Mohawk's parent corporation at the time. Husky Oil Limited objected to the reassessment issued by the Minister, which was subsequently confirmed.
Husky Oil Limited appealed to the Tax Court of Canada. Justice Hogan dismissed the appeal on the basis that subsections 87(4) and 69(4) applied to deem a $15.5 million benefit to Mohawk. The reassessment under appeal was based on the Minister's assumptions of the valuations of the pre-amalgamation FMV of the shares of Lubricants and the post-amalgamation FMV of the Class A, B and C preferred shares of Amalco. The trial judge concluded that, since there was no evidence presented to rebut those assumptions, they must stand as fact. The fact that HB and Mohawk were not related at the time they entered into the above plan did not impact the trial judge's conclusion.
The Appellant appealed Justice Hogan's decision to the Federal Court of Appeal.
The Federal Court of Appeal's Decision
The Federal Court of Appeal allowed the appeal. Justice Sharlow, writing on behalf of the Court, concluded that the "87(4) Exception" did not apply since the $15.5 million "gift portion" was not a benefit that Mohawk desired to have conferred on a person related to Mohawk. After all, neither BEI nor 347 (subsidiaries of Balaclava) were related to Mohawk.
The Crown had not asserted that the 87(4) Exception applied on the basis of a benefit that Mohawk conferred on BEI or 347. Instead, the Crown relied on the argument, which the trial judge accepted, that the amalgamation benefitted Old Husky (and thus HB) because the amalgamation enabled the completion of the whole series of transactions to achieve what Old Husky intended.
However, the Federal Court of Appeal rejected this argument and noted that the objective of the 87(4) Exception is
to deter a taxpayer from using the device of a corporate amalgamation to shift part or all of the value of a predecessor corporation to the amalgamated corporation if, but only if, a person related to the taxpayer has a direct or indirect interest in the amalgamated corporation that will be enhanced by the shift in value.5
Since the 87(4) Exception did not apply, the general rollover rule in paragraph 87(4)(a) applied to deem Mohawk's proceeds of disposition to be equal to the adjusted cost base of the shares of Lubricants, which was $9,891,181.
Finally, since the general rollover rule in paragraph 87(4)(a) applied in this case, the Federal Court of Appeal concluded that subsection 69(4) could not apply. If subsection 69(4) could be applied to the disposition of shares to which paragraph 87(4)(a) applies, the Federal Court of Appeal noted that the result in many cases would be two statutory deeming rules creating two different statutory fictions. This result could not have been intended by Parliament, and one of the provisions must necessarily trump the other. Since subsection 87(4) is a more specific provision than subsection 69(4), then if subsection 87(4) applies in any case, it will necessarily trump subsection 69(4).
Since both bases of the reassessment were rejected, the appeal was allowed in its entirety. The Minister did not seek leave to appeal to the Supreme Court of Canada.
Analysis of the Federal Court of Appeal's Reasons
The Federal Court of Appeal's decision is well-reasoned and is consistent with a textual, contextual and purposive interpretation of subsections 87(4) and 69(4) of the Act. Of particular note, the Federal Court of Appeal:
- limited the scope of the benefit contemplated by the 87(4) Exception to the "gift portion" (i.e., the difference in value between the "old shares" and the "new shares") rather than the overall tax savings to be achieved by the series of However, the Federal Court of Appeal transactions; and
- referred specifically to the text of subsection 87(4) in deciding the appeal rather than an unexpressed legislative intention of what the 87(4) Exception was designed to achieve.
This decision sets out in clear terms the intention of the 87(4) Exception and it will offer clarity to taxpayers contemplating corporate amalgamations to which subsection 87(4) will apply.
The Federal Court of Appeal's closing remarks, however, practically invite the Minister to challenge future similar transactions on the basis of the general anti-avoidance rule ("GAAR") in section 245 of the Act. Since the GAAR was not raised by the Minister in this case, neither the Tax Court nor the Federal Court of Appeal considered its application.
An Observation on the Minister's Valuation Assumptions
The Federal Court of Appeal made an interesting observation in its reasons. The reassessment under appeal was based on two valuations: one valuation was the pre-amalgamation FMV of the shares of Lubricants, which the Minister assumed was $15.5 million. The other valuation was the post-amalgamation FMV of the Class A, B and C preferred shares of Amalco, which the Minister assumed was $0. The trial judge concluded that, since there was no evidence presented to rebut those assumptions, they must stand as fact.
With respect to the pre-amalgamation valuation, the Federal Court of Appeal noted that the $15.5 million valuation was based on an arm's length agreement to pay that amount in 2023, which must necessarily be less than $15.5 million in 1998 dollars (i.e., it should have been the value in 1998 of $15.5 million payable in 2023, without interest).6
With respect to the post-amalgamation valuation, the Federal Court of Appeal noted that the trial judge had correctly observed that the FMV of a right to receive something in the future (i.e., 2023) without interest is less than the stated sum; nevertheless, the trial judge concluded that the value was $0 simply because that was an assumption made by the Minister in its reassessment, and there was no expert valuation evidence to rebut that presumption. The Federal Court of Appeal noted that "it would have been open to the judge to take judicial notice of the fact that the present value of a sum of money payable in 25 years without interest, while undoubtedly less than the stated sum, is probably more than zero,"7 and consequently, the post-amalgamation valuation must have been some amount greater than $0. This factor, according to the Federal Court of Appeal, would have been sufficient to rebut the Minister's assumption that the post-amalgamation valuation of the shares of Amalco was $0. At that point, the onus would have shifted to the Minister to establish the post-amalgamation FMV of Amalco shares, and in the absence of any such evidence, that would have been sufficient for the trial judge to conclude that the reassessment was not justified on the basis of the subsection 87(4) Exception.8
However, these points were not raised by the parties at trial and were not pursued on appeal. The Federal Court of Appeal therefore declined to determine the appeal on these grounds.
These comments, while made in obiter, provide useful tactical guidance to taxpayers that are reassessed on the basis of the Minister's assumptions of valuation (whether on the basis of subsection 87(4) or any other provision). Most notably, it is in a taxpayer's interest to provide at least some rebutting evidence to the Minister's assumed valuations, as that will force the Minister to lead specific expert valuation evidence at trial. In this case, this rebutting evidence could have merely consisted of an expert report that concluded that "the post-amalgamation FMV of Amalco shares must have been greater than zero" (for the simple reasons noted by the Federal Court of Appeal), without expressing any opinion on the actual FMV.
1 2010 DTC 6887, rev'g 2009 DTC 497 (T.C.C.).
2 R.S.C. 1985, c. 1 (5th Supplement), as amended, hereinafter referred to as the "Act." Unless otherwise stated, statutory references in this article are to the Act.
3 See paragraphs 87(4)(a) and (b) of the Act.
4 See paragraphs 87(4)(c), (d) and (e) of the Act.
5 Supra note 1 at paragraph 58.
6 Ibid. at paragraph 49.
7 Ibid. at paragraph 52.
8 Ibid. For a recent summary of the issue of assumptions and onus in tax appeals, refer to the decision of Northland Properties Corporation v. British Columbia (2010), 319 D.L.R. (3d) 334, 2010 BCCA 177 (B.C.C.A.).
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