Canadian residents frequently own shares in foreign corporations (a "Distributor") that "spin off" shares of their foreign subsidiaries (a "Spin-out Corporation") to shareholders. These transactions often occur on a tax-free basis in the home jurisdiction either because it is a tax-favourable jurisdiction, or because the transaction qualifies for tax-free treatment. Generally, the Canadian income tax consequences to Canadian-resident shareholders are not taken into account in planning the transaction, particularly where the Distributor is widely held and the Canadians are not a significant shareholder bloc. This article discusses the considerations under the Income Tax Act (the "Act") of a spin-out to Canadian shareholders by anon-Canadian corporation. This is hardly an academic issue as Canadian taxpayers have been reassessed in respect of foreign spin-offs.
The starting point in determining the tax consequences of a foreign spin-off is section 86.1 of the Act. It provides a tax-efficient regime for distributions that meet the stringent substantive and informational requirements of an "eligible distribution", as discussed below. If section 86.1 does not apply, the consequences under the Act should depend on the legal characterization of the particular reorganization, and the application of specific provisions of the Act to that characterization. On occasion, determining the correct legal characterization of foreign transactions has proven to be the more difficult of these two tasks. This difficulty arises perhaps because the corporate steps in the foreign jurisdiction may differ from the standard Canadian corporate practice. Possible tax consequences, depending on the corporate steps, could be a capital gain, a return of paid-up capital, a dividend-in-kind, ~or even, as we shall see below, anon-taxable capital receipt. Taxpayers will be adversely affected if the distribution is characterized as a dividend-in-kind. In such circumstances, subsection 52(2) of the Act would deem the Distributor's shareholders to have acquired the shares of the Spin-out Corporation at a cost equal to their fair market value at the time of receipt. The adjusted cost base of the shareholder's shares in the Distributor (the "Distributor Shares") would be unaffected by this dividend-in-kind, but the fair market value of such shares would typically decrease as a result of the spin-off. Such decrease in value would accordingly decrease the future gain or increase the future loss on a disposition by the shareholders of his/her Distributor Shares. Any resulting capital loss from the sale of such shares would not offset the tax on the dividend-in-kind. Even if the allowable capital loss could be used to offset a taxable capital gain, the taxpayer would still pay tax at full rates on the dividend-in-kind. The taxpayer may therefore be better off to sell the Distributor Shares prior to the record date for the distribution.
A spin-off distribution will qualify as an "eligible distribution" under section 86.1 if:
(a) the distribution is with respect to all of the taxpayer's common shares of the Distributor (the "Original Shares");
(b) the distribution consists solely of common shares of a Spin-out Corporation that were owned by the Distributor immediately before their distribution to the taxpayer (the "Spin-off Shares");
(c) in the case of a distribution that is not prescribed,
(i) at the time of the distribution, both the Distributor and the Spin-out Corporation are resident in the United States and were never resident in Canada;
(ii) at the time of the distribution, the shares of the class that includes the Original Shares are widely held and actively traded on a designated stock exchange in the United States; and
(iii) under the United States Internal Revenue Code applicable to the distribution, the shareholders of the Distributor who are resident in the United States are not taxable in respect of the distribution;
(d) in the case of a distribution that is "prescribed",
(i) at the time of the distribution, both the Distributor and the Spin-out Corporation are resident in the same country, other than the United States, with which Canada has a tax treaty (the "Foreign Country") and were never resident in Canada;
(ii) at the time of the distribution, the shares of the class that includes the Original Shares are widely held and actively traded on a designated stock exchange;
(iii) under the law of the foreign country, those shareholders of the Distributor who are resident in that country are not taxable in respect of the distribution; and
(iv) the distribution is prescribed subject to such terms and conditions as are considered appropriate in the circumstances;
(e) before the end of the sixth month following the day on which the Distributor first distributes aSpin-off Share in respect of the distribution, the Distributor provides to the Minister of National Revenue information satisfactory to the Minister establishing
(i) that, at the time of the distribution, the shares of the class that includes the Original Shares were widely held and actively traded on a prescribed stock exchange;
(li) that the Distributor and the Spin-out Corporation were never resident in Canada;
(Iii) the date of the distribution;
(iv) the type and fair market value of each property distributed to residents of Canada;
(v) the name and address of each resident of Canada that received property with respect to the distribution;
(vl) in the case of a distribution that is not prescribed, that the distribution is not taxable under the United States Internal Revenue Code applicable to the distribution;
(vii) in the case of a distribution that is prescribed, that the distribution is not taxable under the law of the foreign country;
(viii) such other matters that are required, in prescribed form; and
(f) the taxpayer elects in writing filed with the taxpayer's return of Income for the taxation year in which the distribution occurs that section 86.1 applies to the distribution, and provides information satisfactory to the Minister:
(i) of the number, cost amount (determined without reference to section 86.1) and fair market value of the taxpayer's Original Shares immediately before the distribution;
(II) of the number and fair market value of the taxpayer's Original Shares and the Spin-off Shares immediately after the distribution;
(ili) except where the election is filed with the taxpayer's return of income for the year in which the distribution occurs, concerning the amount of the distribution, the manner in which the distribution was reported by the taxpayer and the details of any subsequent disposition of Original Shares or Spin-off Shares for the purpose of determining any gains or losses from those dispositions; and
(iv) of such other matters that are required, in prescribed form.
If all these requirements are satisfied, the distribution will not result in income or a gain, and subsection 52(2) will not apply. Rather the cost of the Original Shares will be adjusted and, in effect, will be allocated to the Original Shares and Spin-off Shares on the basis of their respective fair market values. Because of the foregoing myriad requirements, a spin-out may not qualify under section 86.1 for one or more reasons. For example, the distribution may not be in respect of shares that are widely held and actively traded on a designated stock exchange (as required under (c)(ii) or (d)(ii) above), there may be property other than the Spin-off Shares distributed on the distribution (contrary to (b) above), or the spin-out may not be of common shares directly owned by the Distributor (contrary to (b) above). Moreover, the transaction must be "prescribed" if both the Distributor and Spin-out Corporation are not U.S. corporations. There are two prescribed transactions and a comfort letter recommending that a third transaction be prescribed, which is somewhat surprising as section 86.1 has been applicable to distributions received after 1997. Impediments for not qualifying for prescribed status are an absence of a tax treaty between Canada and the foreign country, and the spin-off shares not being directly owned by the Distributor immediately before the distribution.
In A/ine Morasse v. Her Majesty the Queen, the Minister assessed the taxpayer for additional Investment income based on the value of a stock distribution, which had been reported on a T5 as a stock dividend. The taxpayer appealed by way of informal procedure.
The stock distribution involved the following steps:
(a) The spin-off was effected by way of escisidn, a procedure under Mexican corporate law in which an existing company is divided, creating a new company to which specified assets and liabilities are allocated;
(b) Telefonos de Mexico S.A. de C.V. ("Telmex") established America Movil S.A. de C.V. ("America Movil") as a separate company with a fully independent legal existence and full capacity to own and dispose of its assets;
(c) Specified assets of Telmex, including shares of specified subsidiaries, were transferred to America Movfl. Businesses conveyed to America Movil were conducted by separate corporations and the continuity of existence of these corporations was undisturbed by the spin-off;
(d) Telmex shareholders were affected as follows:
(i) Owners of Telmex L Shares became owners of the same number of America Movil L Shares;
(ii) Owners of Telmex A Shares became the owners of the same number of America Movil A Shares;
(Iii) Owners of Telmex AA shares became the owners of the same number of America Movil AA Shares; and
(iv) Telmex Shareholders continued to own the same number of Telmex shares.
The Tax Court of Canada (the "TCC") held that section 86.1 did not apply because the transaction was not prescribed (nor could it ever have been prescribed because Telmex never owned the shares of America Movil and thus the distribution would not have satisfied the requirements of (b) above). The taxpayer then argued that the receipt of the America Movil shares did not represent investment income nor any other form of income. The Court agreed; it held that a distribution of the America Movil securities did not give rise to a taxable capital gain since there was no disposition of property by the taxpayer. Moreover, the distribution was neither a stock dividend paid by Telmex (since Telmex did not issue its own shares to the shareholders) nor a dividend paid by America Movil (since the taxpayer was not a shareholder of America Movil at the time it issued its shares to the taxpayer). The distribution was also found not to be a shareholder benefit under subsection 15(1) of the Act (because of the "reorganization" exclusion in that provision), nor a distribution of underlying profits.
THE TYCO SAGA
Subsequent to the Morasse case, there were four cases, all involving the same Tyco spin-off — Capancini v. The Queen,~Ham/ey v. The Queen,~Yang v. The Queen,~and Safora Rezayat v. The Queen.~The first three cases were all determined under the informal procedure of the TCC. The Tax Court of Canada Act states that an informal procedure decision is not to be treated as a precedent in other case. This may account for the unusual judicial history in these cases. As noted by McArthur J. in the Rezayat case, "An eventual decision from the Federal Court would be a blessing".
The following steps were taken in the Tyco spin-off:
(a) Tyco International Ltd. ("Tyco International") spun out its electronics and healthcare business operations to Its wholly owned subsidiaries, Tyco Electronics Ltd. ("Tyco Electronics") and Covidien Ltd. ("Covidien"). All three of these corporations were incorporated under the laws of Bermuda;
(b) Tyco retained for itself its fire, security, engineered products and services business;
(c) The shares of Tyco Electronics and Covidien were distributed to Tyco International's shareholders. At issue in each of the cases was whether the reorganization resulted in those shares being distributed directly to the shareholders, or whether the shares were first distributed to Tyco International, which then distributed them to the shareholders;
(d) Each Tyco International shareholder received a distribution consisting of:
(i) 0.25 shares of Tyco Electronics for each share of Tyco International; and
(ii) 0.25 shares of Covidien for each share of Tyco International;
(e) Essentially, Tyco International shareholders received one Tyco Electronics share, one Covidien share and one new Tyco International share for each four old Tyco International shares they held.
In Ham/ey, Yang, and Rezayat, the taxpayer's appeal was dismissed; in Capanclni the appeal was allowed. The difference in outcomes was seemingly based on a irreconcilable finding of fact in the first three cases that the shares of Tyco Electronics and Covidlen were owned by Tyco International prior to the reorganization, whereas in Capancinf the Court found that the shares were never owned by Tyco International, but rather were created as a result of the reorganization.
In his oral judgment in Ham/ey, Hershfield, J. found that:
The admitted facts or facts established ...the following findings. One, the distribution by Tyco was part of a reorganization of Its holdings, whereby two of its business operations were, in common corporate finance and tax jargon, spun-off to two separate corporate entities in such a manner as to make it, Tyco, the recipient of shares in such separate entities. These shares were then distributed to Tyco shareholders. [Emphasis added.]
Based on these findings, the Court concluded that:
The stock distributions in question then were dividends in kind that had value and the value is income from property and taxable ... as dividends from a foreign corporation, they are specifically covered by paragraph 12(1)(k) and section 90 of the Act and must be included in income under those provisions as set out in the respondent's written submissions and book of authorities.
In Capancini, Bowie, ]. summarized the facts arising from the Tyco spin-off as follows:
Prior to June 29, 2007 Mr. Capancinf owned 225 shares of Tyco International Ltd. (Tyco I) .. , Tyco I underwent a reorganization that involved spinning off two segments of Its business to new corporations, Tyco Electronics Ltd. (Tyco E) and Covidien Ltd., together with a reverse stock split. Tyco E and Covidien were also incorporated under the laws of Bermuda. Under this reorganization Tyco I shareholders each received one Tyco E share, one Covidien share, and one new Tyco I share for each four old Tyco I shares that they held. For fractions over a multiple of four they received a cash payment. The appellant, therefore, received 56 Tyco E shares, 56 Covidien shares, 56 new Tyco I shares and a small cash payment in place of his 225 old Tyco I shares.
After reviewing the jurisprudence, in particular the Morasse case, Bowie, ]. allowed the appeal on the following basis:
... I agree with his conclusion that in these circumstances the new shares are not a stock dividend, because they are not shares of the original company. Nor are they a dividend in kind, as is the case when a wholly owned subsidiary is spun off by a distribution of its shares to shareholders of the parent company. In this case the shares of Tyco E and Covldlen were never owned by Tyco I. They were created in the course of a reorganization, and together the new Tyco I shares they simply comprise the original capital of Tyco I in a different form. [Emphasis added.]
Canadian shareholders that receive spin-off shares frequently learn of the Canadian tax consequences after the transaction, when they receive a T5. Ironically, a transaction intended to benefit shareholders can result in a Canadian tax penalty unless section 86.1 applies. The best approach may be for Canadian shareholders to resort to self-help and sell the shares of the Distributor before receiving the spin-off shares.
Originally published in cchonline.
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