On December 21, 2012, the Minister of Finance released for consultation draft legislative proposals (the December 21 Proposals) to implement certain technical amendments to the Income Tax Act (Canada) (the ITA). Included in the December 21 Proposals are draft changes to the Canadian basis "bump" rules. Such changes are, for the most part, relieving in nature and should reduce uncertainty and risk when utilizing the bump. The government has invited comments by February 19, 2013.
THE BASIS BUMP
Typically, a purchaser seeking to acquire a Canadian target corporation (Target) will form a Canadian acquisition company (Canco) to acquire the shares of Target, following which Canco will amalgamate with Target (to form Amalco), or, less frequently, Target will be wound-up into Canco. Such a merger allows for the push-down of acquisition financing (Canada has no tax consolidation) and the step-up of cross-border paid-up capital (PUC), subject to the application of the recently enacted foreign affiliate (FA) "dumping" rules in section 212.3 of the ITA.
It is generally not tax efficient for a Canadian corporation to be "sandwiched" in between a foreign parent and foreign subsidiaries, especially given the potential impact of the FA dumping rules. (For a detailed discussion of the FA dumping rules, see our October 2012 Blakes Bulletin.) Where a foreign purchaser (Parent) acquires a Target which owns shares of foreign subsidiaries, it will generally be desirable to distribute the foreign subsidiaries out from under Canada following the merger described above. On such a transfer, Amalco (including, in this bulletin, Canco if Target is wound-up into it) will be deemed to dispose of the shares of the foreign subsidiaries for proceeds equal to their fair market value. Assuming that such fair market value is greater than the adjusted cost base (i.e., tax cost) to Amalco of those shares at the time of disposition (which apart from the bump will be the historic tax cost to Target), Amalco will recognize a gain that will be taxable in Canada.
When shares of a Target are acquired, there is generally no ability to "push-down" the tax cost of the acquired shares to the assets of the acquired corporation. A limited exception is the basis bump rule in paragraph 88(1)(d) of the ITA, which generally allows for an elective step-up in basis of non-depreciable capital property (including shares of foreign subsidiaries), potentially to fair market value at the time of the change of control of Target. A bump election, if available, is made in respect of the winding-up or amalgamation of a wholly owned acquired corporation with its Canadian parent (i.e., Target and Canco, respectively). If the bump is available, any shares of foreign subsidiaries can generally be transferred by Amalco out of Canada promptly after acquisition without recognizing any gain or loss. Further, the distribution may be effected free from Canadian non-resident withholding tax by way of return of PUC or intercompany debt repayment. However, no bump is available if the "bump denial" rule applies.
THE BUMP DENIAL RULE
The purpose of the bump denial rule is to preclude the bump from applying in circumstances where selling shareholders (beyond those who held a de minimis aggregate interest in Target) have somehow retained an indirect interest in Target. While the bump denial rule is quite complex in its application, basically, the bump is denied if, as part of the overall series of transactions, any "restricted persons" acquire any property of Target (distributed property) or any "substituted property".
Restricted persons generally mean one or more persons who own or are deemed to own 10% or more of the shares of any class or series of Target. Also included are any one or more persons who own or are deemed to own 10% or more of the shares of any class or series of a corporation that is related to Target, and that has a significant direct or indirect interest in any issued shares of the capital stock of Target. "Specified persons" (i.e., Canco and entities that are related to Canco prior to the acquisition) are carved out of restricted persons.
"Substituted property" generally includes any property (other than certain "specified property") the fair market value of which is wholly or partly attributable to any property of Target. Substituted property also includes any property the fair market value of which is determinable primarily by reference to the fair market value of, or the proceeds from a disposition of, any property of Target. This extremely broad definition of substituted property is frequently problematic, as explained below.
Persons are deemed to own shares actually owned by other persons who are "related" or otherwise not dealing at "arm's length" under Canadian tax rules. This feature of the rule has proven to be challenging to apply even where the essential requirements of the bump are otherwise readily satisfied.
The potential consequences of the bump denial rule are significant. Because the bump does not offer protection for any post-acquisition appreciation in value, it is generally considered advisable to distribute any foreign subsidiary shares out of Canada promptly after the acquisition of Target. It is therefore important to be reasonably sure that the bump is available before closing, because the distribution will crystallize any gain or loss. If it is determined after the fact that the bump denial rule applied, remediation may be difficult.
Because of the absolute nature of the bump denial rule (i.e., the whole bump is denied), purchasers and their tax advisers devote considerable resources to obtaining as much comfort as possible that the bump denial rule will not apply in a given situation. In certain circumstances, as is explained in greater detail below, the commercial aspects of a transaction can be affected by bump considerations.
Over time the Canadian tax community has identified seemingly remote "technical" issues that can arise in circumstances that in no way offend tax policy or are inconsistent with the legislative context of the bump. In many instances the Department of Finance has responded by issuing "comfort letters" (agreeing to recommend relieving changes) that are typically relied upon for planning and financial reporting purposes. The Canada Revenue Agency also has a number of favourable (and practical) administrative positions that address some of the more arcane technical concerns.
Practically, it is often challenging to identify all circumstances that can put the bump at risk, especially where Target is a public company (thus making it difficult if not impossible to identify all restricted persons). This is made even more difficult where Parent is a public company, because Parent cannot control who acquires its publicly traded securities.
The December 21 Proposals implement changes proposed in the comfort letters (reaching back as far as 2001), and in some cases go even further, to eliminate many of the technical and factual concerns that have led to uncertainty and/or commercial constraints.
SELECTED BUMP ISSUES
Set out below are some common examples of issues presented by planning to effect a bump which can give rise to uncertainty (prior to release of the December 21 Proposals).
Generally, any equity or debt issued by Parent, Canco (except as described below) or other entities in the chain of ownership in connection with the acquisition would typically be considered to be substituted property, since some of its value seemingly would be attributable to assets of Target. If the holders of such debt or equity (combined with any other persons acquiring substituted property) in aggregate own 10% or more of the shares of any class or series of Target, then the bump could be denied. Where Target is public, or owned by one or more entities with ultimate disparate ownership such as a private equity fund, it may be very difficult, if not often impossible, to identify all restricted persons without some residual uncertainty. Thus issues can arise if Parent is public (as its equity could be acquired by restricted persons as part of the series, especially if Parent finances the acquisition with an equity offering), or if debt is offered to the public or loaned by a bank syndicate, as Parent would want to be reasonably certain that the persons acquiring indebtedness, or members of the public acquiring equity, as part of an acquisition do not, in aggregate, own 10% or more of the shares of Target.
Incentives for Target Employees/Directors
Any equity-based compensation to be received by management of Target (or its subsidiaries) as part of their future compensation package, especially if received as an inducement to continue on with the company post-closing, possibly could be considered to be substituted property. If, for example, senior management of Target and its subsidiaries (combined with any other persons acquiring substituted property) own in total 10% or more of the shares of any class or series of Target, and those individuals are to receive options or other equity-based management incentives post-closing in connection with the transaction, then that could disqualify the bump.
Under existing bump rules, shares of Canco issued in consideration for the shares of Target are specified property, meaning that shareholder rollovers at the Canadian level will not typically taint a bump. However, any equity "rollover" that Parent may be prepared to entertain is typically at the Parent level, especially where Parent owns other assets. Equity of a foreign Parent is not included in specified property, which means that acquisitions of foreign Parent equity as part of the series is problematic as described above.
THE DECEMBER 21 PROPOSALS
There are three key elements of the December 21 Proposals that should ease the uncertainty and administrative and commercial burdens associated with bump planning. In particular, these elements should alleviate the concerns described above in certain circumstances, while reinforcing the legislative policy of the bump:
- Introduction of a de minimis threshold for attributable property – From and after December 21, 2012, substituted property will exclude property 10% or less of the fair market value of which at the time of acquisition is attributable to distributed property. Thus, where Parent's value is "large" relative to the value of Target, the acquisition by restricted persons of debt, equity, options and other property the value of which is based on the value of Parent will generally not invalidate the bump. This is a new measure, not previously announced in a comfort letter.
- Indebtedness issued for money is specified property – This rule now confirms, from and after 2001, that indebtedness issued solely for consideration consisting of money will not generally cause a bump problem if acquired by restricted persons. This alleviates much of the concern when acquisition financing is provided by a bank (or banking syndicate) and the lender's related entities may have been shareholders of a public Target. This also alleviates concerns regarding the need to obtain historic Target ownership information from bondholders in a public debt offering.
- References to a share in the definition of specified property includes a right to acquire a share – This rule now confirms, from and after 2001, that the right to acquire a share is assimilated to a share for purposes of the relieving definition of specified property. This means that certain transactions involving options and warrants (e.g., the issuance by Canco of options in consideration for options or shares of Target, or the acquisition by Canco of Target options in exchange for Canco shares or indebtedness) will not create any additional bump risk.
The December 21 Proposals also included other measures that "fix" some of the more obscure technical issues, such as the concern that where Target had a controlling shareholder, each of Target's subsidiaries would be a restricted person, and the concern that Parent entities above Canco would not be specified persons before Canco is incorporated.
These new provisions should provide more commercial flexibility when structuring transactions, especially where Parent is comfortable that the 10% de minimis fair market value threshold is met. Also, elimination of many of the more technical concerns should allow for smoother M&A transactions, as the more onerous practical requirements of bump planning are less likely to interfere with the transaction.
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.