Canada: Spin-Outs In M&A: Bridging The Valuation Gap

While companies are reportedly sitting on piles of cash (so much so, that it has become somewhat of a political issue with Canadian cabinet ministers and the Governor of the Bank of Canada urging companies to spend this "dead money"), one might expect such companies to be free spenders when it comes to acquisitions. However, persistent economic uncertainty has made potential purchasers reluctant to spend accumulated cash on acquisitions, and we expect this trend to continue until an economic recovery is firmly established.

In the M&A area, this reluctance to overspend is often coupled with the fact that a target company may have, in addition to its desirable assets, other assets that are less attractive, at least from the prospective acquirer's perspective. This is particularly true in the resource sector where smaller exploration companies will often have a number of properties at different stages of development. If one or two properties prove to be promising and attract the attention of a major resource company, there may be a wide gulf between the value that the target company puts on its other properties and the value that the acquirer is willing to pay for them. Indeed, in many cases the acquirer may view them as superfluous and have no interest in continuing their exploration or development.

Of course, the easiest answer might be for the target to simply sell the valuable asset and keep the other assets and continue their development. This is not always advantageous to the shareholders, however, as such a sale often triggers a taxable event for the target and there may be no tax-effective way to flow the sale proceeds into the hands of shareholders. Similarly, the use of earn-outs (or, in a public company context, contingent value rights), the tool often used to bridge valuation gaps, is not well-suited to long-term projects like mine or oil and gas projects. A spin-out transaction may be a possible alternative solution.

Under a spin-out coupled with an M&A transaction, the acquirer purchases the shares of the target company, but the assets which the acquirer doesn't want are contemporaneously spun-out of the target into a new company, the shares of which are distributed to the target shareholders as part of the transaction. Thus, the target shareholders get paid full value for the target's core assets but also are able to continue to participate in the development of the other assets. Similarly, the acquiror only has to pay for what it actually wants. Such spin-out transactions can often be completed in a reasonably tax-effective manner, depending on the facts.

For these reasons, we anticipate spin-outs will continue to be a feature of M&A in 2013 as a tool for bridging value gaps in acquisition transactions. Beyond their use in M&A, we can also expect that spin-outs will continue to appear as a way of enhancing value within diversified enterprises: see for example the pending Loblaw Companies Limited spin-out of its real estate into a new REIT and the coming proxy battle to push Agrium Inc. to spin out its farm store business.

The basic elements for using a spin-off transaction in connection with an acquisition can be summarized as follows:

  1. The target company ("Target") creates a new company ("Spinco") to aquire and hold the development assets which the acquiror ("Acquiror") is not interested in purchasing.
  2. The shares of Spinco are distributed to the shareholders of Target.
  3. The Acquiror acquires from Target's shareholders their shares of Target.
  4. As a result, Target becomes wholly-owned by the Acquiror and the former shareholders of Target become the shareholders of Spinco. The shareholders also receive consideration for their Target shares, which could consist of cash or securities of the Acquiror.

As one might expect, this simple structure carries with it various tax, securities and corporate complexities which must be dealt with in implementation. Some of the more important of these are discussed below.

CORPORATE LAW

Spin-outs carried out in conjunction with an acquisition are invariably accomplished by way of a statutory plan of arrangement. Because of the necessity for the various steps to be carried out in a precise sequence, a take-over bid is not an effective alternative. Plans of arrangement are commonly used in acquisitions in any event, even in the absence of a Spinco transaction, so this is not unusual. It does mean, however, that a fairness hearing in front of a court must be included as part of the process, which gives dissenting shareholders a ready forum to oppose the deal. A shareholder meeting to approve the transaction, usually by a two-thirds majority of those voting, must also be held.

SECURITIES LAW

A number of points arise in this regard:

  1. The shares of Spinco need to be freely trading in the hands of the Target shareholders receiving them. Subject to restrictions on control blocks, this is generally possible. Consideration may have to be given to the treatment of shares held by shareholders outside Canada, however, especially those in the United States. There may also be securities compliance implications for Target itself, depending on the number of U.S. shareholders it has.
  2. It is generally desirable for the Spinco shares to be listed on a securities exchange, particularly if the shares of Target itself had been listed. Accordingly, it will be necessary to determine whether Spinco, based on the assets it will receive from Target, will meet the listing requirements of the Toronto Stock Exchange or Toronto Venture Exchange. If not, alternative trading arrangements may be necessary.
  3. Outstanding stock options or other incentives will need to be dealt with to the extent they are not simply exercised. Stock exchange approvals may be necessary if options are to accelerate.
  4. Spin-offs done outside the M&A context raise numerous issues in regard to how an existing corporate entity can be divided in two. How management is divided up and compensated, how overheads are dealt with, what happens to historical liabilities, and how to deal with common assets are all questions which must be answered. In the context of an M&A transaction, these questions are often easier to answer because there is a third party to negotiate with which is able to clearly identify what it wants and needs. For example, the Acquiror may have no need for any corporate infrastructure, making it all available to Spinco. Nevertheless, there may still be conflicts of interest to be managed; for example, if members of senior management of Target are going to move to the Acquiror instead of staying with Spinco, their ability to negotiate for Target may be called into question.

TAX MATTERS

The most complex aspects of a Spinco transaction in connection with an acquisition are often tax-related. As a general matter, the tax objectives on a spin-out transaction are to minimize tax at both the level of the corporation effecting the spin-out (Target) and the level of its shareholders.

In normal circumstances, a spin-out transaction might be effected by way of a "butterfly" divisive reorganization, which allows the shareholders of a corporation to hold through two separate corporations the same assets initially held by the existing corporation without giving rise to corporate-level or shareholder-level taxation. However, there are numerous rules limiting the circumstances in which a "butterfly" transaction is permitted, and which make it generally unavailable in an M&A context.

As a result, spin-outs as part of an M&A transaction are typically effected via:

  • a dividend in kind by Target of the Spinco shares;
  • a distribution of the Spinco shares by Target on a reorganization of Target's share capital;
  • a distribution of the Spinco shares by Target as a return of capital; or
  • delivery of the Spinco shares as part of the purchase price from the Acquiror.

The desirability of one technique over another will depend on the facts, including the extent of accrued gains at the corporate and shareholder levels, Target's tax attributes, the make-up of the Target shareholder base and the manner in which the Acquiror is acquiring the Target shares. For Canadian tax purposes all of these forms of spin-out constitute a disposition of the Spinco shares for fair market value proceeds of disposition, causing any accrued gains thereon to be realized. They are therefore most often used where Target's accrued gain (if any) on the Spinco shares is (or can be made to be) relatively small, or where available tax shelter (e.g., loss carryforwards) can be deployed to absorb some or all of any such gains.

Dividends in Kind

A dividend in kind is the simplest form of spin-out, but typically the least tax-effective. Under a dividend in kind, Target simply pays a dividend of the Spinco shares out to the Target shareholders. The taxation of this dividend depends on the identity of the recipient: Canadian individual vs. Canadian corporation vs. non-resident vs. tax-exempt (e.g., pension funds and similar vehicles). However, dividends (unlike capital gains) cannot be sheltered by any available capital losses the Target shareholder has, and non-residents are subject to Canadian withholding tax on dividends but will typically not be taxable in Canada on capital gains from the disposition of shares of public companies. As such, dividend-in-kind spin-outs are rare in the context of an M&A transaction.

Share Capital Reorganizations

A reorganization of Target's share capital is the most common way in which to effect a Spinco transaction without creating a dividend for Canadian tax purposes. Under such a transaction, Target shareholders exchange their existing common shares of Target for (1) shares of a new class of Target common shares, and (2) the Spinco shares.1

If the value of the Spinco shares does not exceed the "paid-up capital"("PUC)"2 of the existing Target shares, no dividend arises on the receipt of Spinco shares. Instead, each holder's adjusted cost base ("ACB") of its Target shares is reduced by the value of the Spinco shares received, as is the PUC of Target's shares.3 Consider for example a situation in which each Target shareholder exchanges each existing Target common share for one new Target common share and one Spinco share. If the fair market value of a Spinco share is $3, the PUC of each existing Target common share is $5, and the shareholder's ACB of that existing Target common share was $8, the result would be as follows:

Deemed dividend
Capital gain
ACB of Spinco share
ACB of new Target common share
PUC of new Target common share

nil
nil
$3
$5
$2

To the extent that the value of the Spinco share exceeds the PUC of the Target share, the excess is deemed to be a dividend for tax purposes.4

Share Capital Returns

Spin-outs may also be effected as a distribution of share capital by Target, with the Spinco shares as the property distributed. Target resolves to reduce the stated capital of its shares by an amount equal to the value of the Spinco shares, and distributes these shares pro rata to the holders of the Target shares. To the extent that the value of the Spinco shares does not exceed the PUC of the Target shares, no dividend should arise for Canadian tax purposes:5 instead, the value of the Spinco shares reduces the PUC of the existing Target common shares and the shareholders' ACB of their Target shares.6

Using the same example described above, no deemed dividend would occur, the PUC of each Target share would be reduced to $2, the holder's ACB of the Target share would be reduced to $5, and the holder's ACB of the Spinco share would be $3: essentially the same result as in the share capital reorganization.

Finally, in an M&A context where Target shareholders are already disposing of their Target shares to Acquiror, a spin-out transaction could occur by virtue of Target shareholders simply receiving Spinco shares from the Acquiror as part of the Target share sale proceeds. In this form of transaction, immediately after purchasing Target, the Acquiror would acquire the Spinco shares from Target and deliver them to Target shareholders, in satisfaction of their right to receive Spinco shares. As with the other forms of non-butterfly spin-out transactions, this would generally involve the realization of any accrued gains on the Spinco shares.7

For Target shareholders, the fair market value of the Spinco shares would simply be added to the proceeds of disposition they receive from the Acquiror on the disposition of their Target shares. The Spinco shares would be treated as the equivalent of cash for purposes of any tax-deferred rollover provision (e.g., ss. 85(1) or 85.1(1) ITA) that may apply to such disposition of Target shares (i.e., where the sale proceeds include Acquiror shares). Target shareholders would generally realize a capital gain (or capital loss) in the amount by which their proceeds of disposition exceed (or are less than) the ACB of their Target shares, as with most M&A transactions.

CONCLUSION

Spin-out transactions may also require planning to deal with other securities, such as debt and employee stock options.

Spin-out transactions are being used with increasing frequency in an M&A context, and should be kept in mind as a tool to help bridge the valuation gap between the buyer and the target in appropriate circumstances.

Footnotes

1 For an example of such a transaction, see the spin-off of Platino Energy Corp. by C&C Energeria Ltd. as part of the acquisition of C&C Energeria by Pacific Rubiales Energy Corp., described in the C&C Energeria Ltd. information circular of November 30, 2012 (available at www.sedar.com).

2 Essentially "paid-up capital" is the Income Tax Act equivalent of corporate law stated capital.

3 If such a reduction in ACB would result in an ACB of less than zero, the "negative" portion is deemed to be an immediate capital gain.

4 For example, if the fair market value of a Spinco shares had been $6, the result would have been a $1 deemed dividend ($6 – $5), with the new Target common share having only nominal PUC and $2 of ACB to the holder and the shareholder having an ACB of $6 in the Spinco share.

5 In addition, in order for no dividend to been deemed to arise for tax purposes, a share capital return must also either come within certain limited circumstances described in s. 84(4.1) ITA, or must be said to be occurring on the winding-up, discontinuance or reorganization of Target's business. The Canada Revenue Agency has issued several favourable advance tax rulings on the latter point as to the scope of a "reorganization", and it is not uncommon for public corporations to seek an advance tax ruling in order to achieve a very high level of comfort.

6 See footnote 3.

7 Acquiror would generally be unable to claim an increase in the ACB of the Spinco shares under s. 88(1)(d) ITA where such shares are being disposed of to Target shareholders.

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