One of the most important considerations for M&A purchasers (especially in cross-border transactions) is managing the tax issues. Foreign purchasers of Canadian entities will need to plan around significant changes to the Income Tax Act (Canada) enacted in 2012.
First of all, revisions were made to Canada's "thin capitalization" rules in 2012. These rules limit the extent to which a Canadian-resident corporation ("Canco") can deduct interest expense incurred on debt owing to "specified non-residents": non-residents of Canada who either are 25%+ shareholders of Canco or who deal non-arm's length with such 25%+ shareholders. Effective January 1, 2013, Canco can only deduct interest expense on an amount of debt owing to specified non-residents equal to 150% of Canco's "equity" (start-of-year unconsolidated retained earnings plus the paid-up capital ("PUC") of Canco shares owned by a non-resident 25%+ Canco shareholder). Previously, the limit had been 200% of such equity. In addition, disallowed interest is now treated as a dividend and subject to dividend withholding tax. See here for more on changes to these rules.
Since most foreign purchasers of a Canadian target use a Canco to make the purchase (for tax and non-tax reasons), a foreign purchaser can now only loan a reduced amount to its Canadian acquisition vehicle to make the purchase, and reduced interest expense deductions must be factored into the purchase price, Going forward, we expect to see Cancos financed to a greater extent with equity or with loans from arm's-length lenders (no thin capitalization limits apply to debt owing to Canadian or arm's-length lenders).
Separately, Canada introduced complex new rules ("foreign affiliate dumping" rules) in 2012 that can apply whenever a foreign purchaser acquires shares of a Canco that itself owns an equity interest in one or more foreign corporations. These rules may apply to either the initial M&A transaction or post-acquisition to any ongoing investment the Canco makes in foreign corporations. Where applicable, they effectively deem Canco to have paid a dividend or effected a capital distribution to its foreign parent. Accelerated or double taxation can arise in various circumstances, and we anticipate foreign purchasers working through these rules carefully whenever the Canadian target has interests in foreign entities. See here for a detailed analysis of these important new rules.
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