The volume of private and public mergers and acquisitions finally has picked up, with large transactions announced almost daily in business periodicals such as The Wall Street Journal and the Financial Post. In 2004, deal volume in Canada measured by value was up 30 percent over 2003. The growth has been broadly based, with 11 of 13 industry groups experiencing increased transaction levels measured by the number and/or value of transactions. Cross-border M&A is a significant feature of the Canadian market, representing 47 percent of transaction volume and 74 percent of value in 2004. The United States continues to be the primary focus of Canadian cross-border M&A, both as a target market and as the jurisdiction of purchaser companies.1 M&A momentum has continued in 2005 with a number of multibillion dollar deals, notably the $7.7 billion Molson-Coors merger, which closed in January 2005; the $3.1 billion acquisition of Masonite by KKR; the US$2.3 billion acquisition of Bombardier Capital’s inventory finance division by GE Commercial Finance; and the acquisition by Onex, through Mid-Western Aircraft Systems, of the Wichita/Tulsa division of Boeing Commercial Airplanes for $1.5 billion.
In light of this trend, it seems particularly appropriate to revisit tax developments affecting such activity. This article will focus on such developments in both the U.S. and in Canada, with particular reference to cross-border issues that arise in connection with M&A transactions affecting U.S. shareholders of Canadian companies, Canadian shareholders of U.S. companies and transactions affecting both U.S. and Canadian companies in acquisitions of one by the other.
In the United States, recent regulatory proposals would vastly expand the availability of tax-free treatment to U.S. shareholders in foreign M&A transactions by permitting, for the first time, foreign and cross-border mergers to qualify as taxfree reorganizations for U.S. tax purposes. In addition to their direct effect on U.S. shareholders of Canadian companies, for example, those proposals could also have important indirect effects, including the determination of the U.S. tax basis of property held by, and earnings and profits of, foreign entities engaged in M&A transactions.
Canada has yet to issue proposed guidance, first announced in 2000, that would permit tax-free treatment to Canadian taxpayers upon an acquisition of a Canadian target by a U.S. company. Meanwhile, such U.S. acquirers that desire to offer Canadians tax-free treatment in Canada are left with traditional but awkward exchangeable share structures. A review of the current state of affairs in Canada is offered below.
Recent U.S. M&A Tax Developments
Recently proposed regulations that would permit "foreign mergers" are perhaps the most significant cross-border tax development in the United States since the adoption of the "check-the-box" rules in 1996. If adopted in their present form, those regulations would—for the first time—permit a merger of two non- U.S. companies, or one U.S. and one non- U.S. company, to be treated as a tax-free reorganization.
This development is important for at least two reasons. First, the nature of the consideration permitted to be received by target shareholders often is more relaxed in a merger or consolidation (consisting in certain cases of up to 60 percent cash and use of nonvoting rather than voting shares). Second, there is no requirement, contained in at least some reorganizations, that the acquiring corporation (or a controlled subsidiary) acquire "substantially all" of the assets of the target corporation (which may restrict pre- and posttransaction restructuring or sales).2 Under the present law, for example, a transaction designed to obtain a "bump" in the basis of certain capital assets for Canadian tax purposes will require a windup of the target company. That windup normally will have the effect of ruling out a tax-free reorganization unless the transaction overall qualifies as a so-called C or D reorganization— and each of those two transactions requires a transfer of substantially all the assets of the target corporation. While a merger requires the target entity to transfer all of its assets and liabilities to the transferee, unlike a C or D reorganization, this does not prevent the target from selling some of its assets and distributing the proceeds to its shareholders, or distributing assets to its shareholders.
The New Proposed U.S. Regulations
The proposed regulations (the New Proposed U.S. Regulations) were published on January 5, 2005, but will take effect only as specified in final regulations.3 The approach of not applying generous new rules to M&A transactions retroactively is a time-honored tradition and provides greater certainty to the markets (for example, that a transaction thought to be taxable would not retroactively be treated as tax-free, thereby avoiding windfalls and wipeouts contrary to expectations of the parties). Nevertheless, the effective date of new regulations is uncertain until the regulations are finalized, and may attract a great deal of lobbying effort.
Under existing law, "a statutory merger or consolidation" is defined in regulations to include only transactions effected "pursuant to the laws of the United States or a state or political subdivision."4 Thus, no transaction involving a foreign entity could qualify as a merger or consolidation.5 Under the New Proposed U.S. Regulations, the requirement that the transaction be limited to those occurring under U.S. law would be eliminated, as would the requirement that entities participating in certain mergers or consolidations be organized under U.S. law.
The preamble to the New Proposed U.S. Regulations gives the following rationale for this approach: "Many foreign jurisdictions now have merger or consolidation statutes that operate in material respects like those of the states, i.e., all assets and liabilities move by operation of law. The Treasury Department and IRS believe that transactions effected pursuant to these statutes should be treated as reorganizations if they satisfy the functional criteria under domestic [s]tatutes."6
Adopting this new approach will permit the Treasury and the IRS to expand the operation of existing regulations that permit mergers with disregarded entities. Presently, such transactions are permitted only with entities formed under the laws of the United States or a political subdivision.7 The approach under the New Proposed U.S. Regulations is more consistent with the general rule under the "check-the-box" regulations that disregarded entities are ignored for all tax purposes.8 The current rule (in the 2003 Regulations) arguably conflicts with the check-the-box rules, because even if both the target corporation in a merger and the owner of a disregarded entity into which the target would merge are organized under U.S. law, the merger would not qualify as a tax-free reorganization. This necessarily means that the separate existence of the disregarded entity is taken into account for at least one purpose. Thus, we believe that the New Proposed U.S. Regulations take the better approach.
Undoubtedly, there will be unanswered questions under the New Proposed U.S. Regulations. For example, will a Canadian amalgamation, which technically involves continuation of the companies involved, qualify as a merger or consolidation? While a favorable answer is probable, there are some technical issues even with such obvious questions.
Technically, even under the New Proposed U.S. Regulations, in a merger the transferor must transfer all of its assets and liabilities to a transferee unit and the transferor’s separate existence must cease for all purposes. In many foreign amalgamations, including under Canadian law, the transferring entities are viewed as continuing their existence in the combined entity. In our view, this does not mean that the transferor’s separate existence continues; it seems a stretch to say that because the foreign law makes a reference to the continuation of the transferors, no effect should be given to the fact that the transferor has ceased to exist for any other purpose. In fact, both the 2003 Regulations and the New Proposed U.S. Regulations allow the transferor and the surviving entity to act or be acted against in the name of the transferor with respect to activities taking place prior to the merger. This indicates that the Treasury and the IRS are aware that, in some respects, the transferor does not completely "go away." In fact, this is consistent with the view in the United States that a reorganization, unlike a taxable sale, is in essence a continuation of the target corporation’s historic enterprise, albeit in modified corporate form.9
In addition, even prior to the issuance of the New Proposed U.S. Regulations, the IRS showed flexibility in dealing with foreign amalgamations. As noted above, the IRS has ruled privately that foreign amalgamations are recharacterized as C or D reorganizations, even though this means that certain pieces of the transaction are ignored for U.S. tax purposes. This indicates that the technical features of the foreign amalgamation statute, namely the continued existence (in the combined entity), may be disregarded. Such a result is not surprising, given that, rather than being too closely held to the form of a transaction, the U.S. tax law tends to be very substance driven.
Though it seems likely that issues such as these will be resolved favorably, it would be reassuring to see an example in the final regulations involving a nation with laws similar to or the same as those in Canada respecting amalgamations.
Need for Additional, Consistent Guidance
FIRPTA. Even where a cross-border merger or consolidation qualifies as a tax-free reorganization, a foreign target corporation owning a U.S. real property interest under the Foreign Investment Real Property Tax Act (FIRPTA) may be required to recognize gain on the transfer of such property unless the FIRPTA regulations that address certain reorganizations are modified to permit such a transaction. Prior to the New Proposed Merger Regulations, of course, there was no need for the FIRPTA rules to address transfers of U.S. real property interests in mergers and consolidations involving foreign targets, because this type of transaction could not qualify as a reorganization in the United States.
Section 367. These rules, which generally apply to override nonrecognition treatment for U.S. corporations and U.S. shareholders on an "outbound" transfer of assets or shares, will have to be revised to incorporate proper tax-avoidance rules.10 Presently, those rules treat as an outbound transfer of shares an otherwise tax-free merger between two U.S. companies where the parent (acquiring) company is foreign. Those rules usually do not treat a transaction that would qualify for tax-free reorganization treatment if it were a wholly domestic transaction as involving both a taxable outbound asset transfer and a taxable outbound share transfer. Presumably, consistent rules will be promulgated here.11
Canada: Still Awaiting Guidance
The increased pace of cross-border M&A activity is renewing calls for the release of long-awaited amendments to the Income Tax Act (Canada) to permit cross-border share-for-share exchanges on a rollover (tax-deferred) basis. Current Canadian rules permit a rollover on an exchange of shares of a Canadian corporation (a Canco) for shares of another Canco and on an exchange of shares of a nonresident corporation for shares of a nonresident corporation, but not on a cross-border exchange. In October 2000, the Canadian Minister of Finance announced his intention that a rollover rule be developed to apply to cross-border share-for-share exchanges where the Canadian shareholder receives only share consideration. The relief will be more limited, therefore, than the recent U.S. proposals, which permit up to 60 percent cash consideration in certain circumstances. In addition, the government’s announcement stated that the rollover rule would not take effect before the release of draft legislation, making it clear that retroactive relief will not be provided. In February 2003, the government reaffirmed its intention to introduce the cross-border share-for-share rollover and announced that draft legislation would be released in the "near future."12 A similar statement was made in the March 2004 federal budget and again in the February 2005 budget. No draft legislation has been forthcoming and the timing of the release of draft legislation remains unknown.
In the meantime, exchangeable share deals offer tax deferral to Canadian shareholders on an acquisition by a foreign purchaser. The exchangeable deals take advantage of the domestic Canco-to- Canco rollover that the Canadian Tax Act provides. The structure of exchangeable deals will be familiar to many readers, but it is worthwhile to recap the basic outline of a typical deal: Foreign parent company (Parentco) establishes a wholly owned Canadian subsidiary (Holdco) that in turn establishes a second-tier Canadian subsidiary (Exchangeco). Exchangeco acquires the stock of Canadian Target. Taxable shareholders (in Canada) can elect to receive exchangeable shares issued by Exchangeco. (Nontaxable shareholders may receive Parentco stock directly.) The terms and conditions of the exchangeable shares mimic those of the Parentco stock; for example, the exchangeable share terms provide that an equivalent dividend must be declared and paid on the exchangeable shares if and when a dividend is declared and paid on the Parentco stock. Liquidity is provided through a retraction right that allows the shareholder to put the exchangeable stock to Exchangeco in exchange for shares of Parentco. The exchangeable shares generally also are subject to an overriding call right of Holdco for equivalent consideration, which can avoid onerous tax consequences arising on a retraction and affords the holder of the exchangeable shares a capital gain. Exchangeable shares usually are nonvoting, with the holder acquiring voting rights in Parentco through a super voting share issued by Parentco to a trustee, voting on instructions from the exchangeable shareholders. There usually is a sunset clause on exchangeable shares effected by a redemption right of Exchangeco at the termination date (subject to the overriding call right of Holdco). The redemption or retraction (or other disposition) of the exchangeable shares will be a taxable event. The sunset date is negotiated, with Canadian shareholders usually desiring the longest possible date to maximize the deferral.
The exchangeable share structure has been used on a number of major crossborder deals, including the Molson- Coors merger earlier this year. Although the structure is more cumbersome and costly than a straightforward cross-border share-for-share rollover and generally offers a limited deferral because of the sunset feature, exchangeable deals will continue to be a feature of cross-border M&A as long as the Canadian government continues to delay on its promised legislation.
As M&A activity escalates (particularly in the cross-border context), it is encouraging to see how, at least in the United States, the tax laws are beginning to evolve at a similar pace. We applaud the Treasury and the IRS for recognizing the realities of the international business market and offering more flexibility to address such realities, and encourage the Canadian government to do the same. Undoubtedly, the market benefits if companies are not constrained by unduly technical restrictions on their ability to engage in cross-border acquisitions.
1 Mergers & Acquisitions in Canada, 2004 annual directory.
2 See code section 368(a)(2)(D) (controlled subsidiary must acquire substantially all the assets of the target company). Compare to "plain" mergers under sections 368(a)(1)(A). Unless otherwise specified, "section" refers to a section of the Internal Revenue Code of 1986, as amended, or to a section of the Income Tax Act, and regulations promulgated thereunder.
3 REG-117969-00 (January 5, 2005). On the same day, proposed regulations were issued that address several technical issues relating to cross-border mergers, such as basis, holding periods and section 367 issues. REG-125628-01 (January 5, 2005).
4 See Treas. Reg. § 1.368-2T(b)(1)(ii).
5 In addition, a "forward triangular merger" of a foreign target corporation into a U.S. or foreign subsidiary of the acquiror (the controlling corporation) could not be tax-free outside the United States, nor could a forward triangular merger of a U.S. corporation into a foreign subsidiary. This is because section 368(a)(2)(D), the provision that would treat such transaction as a reorganization for U.S. tax purposes, requires (by regulation) that the transaction would have qualified as a section 368(a)(1)(A) had the merger been into the controlling corporation. Treas. Reg. § 1.368-2(b)(2). However, a forward triangular merger of a U.S. corporation into a U.S. subsidiary of the controlling corporation appeared to be able to qualify. See, e.g. GCM 39231 (May 7, 1984); Private Letter Ruling 200524019 (June 17, 2005). Private Letter Ruling 9218062 (January 30, 1992).
6 The IRS previously has ruled that an amalgamation under foreign law is recharacterized as a reorganization under section 368(a)(1)(C) (a C Reorganization) or section 368(a)(1)(D) (a D reorganization). See, e.g., Private Letter Ruling 200309020 (February 28, 2003) (D reorganization); Private Letter Ruling 200208022 (February 22, 2002) (D reorganization); Private Letter Ruling 200004025 (January 31, 2000) (D reorganization); Private Letter Ruling 8616026 (January 16, 1986) (C reorganization); PLR 8515073 (January 15, 1985) (C reorganization). If a transaction qualifies as both a C reorganization and a D reorganization, it is treated as a D reorganization. Section 368(a)(2)(A). See also New York State Bar Association Tax Section Letter and Report (No. 1094) on Proposed Regulations (REG-117969, REG-125628-01) Regarding Cross-border Mergers and Acquisitions (July 26, 2005) (recommending that the proposed regulations be revised to address amalgamations and to clarify the application of section 368(a)(2)(D) (on forward triangular mergers) and Section 368(a)(2)(E) (on reverse triangular mergers) to amalgamations).
7 In 2003, the service issued proposed and temporary regulations (the 2003 Regulations) that expanded the definition of "statutory merger or consolidation" to take into account transactions involving entities that are disregarded for U.S. federal income tax purposes. However, the 2003 Regulations do not allow the use of disregarded entities in statutory mergers or consolidations where certain entities, including the disregarded entities, are not organized under the laws of the United States or a state or the District of Columbia.
8 See Treas. Reg. §301.7701-3.
9 Lewis v. Commissioner, 176 F.2d 646; Book Production Industries, Inc. (1965) T.C. Memo 1965-65; Treas. Reg. §1.368-2(a).
10 This vast oversimplification generally describes only section 367(a). Section 367(b) generally includes rules requiring income inclusion by present or former shareholders of a controlled foreign corporation (a CFC). See also Notice 2005-6, 2005-5 I.R.B. 448 (January 6, 2005). Also, recently enacted legislation would treat a foreign corporation as a U.S. corporation if it argues substantailly all of the assets of the U.S. corporations and former shareholders own 80% of the stock of the foreign corporation by reason of such acquisition sec sections 7874.
11 Some hope for reason here can be gleaned from another recently proposed set of regulations dealing with the application of section 367 to section 304 transactions. REG-127740-04 (May 24, 2005). These proposed regulations would cause certain section 304 transactions to not be subject to section 367.
12 Federal Budget, Supplementary Information, February 18, 2003.
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