Canada: Special Issues with Canadian Exchangeable Share Structures in Cross-Border Transactions

Last Updated: October 27 2006

By Gary S. Fogler, Partner, Fasken Martineau DuMoulin LLP and Bill Budgell, CA, Tax Partner, Grant Thornton LLP

This article examines special issues that may arise in the course of cross-border transactions involving U.S., U.K., EU or other non-Canadian acquirers ("Buyers") of shares of Canadian corporations ("Canadian Targets") from Canadian residents ("Canadian Sellers") in consideration for shares of the Buyer.

Background

As noted in Gary Fogler’s 2005 articles (the "Fogler Articles") entitled "U.S.-Canada Cross-Border Acquisitions Using Exchangeable Shares", "U.K.-Canada Cross-Border Acquisitions Using Exchangeable Shares" and "EU-Canada Cross-Border Acquisitions Using Exchangeable Shares", U.S., U.K. and EU corporations have for some time been active acquirers of Canadian corporations using Canadian exchangeable shares as consideration to facilitate their acquisitions.

The primary reason for the use of a Canadian exchangeable share structure in a cross-border transaction is tax-driven: although the sale of shares of a Canadian Target in exchange for shares of an acquiring Canadian corporation can generally be accomplished on a tax-deferred "rollover" basis by the filing of elections under subsection 85(1) of the Income Tax Act (Canada) (the "Tax Act"), thereby deferring any capital gain until such acquired shares are disposed of, this tax-deferred rollover is not available where a Buyer acquires shares of a Canadian Target in exchange for shares of the Buyer.

Therefore, in order to permit the Canadian selling shareholders of the Canadian Target (the "Canadian Sellers") to defer payment of the capital gains tax on the sale of their interest in the Canadian Target (thereby likely requiring the Canadian Sellers to sell a substantial portion of the shares they received from the Buyer), an exchangeable share structure is commonly utilized by the Buyer which has the following basic features:

  1. the Canadian Sellers sell their shares of the Canadian Target for exchangeable shares ("Exchangeable Shares") of a Canadian subsidiary of the Buyer ("Exchangeco");
  2. the Exchangeable Shares are redeemable and retractable subject to the overriding call right of the Buyer or a Canadian subsidiary of the Buyer ("Callco") to purchase the Exchangeable Shares in consideration for shares of the Buyer; and
  3. in accordance with a support agreement entered into by the Buyer and Canadian Sellers, the Exchangeable Shares receive distributions equal to distributions paid on the Buyer’s shares and the Canadian Sellers receive the right to vote the Exchangeable Shares as if they were voting shares of the Buyer (collectively the "Ancillary Rights").

Over the past couple of years, Gary Fogler has represented both Buyers and Canadian Sellers on a number of cross-border transactions using Canadian exchangeable shares. Recently, the authors of this article acted as legal advisors (Gary Fogler is a Toronto, Ontario, Canada partner of Fasken Martineau DuMoulin LLP) and accounting advisors (Bill Budgell is a Canadian partner of Grant Thornton) on a reverse takeover pursuant to which a European corporation, listed on the AIM market of the London Stock Exchange, acquired a Canadian group of companies. To the knowledge of the writers, this transaction is only the second public reverse-takeover involving an AIM listed corporation using a Canadian exchangeable share structure.

In the course of these cross-border transactions, the exchangeable share structure outlined in the Fogler Articles has needed to be modified to address issues specific to each transaction and certain of these issues are the subject of this article.

ISSUES

1. Voting Rights in the Buyer

As noted in the Fogler Articles, Canadian Sellers holding Exchangeable Shares can obtain voting rights in the Buyer by way of the issuance of a special voting share of the Buyer carrying a number of votes in the Buyer equal to the number of outstanding Exchangeable Shares. This special voting share is typically issued to a trustee which exercises the votes in accordance with the respective instructions of each Canadian Seller. This trustee mechanism, while useful where there are many Canadian Sellers, adds fees and administrative complexity to the cross-border structure.

One alternative to the trustee approach, particularly where there are only a few Canadian Sellers, is for the Buyer to agree to authorize a special class of voting shares (each share having one vote at a shareholder meeting of the Buyer) and issue the Canadian Sellers one special voting share for each Exchangeable Share issued to them. The special voting share conditions can provide that the shares are subject to automatic repurchase as Exchangeable Shares are exchanged for shares of the Buyer in order to maintain the one to one ratio between the outstanding Exchangeable Shares and special voting shares.

It should be noted that the issue of a new class of voting shares by a Buyer may not be possible in all instances because the creation of a new class of shares will generally require prior approval of the shareholders of the Buyer. Such shareholder approval may be difficult for the Buyer to obtain, particularly where the Buyer is a widely-held public corporation.

2. Exchangeco as a Subsidiary of Callco

Callco and Exchangeco are shown as wholly-owned subsidiaries of the Buyer in the diagram contained in the Fogler Articles. However, where it is foreseeable that profits of the Canadian Target will eventually be distributed to the Buyer, Exchangeco should be incorporated as a subsidiary of Callco so that all such distributions pass through Callco.

This revised structure will provide relief from the 5% deemed dividend withholding tax payable on dividends or other distributions by a Canadian subsidiary to its non-Canadian parent to the extent that such distribution exceeds the paid up capital (the "puc") of the shares of the Canadian subsidiary. The problem with Exchangeco paying dividends directly to the Buyer is that the puc of the common shares of Exchangeco will generally be nominal because Exchangeco will be nominally capitalized following its incorporation by the Buyer. Therefore, a distribution by Exchangeco to the Buyer will attract the 5% withholding tax on the entire distribution.

However, the puc on Callco’s shares, while also initially nominal on its incorporation, will grow over time because each time that Callco exercises its call right to acquire Exchangeable Shares, Callco will issue its shares to the Buyer in consideration for the Buyer issuing its shares to the Canadian Sellers. Such Callco shares will have puc equal to the fair market value of such Buyer shares. As the puc of Callco’s shares increases, Callco will be able to distribute the Canadian Target's excess cash to the Buyer in a tax effective manner since the 5% withholding tax will not be payable by Callco until its aggregate distributions exceed the enhanced puc of its shares.

3. Limited Partnership Structure

A further change is recommended to the exchangeable share structure where repatriation of excess profits in the Canadian Target is anticipated: the use of a limited partnership (an "LP") in lieu of Exchangeco. An LP provides two principal tax advantages:

a) Part IV Tax

Under Part IV of the Tax Act, a Canadian private corporation is generally liable to pay a 33 1/3% tax on dividends it receives from another corporation unless the other corporation is "connected" with it. This tax is refundable at such time as distributions are paid to the shareholders of the Canadian private corporation (since such shareholders are then taxable on their receipt of such distribution). The issue that arises in an exchangeable share structure is whether a Canadian Seller that is a corporation (a "Corporate Seller"), which has received Exchangeable Shares for its Canadian Target shares, will be liable to pay Part IV tax on any dividends received by it from Exchangeco on the Exchangeable Shares.

As mentioned, the Corporate Seller will not be subject to Part IV tax if Exchangeco is "connected" to the Corporate Seller. Exchangeco is connected to the Corporate Seller if either (a) it is "controlled" by the Corporate Seller or (b) the Corporate Seller owns (i) more than 10% of the voting shares of Exchangeco and (ii) more than 10% of the fair market value of the issued shares of Exchangeco. Unfortunately, the tests in parts (a) and (b)(i) are failed because Callco, rather than the Corporate Seller, controls Exchangeco through its ownership of Exchangeco's common shares. Accordingly, Part IV tax will apply to any dividends paid by Exchangeco to the Corporate Seller.

In order to avoid the Part IV tax, the Corporate Seller should consider selling its shares of the Canadian Target to an LP, rather than Exchangeco, in consideration for units of the LP ("Exchangeable Units") which are exchangeable, similar to Exchangeable Shares, into shares of the Buyer. For purposes of Part IV tax, the Corporate Seller is deemed to own the common shares of the Canadian Target that are held by the LP, notwithstanding the fact that the Corporate Seller will not have any voting units in the LP itself, such voting units being all held by the general partner of the LP (which can be a wholly-owned subsidiary of Callco). As a result, the Corporate Seller will be deemed for this purpose to own a sufficient number of voting shares of the Canadian Target to pass the above-mentioned "connected" tests. Accordingly, dividends paid by the LP to the Corporate Seller will not be subject to Part IV tax.

b) Part VI.1 Tax

As discussed in the Fogler Articles, dividends paid on Exchangeable Shares may result in Exchangeco paying Part VI.1 tax under the Tax Act. This tax is currently an onerous 66 2/3% tax on dividends subject to an annual $500,000 dividend exemption. However, Part VI.1 tax only applies in respect of dividends paid by a corporation: there is no equivalent to Part VI.1 tax in respect to distributions paid by an LP. Accordingly, there will be no Part VI.1 tax payable in respect of dividends if an LP is used instead of Exchangeco to acquire the shares of the Canadian Target from the Canadian Sellers.

The use of an LP in lieu of, or in addition to, Exchangeco does not unduly complicate the overall structure in Canada. The Exchangeable Units are effectively a surrogate for the Exchangeable Shares of Exchangeco and the holders of the Exchangeable Units will also be entitled to the Ancillary Rights. In addition, Canadian taxing authorities treat unit transfers similar to share transfers with the result that so long as the LP is a "Canadian partnership" under the Tax Act (meaning all partners of the LP must be residents of Canada), a Canadian Seller may transfer its shares of the Canadian Target to the LP on a tax-deferred basis in the same manner that it could have transferred such shares to Exchangeco.

However, it should be remembered that LPs are not corporations. For example, the jurisdiction in which the LP is created needs to be carefully considered since Canadian provincial legislation varies on the issue of loss of limited liability by limited partners. In addition, the LP should conduct some business activities in addition to simply holding shares of the Canadian Target in order to meet the common law partnership test of "carrying on a business" (if the LP is not respected as a limited partnership, then its limited partners will still be considered to be the direct owners of the shares of the Canadian Target with the likely result that dividends paid on such shares will subject the Canadian Target to Part VI.1 tax). Finally, an LP will not be the best choice where a Canadian Seller has acquired shares of the Canadian Target pursuant to the exercise of options (discussed below).

4. Stock Options

Canadian Sellers holding stock options in a Canadian Target ("Optionees") will normally exercise their options and acquire shares of the Canadian Target prior to the closing of a cross-border transaction in order to sell those shares to Exchangeco in consideration for Exchangeable Shares. So long as at the time the stock options are granted the Canadian Target is a "Canadian-controlled private corporation" (a "CCPC") (for purposes of the Tax Act, a corporation that is not controlled, directly or indirectly, by non-Canadian residents or a public corporation), the Optionees will receive a taxable benefit in the year that they sell, rather than acquire, the underlying shares of the Canadian Target (the "CCPC Deferral").

The CCPC Deferral on its own, however, will not be sufficient to enable the Optionees to defer recognition of their taxable benefit until such time as they dispose of shares of the Buyer acquired in exchange for Exchangeable Shares. In the absence of any other saving provision in the Tax Act, their tax will be recognized in the year in which they acquire the Exchangeable Shares, thereby potentially forcing the Optionees to immediately exchange their Exchangeable Shares for shares of the Buyer to pay the tax (exactly what the exchangeable share structure was implemented to avoid).

Fortunately, subsection 7(1.5) of the Tax Act bridges this gap (the "7(1.5) Deferral") by enabling the Optionees to bring into income their taxable benefit in the year in which they dispose of their Buyer shares if, among other things, each of the following conditions is met:

  1. the Optionees dispose of or exchange "securities" that were acquired under circumstances in which the CCPC Deferral applied (it should be noted that "securities" is defined to include shares of a corporation but not, for example, a partnership with the result that Optionees must sell their shares of the Canadian Target to Exchangeco rather than an LP in order to make use of the 7(1.5) Deferral); and
  2. the Optionees receive no consideration for the disposition or exchange other than "securities".

Both of these conditions will be satisfied so long as the Optionees receive only Exchangeable Shares for their shares of the Canadian Target. However, although the Optionees will principally receive Exchangeable Shares in consideration for their shares of the Canadian Target, the Optionees will also receive the Ancillary Rights which, as mentioned above, consist primarily of special voting rights and ecomomic equivalence with the holders of shares of the Buyer. Although the Ancillary Rights are generally considered to have only nominal value, in order to avoid any argument as to the availability of the 7(1.5) Deferral, the sale by the Optionees of their Canadian Target shares should be effected in one of the following ways:

  1. the shares of the Canadian Target should be "fractionalized" so that Exchangeco issues Exchangeable Shares in consideration for a certain percentage of each share of the Canadian Target and grants (or causes the Buyer to grant) the Ancillary Rights to the Optionees in consideration for the balance of such shares; or
  2. the Canadian Target should create two classes of shares to be issued to the Optionees on the exercise of their options, one class being sold by the Optionees in consideration for Exchangeable Shares and the other class being sold in consideration of the Ancillary Rights.

In either case, the portion of the proceeds attributable to the Ancillary Rights will be taxable in the year in which the Exchangeable Shares are received.

Conclusion

As should be obvious from the foregoing, there is no single structure that is going to be optimal for every Canadian cross-border exchangeable share transaction. Every deal is fact specific and requires that the interests of the Buyer, Canadian Sellers and other sellers, if any, be balanced and addressed.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions