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.


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.


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.


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.

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