The mergers & acquisitions (M&A) market in Canada is booming again with respect to size and number of transactions. There is no obvious reason why this positive trend should stop in the near future.
Tax can create value if opportunities are identified, synergies are captured and in particular if the M&A financing structure is optimized. Proper structuring at the right time with a clear business focus is therefore essential.
The time has passed when M&A tax structuring was a matter for a generalist. Tax issues become more and more complex, cross-border transactions require international teams, the team must be organized in such a way as to cope with the time pressure which exists in any transaction and systems must be in place to deliver the services in an efficient manner.
This article discusses several aspects of the Canadian tax system particularly relevant to merger and acquisition activity, including the following:
- Overview of the tax system
- Thin capitalization rules
- Loss carry-forward balances
- Acquisition of control rules
- Debt forgiveness
- Foreign affiliate rules
- Tax deferred reorganizations
- Preferred share rules
- Advance tax rulings
- Structuring an M&A transaction
- Shares versus assets considerations
- Use of holding companies and post acquisition reorganizations
- Non-resident owned investment corporations
- Nova Scotia unlimited liability corporations
- Cross-border mergers
- Exchangeable shares
- Triangular amalgamations
Overview of the tax system
Canadian corporations and resident individuals are subject to Canadian income taxes on world-wide income. Non-residents generally are subject to Canadian income taxes only on income derived in Canada and on capital gains realized on the disposal of taxable Canadian property (subject to the provisions of international tax treaties).
Resident individuals in receipt of Canadian dividends claim a credit against personal tax in recognition of underlying corporate tax. For corporations, inter-corporate dividends are generally deductible in determining a recipients taxable income. Relief for foreign tax is given by credit plus deduction if excess tax was paid.
In addition to numerous specific anti-avoidance rules, a general anti-avoidance rule provides statutory non-tax purpose and step-transaction tests.
In addition to income tax, the federal government imposes capital tax, goods and services tax (a VAT-type tax), excise taxes and customs and excise duties and oil and gas royalties. The various provincial governments also impose income and capital taxes. Some provincial governments have a separate retail sales tax (e.g. Ontario) or a combined federal/provincial GST system (e.g. Quebec).
Thin capitalization rules
Canada has statutory thin capitalization rules that can limit the deduction of interest expense on debt from non-resident shareholders. Generally the rules apply only to debt held by specified non-resident shareholders or persons who do not deal with such shareholders at arm's length. A specified shareholder is someone who owns shares entitling the holder to at least 25% of the votes cast at any annual shareholder meeting or shares having a fair market value of 25% or more of the fair market value of all the issued shares of the corporation. The rules can also deem a person to own shares where contingent rights or options exist.
The thin capitalization rules apply whenever debt owing to specified non-resident shareholders at any time in the year exceeds three times the total of retained earnings at the commencement of the year, contributed surplus (if contributed by a specified non-resident shareholder) and the greater of the paid-up capital of shares owned by specified non-resident shareholders at the beginning and end of the year. If the three times threshold is exceeded, the interest deduction is proportionately reduced to the extent of excess debt as a percentage of total debt owing to specified non-resident shareholders.
Back-to-back or conditional loan arrangements can also be caught by these rules.
Loss carryforward balances
Canada segregates losses arising from the disposition of capital property from normal operating losses.
Capital losses can be applied only to offset capital gains. Unused capital losses can be carried back for three taxation years or forward indefinitely.
Non-capital losses can be applied against business or property income or capital gains. Non-capital losses can be carried back for three taxation years or forward for seven taxation years before expiry.
Of note is the fact that taxpayers can decide not to claim certain permissive deductions in order to either reduce a loss or create income to use prior year losses. For example, capital cost allowance (tax depreciation) can be claimed for any amount up to the regulatory maximum. By reducing the claim, it may be possible to preserve tax basis and prevent the expiry of non-capital losses.
Acquisition of control
There are a number of tax events triggered by an acquisition of control of a Canadian company including:
- deemed tax year-end;
- recognition of unrealized losses inherent in assets (e.g. inventory, capital assets);
- expiry of capital loss carryforward balances;
- restriction on future use of non-capital loss carryforward balances.
The overall purpose of these rules is to restrict the use of tax losses after an acquisition of control. The deemed year-end requires the filing of a tax return on which previously unrecognized losses will be reported.
While capital losses generally expire on an acquisition of control, an elective mechanism exists whereby such losses can increase the tax basis of capital assets having unrealized accrued capital gains.
The ability to use non-capital losses after an acquisition of control requires that the business which gave rise to the losses continue to be carried on for profit or with a reasonable expectation of profit. The losses can offset future income generated by that business or a similar business. The existence of a similar business depends on the facts. It should be noted that these provisions apply only to business losses. Property losses (e.g. interest expense in a holding company) will not survive an acquisition of control. Careful planning is required whenever acquiring a tax loss company.
Where debt is settled or extinguished for less than the principal amount, specific debt forgiveness rules apply. The forgiven amount is applied to reduce tax attributes in the following order:
- non-capital losses;
- net capital losses;
- undepreciated cost of depreciable property;
- unamortized basis of intangible property;
- resource expenditure pools;
- cost base of capital property.
If any portion of the forgiven amount remains unapplied, then three-quarters of that unapplied amount is included in income.
Complex rules exist with respect to the application of the forgiven amount to capital property. For example, the tax attributes of related companies should generally be ground-down before reducing the cost base of shares held in related companies.
Parked debt rules can result in the application of the debt forgiveness rules where debt is acquired for less than 80% of its principal amount.
Whether debt forgiveness results when shares are issued in settlement of debt, will depend on the fair market value of the shares. The conversion of an existing debt into a new debt does not generally result in debt forgiveness as long as there is no reduction in the principal amount, irrespective of the fair market value of the new debt.
The acquisition or restructuring of debt in connection with an M&A transaction can complicate a deal and will require advance planning to deal with the issues.
While a discussion of the Canadian foreign affiliate system is beyond the scope of this article, it is worth noting some of the basic features. Most larger Canadian companies with any degree of international operations, have established tax motivated international structures. Reviewing and understanding such existing structures becomes an important element of both M&A tax due diligence and structuring.
The purpose of most international planning is to generate exempt surplus within foreign affiliates in low tax jurisdictions. Exempt surplus can be distributed to the Canadian parent company without incurring Canadian tax. Exempt surplus includes business income of the foreign affiliate. Deeming rules can result in interest paid between foreign affiliates qualifying as exempt surplus. These rules have encouraged the formation of complex international financing structures. Similarly many Canadian companies hold intellectual property in offshore foreign affiliates which charge royalties or licence fees to other related foreign affiliates.
One proposed change of note with respect to foreign corporations relates to the share exchange provisions. It will now be possible for Canadian taxpayers to defer tax on a transaction whereby shares of one foreign corporation are exchanged for shares of another foreign corporation or on a merger of foreign corporations. There is no requirement for both foreign corporations to be in the same jurisdiction.
Tax deferred reorganizations
Special provisions in the federal Income Tax Act are designed to enable taxpayers to carry out a variety of tax-deferred corporate reorganizations. Without these rules, all transactions involving the sale, exchange or conversion of assets or shares would take place at market value. In specifically defined circumstances (generally when a taxpayer's economic interest remains unchanged), certain asset transfers in exchange for shares, share-for-share exchanges, liquidating distributions, and business combinations may be carried out at tax values without the necessity of recognizing gains or losses for income tax purposes. Such tax-free exchanges are commonly referred to as rollovers.
Preferred share rules
The government has concluded that the tax-free nature of inter-corporate dividends provides an opportunity for transferring the benefits of accumulated deductions or losses from the entity that incurred the expense to a financial institution or other preferred share investor. Consequently, complex rules can apply to deny inter-corporate dividend deduction or to apply a special tax on preferred share dividends.
The special tax is imposed on dividends paid on most preferred shares issued after June 18, 1987. If the payer elects to pay a 25% tax on dividends paid, an additional 10% tax is imposed on some corporate recipients. Alternatively, the payer will pay a 40% tax on dividends paid, in which case no additional tax is imposed on the recipient. Dividends paid on certain short-term preferred shares may bear a 66.67% tax instead.
In all cases the tax may effectively be offset against ordinary corporate tax otherwise payable by the issuer so that no net additional tax will be payable by taxable issuers. The tax will apply only to dividends exceeding C$500,000 paid in a year and therefore does not apply to most small corporations. Various other exemptions are also provided. For example, no tax applies on dividends paid to shareholders that also have a significant common equity interest in the payer, and preferred shares issued by a Canadian corporation in financial difficulty may also be exempt from this tax.
Parties to M&A transactions should be careful that they do not unknowingly incur these special taxes which might result from pre- or post-acquisition restructurings.
Advance tax rulings
Taxpayers concerned about a transaction and desiring assurance from Revenue Canada on their interpretation of the tax consequences of the transaction may request an Advance Income Tax Ruling from Revenue Canada. An hourly fee is charged for the time Revenue Canada rulings officers spend considering the request and preparing the rulings. Revenue Canada has agreed to be bound by these rulings, provided a ruling is requested in advance of the transaction, all the material facts are disclosed and the transaction proceeds in the manner and time indicated.
Structuring an M&A transaction
Shares vs. Assets Considerations
One of the critical decisions to be made by both buyers and sellers is whether the transaction will involve assets or shares. Both the commercial and tax aspects must be reviewed in order to determine the most appropriate alternative.
From a commercial perspective, a purchaser of shares will acquire all the assets and assume all the liabilities of the target company. For these purposes, liabilities could include both liabilities known at the date of sale (for example, bank debt) and also contingent liabilities that may be difficult to quantify (for example, environmental liabilities, and the possibility of a re-assessment by the tax authorities). It can be expected that a comprehensive due diligence review of the target company will need to be conducted under a share acquisition. In an asset acquisition, the purchaser will acquire only those assets and assume only those liabilities explicitly identified in the purchase and sale agreement. Only a limited due diligence review is generally required.
From a tax perspective, the vendor and the purchaser may have conflicting preferences with respect to structuring the transaction. The vendor will often prefer a share sale since the capital gains attributable to a share sale would typically attract a lower tax rate when compared to an asset sale followed by a distribution to the target company's shareholders. The purchaser may prefer an asset acquisition instead in order to allocate the purchase price to tangible and intangible assets, which can be written-off or depreciated for tax purposes.
Other tax differences are summarised below.
The share acquisition cost is reflected as the adjusted cost base or ACB of the shares held by the purchaser. No goodwill will arise on the share acquisition and any goodwill amortization recorded for accounting purposes in years subsequent to the acquisition will be a permanent difference for purposes of deferred tax accounting.
If the purchaser acquires shares representing more than 50% of the votes of the target company, then an acquisition of control will arise for tax purposes. The tax attributes of the acquired company (basis, tax losses, etc) will survive subject to the application of the acquisition of control rules discussed above.
The purchase of shares does not generally attract any sales taxes.
The purchaser will record for tax purposes the fair market value of the assets. Such measure presents the purchaser with an opportunity to depreciate the acquired assets at their then fair market values.
A portion of the goodwill generated on the asset acquisition will be deductible for tax purposes as eligible capital expenditure (ECE). Three-quarters of the ECE would be added to a pool that can be depreciated at a 7% declining balance method.
The purchase and sale agreement should identify a reasonable purchase price allocation.
The federal 7% goods and services tax will generally not apply where one registrant sells substantially all of its business assets to another registrant. Some provinces may levy a provincial sales tax on the purchase price paid by the purchaser unless an exemption applies. Generally, exemptions may be available for assets being held for resale such as inventories, and certain equipment used in manufacturing and processing. Although the sale of real property (i.e. land and buildings) will generally not be subject to provincial sales taxes, it may attract Land Transfer Taxes that can range up to about 2% of the value of the real property.
Under an earn-out, the vendor and the purchaser contractually agree that some or all of the purchase price is to be determined by reference to the future performance of the business as indicated by criteria such as cash flows or net earnings. Traditionally, an earn-out would be designed to provide additional funds to the vendor in the event that the performance criteria were subsequently satisfied. An earn-out could be designed for both an asset acquisition and a share acquisition. It is also possible, though, that the earn-out could be designed to benefit the purchaser in that the sales price could be reduced (a reverse earn-out) depending on the circumstances.
An earn-out transaction may trigger the application of paragraph 12(1)(g) of the Canadian Income Tax Act which provides that "any amount received by the taxpayer in the year that was dependent on the use or production from property" is to be included in the vendor's income. According to Revenue Canada's interpretation policies, paragraph 12(l)(g) will generally not apply to a share purchase. However, paragraph 12(1)(g) may apply to an asset purchase. From the vendor's perspective, should paragraph 12(1)(g) apply then the vendor may not be able to realize capital gains treatment on the portion of the proceeds subject to the earn-out provision. These tax consequences arise to the vendor even though the purchaser will not be entitled to a tax deduction for the earn-out payment. Instead, the purchaser must capitalize the earn-out payments.
The provisions of paragraph 12(1)(g) do not apply to a reverse earn-out situation.
Use of holding companies and post-acquisition re-organizations
A common acquisition technique for a non-resident purchaser is to use a Canadian holding company (Holdco) as the vehicle to acquire the shares of the target company. The use of such Holdco offers three benefits:
The ability to return the original amount invested in the acquisition without creating a taxable dividend distribution to a non-resident purchaser.
The non-resident purchaser will incorporate Holdco and subscribe for shares equal to the amount required to purchase the shares of the target company. As the target company generates profits, a tax-free inter-corporate dividend would be paid to Holdco. Holdco would then reduce its capital for Canadian tax purposes and pay the funds to the non-resident purchaser. Such return of capital to the non-resident purchaser will not be subject to a Canadian dividend withholding tax.
It should be recognised that the reduction in Holdco's capital will reduce its equity for purposes of the thin capitalisation rules and may result in the disallowance of the interest expense deduction.
The ability to increase or "bump" the tax basis of certain non-depreciable capital property following a winding-up or amalgamation of a wholly owned subsidiary with Holdco.
As noted in a preceding paragraph, the acquisition of the shares held by the purchaser would represent their ACB for tax purposes. However, the assets of the target company would maintain their historical tax costs. The bump is a means to increase the tax cost of certain assets held within the target company following the completion of the acquisition. The bump itself is calculated as the difference between the ACB of the target company shares held by the Holdco and the tax basis of target company's assets less net liabilities. The assets that are eligible for the bump include land, debt investments, and shares held by the target company. The bump may be valuable where the purchaser intends to sell assets, such as land, held by the target company or where the purchaser intends to sell shares of a subsidiary company held by the target company. Prudent pre-acquisition planning may allow the purchaser to benefit from this bump in situations where it would not otherwise be available. For example, before the acquisition, the target Canadian company might incorporate a division of its business that the purchaser does not want to retain. The bump rules are complex and the bump may be denied where the property, or substituted property, is purchased by persons who had a significant interest in the target corporation before it was acquired.
The ability to match the interest expense on the acquisition debt with the income generated from the target company's business operations.
Holdco would borrow the debt required for the acquisition of target company shares. Following the acquisition, target company would be wound-up into Holdco or amalgamated with Holdco. In this manner, the interest expense on the debt would be offset by the operating profits of the target company's business operations.
Non-resident owned investment companies
A non-resident-owned investment corporation (NRO) is a Canadian corporation owned by non-residents that is effectively taxable as a non-resident of Canada. A Canadian corporation that elects to be an NRO is created under federal or provincial law in the same manner as other Canadian corporations. It pays a refundable federal tax of 25% on its taxable income (excluding certain capital gains). This tax is refunded in the taxation year following the year in which the NRO pays or is deemed to pay dividends to its shareholders, at which time the dividend will be subject to a lessor rate of withholding if the non-resident can benefit from a tax treaty. A stock dividend paid by the NRO is considered to be a dividend for Canadian tax purposes and will generate the tax refund. Such a stock dividend is not treated as a taxable dividend for purposes of some countries (e.g. US).
Provincial income tax is generally not imposed on a NRO except in limited circumstances. A NRO is not subject to the federal large corporations tax (LCT) and can be structured to minimize or eliminate provincial capital taxes.
A corporation must meet the certain criteria throughout a taxation year to qualify as an NRO. These criteria include a requirement that all shares and funded debt of the NRO must be beneficially owned by non-residents of Canada. The NRO can only derive its income from specified sources, which includes interest on debt to a related entity in Canada. In addition, in computing income for tax purposes, an NRO is not allowed to deduct interest expense. Therefore, a NRO is usually funded exclusively through the issuance of share capital and not through debt financing. To the extent that funds are borrowed by the foreign parent to acquire the NRO share, an interest deduction will generally arise in the foreign jurisdiction. In Canada, an interest deduction will arise on loans an operating company has with the NRO.
The NRO offers the following additional benefits:
If the inter-company debt were held directly by the non-resident, then the non-resident would have an income inclusion at the same time that the Canadian operating company has a tax deduction in connection with inter-company interest. Using the NRO as an intermediary permits the Canadian operating company to have the interest deduction when the funds are paid to the NRO, while the non-resident may not recognize an income inclusion until the NRO distributes its income by way of a dividend payment. Therefore, if the NRO reinvests its interest income in, say, preferred shares of the Canadian operating company, then the structure allows an immediate deduction for interest while the non-resident's income inclusion is deferred.
Foreign tax credit
The NRO can be structured such that the non-resident hold shares in both the NRO and the Canadian operating company. The non-resident will have the choice of receiving dividends either from the NRO, which will have borne no Canadian tax except a withholding tax, or from Canco, which will have borne Canadian taxes at roughly 46%. The ability to choose between a dividend with high underlying foreign tax and low underlying foreign tax allows flexibility in managing a company's foreign tax credit use.
Nova Scotia unlimited liability company
A Nova Scotia unlimited liability company (NSULC) is an incorporated company established under the Nova Scotia Companies Act and is a Canadian corporation for Canadian tax purposes. The unlimited liability feature of the NSULC makes it possible for the entity to be treated as a flow through entity for US tax purposes. Several US tax consequences would therefore arise:
The US-resident purchaser could consolidate the Canadian tax results with that of its US operations. Losses incurred by the NSULC could be used to shelter US source income of the US-resident purchaser.
The NSULC structure may allow the US purchaser to obtain a full step up of the underlying assets for US tax purposes by electing to treat the acquisition of the Canadian company as an asset purchase.
The NSULC can be used as a financing structure. Under this circumstance, the acquisition debt would be borrowed by the NSULC and the resulting interest expense would flow through to be claimed by the US-resident purchaser.
The largest trading partner of the US is Canada. Accordingly, most cross-border deals involve purchasers and vendors in Canada and the US.
The cross-border triangular amalgamation may allow a Canadian buyer to use its stock to acquire shares of a US corporation.
In the triangular amalgamation, US Acquisition Co mergers with US Targetco. Instead of receiving shares in the amalgamated US corporation, the US shareholders receive Canco shares.
From an US perspective, several tests must be met to ensure that the US shareholders recognize no gain. The major requirement is that the US shareholders own less than 50% of Canco after the merger.
From a Canadian perspective, it is important that Canco have tax basis in the US Amalco shares equal to the value of the Canco shares issued to the US shareholders. This result can generally be accomplished.
Exchangeable share structures should be considered whenever a US company intends to use its stock (particularly, illiquid stock) as consideration on the purchase of the shares of a Canadian company. For example, assume US Buyerco wants to acquire all of the issued shares of Canco from its Canadian shareholders.
Under Canadian tax law, it is not possible for the Canadian shareholders to contribute their Canco shares to US Buyerco in return for US Buyerco shares on a tax-deferred basis. Such a transaction would be completed at fair market value and could result in capital gains tax payable by the Canadian shareholders.
In order to defer Canadian tax, the Canco shareholders could exchange their Canco common shares for Canco preferred shares having a value equal to the current value of Canco. US Buyerco would subscribe for newly-issued Canco common shares. The Canco preferred shares held by the Canadian shareholders would have share rights designed to mirror the rights of a US Buyerco shareholder. For example, the shares would be exchangeable into shares of US Buyerco at a fixed exchange rate and would entitle the Canadian shareholders to dividends whenever US Buyerco pays a dividend.
In establishing such a structure careful consideration should be given to the Canadian preferred share rules. Also, several US advisers believe that the exchangeable shares may be viewed as stock of the US company. Nevertheless, such structures have been a popular means of completing a cross-border acquisition and deferring Canadian capital gains tax.
The M&A market in Canada is certainly one of the most exciting aspects of business. Structuring transactions is the critical core of this activity. Tax advisors who are real M&A specialists and understand the business rationale which drives a transaction can add real value as deal architects.
* * * * * * * * * * * * * * * *
The foregoing article, prepared by Jim Briggs and Doug Frost of PricewaterhouseCoopers LLP, recently appeared as a special supplement to the International Tax Review.
Jim Briggs leads the firm’s Canadian Mergers & Acquisitions tax practice. He has assisted both domestic and international corporations in undertaking mergers and acquisitions, divestitures, due diligence reviews and establishing structures. E-mail: firstname.lastname@example.org
Doug Frost is a partner in the firm’s Canadian Mergers & Acquisitions tax practice. His clients include companies in the high technology, entertainment, communications and entertainment industries. E-mail: email@example.com
* * * * * * * * * * * * * * * *
The information provided herein is for general guidance on matters of interest only. The application and impact of laws, regulations and administrative practices can vary widely, based on the specific facts involved. In addition, laws, regulations and administrative practices are continually being revised. Accordingly, this information is not intended to constitute legal, accounting, tax, investment or other professional advice or service.
While every effort has been made to ensure the information provided herein is accurate and timely, no decision should be made or action taken on the basis of this information without first consulting a PricewaterhouseCoopers LLP professional. Should you have any questions concerning the information provided herein or require specific advice, please contact your PricewaterhouseCoopers LLP advisor.
PricewaterhouseCoopers refers to the Canadian firm of PricewaterhouseCoopers LLP and other members of the worldwide PricewaterhouseCoopers organization.