What Are Foreign Spin-Off Shares? How To Report Spin-Off Shares Under Section 86.1 Of Canada’s Income Tax Act

Foreign spin-offs

When a Canadian resident shareholder of a foreign corporation (the original corporation) receives from that corporation shares in another foreign corporation (the spin-off corporation), those shares are called spin-off shares.

This situation normally happens when the original corporation spins itself off to create the spin-off corporation and gives its existing shareholders the shares of the spin-off corporation. But broadly, this situation can apply where a corporation holds shares in another corporation and wishes to divest the shareholding in the other corporation to its existing shareholders.

Tax consequences of receiving spin-off shares

Normally, the Canadian resident shareholders who receive the spin-off shares must include the fair market value (FMV) of the spin-off shares in income as taxable foreign dividends. However, section 86.1 allows the shareholders to make a special election to exclude the spin-off shares from income where the distribution is eligible.

As a result of the election, the tax on the receipt of the spin-off shares will be deferred. The adjusted cost base (ACB) of the spin-off shares will not be their fair market value (FMV) as would otherwise be the case.

Instead, the ACB of a spin-off share will be the cost of a share of the original corporation (the original share) that gave rise to the distribution of the spin-off shares, prorated to the FMV of the spin-off share(s) received for each original share. The ACB of the original share is reduced by the same amount, so that the total ACBs of the original shares and of the spin-off shares after the distribution add up to the ACB of the original shares before the distribution.

For example, if before the distribution, the cost of the original share was $100 per share and the FMV of the original share was $150 per share. The original corporation distributed to its shareholders half a spin-off share for every original share. The FMV of a spin-off share is $120 per share. A shareholder of one share of the original corporation will receive half a spin-off share, which has an FMV of $60. Instead of including $60 in his or her income, by making the election under section 86.1, the shareholder can defer the tax on the receipt of the spin-off shares. The ACB of a spin-off share, instead of the FMV of $120 per share, will be:

The ACB of the original share will be reduced to $100 – $28.57 = $71.43.

Eligible distribution of spin-off shares

There are conditions in order for the shareholders to make use of the section 86.1 election. First of all, the shareholders must be Canadian residents. The shareholders can be individuals, trusts, or corporations.

Next, the distribution is for all the common shares of the original corporation that the shareholder owned. The shareholder must have received solely common shares of the spin-off corporation. The shares of the spin-off corporation must have been owned by the original corporation immediately before the spin-off.

Both the original corporation and the spin-off corporation have to be resident in the same foreign country. That foreign country must have a tax treaty with Canada. Neither corporation can ever have been resident in Canada.

The shares of the original corporation must have been widely held and actively traded on a designated stock exchange at the time of the spin-off. If the original corporation is not a public corporation, its shares must have been widely held and be registered with the Securities and Exchange Commission (SEC) of the U.S. as required under the Securities Exchange Act of 1934 of the U.S.

Under the tax laws of the foreign country, the spin-off must not be taxable to shareholders resident in that country.

Within six months of the distribution, the original corporation must provide information to satisfy the Canada Revenue Agency (CRA) that the distribution was indeed eligible. The original corporation will be given the option of permitting the CRA to publish the spin-off in a list maintained by the CRA.

Pro Tax Tip – Verify if the spin-off is eligible

If a spin-off is not eligible, the shareholders receiving spin-off shares must include the fair market value (FMV) of the shares in income as taxable foreign dividends. Therefore, the shareholders making the election must make sure the spin-off is eligible.

Some of the conditions of an eligible spin-off are easily verifiable, whereas some other conditions are not. When in doubt, shareholders should require written representation from the original corporation of the eligibility of the distribution and consult with experienced Canadian tax lawyers for certainty.

FAQ

I received spin-off shares, but the distribution is not listed by the CRA. Was the distribution ineligible?

The list of eligible spin-offs published by the CRA is not complete because it only includes distributions permitted for publication by the original corporations. Shareholders should check with the original corporation from which they received the spin-off shares and consult with experienced Canadian tax lawyers.

I now realize that I had received spin-off shares but failed to make the election under section 86.1 and also failed to report the receipt of the shares. What can I do?

You should consult with an experienced Canadian tax lawyer. However, generally speaking, you can request the CRA for a late election under the taxpayer relief provisions. But note that a relief request must be made within ten years of the end of the tax year to which the election was to be filed.