Canada: Bumping Foreign Affiliate Shares Under The February 27, 2004 Proposals

The February 27, 2004 foreign affiliate proposals present a number of interesting issues for an acquiror of a Canadian target company that owns foreign affiliate shares, particularly where the acquisition is structured to preserve the availability of the tax cost "bump" under paragraphs 88(1)(c) and (d) of the Income Tax Act (Canada)¹. This article first briefly reviews the limitation in proposed paragraph 88(1)(d.4) (including the modified proposal) that would erode the bump room in respect of foreign affiliate shares where prior dividends have been deductible under section 113. It then examines the surplus and deficit reset rules in proposed Regulations 5905(5.1) and (5.2) that will be relevant where the acquiror applies the tax cost bump to foreign affiliate shares. Finally, the article discusses the possibility of achieving a tax cost bump of foreign affiliate shares under the paragraph 111(4)(e) election without losing historical underlying surplus balances.

As originally proposed, paragraph 88(1)(d.4) would have reduced the bump room available in respect of the shares of any top-tier foreign affiliate of the Canadian target company, to the extent that any historical dividends had been paid by the foreign affiliate that were deductible under section 113, except to the extent such dividends were paid out of exempt and taxable surplus arising after the acquisition of control.

The proposed mechanic to achieve this result involves a deemed addition to "cost amount" for purposes of the first of the two overall bump limitations in subparagraph 88(1)(d)(ii). That provision limits the amount of the available bump designation in respect of a particular non-depreciable capital property of the target to the amount by which the fair market value of that property, at the time the acquiror acquired control of the target, exceeds the cost amount to the target of that property immediately before the winding-up or vertical amalgamation of the target into the acquiror. In other words, subparagraph 88(1)(d)(ii) ensures that the cost of non-depreciable capital property of the target distributed to the acquiror on the winding-up or vertical amalgamation is not bumped above its fair market value at the time of the acquisition of control.

Proposed paragraph 88(1)(d.4), as worded in the February 27, 2004 draft legislation package, would add to "cost amount" in subparagraph 88(1)(d)(ii) in respect of shares of a particular foreign affiliate for which a bump designation is made, the amount of all historic section 113 dividends received on shares of that foreign affiliate, except to the extent the dividends were paid out of exempt or taxable surplus arising after the acquisition of control of the target. The effect of adding all prior section 113 dividends to "cost amount" is to reduce the amount that can be designated under paragraph 88(1)(d) in respect of the shares of the particular foreign affiliate. With a reduced designation amount allowed for purposes of paragraph 88(1)(d) by virtue of the paragraph 88(1)(d.4) deemed addition to "cost amount", the acquiror's cost of the foreign affiliate shares under paragraph 88(1)(c) may be bumped only by this reduced amount, and not up to the full fair market value of the foreign affiliate shares at the time of the acquisition of control.

This appears to have been an unintentionally overbroad limitation on the bump room. Why should all dividends paid by a foreign affiliate before the acquisition of control of the target erode the available bump room in respect of the shares of that foreign affiliate? It is only post-acquisition of control foreign affiliate dividends paid out of pre-acquisition of control surplus balances that potentially allow a "double dip" of surplus and basis attributes. The bump effectively treats an acquiror as if it had directly purchased the toptier subsidiaries of the target, by allowing the acquiror to take its tax cost in the shares of the target that disappear on the winding-up or vertical amalgamation, and "push down" that disappearing tax cost to the shares of top-tier target subsidiaries (and other nondepreciable capital property). Where those top-tier target subsidiaries are foreign affiliates, arguably the correct result under the bump is the result that would be obtained had the foreign affiliate been purchased by the acquiror directly – namely full fair market value tax cost (a full bump), but with surplus balances commencing only with the acquisition of control time when the foreign subsidiary first became a foreign affiliate of the acquiror. The proposed surplus reset rules in Regulations 5905(5.1) and (5.2) deal appropriately with the latter point and are discussed below. But the bump limitation in proposed 88(1)(d.4), insofar as the bump room is reduced by pre-acquisition of control dividends, is unwarranted.

Recognizing this, on May 9, 2005, Finance proposed modifications to the version of paragraph 88(1)(d.4) originally released.² In the modified version, there will be an addition to the "cost amount" in subparagraph 88(1)(d)(ii) in respect of shares of a foreign affiliate of target (and a corresponding reduction of bump room in respect of those shares) only to the extent the foreign affiliate paid dividends after the acquisition of control of target that were deductible under paragraphs 113(1)(a) or (b) and were paid out of exempt and taxable surplus earned before the acquisition of control of target. The effect will be to disregard historical pre-acquisition of control dividends paid by the foreign affiliate, and allow a full bump of foreign affiliate shares up to their fair market value at the time the acquiror acquires control of target, just as if the acquiror had purchased the foreign affiliate shares directly.

As noted above, the surplus and deficit reset rules in proposed Regulations 5905(5.1) and (5.2) work together with proposed paragraph 88(1)(d.4) (as proposed to be modified) so that after a bump of top-tier foreign affiliate shares, the acquiror enjoys the same tax attributes as if the foreign affiliate shares had been purchased directly. Arguably, the correct result from a tax policy perspective is that upon a tax cost bump under paragraphs 88(1)(c) and (d), historical exempt and taxable surplus balances generated prior to the acquisition of control should effectively be converted into pre-acquisition surplus (i.e., surplus balances should be reset to nil). This is because upon a direct purchase of the foreign affiliate shares, the "exempt surplus" and "taxable surplus" balances of the foreign affiliate in respect of the acquiror (as each is defined in Regulation 5907(1)) includes earnings and transactions only in respect of the period beginning with the first day of the taxation year of the foreign affiliate in which it last became a foreign affiliate of the acquiror. While the transition tax year timing difference is acknowledged, as a general matter, in a direct purchase of foreign affiliate shares the acquiror would not benefit from historical surplus, but rather only from surpluses generated from the time of the acquisition of control onwards.

Prior to the release of proposed Regulations 5905(5.1) and (5.2), upon a tax cost bump of foreign affiliate shares owned by target carried out by either a winding-up of target into the acquiror under subsection 88(1) or a vertical amalgamation of target and acquiror under subsection 87(11), the post-bump "opening exempt surplus", "opening exempt deficit", "opening taxable surplus", "opening taxable deficit" and "opening underlying foreign tax" of the foreign affiliate in respect of the acquiror under Regulation 5905(5)(d) to (h) would be determined effectively by pooling or adding the respective balances of the foreign affiliate in respect of each of the target and the acquiror as they existed immediately before the winding-up or vertical amalgamation. In the bump context, the foreign affiliate would have surplus balances only in respect of the target, and accordingly the post-bump opening surplus balances of the foreign affiliate in respect of the acquiror would effectively be equal to the pre-bump surplus balances of the foreign affiliate in respect of the target. In other words, the historical surplus balances of the foreign affiliate in respect of the target would carry over and be preserved in respect of the acquiror following the bump in the tax cost of the shares acquired by the acquiror. Thereafter, the acquiror could have accessed historical pre-acquisition of control retained earnings of the foreign affiliate through dividends paid out of its preserved surplus balances, without reducing the bumped tax cost of the foreign affiliate shares as would ordinarily be the case with true "pre-acquisition surplus" dividends.

The anomaly in Regulation 5905(5) that permitted this "double dip" of tax attributes in a winding-up or vertical amalgamation resulting in a paragraph 88(1)(c) and (d) tax cost bump of the foreign affiliate shares is corrected by the mechanic proposed in Regulations 5905(5.1) and (5.2). These rules are proposed to apply in respect of amalgamations that occur, and windings-up that begin, after December 20, 2002.³

The February 27, 2004 version of proposed Regulation 5905(5.1) applies to any vertical amalgamation under subsection 87(11) where there has been a designation of a bump amount under paragraph 88(1)(d) in respect of shares of a foreign affiliate owned by the target and thereby acquired by the acquiror, and sets out several specific rules for purposes of applying the surplus carryover rules in Regulation 5905(5)(d) to (h).

Proposed Regulation 5905(5.2) is an analogous rule applicable to any winding-up under subsection 88(1) where there has been a designation of a bump amount under paragraph 88(1)(d) in respect of shares of a foreign affiliate owned by the target and acquired by the acquiror by virtue of the winding-up. Under both proposed Regulations, the amounts of the exempt surplus or exempt deficit, taxable surplus or taxable deficit, and underlying foreign tax of the top-tier foreign affiliate in respect of the target and the acquiror are all deemed to be nil immediately before the vertical amalgamation or winding-up (5905(5.1)(a) and (5.2)(a)); similarly, all such balances of each lower-tier foreign affiliate in which the top-tier foreign affiliate has an equity percentage, in respect of the target, are also deemed to be nil immediately before the vertical amalgamation or winding-up (5905(5.1)(b) and (5.2)(b)). The exceptions to these surplus reset rules for the top-tier and each underlying foreign affiliate are contained in Regulations 5905(5.1)(c) and (5.2)(c), which effectively deem the acquiror to have held the shares of the top-tier foreign affiliate during the period from the acquisition of control of the target until the vertical amalgamation or winding-up, thereby allowing the acquiror to benefit from all relevant surplus balances generated from the time it acquired control of target.

The effect of these rules is to override the surplus carryover rules in Regulation 5905(5) and preclude the acquiror from accessing historical, pre-acquisition of control surplus balances in the top-tier foreign affiliate of target, and all underlying foreign affiliates, where the acquiror completes a winding-up or vertical amalgamation of target and bumps the tax cost of the top-tier foreign affiliate shares under paragraphs 88(1)(c) and (d). Unlike the December 20, 2002 version, the current proposed Regulations do not attempt to calibrate the surplus reset based on the amount of the bump of the top-tier foreign affiliate shares – thus, any positive designated amount under paragraph 88(1)(d) in respect of the top-tier foreign affiliate shares, even of a nominal amount, will engage the proposed surplus and deficit reset rules in Regulations 5905(5.1) and (5.2). This could work to the acquiror’s advantage where the target’s foreign affiliates have historical deficits on a consolidated basis. Of course, this would work to the acquiror’s disadvantage where there are significantly positive surplus balances that could be lost as a result of the bump.

The alternative method of bumping the tax cost of top-tier foreign affiliate shares of the target company pursuant to a designation under paragraph 111(4)(e) remains unaffected under the February 27, 2004 proposals.

Paragraph 111(4)(e) allows the target corporation, in its return for its taxation year that ends immediately before the acquisition of control by acquiror, to designate a deemed disposition of its appreciated capital property (which could include shares of a top-tier foreign affiliate) for proceeds of disposition at any designated amount between the target’s adjusted cost base of the property and its fair market value at the time immediately before the acquisition of control. This enables the target to utilize its capital loss carryforward balances, including capital losses triggered by virtue of the mandatory write down of adjusted cost base under paragraph 111(4)(c), as well as non-capital losses, to shelter the capital gains resulting from an election under paragraph 111(4)(e). Such capital loss balances would otherwise expire and be unavailable to target or its successor after the acquisition of control by virtue of paragraph 111(4)(a), and non-capital losses would be restricted under subsection 111(5). Paragraph 111(4)(e) thus permits the target to convert pre-acquisition of control capital losses that can be used only before the acquisition of control, and restricted non-capital losses, into adjusted cost base of designated capital properties that are deemed reacquired at the bumped cost amount.

Where the acquiror’s acquisition strategy includes use of the paragraph 88(1)(c) and (d) tax cost bump, designations under paragraph 111(4)(e) are generally not made. This is because the effect of bumping the adjusted cost base of target’s capital properties immediately before the acquisition of control under paragraph 111(4)(e) is simply to reduce the available bump room that can subsequently be designated under paragraph 88(1)(d). Specifically, the starting point in determining the aggregate bump room is the acquiror’s adjusted cost base of its target shares (the 88(1)(b)(ii) amount) less the total cost of all of the target’s property and cash on hand, immediately before the winding-up or vertical amalgamation (the 88(1)(d)(i) amount). A bump in the cost of target’s capital property under paragraph 111(4)(e) merely reduces the potential amount of the bump of the target’s non-depreciable capital property under paragraph 88(1)(d). The acquiror cannot make full use of both potential bump provisions.

However, in the case of top-tier foreign affiliate shares held directly by the target, a tax cost bump under paragraph 111(4)(e) may now in some circumstances provide better results than a bump under paragraphs 88(1)(c) and (d). Whereas a paragraph 88(1)(d) bump designation in respect of particular foreign affiliate shares will reset all relevant historical surplus balances to nil pursuant to proposed Regulations 5905(5.1) and (5.2), a paragraph 111(4)(e) designation to step up the tax cost of the foreign affiliate shares does not appear to result in a loss of historical surplus balances. ⁴ Regardless whether the acquiror continues to hold the bumped foreign affiliate shares indirectly through the target (in which case the affiliate continues to be a foreign affiliate in respect of the target and no provision grinds or resets the affiliate’s historical surplus balances in respect of target), or whether the acquiror causes a winding-up or vertical amalgamation of the target into the acquiror in order to access the paragraph 88(1)(c) and (d) bump in respect of other non-depreciable capital properties of target (but makes no paragraph 88(1)(d) designation in respect of the particular top-tier foreign affiliate shares, in which case the regular surplus continuity rules in Regulation 5905(5) apply without the restrictions in proposed Regulations 5905(5.1) and (5.2)), there is no provision that specifically grinds or resets the historical surplus balances of the foreign affiliate in respect of the target following a paragraph 111(4)(e) designation.⁵

Is the apparent preservation of historical surplus balances following a paragraph 111(4)(e) tax cost bump of foreign affiliate shares a technical deficiency, or an appropriate result from a tax policy perspective? The principal purpose of the paragraph 111(4)(e) designation is to provide relief from the rules that preclude the carry forward of capital losses of target, and restrict the carry forward of non-capital losses of target, following an acquisition of control of target. It effectively allows the acquiror to preserve the target losses that would otherwise be lost or restricted, by converting them into other tax attributes in the form of adjusted cost base of target's capital properties. Thus when the acquiror utilizes a paragraph 111(4)(e) tax cost bump, no additional tax attributes are created – the bumped tax cost arises as a consequence of triggering capital gains that are sheltered with, and thereby reduce, target's capital and non-capital loss attributes. In contrast, the paragraph 88(1)(d) bump may be viewed as placing the acquiror in the same position as if the target foreign affiliate shares had been purchased directly, in which case it is appropriate for historical surplus balances to be reset to nil as at the acquisition of control time and be treated effectively as pre-acquisition surplus. Arguably the paragraph 111(4)(e) tax cost bump does not allow a "double dip" of surplus and basis tax attributes, because the basis bump is effectively "purchased" at the cost of utilizing tax attributes in the target.

The February 27, 2004 foreign affiliate proposals have dramatically changed the factors that must be considered when determining the bump strategy for an acquiror of a target corporation with foreign affiliates.

Proposed Regulations 5905(5.1) and (5.2) now provide a trade-off between utilizing the paragraph 88(1)(c) and (d) tax cost bump in respect of top-tier foreign affiliate shares, and losing all historical pre-acquisition of control surplus balances in that top-tier foreign affiliate and all of its underlying foreign affiliates. On the other hand, there is now the potential opportunity to erase all historical pre-acquisition of control deficit balances in the relevant foreign affiliate group, simply by making a nominal designation under paragraph 88(1)(d) in respect of the top-tier foreign affiliate shares held by the target and allowing the surplus and deficit reset rules in proposed Regulations 5905(5.1) or (5.2) to apply.

In situations where the surplus reset consequences of a paragraph 88(1)(d) tax cost bump of top-tier foreign affiliate shares are determined to be undesirable, it may be appropriate for the acquiror to utilize a paragraph 111(4)(e) designation to increase the adjusted cost base of the foreign affiliate shares without losing the benefit of historical surplus balances. This strategy may be especially useful where the target has pre-acquisition of control capital loss carryforwards, or non-capital losses which may be restricted under subsection 111(5) following the acquisition of control for which there is no better use. In these circumstances, the acquiror could proceed with a winding-up or vertical amalgamation of target into the acquiror in order to utilize the paragraph 88(1)(c) and (d) tax cost bump in respect of other non-depreciable capital properties of the target, but could make no designation under paragraph 88(1)(d) in respect of the particular top-tier foreign affiliate shares where there are large historical surplus balances to be preserved, and instead could utilize the paragraph 111(4)(e) designation to achieve a tax cost bump of the top-tier foreign affiliate shares in that alternative manner. Although the paragraph 111(4)(e) designation would erode the paragraph 88(1)(d) bump room that may be utilized in respect of the other non-depreciable capital properties, this may nonetheless be advantageous in order to preserve the historical surplus balances in the particular foreign affiliate group.

These strategic considerations underscore the principal implication of the February 27, 2004 proposals as they affect the tax cost bump of foreign affiliate shares. It is now critical to have an understanding of the historical surplus and deficit balances in the target’s foreign affiliates, before making a paragraph 88(1)(d) designation to bump the tax cost of the shares of any of the target’s top-tier foreign affiliates.

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.