Income tax issues

Tax Executive, The, Nov, 1999

QUESTION

IV. Section 85 "Triangular Merger" with a Foreign Target Company

Canadian shareholders of an U.S. Company (Target) are unable to effect a tax-free rollover where a Canadian publicly held taxable corporation (Canco) acquires Target in certain transactions that permit U.S. shareholders of Target to obtain tax-free treatment. The steps in the transaction are, as follows. Canco incorporates Subco, an U.S. corporation. Subco merges with Target, also an U.S. company. Subco ceases to exist and Target, the same legal entity as existed before the merger, remains (New Targetco). All the issued and outstanding shares of Target owned by its shareholders before the merger are cancelled and converted to a right to receive shares of Canco. New Targetco issues common shares to Canco in consideration for Canco issuing its common shares to Targetco shareholders.

The purpose of structuring the acquisition in this fashion is to facilitate the acquisition of Target by Canco by means of a "triangular merger," which minimizes or even eliminates the U.S. tax effect for U.S. shareholders of Target. The outcome of the transaction is an acquisition of Target without a direct disposition to Canco of Target shareholders' shares. From the perspective of Target's shareholders, however, the transaction is equivalent to a direct share-for-share exchange, which is accorded tax-free rollover treatment under the Act. We believe that equivalent transactions should be taxed in a consistent fashion and, hence, recommend that the Department of Finance amend the Act to accord "triangular merger" transactions tax-free rollover treatment. We invite the Department's comments.

RESPONSE

Although there is no longer work currently underway on this issue, the Department of Finance may in the future review the treatment of Canadian shareholders in the context of a "triangular U.S. merger" with a view to determining what, if any, amendments should be made to the Act. Any proposed amendment allowing for rollover treatment to the Canadian shareholders of course would have to ensure, amongst other things, that all appropriate downward adjustments were made to Canco's adjusted cost base in its shares of Target to reflect any rollover to the Canadian shareholders.

QUESTION

XII. Part VI.1 Tax Creditable Against Part I and Part VI Tax

In reviewing the preferred shares legislation, we note what appears to be an inconsistency between the treatment of shareholders with a substantial interest (25-percent ownership) in the preferred-share dividend-paying corporation and the transfer of the Part VI.1 tax under subsection 191.3(1) where dividends are paid to a related party (i.e., a greater than 50-percent owner). Under the definition of "excluded shares," dividends paid to a shareholder with a substantial interest in the payer corporation are not subject to the Part VI.1 tax. The preferred shares rules also permit taxpayers to enter into agreements with related corporations for the assumption of the liability for the Part VI.1 tax on the dividends paid on taxable preferred shares.

Technically, a taxpayer may be able to organize its financing in a fashion that effectively transfers this tax to an unrelated corporation through a corporation with a substantial interest in the taxpayer. Specifically, corporation A can issue taxable preferred shares to corporation B, which holds a substantial interest in corporation A, and there would be no tax exigible on dividends paid in respect of these shares because they are excluded shares. Corporation B would then issue its own taxable preferred shares to a related subsidiary C, pay the Part VI.1 tax on dividends it pays, and enter into an agreement with one of its related corporations to transfer the Part VI.1 tax on these preferred shares. The result is as though corporation A transferred the tax directly to corporation C, the subsidiary of corporation B, an unrelated party that holds the substantial interest in corporation A.

In order to remove the inconsistency in the preferred shares rules, we recommend that the Act be amended to permit a taxpayer to enter into an agreement to transfer the tax on the dividends of a taxable preferred share to a corporation holding a substantial interest in the paying corporation or to a corporation related to the corporation holding the substantial interest. Such a change would also eliminate the tax trap that arises where, subsequent to a dividend payment, the taxpayer's ownership of the dividend-paying corporation subsequently falls below the 50-percent ownership threshold. In that situation, the transfer of the Part VI.1 tax to a related party is not permitted.

RESPONSE

The Department's representative noted that under the current law, while it might be technically possible to effect the transaction described, GAAR could be applicable. The fact that it may be possible to reach a particular result by an indirect route does not necessarily imply that the Act ought to provide a direct route.

Nonetheless, the Department is willing to consider the possibility of changing the required relationship for transfers of Part VI.1 liability. The preferred share tax effectively is only payable by issuers that are in a loss position or otherwise not paying Part I tax. The transfer of that tax liability to a person who can use it to offset Part I tax is thus a type of loss transfer. In the past, the Act has based some of its rules with respect to loss transfers on the related test - an example being the rules relating to acquisition of control. The amendment to subsection 69(11) in the last technical bill, however, represented a shift toward the affiliated person standard in this respect. Given that shift, the Department is willing to consider whether it may be appropriate to change the threshold for transferring Part VI.1 liability to the affiliated standard.