Gregory M. Johnson, Wesley R. Novotny, "An Update on Flow-through Shares in the Energy Sector", 2016 Conference Report (Canadian Tax Foundation),12:1-39

Summaries

Application based only on valid flow-through share (FTS) agreement (p. 12:7)

... The Canada Revenue Agency's (CRA's) administrative position is that subsection 66.3(3) applies regardless whether the PBC actually renounces any of the covenanted renunciations. [f.n. 35 … 1999-0014275 … and … 2002-0128435 …]. A purported FTS which is ultimately determined to be a prescribed share is not, however, subject to subsection 63.3(3) and instead has full cost base. [f.n. 36 … 2000-0062937 …].

No tracing and aggregation of CEE before flow-through share issuance (pp. 12:8)

The PBC is not required to trace the FTS subscription proceeds to the actual payment of the relevant expenses incurred. [f.n. 40 … 9507845 …]. ...

Although no renunciation of a relevant expenditure is permitted unless the PBC actually issues a share or right to a share, nothing prevents a PBC and a FTS subscriber from executing a subscription agreement before any consideration is paid to the PBC or the FTS is issued. This allows the PBC to aggregate the relevant expenditures for renunciation prior to receiving payment for and issuing the FTS. [f.n. 46 … 9604945 …].

Whether deletion of using look-back rule results in a new agreement rather than the shares being issued pursuant to the actual old flow-through share agreement (p. 12:14)

[In 2006-0212861R3] CRA was asked whether an amendment to an FTS subscription agreement would result in a new agreement and hence restrict the ability of the FTS holders to deduct the renounced expenditures. The ammendment permitted the relevant expenditures to be incurred and renounce under the general rule, insted of under the initially drafted lookback rule. ...The CRA ruled that the proposed amendment did not result in a new subscription agreement and that the FTS holder would be able to deduct the renounced amounts under the amended general rule timelines.

Potential issue if flow-through share issued after signing of merger agreement (pp 12:17-18)

Regulation 6202.1(1)(d) could result in a prescribed-share issue if it can reasonably be expected that the PBC or a "specified person" will acquire or cancel the FTS within five years of issuance. ... A potentially problematic scenario is one in which a merger agreement has been signed between the PBC and an acquiror and the FTS are subsequently issued. The acquiror could be a "specified person" and the merger does not have a fair market value exclusion for the purposes of Regulation 6202.1(1)(d).

Flow-through shares issued after announcement of long-form amalgamation may be prescribed shares (pp. 12:20-21)

On an amalgamation, it is possible that subsection 84(9) will apply to deem the FTS to be disposed of to the PBC. [f.n. 78 The CRA stated that subsection 84(9) could potentially apply to an amalgamation in CRA document no. 9415495, August 12, 1994, CRA document no. 9429925, March 20, 1995; and CRA document no. 9130715, May 11, 1994]. ... Assuming that subsection 84(9) applies to an amalgamation, FTS that are issued after an announcement of a long-form amalgamation may result in a prescribed-share issue under regulation 6202.1(1)(d). This result occurs because the PBC, as a consequence of subsection 84(9), may reasonably be expected to acquire the FTS within five years.

Loss restriction event should not create flow-through share timing issues (p. 12:18)

...Fortunately, the operating FTS provisions [f.n. 72 For example, the definition of FTS in subsection 66(15) and subsections 66(12.6), (12.62), and (12.66)]. determine time by reference to calendar years and not taxation years.

...Thus, the stub taxation year created on an LRE should not, in and of itself, create any timing issues for the issuing FTS or for the incurring and renouncing qualifying expenditures.

Successoring rules not an issue for flow-through shares (p. 12:18)

...[S]ubsection 66.7(10) stipulates that it does not apply for the operative FTS provisions, and therefore the successor rules should not be an issue for the PBC.

Possibility that s. 88(1.5) does not apply following the winding-up distribution and before the dissolution (p. 12:19)

...[N]o subsequent issues under the FTS rules should result on the subsequent windup or amalgamation of the PBC target into the parent. As noted by some commentators, [f.n. 77 Mike J. Hegedus, Andrew Bateman, "A Closer Look at Subsection 88(1.5) of the Income Tax Act", Resource Sector Taxation, (Federated Press) Vol. VIII, No. 3, 2011, p. 591] however, there can be some uncertainty about when subsection 88(1.5) applies in the context of a windup. The possibilities are that subsection 88(1.5) applies (1) on the formal winding up of the subsidiary ("the dissolution date"); or (2) on the effective date of the shareholder resolution and the distribution and assumption agreement ("the effective date").

Under the dissolution-date theory, the timing could have significant consequences if the formal dissolution is delayed. During this gap period, the parent would have acquired the subsidiary's assets on the effective date and presumably would be the only entity incurring qualifying expenses that could be renounced to the FTS holders. Thus, there would be an issue because the original PBC is not incurring the qualifying expenses. If the effective-date theory is correct, there should not be a gap issue. On balance, the effective-date theory is preferable because it is consistent with section 88 and meets the policy objectives of subsection 88(1.5).

Accessing CEE of sub if parent has incurred insufficient CEE (pp. 12:21)

Consider a scenario where a PBC has issued FTS but has failed to incur enough qualifying expenditures to renounce to the FTS holders, but a wholly owned subsidiary has incurred enough qualifying expenditures to make up the shortfall. A potential remedy is to have the PBC undertake a windup or vertical amalgamation with the wholly owned subsidiary. Owing to the continuity language in subsections 87(1.2) and 88(1.5), the new corporation and parent, respectively, are deemed to be the same as, and a continuation of, the predecessors and the subsidiary, as the case may be. Hence, it may be possible to use the CDE and CEE incurred by the subsidiary as renunciations by the new corporation or parent such that the FTS obligations could be met. However, this position is not free from doubt and the better planning structure is to have the parent and subsidiary enter into a back-to-back FTS subscription agreement.

Issues under s. 87(4.4)(d)(i) if further disposition by 1st purchaser or where dissent on amalgamation (pp. 12:19-20)

Subsection 87(4.4) applies where:

  • there is an amalgamation of two PBCs or a PBC and a company that has never carried on business (for example, a shell corporation);
  • a FTS (or a qualifying right) was issued by the predecessor PBC; and
  • the new corporation (that is, amalco) issues a new share to the FTS holder (or to any subsequent holder that acquired the FTS) that is substantially the same as the FTS (or amalco is obliged to issue a qualifying FTS). …

…[Scenario #3] The FTS holder disposes of its FTS to purchaser 1, who then sells to purchaser 2. This arguably satisfies the conditions of subparagraph 87(4.4)(d)(i), although it is unclear whether the parenthetical in the provision specifically contemplates more than one disposition.

…[Scenario #4] The FTS holder acquires the FTS after the amalgamation agreement has been entered into, and the FTS holder decides to dissent from the amalgamation and receives a cash payment in consideration for the FTS. In this case, the requirement in subparagraph 87(4.4)(d)(i) has not been met and the dissent right also creates a prescribed-share issue because the FTS subscriber can get the FTS consideration back. This would clearly be a problem with respect to regulations 6202.1(1)(b) and (d).

Prescribed share issues if flow-through subscription receipts (p. 12:21-22)

[I]f the subscription agreement for subscription receipts were structured as FTS, a prescribed-right issue would immediately be triggered – namely, it would be possible that the holder could get the subscription price back for the subscription receipt if the escrow conditions were not met. The fact that the subscription receipt offering is subject to conditionality falls squarely within regulation 6202.1(1.1)(c) because the PBC has a contingent obligation to return the subscription receipt proceeds. The only way to structure around this would be to issue the shares received on the exchange of subscription receipts as FTS. …

...[P]aragraphs 66(12.66)(a.1) and (c) require that the subscription agreement and the consideration be received in the same calendar year... .

[and earlier:] In the interim period, the subscriber may also be entitled to dividend equivalents payments ("DEPs"). …

...DEPs are typically funded out of interest on the escrowed funds with any shortfall made up by effectively paying a portion of the escrow property back to the subscribers, which in turn reduces the price of the shares that will be issued. Thus, it is possible that the actual issuance price of the shares (and thus the FTS) will be reduced over time. This raises an issue under regulation 6202.1(2)(a).

Implications of underwriters acquiring flow-through shares (p. 12:22-23)

When underwriters or agents (UWs) are engaged to sell the FTS, care must be taken to correctly structure the underwriting agreement (UWA). If the UWA has the UWs acquire the FTS and then sell them to the intended subscribers, … the initial subscriber is the UW and the intended subscribers are subsequent purchasers who are not technically entitled to any renunciations. This is typically remedied by having an agency agreement with a backstop or the UWs being entitled to find substituted purchasers.

If the UWs do end up buying FTS (because they could not sell the FTS), a prescribed-share issue could arise owing to the fees earned by the UWs. These fees could be viewed as a return of consideration paid by the PBC to the UWs and could fall within regulation 6202.1(1)(c). However, the alternative (and better) view is that the fee is simply for services rendered. Given the level of assurance required on public FTS deals, however, it is better to err on the side of caution and assume that the financial fee could create a prescribed-share issue.

No need to contractually preclude general common law right to sue (p. 12:23)

Most provinces have certain statutory rights of rescission. …

All subscription agreements will generally have a covenant that the PBC will indemnify FTS holders if the tax deductions promised are not delivered.

In private discussions, the CRA has confirmed that the subscription agreement need not restrict damages to additional federal and provincial taxes payable since the CRA does not consider a general common-law right to sue for damages otherwise available to constitute a prescribed-share issue.

General release of claims on implementation of CCAA compromise (p. 12:25)

Generally, a [CCAA] plan that provides a release of claims that specifically contemplates the existence of future claims arising from FTS--and provides that such claims are irrevocably, fully and finally settled, released and discharged--should release and protect a PBC from any claims by the CRA in respect of the FTS. Accordingly, a PBC that incurs insufficient qualifying expenses and subsequently claims protection under CCAA should generally be immune from any tax or penalties levied by the CRA in respect of its FTS agreement.

Likely release of penalties (p. 12:25-26)

There is an exception to the general rules in section 19(2)(a) of the CCAA. The exception excludes from claims compromised by the CCAA proceedings a fine or penalty imposed by a court in relation to an offence, unless the plan explicitly deals with it. ...

...Subsections 163(2.21) and (2.22) can impose a 25 percent penalty in respect of the portion of a renunciation in excess of the renunciation actually available ("the lookback penalty").

..[T]he CCAA exception is unlikely to apply to the lookback penalty because it is not a penalty imposed by a court. It is imposed either by statute or, possibly, by the Tax Court of Canada, and "a court" as defined in section 2 of the CCAA does not include the Tax Court.

Indemnity claims of flow-through shareholder generally disappear on CCAA compromise (pp. 12:27)

[I]n National Bank of Canada v. Merit Energy Ltd., [f.n. 101 2001 ABQB 583]… the court held that the FTS indemnity claim was an equity claim. ... [f.n. 102 aff’d 2002 ABCA 5]. … In EarthFirst Canada Inc. (Re), [f.n. 103 2009 ABQB 316]… the court confirmed… in Merit Energy. …

On the basis of these authorities and the amended CCAA, it appears that any FTS holders' claims that arise pursuant to an indemnity provided by a PBC in an FTS subscription agreement will be treated as equity for CCAA purposes. As a result, those claims will rank after debt claims in respect of the PBC... .

No need to contractually preclude general common law right to sue (p. 12:23)

Most provinces have certain statutory rights of rescission. …

All subscription agreements will generally have a covenant that the PBC will indemnify FTS holders if the tax deductions promised are not delivered. ...

In private discussions, the CRA has confirmed that the subscription agreement need not restrict damages to additional federal and provincial taxes payable since the CRA does not consider a general common-law right to sue for damages otherwise available to constitute a prescribed-share issue.

No need to contractually preclude general common law right to sue (p. 12:23)

Most provinces have certain statutory rights of rescission. …

All subscription agreements will generally have a covenant that the PBC will indemnify FTS holders if the tax deductions promised are not delivered. ...

In private discussions, the CRA has confirmed that the subscription agreement need not restrict damages to additional federal and provincial taxes payable since the CRA does not consider a general common-law right to sue for damages otherwise available to constitute a prescribed-share issue.

Protection through escrowing subscription receipts (p. 12:28)

A basic plan involves having the investors sign the subscription agreement with the PBC and pay the subscription amounts to the PBC. As part of the agreement, the PBC immediately transfers the funds to an escrow agent. As the PBC incurs the relevant expenses, the funds are released by the escrow agent to the PBC, which then issues the FTS to the investor. At a predetermined point in the future, if the PBC has not incurred the required relevant expenses, whatever funds remain with the escrow agent are returned to the investors and are not amounts used to subscribe for a FTS or a right to a FTS. [f.n. 105 Care must be taken in using the escrow approach with the lookback rule. … [I]t may be necessary for the escrow agreement to provide that the amount that the PBC has been spent on or before December 31 of the first year (at the latest) will be released to the PBC in return for FTS, with the remaining unspent amounts being returned to the investors.] …

...In such a case, are the investors actually putting their invested funds at risk? The CRA has stated that this escrow arrangement would not offend the prescribed share rules. [f.n. 106 "Revenue Canada Roundtable" … 1988, … question 23…]

Inclusion of flow-through share indemnity payment under s. 12(1)(x)(iv) and deduction under s. 12(2) as “outlay" (p.12:28-29)

...The CRA's view [f.n. 97 … 1991-167 …] was that the amounts paid by the PBC to the partnership under a typical flowthrough indemnity would receive the same tax treatment (for the PBC and the FTS holder) regardless of whether they were (1) simply paid out under the indemnity, (2) paid by the PBC after it was sued but before a court order, and (3) paid pursuant to a court order. …

...The interpretation goes on to state that the payments would be reimbursements of an outlay that would be included in the partners' income under … subparagraph 12(1)(x)(iv). …

...[T]he partners would likely be entitled to relief from the paragraph 12(1)(x) income inclusion under subsection 12(2.2). .. The…interpretation was silent on how the election…would be made in the context of the indemnity payments being made to a partnership. Consideration should be given to whether the partnership or the partner should make the election.

Flow-through shares issued after announcement of long-form amalgamation may be prescribed shares (p. 12:20-21)

...On an amalgamation, it is possible that subsection 84(9) will apply to deem the FTS to be disposed of to the PBC. [f.n. 78 The CRA stated that subsection 84(9) could potentially apply to an amalgamation in CRA document no. 9415495, August 12, 1994; CRA document no. 9429925, March 20, 1995; and CRA document no. 9130715, May 11, 1994].

...Assuming that subsection 84(9) applies to an amalgamation, FTS that are issued after an announcement of a long-form amalgamation may result in a prescribed-share issue under Regulation 6202.1(1)(d). This resuly occurs because the PBC, as a consequence of subsection 84(9), may reasonably be expected to acquire the FTS within 5 years.