History of s. 55(3.1)(b) (pp. 29:3)
[The main purpose of the original version of subsection 55(3.1) was to prevent…using the butterfly exemption rules to indirectly gain a treay exemption for a gain on a share sale that would not otherwise qualify for treaty protection. ...
[T]he changes proposed by the 1994 federal budget and as described in the Department of Finance explanatory notes accompanying the November 1994 draft legislation ensured that all purchase butterfly transactions (domestic and cross-border) would be denied the protection of the paragraph 55(3)(b) exemption. The new provisions also introduced a 10 percent de minimis exception to allow for sales and purchases by shareholders with insignificant interests... .
Denial of s. 55(3)(a) exemption (pp. 29:5)
[The following list] illustrates the basic manner in which a Canadian butterfly transaction is integrated into a cross-border spin-off. ...:
1) Foreign Pubco establishes Canadian Newco (the TC).
2) Foreign Pubco transfers shares of its Canadian subsidiary (the DC) with a FMV equal to the net FMV of the spin business to the TC.
3) DC transfers the spin business to the TC on a tax-deferred basis under subsection 85(1).
4) The TC shares owned by the DC, and the DC shares owned by the TC are cross-redeemed in exchange for promissory notes of equal value.
5) The promissory notes are set-off against each other and cancelled.
6) Foreign Pubco transfers its foreign spin assets to Foreign Spinco.
7) Foreign Pubco transfers the TC (which owns the spin business) to Foreign Spinco
8) The remaining spinoff steps are completed, and Foreign Spinco is ultimately distributed to the Foreign Pubco shareholders.In [the base case outlined above]..., Foreign Pubco's gain or loss from the disposition of the spinoff shares is not included in computing its taxable income earned in Canada. In addition, the ultimate spinoff transaction is typically designed to be a tax-free transaction to Foreign Pubco (no recognition of gain or loss). As a result, paragraph 55(3.01)(e) deems Foreign Pubco to have disposed of those shares for proceeds that are less than FMV, and therefore the exemption in paragraph 55(3)(a) does not apply.
Requirement for Canadian spin business to represent under 10% of Foreign Spinco (pp. 29:8)
[T]he Canadian spin business must be relatively insignificant in the context of the overall spin-off and...other spin assets need to be contributed to Foreign Spinco before the contribution (or butterfly) of the Canadian spin business assets to ensure that the Foreign Spinco shares never derive 10 percent or more of their FMV from the TC shares. [fn 20: [The] 10 percent threshold must be maintained throughout the series of transactions-- for example, by ensuring that there are sufficient other assets in Foreign Spinco when it incorporates the TC. ...]
If the shares of Foreign Spinco derive 10 percent or more of their FMV from the Canadian spin business (or the shares of TC), then the transfer of the Foreign Spinco shares is subject to subclause 55(3.1)(b)(i)(A)(II), and therefore the paragraph 55(3)(b) exemption is unavailable. ...
No transfer of TC to a person (Foreign Spinco) who will cease to be related to Foreign Pubco (p. 29:8-10)
Another essential consideration that the Canadian separation transaction must satisfy to qualify under paragraph 55(3)(b) is that any transfer of the DC shares by Foreign Pubco must be a "permitted exchange". ...
Subparagraph 55(3.1)(b)(i) does not permit a transfer of the shares of the TC by a specified shareholder of the TC (i.e., Foreign Pubco) to a person who will cease to be related to the transferor as part of the series….
A potential solution to this issue is to slightly reorder the steps outlined above by establishing the TC under Foreign Spinco at the outset so that no subsequent transfer of the TC shares is required. The DC shares can then be transferred in sequential permitted exchanges from Foreign Pubco to Foreign Spinco and then to the TC. ...
Three-party exchange to address deemed transferee rule (pp. 29:11)
Adjusting the steps as illustrated... raises the issue of the deemed transferee rule in paragraph 55(3.2)(h)….[which] provides that each corporation that is a shareholder (and specified shareholder) of a DC at any time during the course of a series of transactions or events that includes a distribution is deemed to be a TC in relation to the DC. In the modified steps noted in figure 4, Foreign Spinco is deemed a TC if, at any time in the series, it was a shareholder of the DC… .
The solution…is the so-called three-party share exchange….
[F]oreign Pubco, Foreign Spinco, and the TC enter into a three-party share exchange agreement as follows:
1) Foreign Pubco transfers the DC shares directly to TC as consideration for the shares of Foreign Spinco issued in step 3.
2) The TC issues common shares to Foreign Spinco as consideration for the DC shares.
3) As consideration for the TC shares, Foreign Spinco issues shares to Foreign Pubco.
3-party exchange as permitted exchange (pp. 29:14-16)
These steps ...avoid the transitory acquisition of the DC shares by Foreign Spinco, which would otherwise qualify Foreign Spinco as a TC under paragraph 55(3.2)(h). The question, therefore, is whether a transfer that bypasses Foreign Spinco in this manner can still qualify as a permitted exchange.
The first requirement in the definition of "permitted exchange" is that there be an exchange of the DC shares for shares "of another corporation", which for the purposes of the provision is defined as "the acquiror". There is, however, no requirement that the acquiror be the corporation that actually acquires the DC shares. Instead, the only requirement is that the transferor (Foreign Pubco) receive shares of the acquiror as consideration for the transfer of the DC shares. ...
The second requirement is that no share of the capital stock of the acquiror outstanding immediately after the exchange be owned at that time by any person or partnership other than a participant. The only participant in figure 5 is Foreign Pubco, and Foreign Pubco owns all of the shares of Foreign Spinco immediately after the exchange. ...
The final requirement is that subparagraph (b)(iii) of the definition of permitted exchange apply. ...
As in the above example, if Foreign Pubco is the only DC shareholder and the only participant to the exchange, variables B and C are the same, and the fraction equals 1. As a result, the requirement in paragraph (b)(iii) is met. [fn 28: [I] t is often preferable to consolidate the DC shareholdings in the group in a single shareholder/participant immediately before the three-party share exchange. ...[P]ursuant to paragraph 55(3.2)(c) a person who acquires a share of the DC in contemplation of the butterfly distribution is deemed, in respect of the acquisition, not to be related to the person from whom it acquired the share, unless it acquired all of the shares of the DC that were owned by the other person. ...]
Substituted property issue under s. 55(3.1)(b)(i)(C) on 3-party exchange (pp. 29:16-17)
Clause 55(3.1)(b)(i)(C) examines, inter alia, whether the property (or substituted property) is acquired by a person who is unrelated to the vendor, or who ceases to be related to the vendor as part of the series, unless the property is acquired on a permitted exchange. ...
[I]t is unclear whether the Foreign Spinco shares qualify as property substituted for the DC shares. ...
[I]n our view, a subsequent disposition of substituted property that is acquired on a relevant excluded transaction (a permitted exchange, permitted acquisition or permitted redemption) should not be tested under clause 55(3.1)(b)(i)(C). Rather, a subsequent disposition of the property should be retested, starting with clause 55(3.1)(b)(i)(A). In this case, the Foreign Spinco shares do not qualify as property under this clause because they do not derive 10 percent or more of their FMV from the DC or TC shares; therefore, any disposition of them shares should not violate subparagraph 55(3.1)(b)(i). ...
We understand that this general interpretation has been accepted by the CRA, after consultation with the Department of Finance… .
Narrow meaning of “reorganization” in context of ss. 55(3.1)(b) to (d) (p. 29:18)
[T]he CRA has given a relatively narrow meaning to the term ["reorganization"] in this context:
[T]he "reorganization" referred to in section 55 would normally include only transfers of property by the distributing corporation to its shareholders (or corporations related to its shareholders) and the cross-redemption of shares or winding up of the distributing corporation. [fn 32:… 1996 Corporate Management Tax Conference ... 24:17-18.]
The CRA adopted this interpretation in the first cross-border butterfly ruling in 2006... with a specific statement in the comments section….
In the context of a cross-border butterfly, therefore, it is necessary to ensure only that the series of transactions or events does not include prohibited transactions or events described in 55(3.1)(a) or (b), and the continuity-of-interests rules in paragraphs 55(3.1)(c) and (d) should be largely irrelevant.
Reverse foreign spin-offs problematic (pp. 29:20-21)
Consider a reverse foreign spinoff, in which the keep assets are butterflied to the TC as part of the three-party share exchange, and the Foreign Spinco that is distributed to the Foreign Pubco shareholders is the existing shareholder of the DC.
In figure 6, Foreign Spinco (the existing shareholder of the DC) is a deemed TC under paragraph 55(3.2)(h), and therefore the transfer of its shares is problematic, regardless of whether the DC shares represent far less than 10 percent of the FMV of Foreign Spinco. Unlike the more typical transaction outlined above, here the new Foreign Keepco, rather than the existing Foreign Spinco, is a party to the three-party share exchange and therefore the shares of Foreign Spinco remain tainted and cannot be distributed outside the group without violating paragraph 55(3.1)(b). Furthermore, because Foreign Spinco is a deemed transferee corporation at the beginning of the series of transactions that includes the butterfly, it cannot easily (or perhaps ever) be cleansed of its TC status as part of the series. This … may not have arisen if, for example, Foreign Spinco held the DC shares through a single purpose foreign holding company. In this case, deemed TC status would extend only to that foreign holding company, and not to Foreign Spinco. Rather, Foreign Spinco would be tested only under the 10 percent de minimis rule… .
No rollover in 3-party exchange (p. 29:27)
If the transferred DC shares in a cross-border butterfly transaction are taxable Canadian property, any gain realized by the non-resident transferor is taxable under the Act (subject to possible application of a treaty exemption), unless the transfer is completed on a rollover basis under subsection 85(1). ...
Because the three-party share exchange is structured to ensure that the transferor (Foreign Pubco) does not receive the share consideration directly from TC, it may be difficult to take a seemingly opposite position in the context of subsection 85(1).
Non-application of s. 212.1 on 3-party exchange (p. 29:29)
Paragraph 212.1(1)(b) also provides that in computing the PUC of any shares issued by the purchaser corporation, the PUC may be reduced when any increase in the PUC in respect of the shares of purchaser corporation exists "by virtue of the disposition" of the subject shares. ... In the context of the three-party share exchange, the increase in the PUC in respect of the shares of TC issued to Foreign Spinco is clearly related to the disposition of the preferred shares of the DC. In other words, the increase exists "by virtue of the disposition" of the preferred shares of DC by Foreign Pubco to the TC. Consequently, the PUC of the newly issued shares of the TC will be limited to the PUC of the DC preferred shares pursuant to paragraph 212.1(1)(b).
Net cash/investment property transferred driven by relative FMV of spun-off business assets (p.29:20)
[T]he CRA requires that the redemption amount of the DC preferred shares be equal to the amount obtained by multiplying the aggregate FMV of the outstanding common shares of DC, immediately before the conversion, by the butterly percentage. "Butterfly percentage"… mean[s] the proportion, expressed as a percentage, that the net FMV of the business property owned (directly and indirectly) by the DC that relates to the spin business transferred to the TC is of the net FMV of all the business property of DC, determined immediately before the transfer of property by the DC to the TC. ... Therefore, the amount of cash or near-cash and investment property to be transferred is always determined by the relative net FMV of the butterflied business property.
Transferee of actual DC may be treated as DC (pp.29:22)
An interesting question that arises is whether,…corporations other than the "actual" DC may qualify as a "distributing corporation".
In a 2011 CRA ruling [2011-0425441R3], a Canadian DC undertook an initial separation transaction whereby it isolated one its business lines into a new Canadian subsidiary and then transferred that to a TC in a traditional butterfly transaction. At the same time, Foreign Pubco transferred its remaining DC shares (representing DC's other business line) to a newly established foreign subsidiary of Foreign Pubco (Newco 3). Foreign Pubco then transferred Newco 3 to a newly established foreign subsidiary (Newco 4) of Foreign Spinco in a transaction structured as a three-party share exchange (and therefore a permitted exchange).
[U]nder the definition of "distribution" in subsection 55(1), the only requirement is that each TC receive its pro rata share of each type of property owned by the DC immediately before the distribution. If a wholly owned subsidiary (Newco 3) is wound up into its parent (Newco 4), the pro rata requirement is necessarily satisfied because 100 percent of Newco 3's property is transferred to Newco 4. This means that Newco 3 technically qualifies as a DC, a position that the CRA implicitly accepted in the circumstances of the above ruling. As a result, the transfer of the membership interests in Newco 3 to Newco 4 constituted a permitted exchange of membership interests in Newco 3 (a DC) in contemplation of the distribution (by Newco 3); more importantly, it also qualified as a permitted acquisition in relation to the first distribution by the real DC (the DC in respect of which subsection 55(2) would otherwise apply). In other words, qualifying the transfer of Newco 3 to Newco 4 as a permitted exchange was critical to ensuring that the transfer did not adversely impact the butterfly transaction (the first distribution) implemented by the DC. ...
Payment of excess cash received by TC dividended to original parent (pp. 29:23-24)
If more than the desired amount of cash is transferred to TC, it may be possible to extract the excess immediately after the distribution by way of a dividend from TC to Foreign Pubco. In 2006 [2006-0215751R3], the CRA ruled favorably in respect of a butterfly transaction in which, after the distribution and before the final spin-out, the TC (and subsequently its shareholder) paid cash dividends equal to the excess cash received by the TC on the butterfly... . This cash was ultimately received by Foreign Pubco, the parent company of both the DC and the TC. …The only condition seems to have been that the cash not find its way back to the DC.
[T]he department is prepared to accept a discrepancy of up to 1 percent, determined as a percentage of the amount of each type of property that a transferee has received as compared with what that transferee would have received if it had received its appropriate pro rata share of that type of property. [fn 44: ...1991 Conference Report, 14:1-15. See also ...2008-0296141R3 ... and... 2012-043981R3]
[C]onsider the example in the accompanying table.
Business Assets Net FMV Cash Amount Spin assets $100,000 Total Cash $15,000 Total assets $400,000 Butterfly percentage $3,750 Butterfly percentage 25 percent 1 percent error allowance $37.50 In the table, the 1 percent discrepancy allowance actually implies only a 0.25 percent variance in the butterfly percentage. ...
Whether non-participatation by minor pref shareholders busts permitted exchange (pp. 29:25-26)
Another interesting question that arises in the context of the definition of a permitted exchange is whether the formula can be satisfied in the context of cross-border butterfly if certain shareholders do not participate in the three-party share exchange. For example, assume that a preferred shareholder owing 1 percent of the FMV of DC does not participate... . It is clear that the FMV of the Foregin Spinco shares issued to Foreign Pubco cannot equal the amount determined by the formula in the definition of permitted exchange. Foreign Pubco owns 100 percent of the FMV of the Foreign Spinco shares (it is the only shareholder), but Foreign Spinco owns approximately 99 percent of the FMV of all the issued and outstanding shares of DC. ...
The CRA does not believe that a transaction can qualify as a permitted exchange if certain shareholders are excluded in this manner. ... [I]t is arguable that the FMV of the Foreign Spinco shares can still approximate the amount determined under the permitted exchange formula in this context,…
The CRA has confirmed that the position as outlined above in the context of the definition of distribution will be applied to the definition of permitted exchange, and that a 1 percent discrepancy is permitted. [fn 44: 2007-0237501R3]…CRA implicitly expects this discrepancy to arise because of normal valuation issues… . However, it is unclear why equally immaterial discrepancies caused by the exclusion of a de minimis shareholder should not be acceptable.
One-way price adjustments (pp. 29:26-27)
CRA has accepted a one-way cash adjustment mechanism...[which] allows the DC to make an additional transfer cash or near-cash to the TC within a limited period after closing to ensure that the butterfly percentage of the cash or near-cash property was ultimately transferred to the TC. [fn 46: ...2014-0530961R3...and...2013-0491651R3] The acceptance of this one-way cash adjustment is likely premised on the fact that the CRA considers the further transfer of cash or near-cash property by the DC to be part of the distribution. However, this one-way cash adjustment mechanism does not address the situation where TC receives net FMV of cash or near-cash property in excess of the required pro-rata share on the distribution.
Adverse application of thin cap rules in first post-butterfly year (pp. 29:28)
[A] Canadian DC has cross-border debt owing to a specified non-resident..., has no relevant paid-up capital (PUC) and relies exclusively on its retained earnings as its "equity amount" to support the debt for purposes of 18(4)… . The accounting for the butterfly transaction results in a movement of retained earnings from the DC to the TC. [fn 50: ...[U]nder US GAAP an amount equal to the net book value of the transferred assets will be a reduction (debit) to DC's retained earnings and an increase (credit) to TC's retained earnings.]
[T]he retained earnings are not be in TC "at the beginning of the year"…As a result, TC would almost automatically have insufficient equity to support the debt in its first taxation year.
[There] could be…a taxation year-end for the TC immediately before the transaction. The butterfly transactions could then occur in sequence at the very beginning of the new tax year…. In the past, the CRA has seemed to interpret the timing requirements in the thin capitalization rules quite restrictively. [fn 51: [C]RA's…long-standing administrative position that the relevant equity amounts must nonetheless be present in the company at the first moment of that day (i.e., date of incorporation)….] If this approach fails, however, another option might be to have a year-end for the TC immediately after the butterfly transaction. In this case, the thin capitalization issue would arise only for the TC's first (short) taxation year…
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