Epsilon -- summary under Outbound continuances

Overview

Epsilon is an Alberta corporation holding, through US subsidiaries, a profitable U.S. oil and gas business. It is proposing to continue out of Canada and be "domesticated" as a Delaware corporation pursuant to the continuance “export” provisions in the ABCA and the domestication provisions in the Delaware General Corporation Law. Although this will result in a deemed disposition of all its property (s. 128.1(4)(b)) and an exit tax calculated at 5% of NAV minus PUC (s. 219.1), management does not anticipate any material Canadian income tax under these rules based on current values and Canadian tax attributes including significant loss carryforwards and (it would appear) significant paid-up capital for its shares.

U.S. shareholders holding less than 10% of its shares can elect, in lieu of recognizing gain, based on the FMV of their shares, to include in income as a deemed dividend the “all earnings and profits amount” attributable to their shares, which management estimates to be nil.

As discussed in a post on the continuance of Gastar Exploration (with a U.S. natural gas business) from Alberta to Delaware, that continuance was regarded from a U.S. tax perspective as entailing a transfer by Gastar of all its assets to the new Delaware corporation (Gastar Delaware), followed by a distribution by Gastar of Gastar Delaware to its shareholders. This distribution step was problematic as Gastar Delaware was a United States real property holding company for FIRPTA purposes. Notwithstanding that essentially the only properties of Epsilon are its U.S. oil and gas interests, its disclosure indicates that the domesticated Epsilon is not anticipated to be a USRPHC.

Epsilon

Epsilon, which was incorporated under the Alberta Business Corporations Act (“ABCA”) on March 14, 2005 and whose common shares trade on the TSX, is a North American on-shore focused independent oil and gas company whose primary areas of operation are Pennsylvania and Oklahoma and which conducts operations in the U.S. through wholly-owned subsidiaries.

Domestication (continuance)

Epsilon's Board is proposing to change its jurisdiction of incorporation from Alberta to Delaware through a continuance under s. 189 of the ABCA and a domestication under s. 388 of the Delaware General Corporation Law (“DGCL”). Under the DGCL, a corporation becomes domesticated in the State of Delaware by filing a certificate of corporate domestication and a certificate of incorporation with the Secretary of State of the State of Delaware. The domesticated corporation, which will be called Epsilon Energy, Inc., will become subject to the DGCL on the date of its domestication, but will be deemed for purposes of the DGCL to have commenced its existence in Delaware on the date it originally commenced existence in Canada. Upon listing on the Nasdaq Capital Market, Epsilon intends to apply to delist its common shares from the Toronto Stock Exchange.

Reasons for domestication

The domestication is intended to enhance shareholder value over the long-term by, among other things, improving its ability and flexibility to meet future equity and debt financing needs. In addition, its corporate offices and operations are located in the U.S. and a large percentage of its shareholders are located there.

Canadian tax consequences

S. 128.1(4)(b)

Upon the domestication, the Corporation will cease to be Canadian-resident corporation and its taxation year will be deemed to end immediately before that time. In addition, each property owned by the Corporation immediately before the deemed year end will be deemed to have been disposed of under s. 128.1(4)(b) for proceeds of disposition equal to its fair market value.

S. 219.1

The Corporation will also be subject to an additional tax under Part XIV on the amount by which the fair market value, immediately before its deemed year end resulting from the domestication, of all of the property owned by the Corporation exceeds the total of its liabilities and the paid-up capital of all the issued and outstanding shares of the Corporation immediately before the deemed year end. This additional tax is generally payable at the rate of 25%, but will be reduced to 5% under the Canada-U,S. Treaty unless it can reasonably be concluded that one of the main reasons for the Corporation becoming resident in the United States was to reduce the amount of such additional tax or Canadian withholding tax.

No expectation of exit tax

Management has advised that based upon the current fair market value of the properties of the Corporation, the tax costs of such properties, the aggregate of the paid-up capital of the shares and the liabilities of the Corporation, and the Corporation’s available capital and non-capital loss carryforwards, the domestication should result in no tax payment by the Corporation.

Epsilon shareholders

A Resident Shareholder will not be considered to have disposed of his or her common shares or to have realized a taxable capital gain or loss by reason only of the domestication. The domestication will not result in a disposition of a shareholder’s shares. Following the domestication, any dividends received by a Resident Shareholder on stock of Epsilon Energy, Inc. will be included in computing the shareholder’s income as U.S. source non-business income.

Dissenting shareholders

Based upon the limited guidance available in respect of the Canadian federal tax treatment of a dissenting Resident Shareholder who receives cash for shares following the domestication, the Canadian tax treatment of such a shareholder in such circumstances is not without doubt. However, it is expected that such amounts will constitute proceeds of disposition of stock of Epsilon Energy, Inc. of such a Resident Shareholder….

U.S. tax consequences

F or D reorg

The domestication will constitute a reorganization under s. 368(a)(1)(F), and generally will not represent a taxable transaction to the Corporation for U.S. federal income tax purposes, provided that holders of not more than 1% of the Corporation’s common shares entitled to vote on the transaction elect to exercise their dissenters’ rights. If the domestication does not qualify as an F reorganization for the reason stated above, it will qualify as a tax-free transaction under s. 368(a)(1)(D), unless the Corporation is required to use an amount of its assets to satisfy claims of dissenting shareholders which would prevent the Corporation from transferring substantially all of its assets to Epsilon Energy, Inc., the Delaware corporation.

S. 367 for 10% shareholders

Pursuant to the Treasury Regulations under Code s. 367, any U.S. shareholder that owns, directly or through attribution, 10% or more of the combined voting power of all classes of Epsilon’s stock of 10% or more of the total value of shares of all classes of its stock at the time of the domestication (a “10% shareholder”) will have to recognize a deemed dividend on the domestication equal to the “all earnings and profits amount”, within the meaning of Treasury Regulations s. 1.367(b)-2, attributable to such shareholder’s shares in the Corporation.

S. 367 for non-10% shareholders

Any U.S. shareholder that is not a 10% Shareholder but whose shares have a fair market value of less than $50,000 on the date of domestication, will recognize no gain or loss as a result of the domestication. A U.S. shareholder that is not a 10% Shareholder but whose shares have a fair market value of at least $50,000 on the date of the domestication must generally recognize gain (but not loss) on the domestication equal to the difference between the fair market value of the Epsilon Energy, Inc. common stock received at the time of the domestication over the shareholder’s tax basis in our shares. Such a shareholder, however, instead of recognizing gain, may elect to include in income as a deemed dividend the “all earnings and profits amount” attributable to its shares in the Corporation. Management believes that no U.S. shareholder of the Corporation should have a positive “all earnings and profits amount” attributable to such shareholder’s shares in the Corporation.

PFIC rules

The Corporation believes that it is not and has never been a PFIC. Accordingly, the domestication should not be a taxable event for any U.S. Holder based on an application of the PFIC rules.

Non-USRPHC status

Epsilon does not consider itself to be a USRPHC, i.e, it does not consider that the fair market value of its U.S. real property interest equals or exceeds 50% of the sum of the fair market value of its worldwide real estate real property interests and its other assets used or held for use in a trade or business.