Subsection 55(3.1)

Exchange of shares to DC on permitted exchange (p. 3)

As a pre-distribution step in a typical spinoff butterfly, shareholders of the distributing corporation exchange their common shares in the distributing corporation for new common and preferred shares in the distributing corporation on a tax-deferred basis under subsection 51(1) or 86(1). Such an exchange is a "permitted exchange" under subsection 55(1), provided that it does not result in an acquisition of control of the distributing corporation. Thus, one presumes that the exchange is unobjectionable under the butterfly rules in section 55. However, the share exchange may technically infringe paragraph 55(3.1)(a). If that is the case, paragraph 55(3)(b) will not operate to prevent the application of subsection 55(2).

Application of s. 55(3.1)(a) to permitted exchange? (p. 3)

Paragraph 55(3.1)(a) will cause paragraph 55(3)(b) not to apply where, in contemplation of and before a distribution made in the course of the reorganization in which the dividend was received, property became property of the distributing corporation otherwise than as a result of certain enumerated exceptions, none of which appears to apply to a share exchange. Thus, whether paragraph 55(3.1)(a) will apply to the share exchange turns on whether the old shares become property of the distributing corporation.

Acquisition by DC on permitted exchange (p. 3)

[I]t appears that corporate law does not preclude the possibility of the old shares becoming property of the distributing corporation on the share exchange.

CRA position (p. 4)

Notwithstanding the analysis above, the CRA does not appear to consider a share exchange objectionable: it has issued favourable rulings in the past (9813073 (1998) and 9727303 (1998)) when a share exchange took place as a pre-distribution step in a spinoff butterfly. These rulings were given before the November 26, 2004 Department of Finance comfort letter was issued. That letter was the impetus for the exclusion of public corporations from the application of paragraph 55(3.1)(a).

Discussion of effect of contractual agreements on property-becoming-property test in s. 55(3.1)(a).

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).

Purpose of s. 55(3.1)(c) continuity-of-interest rule (p.3)

The underlying purpose of paragraph 55(3.1)(c) is to prevent a butterfly whereby a group of companies engages in a premeditated series of transactions that transfers assets from the distributing company (DC) to the transferee company (TC), with the intention, from the outset, of having the TC immediately sell those assets to an unrelated third party within the same series so that the shareholder can “cash out” or otherwise gain some type of tax benefit.

Technical issues (pp. 4-5)

Technical issues include:

• Regarding the connecting factor in s. 55(3.1)(c)(i) that (to disqualify the butterfly) requires that the property be acquired from TC by a non-related person in the same series of transactions or events as the butterfly, s. 248(10) “is broad enough to catch any transactions that have some connection, however remote, with the butterfly” so “that a very conservative interpretation could preclude the TC from ever disposing of property received in the butterfly to a non-related person because the series seemingly continues in perpetuity.”
• The carve-out from the above rule for dispositions of property to unrelated persons in the ordinary course of business creates difficulties of interpretation, for example, where “the taxpayer’s ‘ordinary business’ involves transactions that are large and relatively few in number.”
• Respecting the accessing of a further carve-out (which applies inter alia where the property that is disposed of to unrelated persons as part of the series constitutes less than 10% of the FMV of all of the butterflied property -- ignoring for these purposes, money and indebtedness), the property so disposed of cannot exceed 10% of the total value of the butterflied property at any time after the butterfly and prior to the end of the series – so that even if the FMV of certain property constituted, for example, 7% of the total FMV on the disposition date, it might exceed 10% of the total FMV at some point between the butterfly date and the disposition date, so as to put the butterfly offside.