Words and Phrases - "reorganization"
Foix v. The Queen, 2021 TCC 52, aff'd 2023 FCA 38
The shareholders of a private Canadian company (“W4N”) exploiting a valuable item of software had agreed in principle to sell W4N to a U.S. public company (“EMC”) for U.S.$50 million. However, EMC was amenable to a reorganization being implemented to permit the shareholders to extract the cash and investment type assets of W4N that were in excess of the needs of the business. The shareholder group consisted of (i) two unrelated individuals (Souty, and Foix – who held his shares through a passive portfolio company (“Virtuose”),) (ii) trusts for the two respective families (the Souty and Foix Trusts) and (iii) after giving effect to intricate preliminary transactions, two holding companies for Souty and Foix through which they held a portion of their shares of W4N (in the case of “Souty Holdco”) or of Virtuose (in the case of “Foix Holdco”). What was implemented were hybrid transactions in which there was both an asset sale by W4N to EMC, and a share sale by the Souty/Foix shareholder groups to a Canadian subsidiary (“EMC Canada”) of EMC.
In very general terms, the steps (which are described in greater detail in the pleadings than in the reasons for judgment) involved:
- The payment of safe income dividends by W4N to Souty Holdco and Virtuose, and by Virtuose to Foix Holdco, through stated capital increases by W4N and then Virtuose (thereby increasing the ACB of the affected shares under s. 53(1)(b).)
- Souty and Foix exchanging a portion of their shares of W4N or Virtuose for shares of a new class of the same corporation, and electing under s. 85(1) so as to realize a capital gain of $750,000 each, for which the s. 110.6 capital gains deduction was claimed.
- Souty Trust and Foix Trust selling shares of W4N to EMC Canada for notes of EMC Canada, with the resulting capital gains of $5 million (approximately equaling the proceeds) ultimately being distributed to various family beneficiaries.
- W4N selling its business assets to EMC for notes, thereby realizing a s. 14(1) eligible capital amount and an addition to its capital dividend account of $22 million, which was declared as a capital dividend to Souty Holdco and Virtuose – and then paid through a distribution of $22 million in notes immediately after step 5.
- Souty and Virtuose selling special voting shares of W4N to EMC Canada for nominal consideration so as to effect an acquisition of control of W4N and a resulting year end.
- The balance of the shares of W4N now being sold directly, or through a sale of the balance of the Virtuose shares, for cash consideration of over $15 million, such that Souty Holdco and Virtuose reported capital gains of around $4.7 million each (reflecting a reduction for the ACB bump in step 1), and modest capital gains were reported by Souty and Foix on the sale of their respective shares for about $0.8 million each (having regard to their purported s. 110.6 ACB step-up in step 2 to $0.75 million).
- EMC Canada, Virtuose and W4N then amalgamating, so that the Amalco received the cash and near-cash assets of W4N, consisting of a $22 million note owing by EMC (representing half of the sales proceeds from step 4 above) and cash and near-cash assets (including trade receivables and an investment tax credit receivable) of $4.5 million.
The requisite cash was paid on the closing, pursuant to step 6 and in repayment of the above notes (although Boyle J noted at para. 45(ii) that the sales agreement failed to in fact require that the note referred to in step 7 be repaid). CRA assessed on the basis that the $2.5 million received by Souty Trust in step 3 and the $0.8 million received by each of Souty and Foix in step 6 were deemed to be dividends under s. 84(2).
In finding that s. 84(2) applied to the sales proceeds received by the W4N shareholders, Boyle J first found that “funds or property” of W4N had been “distributed or otherwise appropriated in any manner whatever to or for the benefit of the shareholders,” stating (at paras. 58-60, 62-64, TaxInterpretations translation):
In general, the courts have taken a fungible approach to cash and cash equivalents held by a corporation, where there are structured, concurrent and interrelated indirect transactions, allowing them to be treated as indirect distributions made on the winding-up, discontinuance or reorganization of the business for the purposes of subsection 84(2) and its predecessor provisions. …
On all the facts of this case, as well as the language of subsection 84(2) and the way it has been interpreted and applied in the case law, it is clear that certain funds or property of W4N were distributed or otherwise appropriated to or for the benefit of its shareholders. ...
EMC either agreed or proposed that W4N's shareholders withdraw W4N's excess cash fairly early in the discussions and negotiations. …
I find that it was Messrs. Foix and Souty and their advisors who implemented and directed the transactional structure of the prior reorganization that constituted part of the sale transactions and which allowed the withdrawal of the excess cash indirectly from W4N to its shareholders.
As in RMM Equilease, EMC and EMC Canada, by virtue of their purchase of the business assets and shares of W4N, were the vehicles and intermediaries through which the distribution of W4N's funds or property to or for the benefit of its shareholders took place as a result of the earlier reorganization. This is the case even if, in the present case, they were not mere instruments for the accomplishment of those purposes in the transactions. It does not matter that EMC and EMC Canada had other very significant interests in the share and asset purchase agreement. This does not preclude them from being recognized and treated as instrumentalities for the purposes of the indirect distribution or appropriation.
It is clear that W4N's excess cash was used to finance and effect an indirect distribution to the appellants in a roundabout way, somewhat reminiscent of the arm's length sale transactions in Merritt.
The agreement between the parties specified that, following the closing, Amalco was not entitled to exploit the software that it had sold except for any sale of any use licences to Canadian customers and related maintenance services. After reviewing the Merritt, Smythe, MacDonald, Kennedy, McMullen and Descarries decisions in this regard and in finding that there also had been a reorganization of the business of W4N, Boyle J stated (at para. 73):
The transactions entered into pursuant to the share and asset purchase agreement, including the earlier reorganization, constituted a process that took place over a period of approximately five weeks, whereby W4N reorganized its business (and its financial structure) through a series of transactions, each of which was carried out in contemplation of the others. After the sale of W4N's business assets to EMC and W4N's shares to EMC Canada, and after the amalgamation of W4N to form the amalgamated company EMC Canada, the business of the former W4N was operated by the amalgamated company EMC Canada in a very different manner than it had been when Mr. Foix and Mr. Souty controlled W4N. The fact that EMC continued to use the purchased business assets in perhaps a similar manner is not relevant to this analysis. Subsection 84(2) refers to a single corporation, W4N, which became the amalgamated corporation EMC Canada. I found above that after the sale of its assets and shares, the business of W4N could not and did not continue to be operated as usual within the amalgamated corporation EMC Canada. In any event, the evidence before me does not permit me to conclude, on a balance of probabilities, that EMC continued to carry on the business of W4N in the same manner and form as W4N before it.
Christian Desjardins, Nik Diksic, "Cross-Border Butterflies in the Context of Public Spin-Off Transactions", 2015 CTF Annual Conference paper
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).
| Locations of other summaries | Wordcount | |
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| Tax Topics - Income Tax Act - Section 55 - Subsection 55(1) - Distribution | 1439 |
1996 Corporate Management Tax Conference Roundtable, Q. 16 (Canadian Tax Foundation), at 24:19
When does a reorganization end (that is, when are subsequent transactions considered part of the "reorganization" and when are they outside the "reorganization" or part of a second reorganization)? The Directorate responded:
[T]he 1994 amendments to the butterfly provisions made it clear that the word "reorganization" as it is now used in the context of section 55 is intended to have a narrower meaning than elsewhere in the Act. The rules in subsection 55(3.1) now specify the transactions that may and may not be carried out in contemplation of or after a butterfly distribution. Accordingly...the "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.
Thus the following transactions, occurring after a pro rata distribution and cross-redemption of shares, would normally not be considered to occur as part of the butterfly reorganization:
- an amalgamation of a transferee corporation with its parent;
- a winding up of a transferee corporation into its parent;
- a transfer of butterflied property by a transferee corporation a) to another shareholder of the distributing corporation; b) back to the distributing corporation; c) to its subsidiary; d) to a third party.
On the other hand, the reorganization would normally include all transfers of property by the distributing corporation to its corporate shareholders (or to corporations related to such shareholders), including taxable sales and dividends.
13 January 1993 External T.I. 5-923395
RC does not as a general rule express an opinion on the reasonableness of a method proposed to be used in arriving at the fair market value of a property at a particular point in time, and will become involved only after the fact if it considers the value assigned to the property to be unreasonable in the circumstances.
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| Tax Topics - Income Tax Act - 101-110 - Section 110 - Subsection 110(1.5) | 87 |
Kennedy v. MNR, 72 DTC 6357, [1972] CTC 429 (FCTD), aff'd 73 DTC 5359 (FCA)
A corporation of which the taxpayer was the sole shareholder purchased a property for use as the new site for its car dealership business, paid for some renovation work and then sold the property to the taxpayer at a price that was less than its total cost including that of the renovation work, with the property then being leased back to the corporation for use in its business.
Cattanach J. stated (at p. 6362):
"If an undertaking of some definite kind is being carried on but it is concluded that this undertaking should not be wound-up but should be continued in an altered form in such manner that substantially the same persons will continue to carry on the undertaking, that is what I understand to be a reorganization.
...
[T]he word 'reorganization' presupposes the conclusion of the conduct of the business in one form and its continuance in a different form.
In the Shorter Oxford Dictionary ... the words 'reorganization' is defined as 'a fresh organization' ... .
Here, there was no "fresh" organization as the same corporation continued the same business in the same manner in the same form - the sale by it of a capital asset did not result in the end of its business.
Accordingly, there was no "reorganization" of the business for purposes of s. 8(1) of the pre-1972 Act (now, s. 15(1)).