While every transaction presents its own unique facts and circumstances, certain themes arise more frequently than others. This holds true when it comes to non-Canadian buyers seeking to buy the shares of a Canadian corporation. Below we explore five key tax issues commonly seen with these types of transactions.
Issue 1: Canadian Acquisition Entity
It is typical for buyers to establish a Canadian acquisition corporation to effect the acquisition of a target company rather than the buyer acquiring shares directly. There are several reasons for using such a structure. For the purposes of this topic, we will refer to the Canadian acquisition corporation as “Acquireco.”
First, to the extent that Acquireco is funded with equity, the corporate stated capital (or “paid-up capital” for tax purposes) will be established at an amount equal the purchase price. This cross-border capital can be important in deferring Canadian withholding tax on future distributions out of Canada. In particular, an amount equal to this cross-border capital can be extracted from Canada free of Canadian withholding tax. This is important given Canadian tax rules generally allow a corporation to distribute paid-up capital ahead of retained earnings or other corporate surplus. If the buyer otherwise directly acquired the target’s shares, the amount of cross-border capital would generally be limited to the historical paid-up capital of the target, which is often less than the current fair market value of the shares of the target. Moreover, in some circumstances, there may be uncertainty regarding the amount of the existing capital of the target (e.g., where the target has a history of multiple mergers or similar transactions that would require a tracing of paid-up capital through a number of entities).
Second, where the seller holds non-depreciable capital properties, such as shares of subsidiaries (including foreign affiliates), dissolving or vertically amalgamating the seller into Acquireco may allow the buyer to increase (or “bump”) the cost of those properties up to the lesser of fair market value and the purchase price. This bump is not available where the buyer acquires the shares of the target directly. The bump allows the buyer to subsequently sell off or repatriate those properties without any Canadian withholding tax or any Canadian taxation for any gains accrued prior to the acquisition date. As a general matter, the bump is not available where the consideration includes stock of the buyer (unless the target represents less than 10 per cent of the capital of the buyer).
Third, subject to the capitalization issues discussed below, by using Acquireco, the buyer can introduce leverage into the target by capitalizing Acquireco with the desired levels of debt and equity to fund the purchase price. The interest deductions associated with such debt can then be effectively shifted into the target operations by having it dissolve into, or vertically amalgamate with, Acquireco following closing. If the buyer were to acquire the shares directly, there may be limitations in the ability to recapitalize equity into debt following closing and obtain the associated interest deductions.
Issue 2: Offshore Holding Entity
Depending on the buyer’s jurisdiction of residence, it may be desirable to effect an acquisition through companies residing in certain jurisdictions that have favourable tax treaties with Canada. For example, a buyer resident in a jurisdiction with which Canada does not have a tax treaty would generally be exposed to Canadian withholding tax at a rate of 25 per cent for dividends or interest paid by the Canadian corporation to the buyer. By utilizing a holding entity in a treaty jurisdiction, it is generally possible to reduce the withholding tax on dividends to 15 per cent or even 5 per cent, and in the case of interest, to 10 per cent (and in one case, zero). In addition, where it is expected the Canadian corporation will derive its value principally from real property located in Canada (including resource related rights), Luxembourg or Dutch holding structures have historically exempted any gain on an ultimate sale from Canadian taxation. Absent this exemption Canada would generally be entitled to tax any gains realized by the buyer on a sale of the Canadian entity.
In considering such a structure, there needs to be an analysis of an appropriate jurisdiction. The most common jurisdictions (such as Luxembourg and the Netherlands) are those that impose little to no tax on interest, dividend, gain or other income that may be realized by the shareholder.
In order to substantiate the use of these structures, residency in the treaty jurisdiction must be established and maintained, and the offshore entity must be the beneficial owner of the investment in the Canadian entity. Proper attention to detail in establishing and operating the offshore entity is critical in this regard.
Holding company structures have come into renewed focus by Canada and the OECD. A multilateral treaty on perceived abusive treaty-shopping was signed earlier this year that, once ratified, will introduce a treaty-entitlement test in a large number of Canada’s tax treaties. The base case in this regard is referred to as the “principal purpose test,” which provides that the benefits of an applicable tax treaty will be denied where one of the principal purposes of the taxpayer in establishing the entity was to access the benefits of the particular treaty. While there is certainly some ambiguity in how this test will be interpreted in practice, these rules will require thoughtful analysis to ensure any intended treaty benefits can be realized.
Issue 3: Capitalization
How a Canadian business is capitalized is an important aspect of tax planning and optimization for buyers.
Canada, like many sophisticated tax regimes (particularly those with extensive inbound investment), has so-called thin-capitalization rules to ensure Canadian business operations are not excessively levered. These rules limit the extent to which business profits can be extracted as deductible interest payments rather than being taxed at the Canadian corporate level. Generally, these rules limit the amount of debt to a 1.5:1 ratio, such that the amount of non-resident related-party debt in the Canadian entity cannot exceed one and one-half times the equity position of the non-resident controlling shareholder. Equity for these purposes includes invested equity (paid-up capital) as well the retained earnings of the Canadian entity and any corporate surplus. The test is measured on a monthly basis, so parties must be mindful of capitalization ratios on an ongoing basis, particularly if the leverage is close to the prescribed limit. Where the thin-capitalization restrictions apply, the interest payable on any debt over and above the limit is not deductible to the Canadian entity, and that excess amount is deemed to be a dividend rather than interest which may impact the withholding tax rate applicable to such payments.
Generally, loans from arm’s length parties would be excluded from the thin-capitalization limits. However, to prevent potential abuses, there are back-to-back rules that must be considered. These rules would generally attribute any loan from a direct lender to the “ultimate funder” where a non-resident has made a deposit or other advance to the lender on condition that the lender make the loan to the Canadian entity, or where the lender has some right in respect of such non-resident that would provide protection in respect of the loan to the Canadian entity (such as a right to some other property, or a right to put the loan to the ultimate funder). The legislation does not generally apply where a foreign parent simply guarantees a debt of the Canadian entity. These back-to-back rules can apply not only for thin-capitalization purposes, but also to arrangements that might reduce the rate of withholding tax on interest, lease or royalty payments out of Canada.
Issue 4: Foreign Affiliate Issues
Where the assets of a Canadian target include shares of non-Canadian subsidiaries (foreign affiliates), additional tax considerations arise.
First, it would generally be tax inefficient for the buyer to want to hold non-Canadian subsidiaries through a Canadian entity. Consequently, where there is material value in the foreign affiliates of the target, the buyer would typically want to extract those foreign affiliates from Canada and either reorganize or combine such entities into its own corporate structure. The most tax efficient means of achieving this extraction would be through the use of the bump, described above. If a bump is not available, then consideration can be given to extracting those foreign affiliates that are not in significant accrued gain positions, or to the extent that any such gains could be sheltered with tax attributes of the target.
Second, certain rules, referred to as the foreign affiliate dumping (FAD) rules, were introduced to address perceived overleveraging of Canadian business operations by foreign multinationals. Given Canada’s favourable treatment of the active business earnings of foreign affiliates resident in designated treaty countries, it was attractive for foreign multinationals to transfer certain foreign affiliate investments under their Canadian subsidiaries using debt such that the interest on that debt could be used to shelter Canadian operating profits. The FAD rules can now give rise to a deemed dividend out of Canada where a Canadian subsidiary controlled for a foreign corporation makes an investment in a foreign subsidiary. Where more than 75 per cent of the seller’s value is derived from foreign affiliates, the acquisition itself is considered an “investment” for these purposes, such that consideration of the FAD rules needs to occur as part of the acquisition itself. These rules provide another incentive for planning to extract foreign subsidiaries out of Canada in connection with an acquisition. If that cannot be done, future investment in the foreign subsidiaries should be structured to avoid any deemed dividends under these rules.
Issue 5: Dealing with Incentive Plans
An issue that inevitably draws additional scrutiny of target management and directors in the case of a proposed acquisition is the treatment of any outstanding incentive rights, as well as what new incentive rights will be offered to those individuals that may continue with the business after the acquisition is completed.
The most typical issue in this regard relates to the exercise or termination of employee stock options and ensuring that the capital gains-like treatment afforded to typical stock options is not jeopardized. Canadian tax rules also provide for rollover treatment for existing stock options (where the new options are issued by a related Canadian or foreign buyer), provided that there is no increase in the “in-the-money” amount of the options on the exchange. Issues can arise where the buyer is not offering to acquire all or substantially all of the stock of the target (such as where existing management or some other significant shareholder retains an interest in the target following the acquisition), and further consideration may be required if this is case.
With respect to new incentives to be offered to continuing employees, tax issues generally arise as the incentives offered by the buyer may not be tax effective for Canadians. For example, the concept of restricted stock is quite common in the U.S., but the same incentive would be taxed quite inefficiently in Canada. Planning in this area typically involves determining what changes, if any, are required to the incentives usually offered by the buyer to preserve elements of Canadian tax efficiency without impairing the underlying commercial objectives associated with the particular incentive.