On June 29, 2007, Tyco International Ltd. (“Tyco”) underwent a corporate reorganization that involved spinning off Tyco Electronics Ltd. (“Electronics”) and Covidien Ltd. (“Covidien”), and a stock consolidation.  This simple and common place corporate reorganization spawned a series of separate cases in the Tax Court of Canada (“TCC”) that examined whether the shares of Electronics and Covidien distributed to Tyco’s shareholders, pursuant to the reorganization, are taxable dividends in kind.  Although each of the four cases arose from a single corporate reorganization, the TCC arrived at two different sets of rulings.  Despite the different outcomes, these decisions actually reinforce the precedent that certain share distributions from foreign spin off transactions are not taxable as dividends in kind.

Background

Under the corporate reorganization, Tyco distributed to its shareholders one share in Electronics and Covidien for every four Tyco shares.  After this distribution, every four shares of Tyco were consolidated into one new share in Tyco.  Tyco’s press release about the corporate reorganization described the share distribution as a tax free dividend distribution in the U.S.  The taxpayers’ brokers treated the distribution as dividends and issued T5 forms to each taxpayer.

Each of the four Canadian resident taxpayers were shareholders of Tyco who received the shares of Electronics and Covidien, and had their respective holdings of Tyco shares reduced.  None of them included the fair market value of the shares received as income.

Tyco, Electronics and Covidien were all residents of Bermuda.  Since there is no tax treaty between Bermuda and Canada, the shares distributed did not qualify as an “eligible distribution” under paragraph 86.1(2)(d) of the Income Tax Act (“ITA”).  Canada Revenue Agency (“CRA”) reassessed the taxpayers and treated the shares in Electronics and Covidien as dividends in kind.  This increased the taxpayers’ income by the fair market value of the shares received.  All four taxpayers appealed to the TCC.

The TCC Decisions

At trial, the taxpayers argued that they did not receive any net economic benefit from the shares distributed.  In their view, the shares in Tyco were simply replaced by shares in Electronics and Covidien and the value of their overall shareholdings did not change.  Thus, they argued that there is no increase in income on which to levy a tax.  Conversely, CRA argued that the shares were taxable dividends in kind by virtue of section 90, paragraph 12(1)(k) and subsection 52(2) of the ITA.

In Capancini v. Canada[1] (“Capancini”), heard under the TCC informal procedure, the TCC rejected CRA’s categorization of the shares as dividends in kind.  Bowie J. held that the facts in this case were indistinguishable from the facts in Morasse v. The Queen[2] (“Morasse”).  Morasse is an earlier TCC decision, also heard under the informal procedure, that favored the taxpayer.

In Morasse, the taxpayer owned 400 American Depository Receipts of Telmex, a company resident in Mexico.  This company underwent a reorganization and spun off a business segment into a new company using a procedure unique to Mexican corporate law.  Prior to this, the business segment was never a separate corporate entity with issued and outstanding shares.  The shares in the new company were only created when the business segment was spun off.  As part of the reorganization, the shareholders of  Telmex received one share in the newly formed company for every share of Telmex.  In Morasse, the TCC ruled that the new shares distributed to the taxpayer were not stock dividends nor were the shares distributed in lieu of payment of dividends.  Furthermore, the judgment stated that the shares received were “not as part of any distribution of profits, but as recognition of a shift of capital”[3] from the Mexican company to the new company.

In Capancini, Bowie J. made a finding of fact that, just like the distributing company in Morasse, Tyco never owned the shares of Electronics and Covidien, which were only created as part of the reorganization.  According to Bowie J., the distributed shares in Electronics and Covidien were not dividends in kind “as is the case when a wholly owned subsidiary is spun off by a distribution of its shares to shareholders of the parent company”.[4]  Rather, the shares of Electronics and Covidien are part of the capital of Tyco albeit in a different form.  Consistent with Morasse, Bowie J. also ruled that the fact that the taxpayer’s broker described the shares received as stock dividends and issued a T5 form is not determinative of the issue.  Finally, Bowie J. defined “dividend” as a pro-rata distribution of a company’s profits to its shareholders.  He held that the shares distributed were not from Tyco’s profits, and hence, are not dividends.

Capancini was followed by three additional cases in the TCC, all relating to the same Tyco reorganization.  Arranged chronologically, these cases are Hamley v. Canada[5] (“Hamley”), Yang v. Canada[6] (“Yang”), and Rezayat v. Canada[7] (“Rezayat”).  Again, each case was heard under the informal procedure.  However, unlike Capancini, the TCC ruled against each of the three appellant taxpayers.  This is a curious result considering that the facts in each case were largely identical.

None of the three judges declined to follow Capancini or Morasse even though they had that option since the decisions from Capancini and Morasse were rendered under the informal procedure and are not binding precedents.  Instead, the basis used by the judges in Hamley, Yang and Rezayat to support their respective decisions was a different finding of fact than that in Capancini.  In all three cases, unlike Bowie J. in Capancini, the judges found that Tyco did indeed own all the shares of Electronics and Covidien prior to the reorganization and that the shares were distributed as part of the reorganization.  Therefore, the three judges ruled against the taxpayers and held that the distributed shares in Electronics and Covidien were dividends in kind.

McArthur J. in Rezayat stated that Bowie J. had a different and incomplete set of facts when he heard the appeal in Capancini.  McArthur J., and Sheridan J. in Yang, referred to multiple documents that pointed to Tyco’s ownership of shares in Electronics and Covidien.  For example, Sheridan J. referenced a decision of provincial securities regulators which included a representation by Tyco that Electronics and Covidien were fully owned subsidiaries, and a statement by Tyco that the distributions were dividends in kind.  Filings with the U.S. Securities and Exchange Commission show that Electronics and Covidien were incorporated and issued stock prior to March 20, 2007.

In addition, McArthur J. highlighted the timing and ordering of the transactions whereby a distribution of shares in Electronics and Covidien was followed by a consolidation of Tyco’s shares.  Based on this, McArthur J. concluded that the transactions were not an exchange or redemption.  He also held that there was no evidence that the shares were a return of capital.  Furthermore, McArthur J. disagreed with the taxpayer’s assertion that she did not receive an economic benefit from the distributions.  The consolidation of Tyco’s shares reduced the number of Tyco shares held by the taxpayer, but did not reduce her total adjusted cost base of those shares.  Thus, this will reduce the capital gain or increase the capital loss from any subsequent sale of the Tyco shares.   

Concluding Remarks

Even though the outcomes in Hamley, Yang and Rezayat differed from that in Capancini, all four cases support the precedent set in Morasse that shares distributed pursuant to a foreign spin off transaction is a dividend in kind only if the parent corporation owned the shares prior to the distribution.  Therefore, where a particular business or division of a corporation is spun off into a newly created corporation, the shares of which were not owned by the distributing corporation, the shareholders of the distributing corporation who acquire shares of the new corporation will likely not be taxed in Canada.  It is unclear how wide the scope of this exception will be in practice as it will depend on the structuring of spin-offs under foreign tax and corporate law.  For instance, under the U.S. tax regime, one of the requirements of a tax free spin off in the U.S. is that the corporation being spun off is controlled by the distributing corporation.  Thus, Canadian shareholders of a U.S. corporation who receive shares pursuant to a tax free spin off transaction in the U.S. will likely not benefit from the aforementioned TCC rulings.

While subsequent courts do not need to follow judgments from cases heard under the informal procedure, these decisions still carry persuasive authority.  This is evinced from the fact that the judges in Hamley, Yang and Rezayat chose to distinguish Capancini on the facts, rather than simply declining to follow Capancini.  Regardless, taxpayers should still be mindful of the risk that subsequent courts may depart from the precedent set in the aforementioned cases, especially if engaging in tax planning activities.