US and other foreign acquirers continue to be active suitors for Canadian businesses. Often these buyers wish to pay for the target company with their shares or a combination of shares and cash. And many Canadian sellers are more than happy to take share consideration, particularly where the foreign buyer has attractive growth prospects.
However, Canadian sellers invariably do not want to pay tax on the shares they receive, at least not immediately. In many cases, that would result in their having to sell the shares in order to pay the tax. As a result, such U.S., UK, EU and other cross-border share exchange transactions are commonly structured to provide Canadian sellers with exchangeable shares, deferring the capital gains tax that the sellers would otherwise have to pay until the exchangeable shares are exchanged for shares of the foreign acquirer.
While the exchangeable share structure is essentially just a veneer on the underlying share purchase transaction, it definitely adds complexity to the transaction. Much of the complexity arises as a result of the sellers wanting their exchangeable shares to be equivalent to the shares of the buyer.
This article discusses:
- the options available to enable Canadian sellers to vote their exchangeable shares at buyer shareholder meetings
- the need to consider additional special voting rights to maintain the "Canadian-controlled private corporation" (CCPC) status of the target Canadian company.
Structure of an Exchangeable Share Transaction
In a typical exchangeable share transaction, the non-Canadian acquirer (Buyer) incorporates a Canadian subsidiary (Exchangeco) to acquire all of the shares (Target Shares) of a Canadian company (Target) from the Canadian resident shareholders (Sellers). Exchangeco acquires the Target Shares on a roll-over basis in exchange for non-voting exchangeable shares of Exchangeco (Exchangeable Shares) and the Exchangeable Shares are eventually exchanged for voting common stock of the Buyer (Buyer Shares). The effect of the transaction is to defer the capital gains tax otherwise payable by the Sellers at the time of sale until the Exchangeable Shares are exchanged for Buyer Shares.
Exchangeable Shares are generally structured to be the economic and voting equivalent of the Buyer Shares, allowing the Sellers to participate in the economic success and governance of the Buyer as though they had actually received Buyer Shares. Therefore, it is typical in exchangeable share transactions for the Buyer to provide "ancillary rights" to the Sellers, including dividends equal to those paid to holders of Buyer Shares, shareholder information, anti-dilution rights, automatic exchange rights in certain circumstances and, most relevant for purposes of this article, the ability to vote the Exchangeable Shares with common stock of the Buyer at annual or special meetings of the Buyer.
Note that in cases where the Target is small relative to the Buyer, the Sellers may not insist on voting rights. Notwithstanding, where the Buyer is a U.S. corporation, there may well be sufficient tax and other benefits to the Buyer (e.g., under Internal Revenue Code Section 338(g)) for the Buyer to require the Sellers to receive voting rights at the time that the Exchangeable Shares are issued.
Voting Rights for Sellers
One common way for Sellers holding Exchangeable Shares to obtain voting rights at Buyer shareholder meetings is through the issuance of a single special voting share of the Buyer carrying a number of votes in the Buyer equal to the number of outstanding Exchangeable Shares from time to time (i.e., as the Sellers' Exchangeable Shares are exchanged, the number of votes exercisable by the Sellers correspondingly decreases). The special voting share is typically issued to a voting trustee which exercises the votes pursuant to a voting trust agreement in accordance with the respective instructions of each Seller. The voting trust agreement also usually permits a Seller to obtain a proxy to vote in person at a Buyer shareholder meeting.
The voting trustee approach, while convenient where there are many Sellers, adds fees and administrative complexity to the cross-border structure (for example, often a corporate trustee is retained). To reduce these costs, in situations where there are very few Sellers or where one of the Sellers holds a majority of the Target Shares, one of the Sellers may agree to act, without charge and with appropriate indemnification, as voting trustee for the Sellers.
An alternative to the voting trustee approach is the issue by the Buyer to the Sellers of one voting share of the Buyer for each Exchangeable Share issued to them on completion of the exchangeable share transaction. The share conditions for this class of voting share should provide that:
- the voting shares have no rights other than voting at Buyer shareholder meetings (unless they are a series of preferred shares and therefore require an additional preferential right (e.g., payment of a nominal aggregate amount on liquidation))
- the voting shares are subject to automatic repurchase or redemption for nil consideration as Exchangeable Shares are exchanged for Buyer Shares in order to maintain the one to one ratio between the outstanding Exchangeable Shares and the voting shares.
It should be noted that in each of the above cases the Buyer will be required to issue a new class of voting shares prior to the closing of the exchangeable share transaction. However, creating a new class of shares generally requires shareholder approval which may not be economically practicable or even possible on a timely basis, particularly where the Buyer is a public company. Timing will not be a problem where the Buyer has previously received shareholder approval for the creation of a class of "blank check preferred stock", whose terms and conditions may be expressly determined by the Buyer's board of directors in its discretion. In such case, a series of these preferred shares can be authorized and issued without further recourse to the Buyer's shareholders for use as either a single special voting share or a number of voting shares equal to the number of Exchangeable Shares.
Depending on the relative sizes of the Buyer and Target, the Sellers may acquire a material future ownership interest in the Buyer as a result of the exchangeable share transaction. The Sellers may therefore wish to obtain some immediate control over the corporate governance and business of the Buyer. In such case, the Sellers may request certain rights including, for example, the right to elect one or more members of the board of directors of the Buyer and, possibly, the right to veto certain material corporate actions and business decisions of the Buyer. These rights can be enshrined in the share provisions for the voting shares.
CCPC Status of Target
The foregoing discussion has focused on issues arising in connection with voting by Sellers at Buyer shareholder meetings. Another potentially important issue arises as a result of the change of control of the Target following its acquisition by the Buyer (note that this issue arises whether or not an exchangeable share structure is used). In particular, where the Target is a "Canadian-controlled private corporation" (CCPC), it is, among other things, eligible to receive investment tax credits for scientific research and experimental development (SRED) at a favourable rate, as a percentage of the SRED's, and on a refundable basis. Since the Buyer will control the Target through Exchangeco after completion of the transaction, the Target will no longer be a CCPC with the result that the refundable feature will be lost and the rate of the tax credit will be reduced.
Therefore, where these SRED benefits are substantial, consideration should be given to structuring the exchangeable share transaction to try to preserve the Target's CCPC status. For example, a possible approach might be for Exchangeco to issue a multiple voting share to an independent but friendly Canadian resident that gives the Canadian resident voting control of Exchangeco. However, any such action should first be discussed with tax advisors.