There has been a trend for a number of years for many public companies to seek to dispose of business operations that are outside of their core business or which otherwise are more appropriately owned by a separate public company, for example because their true value is not being reflected as part of a conglomerate. One way of doing this would be to arrange for an arm's length sale of the business to be disposed of (referred to herein as the "non-core business") and distribute the net proceeds of the sale to the corporation's shareholders (except to the extent that any of such proceeds are considered necessary to support the core business(es)). However, proceeding in this manner has at least three disadvantages:
- the process of finding a buyer willing to pay an acceptable price may be time consuming and expensive;
- such a sale and distribution generally leaves both the corporation and the shareholders exposed to tax depending upon the tax basis of the business that is sold and the share capital accounts for tax purposes;
- shareholders of the corporation who wish to continue to invest in the non-core business are denied the opportunity to do so otherwise than by investing in the acquirer corporation which may not be feasible.
As an alternative to the third party sale, a corporation (referred to herein as "Pubco") may effect some manner of spinoff of the business in a way that minimizes the tax cost to Pubco and the shareholders and allows the shareholders to continue to hold their pro rata interest in the corporation ("Subco") which owns the business to be disposed of. Two ways in which such a spinoff may be accomplished, and which have been pursued in the past number of years by various public corporations in Canada, are the "butterfly" spinoff transaction and the distribution by way of dividend in kind and/or reduction of capital to the shareholders of Pubco. The spinoff butterfly transaction is subject to a number of complex technical rules which must be met before, as part of, and after the butterfly spinoff. Details of these rules are outside the scope of this article which is intended merely to set out the essential structure of a public butterfly transaction where all such rules are complied with. The public spinoff butterfly is usually accomplished by a court mandated arrangement under the applicable corporate law statute (the "Arrangement"). Under the Arrangement the shareholders of Pubco transfer to a Canadian Newco shares of Pubco having a value equal to the value of the shares of Subco, on a rollover basis, for equity of Newco, and through a series of transactions which give rise to no immediate tax under the Income Tax Act (Canada) (the "Act"), Pubco transfers the shares of Subco to Newco for redeemable and retractable preferred shares ("Newco Preferred Shares"), also on a rollover basis. The shareholdings between Pubco and Newco are cancelled by way of issuance of demand non-interest bearing promissory notes to redeem/repurchase the inter-company shares for their fair market value, in the case of Newco to Pubco to redeem the Newco Preferred Shares, and in the case of Pubco, to Newco to repurchase/redeem the Pubco shares. The issuance of the promissory notes gives rise to tax-free inter-corporate dividends, and the promissory notes are satisfied by way of set-off. The equity in Newco is listed on an appropriate stock exchange such that upon completion of the Arrangement the shareholders of Pubco will hold shares in Pubco which continues to own the core business, and shares in the new public company, Newco, which owns all of the shares of Subco, which carries on the business that has been spun off.
The advantage of the spinoff butterfly transaction is that if carried out in accordance with the rules of the Act no tax is payable by Pubco or the shareholders. If desired an advance income tax ruling should be available from the Canada Revenue Agency ("CRA") in respect of the proposed spinoff.
The disadvantages of a spinoff butterfly transaction include the fact that Pubco does not receive any actual proceeds for the business disposed of plus the fact that the spinoff process may be relatively costly and will involve delays particularly where an advance income tax ruling is sought.
A dividend in kind of the shares of Subco to the shareholders of Pubco can be accomplished quickly and generally should not require the approval of the shareholders. However, under this option Pubco will be deemed to dispose of the shares of Subco for their fair market value with possible resulting capital gain, and the shareholders will be considered to receive a taxable dividend in an amount equal to the fair market value of the shares of Subco which they receive.
Where Pubco elects to sell Subco to a third party and distribute the after-tax proceeds to its shareholders, an alternative to paying a dividend is to distribute the net proceeds of sale as a reduction of capital of Pubco, to the extent that there is meaningful paid-up capital in the shares of Pubco, and rely upon the exception in subsection 84(4.1) of the Act for public company distributions of capital in the course of a reorganization, which provision will be amended by the October 24, 2012 draft Technical Amendments (the "Technical Amendments"). The Technical Amendments provide an exception to the general rule that a distribution by way of reduction of capital by a public company to its shareholders is deemed to be a taxable dividend. The Technical Amendments will expand the situations where a distribution by way of reduction of capital is not deemed to be a dividend, to include such a distribution where the distribution can reasonably be considered to be derived from proceeds realized from a transaction that did not occur in the ordinary course of the distributing corporation's business, and such proceeds were derived from a transaction that occurred no more than 24 months before such distribution.
Spinoff by Rights Offering
A fourth way of accomplishing a public company spinoff is by way of a rights offering. In that situation rights ("Rights") to purchase Subco common shares ("Subco shares") at a specified price would be issued pro rata to the shareholders of Pubco. Typically the Rights would have a fairly short expiry period consistent with their purpose. Where Subco is a public company a portion of whose common shares trade on a North American stock exchange, there will already be a public profile for Subco as well as a trading value for its shares. While this undoubtedly helps to make a Rights offering for shares of a Subco a success, a Rights offering for a private subsidiary should also be viable. In either case the Rights must be issued pursuant to a prospectus containing the usual detailed disclosure provided by that document.
A spinoff reorganization effected by Rights offering has certain advantages over the other three methods in the appropriate circumstances as follows:
- by disposing of the Subco shares through the exercise of Rights, Pubco receives payment of the exercise price of such Rights, potentially resulting in significant cash proceeds to be applied to its core business and to pay any taxes arising from the disposition;
- shareholders of Pubco are given the opportunity to fully maintain their pro rata indirect investment in Subco by exercising their Rights at a fair price;
- if by their terms the Rights are short-term and exercisable for a price that is equal to or greater than the fair market value of the shares of Subco at the time of their issuance, the shareholders of Subco may have little or no income inclusion as a result of the receipt of the Rights.
A major disadvantage from the point of view of Pubco is that the disposition of the shares of Subco pursuant to the exercise of the Rights and the payment of the exercise price will be a taxable disposition and therefore the "spinoff by rights offering" may only be attractive to Pubco where Pubco either has a relatively high cost base in the shares of Subco, or has available tax shelter, to shelter any resulting capital gain, for example shelter in the form of net capital losses. In such a case, the Rights offering if successful will provide Pubco with liquid proceeds for the Subco shares within a fairly short time frame. In order to ensure that Pubco receives a minimum amount for the Subco shares, or to ensure the complete disposition of the Subco shares, Pubco may enter into some form of backup commitment ("Backup Commitment"). Such a Backup Commitment is a commitment to acquire from Pubco any Subco shares for which the Rights expire unexercised, at the exercise price stipulated in the Rights. Typically the Backup Commitment would be with a related corporation forming part of the same corporate group.
The disadvantage for the shareholders is that they must pay in cash the full fair market value of the shares of Subco acquired on the exercise of the Rights.
Canadian Tax Consequences
Where a Canadian corporation such as Pubco distributes to the holders of its common shares Rights to acquire shares of a second corporation, Subco, on a pro rata basis, such distribution constitutes a taxable shareholder benefit to the extent of the fair market value of the Rights so distributed. A well-known exception to this rule only applies where the rights are to acquire common shares of the issuer corporation.
Provided that the exercise price of the Rights is not less than the fair market value of the Subco shares for which the Rights are exercisable, the fair market value of the Rights should generally be negligible given the short period within which they must be exercised before they expire. The actual exercise of such a Right to acquire Subco shares is a rollover under the Act pursuant to subsection 49(3) to a shareholder who acquired the Rights as capital property. Any amount required to be included in computing income as a result of the receipt of the Rights will be added to the exercice price in computing the cost to the Rights holder of the Subco shares acquired on exercise.
Subject to the potential inclusion in their income of a relatively limited amount in respect of the issuance of the Rights, a Rights offering as described above provides the common shareholders of Pubco with the opportunity to retain their pro rata underlying interest in Subco and its business by way of exercise of the Rights and payment of the exercise price. Following exercise of the Rights the holder will own publically traded securities of two corporations: the Subco shares acquired on exercise of the Rights and the holder's residual interest in the common shares of Pubco.
To the extent Rights are exercised, such a Rights offering will provide Pubco with consideration for its Subco shares which it would not have received under the alternatives of a butterfly transaction or a dividend-in-kind transaction. However, it must be noted that without a Backup Commitment such as described above that ensures the ultimate disposition of all of the Subco Shares held by Pubco, including those for which Rights expire unexercised, Pubco is not able to guarantee the complete disposition of its interest in Subco, which may be a significant drawback depending on the circumstances.