Corporate spin-off transactions have again become a preferred structure for companies to release shareholder value and achieve other business purposes. In a spin-off, the parent corporation (Pubco) divides the assets and liabilities of the firm and chooses the capital structure for the new stand-alone entity (Spinco).
Pubco may undertake a spin-off transaction to distribute corporate assets to its shareholders for various reasons. For example, Pubco may decide to divest itself of a business that becomes incompatible with, or diverts resources away from, its core business operations. Apart from allowing Pubco to focus on its core business activities, spinning off non-core business assets may enhance Pubco’s ability to obtain financing for its remaining business segments, and increase Pubco’s attractiveness to investors interested only in its core business. Spinning off distinct business operations or assets of Pubco can maximize shareholder value by simplifying the valuation of Pubco, allowing capital markets to more precisely compare Pubco with its industry competitors. It can also “unlock” the value of the assets that are spun off if, for example, their value was not fully reflected in the trading price of Pubco’s common shares.
There are several ways of implementing a corporate spin-off. Three common alternatives used in order to minimize tax consequences under the Income Tax Act (Canada) (ITA) are a butterfly transaction, a return of capital transaction, and a share capital reorganization transaction. Each of these alternatives is discussed in more detail below. In a butterfly transaction, Pubco shareholders transfer to Pubco a portion of their Pubco common shares in exchange for Spinco common shares. In a return of capital transaction, Pubco distributes Spinco common shares to its shareholders as a return of all or part of the stated capital of the shareholders’ existing Pubco common shares. In a share capital reorganization, Pubco shareholders exchange all of their existing Pubco common shares for Spinco common shares and a new class of Pubco common shares.
The preferred method of effecting a spin-off will depend upon the particular circumstances of Pubco and its shareholders, particularly Pubco’s tax position in relation to the assets to be distributed to its shareholders, and the tax position of Pubco’s shareholders, including whether Pubco has any non-resident shareholders that may be subject to foreign tax as a result of the spin-off. Determining the preferred method generally involves estimating and comparing the tax results under alternative methods, as well as considering the impact of corporate and other non-tax issues that may affect the spin-off process.
In this bulletin, we will describe the three tax effective methods Pubco may use to spin off corporate assets to arm’s length shareholders who hold their Pubco common shares as capital property, and discuss the circumstances in which one method may be preferred to the others.
A butterfly transaction allows Pubco to essentially divide itself into two public companies by distributing some of its assets to Spinco on a tax-deferred basis, with Pubco shareholders receiving common shares in Spinco in the same proportion as their ownership in Pubco. To achieve tax deferral for Spinco, Pubco and Pubco shareholders, the butterfly transaction must comply with complex technical rules in section 55 of the ITA, as supplemented by Canada Revenue Agency (CRA) administrative policy developed over a number of years. In a public company spin-off, it is not necessary that Spinco receive the same pro rata portion of each type of property (generally, cash, business property and investment property) owned by Pubco, but the shareholders of Pubco must receive the same pro rata shareholding in both Pubco and Spinco as they had in Pubco prior to the butterfly.
While the precise steps required to implement a butterfly will vary depending on the particular circumstances and may involve a pre-butterfly reorganization of the capital of Pubco, a butterfly transaction generally involves the following basic steps:
- The shareholders of Pubco exchange a percentage of their Pubco common shares for Spinco common shares on a fully tax-deferred basis (by automatic rollover under section 85.1) or on a partially tax-deferred basis (by filing a joint section 85 election). The share percentage is generally equal to the percentage, based on fair market value, of Pubco’s assets that are transferred to Spinco (see below).
- Pubco transfers assets to Spinco in exchange for non-voting preferred shares of Spinco with a redemption amount equal to the fair market value of the transferred assets. Pubco and Spinco jointly file an election under section 85 of the ITA so that the transfer occurs on a tax-deferred basis.
- Pubco purchases for cancellation the Pubco common shares acquired by Spinco by issuing to Spinco a promissory note equal to the fair market value of the Pubco common shares. The amount by which the purchase price exceeds the paid-up capital (PUC) of the Pubco common shares is deemed to be received by Spinco as a tax-free intercorporate dividend, and reduces Spinco’s proceeds of disposition of the Pubco common shares so that no capital gain arises on the disposition.
- Spinco redeems the Spinco preferred shares acquired by Pubco by issuing to Pubco a promissory note equal to the fair market value of the Spinco preferred shares. The tax consequences to Pubco on the redemption are the same as for Spinco on the purchase for cancellation of the Pubco common shares.
- The amounts owing under the Pubco and Spinco promissory notes are set off against each other and the notes are cancelled.
Numerous rules and prohibitions contained in section 55 of the ITA must be followed to ensure that the butterfly is tax effective for Spinco, Pubco and Pubco’s shareholders. Transactions entered into both before and after the completion of the butterfly transaction and which occur as part of the same “series of transactions” or “in contemplation” of the butterfly transaction can cause the butterfly to be taxable to Pubco or Spinco. Examples of transactions that may put the butterfly offside include share sales or acquisitions by a significant shareholder (generally a holder of 10% or more shares), an acquisition of control of either Pubco or Spinco, or the sale of a significant asset by either corporation. In addition, for three years after the spin-off, Pubco is prohibited from engaging in a split-up transaction, and Spinco is prohibited from engaging in a split-up transaction or a subsequent spin-off. Accordingly, even after the butterfly is completed, there remains a residual risk that the tax benefits of the butterfly could be denied if Pubco, Spinco or a significant shareholder carries out a prohibited transaction.
The rules in section 55 are complicated and if inadvertently violated, could result in Canadian tax consequences to Pubco (in respect of the gain on the assets spun off) and to Spinco (on the value of the acquired assets). Other tax considerations may also need to be considered, such as the application of other dividend deduction denial rules on the share redemption or share purchase for cancellation. Due to the complexity of the rules, the completion of a butterfly transaction is generally made conditional upon obtaining a favourable advance income tax ruling from the CRA confirming the intended tax consequences of the butterfly.
The advantage of a butterfly transaction over other spin-off methods is the ability for Pubco, as well as its shareholders, to obtain tax-deferred treatment on the distribution of assets. If there is no accrued gain in the Pubco assets to be spun off, or Pubco is able to shelter the resulting gain, then another spin-off method which achieves tax deferral for Pubco’s shareholders may be preferable, to avoid subjecting Pubco, Spinco and the shareholders to the onerous section 55 restrictions. In other circumstances, it may not be possible or practical to comply with the rules in section 55, such as where the purpose of the spin-off is to facilitate an acquisition of control of Pubco or Spinco following the spin-off, or significant shareholders of Pubco do not want to be restricted from disposing of their Spinco common shares for a period of time following the butterfly. In such cases, it may be preferable for Pubco to use an alternative method of spinning off assets on a tax-deferred basis to its shareholders.
RETURN OF CAPITAL TRANSACTION
A return of capital transaction is the simplest of the three methods from a Canadian income tax perspective. As a preliminary step of the return of capital transaction, certain of the business assets of Pubco may need to be transferred to Spinco on a tax efficient basis. Under this method, Pubco reduces the corporate stated capital of its common shares by an amount equal to the fair market value of the Spinco common shares, and distributes the Spinco common shares on a pro rata basis to its shareholders.
The return of capital method would be a viable option where the Pubco common shares have a high stated capital and high PUC in relation to the fair market value of the assets to be spun off so as to permit a distribution of Spinco common shares to Pubco’s shareholders to be treated entirely as a return of capital on their existing Pubco common shares. In considering this alternative, keep in mind that a Pubco’s stated capital may not necessarily equal its PUC and, in fact, could be a greater amount if Pubco has issued its share capital as part of a share or property exchange.
To ensure that a return of capital is not treated as a taxable dividend, the reduction of capital must be effected on the winding-up, discontinuance or reorganization of the company’s business under subsection 84(2) or on a share exchange to which section 86 applies (such as the share capital reorganization discussed below). The CRA has issued a number of favorable advance tax rulings on return of capital spin-offs qualifying as reorganizations under subsection 84(2). A proposal to amend subsection 84(4.1), which would generally apply to amounts paid after 1996, provides a third exception to taxable dividend treatment where the payment is derived from proceeds of disposition realized by Pubco (or another entity in which Pubco has an interest) from a transaction that occurred outside the ordinary course of the business of Pubco (or that other entity) and the payment is made within 24 months after the completion of that non-ordinary course transaction.
On a return of capital, the adjusted cost base (ACB) and PUC of the Pubco common shares held by a Pubco shareholder are generally reduced by an amount equal to the fair market value of the Spinco common shares. If that reduction exceeds the shareholder’s ACB of the shares, the shareholder is deemed to realize a capital gain equal to the amount of the excess. The same amount is then added back to the shareholder’s ACB to avoid double taxation on a future disposition of the shares. Although the Pubco shareholders will not have “paid” for the Spinco shares, several CRA rulings have confirmed that such shares are acquired at a cost equal to their fair market value.
No rollover is available to Pubco under the return of capital method, so Pubco would be deemed to have disposed of the assets spun off to its shareholders for proceeds equal to their fair market value. Accordingly, Pubco would realize any accrued gain (or loss, subject to the application of stop-loss rules) on the assets distributed to the extent that the fair market value of the assets exceeds (or is less than) the ACB of the assets to Pubco.
The main advantage of a return of capital transaction is that the mechanics of implementing the transaction are simpler than for a butterfly or a share capital reorganization transaction. Consequently, unlike butterfly transactions, many return of capital transactions are implemented without first obtaining a favourable CRA advance income tax ruling. A return of capital may be the preferred method where either the spin-off would not result in a taxable gain for Pubco or a gain realized by Pubco on the spin-off could be sheltered by other tax attributes (such as unused losses) available to Pubco. Meeting the requirements of the proposed exception in subsection 84(4.1) is fairly easy in most cases since return of capital transactions are typically effected under a Plan of Arrangement or implemented pursuant to a special resolution of the shareholders of Pubco. However, since the proposed exception has not yet been enacted, a return of capital transaction may be structured so that it also qualifies for the exception under subsection 84(2) as a “reorganization” of Pubco’s business, with the return of capital occurring “on” that reorganization.
SHARE CAPITAL REORGANIZATION
As a preliminary step of the reorganization, Pubco may need to transfer certain assets to Spinco on a tax-efficient basis. Under this spin-off method, Pubco’s shareholders exchange all of their existing Pubco common shares for a combination of a new class of Pubco shares and Spinco common shares. Section 86 of the ITA provides a rollover to a Pubco shareholder (whether Canadian resident or non-resident) on the share exchange if all of the following requirements are met:
- The share exchange occurs in the course of a reorganization of the capital of Pubco (the amendment of Pubco’s articles to create a new class of Pubco shares would generally satisfy this requirement);
- The shareholder holds the existing Pubco common shares as capital property; and
- On the exchange, the Pubco shareholder disposes of all of the Pubco common shares held by it and receives from Pubco other shares of Pubco.
If section 86 applies to the share exchange, a Pubco shareholder is deemed to have received the Spinco common shares at a cost equal to their fair market value, and to have received the new Pubco common shares at a cost equal to the excess (if any) of the ACB of the old Pubco common shares over the fair market value of the Spinco common shares. Further, the shareholder is deemed to have disposed of the old Pubco common shares for proceeds of disposition equal to the aggregate cost of the new Pubco common shares and the Spinco common shares.
On a share capital reorganization spin-off, a Pubco shareholder would generally receive a full automatic rollover on the exchange unless the fair market value of the Spinco common shares exceeds the shareholder’s ACB of the old Pubco common shares. In that case, the shareholder’s proceeds of disposition of the old Pubco shares, which would equal the fair market value of the Spinco common shares, would exceed the ACB of those shares, triggering a capital gain.
Similarly, a Pubco shareholder would not realize a deemed dividend on the exchange unless the fair market value of the Spinco common shares exceeds the PUC of the old Pubco shares. If a deemed dividend arises, it would reduce the amount of any capital gain that may be realized by the shareholder on the disposition of the old Pubco common shares.
Since Pubco shareholders generally would not realize a capital gain (or deemed dividend) on a share capital reorganization unless the fair market value of their Spinco common shares exceeds the ACB (or PUC) of the old Pubco shares disposed of, the tax consequences to Pubco shareholders of this method and the return of capital method are similar. As is the case with the return of capital method, no rollover is available to Pubco under the share capital reorganization method, so Pubco would realize a capital gain to the extent that the fair market value of the assets spun off exceeds the assets’ ACB to Pubco and it cannot otherwise shelter the gain.
A share capital reorganization transaction is often the preferred method to effect a corporate spin-off in conjunction with a merger and acquisition transaction. While a share capital reorganization is a more complicated transaction to implement than a return of capital, it is normally completed without obtaining an advance income tax ruling from the CRA, which saves both cost and time in implementing the spin-off. As with the return of capital method, it may be the favoured method where either the distribution of Spinco common shares would not result in a taxable gain for Pubco or a gain realized by Pubco on the distribution of Spinco common shares could be sheltered by other tax attributes (such as unused losses) available to Pubco.
Where there is insufficient PUC in the Pubco common shares to allow the Spinco common shares to be distributed without triggering a deemed dividend under this method or the return of capital method, or if a significant number of Pubco shareholders hold their Pubco common shares at an ACB that is significantly less than the fair market value of the Spinco common shares, a butterfly transaction will be the preferred spin-off method if it is feasible to carry out.
OTHER STRUCTURING CONSIDERATIONS
Regardless of the method used to implement a spin-off, a key issue for Pubco will be to accurately determine the fair market value of the assets which are spun off, since that value will determine the tax consequences to Pubco on the disposition of the spun off assets, as well as the tax cost to Pubco’s shareholders of the Spinco common shares and the amount of any deemed dividend and/or capital gain potentially arising on the spin-off transaction. Another important consideration will be to ensure that Spinco qualifies as a public corporation under the ITA so that its shares are qualified investments for any tax-deferred plan shareholders (such as RRSPs).
Other tax considerations that may be relevant in structuring a spin-off of Pubco may include the effect of the spin-off on any outstanding stock options or convertible securities such as warrants or convertible debt of Pubco. Where Pubco has non-resident shareholders, a relevant consideration will be whether, and to what extent, the spin-off may be a taxable transaction in the non-residents’ taxing jurisdictions. Also, Pubco may become subject to Part XIII non-resident withholding tax reporting and remittance obligations on the spin-off if a dividend is deemed to be received by its non-resident shareholders under either the return of capital method or the share capital reorganization method.
From a corporate and securities law perspective, a butterfly transaction and a share capital reorganization transaction are effected by a Plan of Arrangement, which generally requires approval by 66-2/3% of the votes attached to the Pubco common shares, as well as court and securities regulatory approvals. A Plan of Arrangement may also be used to effect a return of capital where, for example, the return of capital is carried out in conjunction with another transaction, or Pubco must satisfy U.S. securities law disclosure requirements in respect of its U.S. shareholders.