Divisive Reorganizations

Brian R. Carr
Moskowitz + Meredith/ KPMG

May 30, 2011

Introduction

2
Diagram I

Mr. A Ms. B

60% 40%

Corporation X

100% 100%

Subsidiary Y Subsidiary Z

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Diagram II – “SPLIT-UP”

Mr. A Ms. B

Subsidiary Y Subsidiary Z

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Diagram III

SHAREHOLDERS

CP LIMITED
$10
$30
$20 $25 $15

Canadian Canadian
PanCanadian
Pacific Pacific CP Ships
Petroleum Fording Inc.
Railway Hotels and Limited
Limited
Company Resorts Inc.

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Diagram IV – “SPIN-OFF”

SHAREHOLDERS

$30 $10
$20 $25 $15

Canadian Canadian
PanCanadian
Pacific Pacific CP Ships
Petroleum Fording Inc.
Railway Hotels and Limited
Limited
Company Resorts Inc.

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Development of Butterflies

an exception to an anti-
avoidance rule

Development of Butterflies
Act does not permit a direct
distribution of assets to a
shareholder on a tax-
deferred basis

no complete code
specifying how to
implement a butterfly

7
The Missing Provision - Diagram V

Mr. A Ms. B
360 common shares 240 common shares
P.U.C. $1/share P.U.C. $1/share

Corporation X
ACB - $360 ACB - $240
FMV - $600 FMV - $400

Subsidiary Y Subsidiary Z

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Diagram VI

Mr. A Ms. B

Corporation B
360 common shares
P.U.C. $1/share

Corporation X
ACB - $240
F.M.V. - $400

Subsidiary Y Subsidiary Z

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Building Blocks

Relevant Provisions
Subsection 85(1)
Subsection 85(2.1)
Subsection 112(1)
Subsection 84(3)
Subsection 52(2)
Subsection 85.1
Section 86
Subsection 55(2)

Not Covered
Part IV
Part IV.I
Part VI.I

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Ss. 85(1): Example 1 – Diagram VII

Corporation X

Common Common
Shares Shares

Corporation B Corporation A

Preferred Shares
Fair Market Value - $1,000 Fair Market Value - $1,000 Fair Market Value - $1,000
Adjusted Cost Base - $ 600 Paid-up Capital - $ 600 Adjusted Cost Base - $ 600
Adjusted Cost Base - $ 600
After Transfer Before Transfer

Shares of CIBC
Shares of CIBC
and Other Assets

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Ss. 84(3): Example 2

Deemed Dividend $ 400

(84(3))
Subsection 112(1)
Proceeds of Disposition $ 600
Capital Gain $ 0
Cost of Promissory Note $1,000
Subsection 52(2)

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Diagram VIII

Corporation X

Corporation B Corporation A

Fair Market Value - $1,000

Adjusted Cost Base - $600

$1,000 Note of
Shares of CIBC Corporation B
and Other Assets

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Diagram IX

Shareholders

Corporation A

Shares of CIBC
and Other Assets

14
Diagram X

Shareholders

Corporation B Corporation A

Shares of CIBC
and Other Assets

15
Diagram XI

Shareholders

Common
Common or
Class B Shares

Corporation B Corporation A
Preferred Shares

Shares of CIBC Other Assets

16
Diagram XII

Shareholders

Corporation B Corporation A

Shares of CIBC Other Assets

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Example 3 - Diagram XIII

Corporation A Corporation B
Retraction Amount - $1,000,000
Paid-Up Capital - $600,000
Adjusted Cost Base - $600,000

Tax Cost - $600,000

Division

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Divisive Reorganizations

Abuses

Can’t cash out

Subsection 55(2)

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Subsection 55(2)

•Stops abuses
•Dividend deemed not to be a
dividend
•Where shares are sold
•Deemed to be proceeds of
disposition
•Where shares not disposed of
•Deemed to be a gain

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Subsection 55(2) – cont’d

Does not apply to safe income

Does not apply to that portion of

the dividend that is subject to

Part IV tax

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Diagram XIV

Mr. A. Ms. B.

Corporation B

Corporation X

Corporation Y Corporation Z

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Diagram XV

Ms. B.
ACB - $240
PUC - $240
Mr. A. FMC - $400

Corporation B

Corporation X
Subco B

ACB - $240
PUC - $240
FMC - $400

Subsidiary Y Subsidiary Z

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Diagram XVI

Mr. A. Ms. B.

Corporation B

Corporation X

Preferred
Shares
ACB - $240
PUC - $240
FMV - $400 Subco B

Subsidiary Y

Subsidiary Z

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Diagram XVII

Mr. A. Ms. B.

Corporation B

Corporation X

$400 note of Subco B

SubCo B

Subsidiary Y Subsidiary Z

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Diagram XVIII

Mr. A Ms. B

Corporation A Corporation B

Subsidiary Y Subsidiary Z

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Diagram XIX

Ms. B.

Mr. A.
Corporation B
240 preference shares
PUC - $240
ACB - $400

Corporation X

Subsidiary Y Subsidiary Z

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Diagram XX

Ms. B.
Mr. A.
Corporation B

Corporation X
Subsidiary Z

Subsidiary Y Note of
Corporation B

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Diagram XXI

Mr. A. Ms. B.

Corporation X Corporation B

Subsidiary Y Subsidiary Z

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Diagram XXII

Shareholders

$40

CP Limited

$30

$10
Canadian Pacific
Railway
CP Ships Limited Company

30
Diagram XXIII

CP Limited $30
Common
Shares Class B Shares
$10
$10
Newco CP Limited

Class A Shares
$10 $30

CP Ships Limited
Canadian Pacific
Railway Company

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Diagram XXIV

Shareholders

Class A Shares
Newco CP Limited

Preferred Shares

Canadian Pacific
Railway Company
CP Ships Limited

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Diagram XXV

Shareholders

CP Limited
Newco

Notes of CP Limited Notes of

Newco

Canadian
CP Ships Limited Pacific Railway
Company

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Diagram XXVI

Shareholders

Canadian Pacific
CP Ships
Railway Company
Limited

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Development of Abuses

Can’t Cash Out

Subsection 55(2)

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Diagram XXVII

Mr. A Ms. B

Corporation X

Investment Business
Assets Assets

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Diagram XXVIII

Mr. A Ms. B

Corporation A Corporation X

Investment Business
Assets Assets

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Exceptions to Subsection 55(2)

Paragraph 55(3)(a)
ƒ Internal reorganizations

ƒ Paragraph 55(3)(b)
ƒ Butterflies

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Example 4 - Diagram XXIX

Corporation A

Corporation B

Division I Division II Division III

39
Diagram XXX

Corporation A

Common Shares

Newco Corporation B
Preferred Shares

Division I Division II Division III

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Diagram XXXI

Corporation A

NewCo Corporation B

Division II Division III

Division I

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Divisive Reorganizations

55(3)(b)
ƒ Distribution by Distributing Corporation
ƒ Distributing Corporation wound up or shares
held by transferee corporation redeemed or
cancelled
Characteristics
ƒ Transfer of a corporate asset using
subsection 85(1) election
ƒ A redemption or purchase for cancellation of
the shares of transferor and transferee
corporations
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Meaning of Distribution

AxB
C

A = Fair market value of each type of property

owned by the distributing corporation

B = Fair market value of shares of the distributing

corporation owned by transferee corporation

C = Fair market value of all shares of the

distributing corporation

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Technical Analysis Overview

Subsection 55(3.1):
ƒ Contains property becoming property rules

ƒ Limits transfers of shares of a transferee

corporation or of the distributing
corporation
ƒ Contains acquisition of control rules
ƒ Contains additional restrictions to prevent
a “purchase butterfly”
ƒ Imposes a continuity of interest concept

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Evolution of Butterflies

No attempt to codify rules

Codification of don’ts

Act does not tell how to do a butterfly

45
Administrative Rules

Caution – don’t think you know the rules

ƒ Types of property

ƒ Allocation of debt

ƒ Consolidated look-through approach

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Administrative Rules – cont’d

Type of property

ƒ Cash or near cash

ƒ Business property

ƒ Investment property

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Administrative Rules – cont’d

Allocation of debt

ƒ Deduct debt to obtain FMV of asset

ƒ Cash = current assets less current liabilities

ƒ Specific debt to specific liabilities

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Administrative Rules – cont’d

Any excess specific debt reduces value of

assets of a similar type

Liabilities that relate to a type of property

allocated to that type

Remaining liabilities allocated pro rata to

three types of property

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Example 5 – Diagram XXXII

Consolidated Look-through Approach

Corporation A Corporation B
50% 50%

Corporation X

Division I 50% Division 2

(10 of 20)
$45 $55

Corporation Y

B.A. I.A.
$100 $20
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Types of Property - Difficulties

If more than one type of property

First Butterflies – investment property

Today – operating corporations

Preference – classify as business property

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Types of Property – Difficulties – cont’d

Golden Rule – can’t cash out

Receivables, inventories, prepaids initially

treated as cash – subsequently treated as
business assets

Look at corporations after the butterfly

If no cash before – no cash after

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Example 6

Balance Sheet of Distributing Corporation

Current Assets
Cash 75
Accounts Receivable 100
Inventories 150
Prepaid Expenses 25

Land 500

Building 300

Current Liabilities 400

Mortgages 150

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Example 6 (cont’d)

Balance Sheet of Transferee Corporation A

Not Acceptable
Acceptable

Current Assets
Cash 50 75
Accounts Receivable 100 100
Inventories 50 150
Prepaid Expenses 0 0

Land 250 200

Building 200 150
Current Liabilities 200 300
Mortgage 150 75

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Example 6 (cont’d)

Balance Sheet of Transferee Corporation B

Not Acceptable
Acceptable

Current Assets
Cash 25 0
Accounts Receivable 0 0
Inventories 100 0
Prepaid Expenses
25 25

Land 250 300

Building 100 150
Current Liabilities 200 100
Mortgage 0 75

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Types of Property

Financial instrument

Purpose change

Committed cash – business asset

Partial butterfly

Purchase butterfly

Public company spin-offs

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Property Becoming Property

Difficulties in practice
Can’t stop operations
“In contemplation of” = but for

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Example 7 – Diagram XXXIII

$42.85
Corporation A Corporation X

Division Division
1 2

$30 $70

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Exemptions to Rule

•Amalgamation of corporations related to

distributing corporation
•Amalgamation to form distributing
corporation
•Receipt of property which is subsequently
butterflied
•Disposition of property by the distributing
corporation
•Disposition of property by a corporation
controlled by the distributing corporation
•Disposition for cash or non-convertible debt
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Continuity of Share Ownership

Limits sales of shares of distributing

corporation or transferee corporation

Specified shareholder

Change of control of a distributing corporation

or transferee corporation

Additional restrictions

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Example 8 – Diagram XXXIV

Acquisition by Transferee Corporation

Other
Corporation Y
Shareholders
Corporation Corporation
A CC

Corporation
B

20% 20% 20% 40%

40%

Corporation X

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Example 9 – Diagram XXXV

Acquisition of Control of Distributing Corporation

Other
Shareholders Corporation A

20%
30%
Corporation
Other B
Shareholders

50%
20%

Corporation X

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Post-Butterfly Restrictions

•Continuity of interest
•Cashing out
•Paragraph 55(3.1)( c) applies where a transferee
corporation sells more than 10% of the assets received
on the transfer
•Paragraph 55(3.1)(d) applies where more than 10% of
property retained by the distributing corporation is
acquired by a partnership or by a person that is not
related to the distributing corporation
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Example 10 – Diagram XXXVI

Distribution of Business Property

Corporation A Corporation B
25% 75%
(30) (70)

Corporation X

Division Division
1 2

$30,000,000 $70,000,000
($25,000,000) ($75,000,000)
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QUESTIONS?

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