understanding section 55 and butterfly reorganizations · understanding section 55 and butterfly...

Understanding Section 55 and Butterfly Reorganizations

Sponsored by CCH Canadian Limited

Greg Wiebe, TorontoRick McLean, TorontoGregory Bell, Ottawa

© 2010 KPMG LLP, a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in Canada.

Greg WiebeGreg Wiebe

Canadian Managing Partner - Tax

KPMG LLP

© 2010 KPMG International Cooperative (“KPMG International”). KPMG International provides no client services and is a Swiss entity with which the independent member firms of the KPMG network are affiliated 2

Agenda

• Overview of Subsection 55(2)• Exceptions from Subsection 55(2)• Types of Butterflies• Qualifying for the Exemption• Butterfly Denial Rules• Public Company Spin-offs• Related Issues• Wrap-up• Appendix


Gregory BellGregory BellTax Partner - Ottawa

KPMG LLP

Rick McLeanRick McLeanTax Partner - Toronto

KPMG LLP


Overview of Subsection 55(2)

• Anti-avoidance rule• Recharacterizes dividends received by a corporation as

a capital gain or proceeds of disposition• Exceptions:

• safe income dividends• dividends subject to Part IV tax• dividends arising in certain “related party” transactions –

paragraph 55(3)(a) • dividends arising in butterfly reorganizations –

paragraph 55(3)(b)


Purpose of Subsection 55(2) — Example 1

ShareholderShareholder

FMV 100ACB 0PUC 0

FMV 100ACB 0PUC 0

• Vendorco to sell Targetco to Purchaseco

• Vendorco would realize capital gain of $100

Vendorco UnrelatedPurchaseco

Targetco




FMV 0ACB 0PUC 0

FMV 0ACB 0PUC 0

• Purchaseco lends $100 to Targetco

• Targetco pays $100 dividend to Vendorco

• Dividend deductible under subsection 112(1)

• Vendorco sells Targetco to Purchaseco for $nil

• “PURPOSE” of dividend was to reduce capital gain on shares of Targetco

Loan 100Loan 100Div 100Div 100

Vendorco

Targetco

UnrelatedPurchaseco




Sell propertyFMV 100

ACB 0

Sell propertyFMV 100

ACB 0

Keep propertyKeep property

• Vendorco to sell Sell Property to Purchaseco

• Vendorco would realize capital gain / income on saleUnrelated

PurchasecoVendorco




Keep propertyKeep property Sell propertySell propertyS85 tax-deferredS85 tax-deferred

PrefsFMV 100

ACB 0PUC 0

PrefsFMV 100

ACB 0PUC 0

• Vendorco transfers sell property to Purchaseco on tax-deferred rollover

• Purchaseco issues preferred shares to Vendorco

• Purchaseco redeems preferred shares

• Deemed dividend on redemption rather than capital gain

• RESULT of deemed dividend was reduction of capital gain on preferred shares

• No gain / income realized on transfer of Sell Property

UnrelatedPurchasecoVendorco


Subsection 55(2) — Resident Corporation Receives Taxable Dividend

Where a corporation resident in Canada has received a taxable dividend in respect of which it is entitled to a deduction under subsections 112(1) or 112(2) or 138(6)...


Subsection 55(2) — Part of a Series

...as part of a transaction or event or a series of transactions or events


Subsection 55(2) — Purpose or Results Test

...one of the purposes of which (or, in the case of a dividend under subsection 84(3), one of the results of which) was to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized on a disposition at fair market value of any share of capital stock immediately before the dividend...


What Happens if Subsection 55(2) Applies?

• Not a dividend received• Proceeds of disposition if share disposed of• Deemed gain on disposition of a capital property if

share not disposed of• Dividend payor is still considered to have paid a

dividend– Consider impact on tax pools such as GRIP


Exceptions from Subsection 55(2)


First Exception: Income Earned or Realized “Safe Income”

...and that [the capital gain] could reasonably be considered to be attributable to anything other than income earned or realized by any corporation after 1971 and before the safe-income determination time.


Second Exception: Part IV Tax

...subject to tax under Part IV that is not refunded as a consequence of the payment of a dividend to a corporation when the payment is part of the series.


Third Exception: Subsection 55(3)(a) Transactions

• Exemption for dividends arising in so-called related- party transaction

• Must satisfy all the tests in paragraph 55(3)(a) to escape subsection 55(2)


Fourth Exception: Paragraph 55(3)(b) Butterfly Reorganizations

• Divide company among its shareholders• Relies on other provisions

– Subsection 85(1): Tax-deferred rollover– Subsection 84(3): Deemed dividend (not proceeds of disposition)– Subsection 112(1): Taxable dividends generally deductible by

corporate recipients• No specific rule allows non-taxable division of a company

– e.g., tax-deferred wind-up rule in subsection 88(1) only applies to 90%-owned subsidiaries


Types of Butterflies


Types of Butterflies

• Split-up• Spin-off


Types of Butterflies — Split-up vs Spin-off Before

BA40%60%

FMV $400FMV $600

• Shareholders A and B to implement a butterfly of Distributing Corporation (DC)

• Either Spin-off or Split-up

Distributing Corp (DC)

Opco 1 Opco 2


Split-up Butterfly — After

A B

FMV $600 FMV $400

• A split-up butterfly involves a transfer of property of the DC to one or more corporate shareholders (the Transferee Corporations)

• In a split-up butterfly, a shareholder or group of shareholders takes its proportionate share of the Distributing Corporations’ assets and liabilities and exits

• This is an example of a “single-wing” split-up (one Transferee)• The basic requirements for a split-up butterfly are contained in paragraph (b)(ii) of the definition

of “permitted exchange” in subsection 55(1)

Opco 1 Opco 2

TransfereeDC


Spin-off Butterfly — After

40%

60%40%

60%

FMV $600 FMV $400

A B

• A spin-off butterfly involves a transfer of property to one or more Transferee Corporations owned by ALL DC shareholders in the same proportions that they own in the DC

• Basic requirements for a spin-off butterfly are contained in paragraph (b)(iii) of the definition of “permitted exchange” in subsection 55(1)

DC Transferee

Opco 1 Opco 2


Spin-off Butterfly — Basic Steps Before

Shareholder(s)

Asset 1 (40% of net FMV)


• Distributing Corporation is owned by several unrelated shareholders• Asset 1 is to be spun-off to a new corporation owned by all of the

shareholders of DC

DC


Spin-off Butterfly — Basics Steps Creation of Transferee and Permitted Exchange



40%

60%

Shareholder(s)

• All DC shareholders transfer 40% of their DC shares to new corporation (“Transferee”)

• The transfer of shares is called a “permitted exchange”• Rollovers available under subsection 85(1) or section 85.1

DCTransferee


Spin-off Butterfly — Basics Steps Transfer of Property to TC = “Distribution”

Shareholder(s)

Asset 1 Asset 2

preferred

60% common

40% common

100% common

• DC transfers 40% of its net assets (Asset 1) to Transferee on rollover basis• DC receives preferred shares of Transferee• The transfer of property is called the “distribution”

Transferee DC

S85 tax-deferredS85 tax-deferred


Spin-off Butterfly — Basics Steps Cross-cancellation of Shares Results in Dividends

Asset 2Asset 1

100% 100%

Shareholder(s)

note

note

• DC purchases for cancellation its common shares held by Transferee for a note• Transferee redeems its preferred shares held by DC for note• The share redemptions / purchases for cancellation are called “permitted redemptions”• The deemed dividends arising on the cross-redemptions are the dividends that are protected from

subsection 55(2) by the exemption in paragraph 55(3)(b)

Transferee DC


Spin-off Butterfly — Basics Steps Notes Offset

Asset 2Asset 1

100% 100%

Shareholder(s)

• The notes are set off against each other and cancelled

Transferee DC


Full Split-up ("Double-wing") Butterfly

• All property of Distributing Corporation transferred to Transferee Corporations

• Distributing Corporation is wound-up


Full Split-up Butterfly — Basic Steps

Common Common

• DC transfers or distributes a pro rata amount of its property to each Transferee on rollover basis

• DC receives preferred shares of each Transferee

Property

S85 transfer of property

Pref Pref

Transferee A Transferee B

DC



• Each Transferee redeems its preferred shares held by DC for a note• DC winds-up and distributes notes• Deemed dividends arise on share redemptions and wind-up

Property

Note Note

Property


DC



Property Property



Qualifying for the Exemption


Paragraph 55(3)(b) — Statutory Requirements

• “In the course of a reorganization”• DC makes a “distribution”• DC wound up or transferee cross-ownership eliminated• Exemption applies only to dividends from permitted

redemptions or wind-up of DC


Distribution – Subsection 55(1) Definition

• Definition of “distribution” requires:– the Distributing Corporation to make a pro rata distribution of– each “type of property” to– each Transferee Corporation

• Pro rata based on % ownership (by value) of Distributing Corporation• Achieving a pro rata distribution is paramount to achieving a successful

butterfly reorganization • Public company spin-off butterflies are exempt from requirement to

distribute each type of property


Pro-Rata Distribution —Types of Property Requirement

• Each Transferee Corporation must receive its proportionate share of each type of property owned by the Distributing Corporation

• The Act does not define “types of property”• CRA says there are three types:

– cash and near cash– investment property– business property

• Intended to prevent a “cashing out” of a shareholder• Without pro-rata distribution requirement, could distribute only cash

property to a shareholder to allow the shareholder to “sell out” on a tax- free basis


Pro Rata Test

• Gross or Net Assets– Gross – sanctioned by the Act– Net – allowed administratively

• Example – Two equal shareholders– The assets of DC are two properties of the same type: property A and

property B:FMV of property A: $1,100FMV of property B: 1,000Total liabilities: (300)Net: $1,800

– Assets cannot be split on a gross basis, but could be split on a net basis by assuming $200 of liabilities with property A and $100 of liabilities with property B so that each transferee receives $900 of net property.


Pro-Rata Distribution Requirement — Spin-off Butterfly Example



40%60%

Shareholder(s)

• In earlier spin-off butterfly example, Transferee became 40% shareholder of DC• DC was required to transfer or “distribute” 40% of each type of property (net of

liabilities) to Transferee

Transferee DC


Look-Through Concept

• Property determined on a consolidated look-through basis

• In characterizing DC’s property, it is necessary to “look through” the shares of its subsidiaries and other corporations over which it has significant influence

• Assets and liabilities of such entities effectively treated as those of DC


A B

FMV $600 FMV $400

• In earlier split-up butterfly example, DC was required to transfer or “distribute” 40% of each type of property (net of liabilities) to Transferee

• Shares of Opco 2 must represent 40% of each type of property– Look to underlying assets / liabilities of Opco 1 and Opco 2

Opco 1 Opco 2

TransfereeDC

Pro-Rata Distribution Requirement — Split-up Butterfly Example


Butterfly Denial Rules


Butterfly Denial Rules — Subsection 55(3.1)

• Butterfly will fail and dividends subject to subsection 55(2) if:

– Acquisitions of property before butterfly – prevent tax- deferred asset exchanges and “cashing out” – paragraph 55(3.1)(a)

– Insufficient continuity of shareholder interests – prevent “purchase butterflies” – paragraph 55(3.1)(b)

– Insufficient continuity of assets – maintain continuity of interest in underlying assets – paragraphs 55(3.1)(c), (d)


Application of Butterfly Denial Rules — Spin-off Butterfly Example

Paragraph 55(3.1)(a) “Property Becoming Property” Rule• DC cannot acquire property in contemplation of butterfly distribution• Intended to prevent change in mix of types of property of DC• Intended to prevent parties from exchanging or “swapping” properties• Exceptions for certain related-party transfers

– e.g., DC could transfer property to subsidiary of DC• Sale of property for cash or non-convertible debt before butterfly is allowed

Asset 2Asset 1

100% 100%

Shareholder(s)

Transferee DC



Paragraph 55(3.1)(b) “Continuity of Interests” Rule• Intended to prevent “purchase butterflies”• “Specified shareholders” (generally 10%) cannot dispose of shares of DC or Transferee to

unrelated persons• Acquisitions of control of DC or Transferee are not allowed• There are restrictions on acquiring shares of DC in contemplation of the butterfly

Asset 2Asset 1

100% 100%

Shareholder(s)

Transferee DC


Exceptions to “Continuity of Interests” Rule• "Permitted exchange” - allows for transfer of shares of DC to Transferee• "Permitted redemption” - allows for disposition of shares on cross-redemption• "Permitted acquisition“ generally to facilitate sequential butterflies• Definitions found in subsection 55(1)

Asset 2Asset 1

100% 100%

Shareholder(s)

Transferee DC



• Paragraph 55(3.1)(c) “Continuity of Assets” Rule for Transferee Corporation– Transferee is restricted from selling butterflied property

• Paragraph 55(3.1)(d) “Continuity of Assets” Rule for Distributing Corporation– DC is restricted from selling non-butterflied property

• Rules apply if more than 10% of fair market value of property of TC or DC is sold

Asset 2Asset 1

100% 100%

Shareholder(s)

Transferee DC



Exceptions to “Continuity of Asset” Rules• Dispositions in ordinary course of business

– Not defined• On sequential butterflies• On an amalgamation with a related corporation• Rules do not apply to dispositions of cash or debt receivable

Asset 2Asset 1

100% 100%

Shareholder(s)

Transferee DC



Public Company Spin-offs


Public Company Spin-off Rules

• Public company spin-offs are not subject to the “types of property” requirements

– “types of property” rules prevent “cashing out” transactions

– not relevant in public company spin-off butterflies

• Can distribute any mix of property

• Only applies to spin-offs (and not split-ups)

• Applies to wholly-owned subsidiaries of public companies

• Distributing corporation can do another spin-off but not a split-up butterfly within three years

• Transferee cannot do any butterfly for three years


Related Issues


Related Issues

• Part IV tax and RDTOH

• Part V1.1 tax

• Eligible dividend designations

• CDA elections

• Acquisition of control


Questions?

The only comprehensive reference source on section 55 and butterfly reorganizations in Canada.

www.cch.ca/butterfly

Greg Wiebe (416) 777-3271 [email protected]

Rick McLean (416) 777-8584 [email protected]

Gregory Bell (613) 212-2800 [email protected]

Today’s presenters

This webinar is sponsored by CCH Canadian Limited.

For more information, please visit www.cch.ca or call customer Service at 1-800-268-4522.

Information is current to September 1, 2010. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

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