Section 86

CRA ruled on a butterfly spin-off by a listed Canadian corporation (DC) of its indirect interest in a foreign project to a “SpinCo” to be held by its shareholders, with most of the steps to occur pursuant to a plan of arrangement. The “old” common shares of DC were split into “new” common shares (bearing 2 votes per share) and preference shares pursuant to a s. 86 reorganization, with the DC shareholders then transferring their preference shares to SpinCo for SpinCo common shares. However, immediately before the effective set-off of the notes owing by DC and SpinCo to each other as a result of the subsequent butterfly mechanics, the “new” DC common shares were to be converted under s. 51 back into “old” common shares.

A corporation incorporated under the Canada Business Corporations Act (Opco) was continued as a co-operative under the Co-operative Corporations Act (Ontario), so that a certificate of discontinuance and certificate of continuance were issued under each statute. On the continuance, each common share of Opco was “converted” pursuant to the articles of continuance into a share of the share capital of the co-operative, having the same paid-up capital. CRA provided rulings respecting:

• the continuance not resulting in a disposition by Opco of its assets;
• the absence of a deemed dividend under s. 84(1) having regard to the safe harbor in s. 84(1)(c);
• the s. 86(1) rollover applying to the conversion of the shares on the continuance; and
• no deemed dividend arising under s. 84(3) having regard to the rule in s. 84(5).

As a preliminary to a gross-asset butterfly transaction in which DC (whose preferred shares and common shares each were owned equally by three siblings) will spin-off 1/3 of its assets to two transferee corporations (TC1 and TC2) formed by two of the siblings, DC’s articles will be amended to change all of the DC preferred shares into DC common shares.

Ruling that s. 86(1) (and not s. 86(2)) will apply provided that no s. 85(1) election is filed and the preferred shares are capital property.

CRA ruled on the s. 55(3)(a) spin-off by DC (held by three siblings through holding companies and, in turn, holding three Opcos as well as three Landcos, one of them 50% owned by a third party) of the three Landcos to newly-formed TC held by the same holding companies. Although no s. 86 ruling was given, the letter described a preliminary s. 86 reorganization to create the DC special shares that could then be transferred on a s. 85(1) rollover basis by the Holdcos to TC. The s. 86 reorganization entailed an exchange of the old common shares (and old special shares) for “new” common shares and the new special shares, with the new common shares apparently having the same attributes as the old common shares.

It is common for corporations to include multiple share classes in their corporate structure in contemplation of subsequent reorganizations or restructurings. Is the filing of articles of amendment required in order to meet the condition in s. 86(1) that there has been a reorganization of capital?

CRA indicated that it is maintaining its longstanding position that a reorganization of capital in the s. 86(1) context should normally require an amendment to the articles of incorporation. As noted in 2010-0373271C6, if s. 86(1) is not applicable in a given situation, there could be another rollover provision such as s. 51 or 85 that could apply.

Preliminary reorganization

An arrangement agreement is entered into between Parent (a listed Canadian public corporation) and its new subsidiary Newco (governed by the same Business Corporations Act as Parent) and a preliminary reorganization is competed, including a transfer by “Second Tier US Subsidiary” of two LLCs (the “Specified Subsidiaries”) carrying on active businesses to US Holdco and the transfer by Parent of its shares of US Holdco to Newco for Newco shares on a non-rollover basis (given an expectation that the ACB of the transferred shares should equal their aggregate FMV at that time).

S. 86 reorg

Parent will effect a reorganization of its capital. The notice of articles and articles of Parent will be amended:

(i) To change the Common Shares into Class A Common which, in contrast to the Common Shares, will have more than one vote per share;

(ii) To create a new class of common shares of Parent (the “New Common Shares”), which will have the same terms and attributes as the Common Shares immediately prior to the change in (i).

Each issued and outstanding Class A Common Share will then be exchanged for one New Common Share and a specified fraction of a Newco Share (the “Exchange”), with no s. 85 election being made.

The capital respecting the newly-issued New Common Shares equals the aggregate PUC of the Class A Common Shares minus the aggregate FMV, at the time of the Exchange, of the Newco Shares so distributed; and the aggregate FMV at that time of the Newco Shares will not exceed the aggregate PUC respecting the Class A Common Shares.

Rulings

Re the change of the common shares into Class A Common Shares not being a disposition and re the application of s. 86 and non-application of ss. 84(2), (3) and (4.1) to Exchange.

As a preliminary step in a s. 55(3)(a) spin-off transaction, a preliminary s. 86 reorg was effected through an exchange of the “old” common shares of Subco for newly created common shares (having more votes per shares) and preferred shares also newly created by articles of amendment (having a distinguishing dividend feature which, in fact, was not utilized before the shares were redeemed) pursuant to a share exchange agreement - rather than by virtue of articles of amendment changing the old shares into the new shares. CRA ruled that s. 86(1) would apply.

As part of a s. 55(3)(a) spin-off transaction, Sub2 and its Parent undertake a s. 86 reorganization of Sub 2’s capital so that, following articles of amendment, Parent will exchange all of the issued and outstanding shares of Sub2 for Sub2 New Common Shares and (non-voting redeemable retractable) Sub2 Preferred Shares. A paragraph was added to the ruling letter stating:

[T]he aggregate [stated] Capital of the newly issued Sub2 New Common Shares and Sub2 Preferred Shares for purposes of Act 2 will be equal to the PUC of the Exchanged Sub2 Shares, immediately before the exchange, and … such Capital will be allocated to the newly issued Sub2 New Common Shares, as a class, and to the newly issued Sub2 Preferred Shares, as a class, proportionately based on each classes respective FMV.

DC is a public corporation with two classes of common shares (namely, multiple and subordinate voting shares). Preliminarily to a butterfly spin-off by DC to Spinco, there is a s. 86 exchange respecting both the multiple voting and subordinate voting shares, in each case, for shares of two "new" classes, ie., "new" common shares and redeemable special shares. Immediately before the exchange, both Class will be redesignated pursuant to Articles of Amendment and have their number of votes per share increased (presumably , proportionately). Then, on each of the two s. 86 exchanges, the stated capital of each old common share is to be allocated to that of the two new replacement shares based on their relative FMV. The new common shares issued on each of the two exchanges have identical attributes to the old ones (before their votes per share were momentarily increased), except for their share provisions referring to the prior rights of the special shares (mainly, to receipt of any redemption amount).

A spin-off butterfly reorganization by DC (a Canadian controlled private corporation) commenced with what was ruled to be a s. 86 reorganization under which the DC shareholders exchanged their old common and preferred shares for special "butterfly" shares and new common shares. The new common shares' attributes were accepted as being different from those of the old shares on the basis of a more restricted right to receive stock dividends and on the basis of a right of the holders to receive quarterly financial statements.

See summary under s. 55(1) – distribution.

Preliminarily to a split-up butterfly of DC which, in turn will precede a spin-off by Foreign PubCo (DC's non-resident indirect public company parent), the common shares of DC will be changed by articles of amendment into a shares of a new class of common shares (the "DC New Common Shares") having one vote per share and shares of a new class of non-voting redeemable retractable non-cumulative special shares (the "DC Special Shares"), with the cumulative stated capital of the issued DC New Common Shares and DC Special Shares not exceeding that of the old common shares.

CRA did not rule that this reorganization would qualify under s. 86.

See detailed summary under s. 55(1) - distribution.

Q.B.C.A. s. 91 of the new Q.B.C.A. permits a corporation to convert the shares of a particular class into shares of a new class, through a simple resolution of the board of directors, and with no filing of articles of amendment being required unless this is necessary to change the authorized share capital.

Is a s. 91 conversion an exchange of shares by a shareholder in the course of a reorganization of the capital within the meaning of ITA s. 86? CRA responded:

In general, the CRA is of the view that capital will be reorganized for the purposes of section 86 in the situation where the provisions of the corporation's incorporating act require an amendment of its articles.

In a situation where, for tax purposes, there is a disposition of a share held by a taxpayer resulting from a conversion permitted by Q.B.C.A. section 91, we believe that such a transaction would normally come within subsection 51(1), an automatic rollover provision. We are also of the view that the conversion provided for in Q.B.C.A. section 91 should not be considered as being made "in the course of a reorganization of the capital of a corporation". Section 86 would therefore be inapplicable.

2008-0285241C6 indicated that a shareholders' agreement should not contain clauses that would have the effect of reducing the value of freeze preferred shares. What are examples of clauses in a shareholder agreement (unanimous or otherwise) that would decrease the value of the freeze preferred shares? CRA responded:

[A] clause in a shareholders agreement (unanimous or otherwise) results in a reduction in the FMV of the freeze preferred shares where such a clause provides inter alia that:

• The holder of the freeze preferred shares agrees not to redeem all of its shares at the same time;
• The holder of the freeze preferred shares undertakes not to request the redemption of the holder’s shares without the agreement of all shareholders of the corporation; or,
• The holder of the freeze preferred shares agrees to accept as payment for the redemption of the freeze preferred shares a term note that does not bear interest at a rate that in the circumstances is a reasonable commercial rate.

Proposed transactions

BV, which is a private limited liability company under Dutch law, will convert into a Dutch cooperative ("DC") pursuant to the Dutch Civil Code. By virtue of the execution of the notarial deed effecting the conversion before a notary, DC will be regarded as a legal entity under the Dutch Civil Code that continues to exist separate and apart from its shareholders. On the conversion of BV into DC, the issued share capital of BV will be cancelled and its shareholders (Holdco and Newco) will automatically become members of DC holding membership interests proportionate to their respective shareholdings in BV immediately before such conversion.

Ruling

The cancellation of the shares in the capital of BV on the conversion in exchange for the issuance of the membership interests in DC will occur on a tax-deferred basis under s. 86(1).

An estate freeze was implemented for the benefit of X’s child under which X’s Holdco and a third-party Holdco exchanged 60% and 40% of the Opco Class A common shares for 60% and 40% of a newly-created class of preferred shares and X’s child and the third-party Holdco subscribed $60 and $40 for Class A common shares. CRA in the course of addressing s. 55(3)(a) issues accepted that this constituted a s. 86(1) capital reorganization.

With a view to implementing a butterfly reorganization, the common shares of BCo are exchanged for newly created common shares of CCo (having the same attributes as the exchanged common shares) and newly created preferred shares.

S.86 ruling given but with comment that "GAAR might apply if the purpose of such reorganization is to take advantage of the exception in subsection 84(4.1)".

Are the rules in ss. 51(1), 85.1(1) or 86(1) (which refer to a "taxpayer") available to a partnership in a reorganization where it exchanges shares of a Canadian corporation, even though those provisions refer to a "taxpayer"? CRA responded:

Based on … subsection 96(1), the CRA's practice is to treat a partnership as a person and a taxpayer when calculating income at the partnership level under Division B of Part I … .

… [A] partnership would generally be considered a "taxpayer" for the purposes of subsections 51(1), 85.1(1) and 86(1) and would therefore be entitled to rely on the rules contained therein … . [T]he fact that one of the members of the particular partnership is a non-resident of Canada would not change this.

A simplified example.

The CCRA requirement that freeze preference shares be redeemable at the option of the holder would not be satisfied where the holder of such shares undertakes in writing not to request redemption of such shares without the agreement of all the shareholders of the corporation. CCRA indicated that “its concern is to ensure that the total value of the consideration received in shares (redemption value) and non-shares is equal to the fair market value of the property disposed of pursuant to subsection 85(1).”

The fact that the exchange shares were authorized before the exchange was contemplated would make little difference as to whether the shares disposed of on the exchange would be disposed of in the course of a reorganization, unless other factors dictated otherwise.

Re potential application of s. 86(2) where, following a decline in the fair market value of Opco, the holder of redeemable preferred shares exchanges those preferred shares for new preferred shares having a lower redemption amount and for an option, while his son continues to hold the common shares.

On a reorganization of capital, Ms. A exchanges her common shares of Aco, having a PUC and ACB of $10 and an FMV of $10,000 (with the balance of the common shares being continued to be held by her husband) in exchange for newly-created preferred shares having an FMV and stated capital of $10,000. CCRA confirmed that, pursuant to ss. 86(1) and (2.1), the ACB and PUC of her preferred shares would be $10 (so that no deemed dividend would arise pursuant to ss. 84(3) and (5)). Consequently, her redemption of the preferred shares for $10,000 would generate a deemed dividend of $10,000.