The anti-Morris Trust rules do not operate in Canada. That’s the bottom line of a recent court ruling involving a complex reorganization transaction that eventually garnered favorable tax treatment for the parent company.
In the United States, the anti-Morris Trust rules, which can be found in Section 355(e) of the Internal Revenue Code, govern parent-company spin-off transactions with regard to tax treatment. In general, the rules state that an otherwise tax-free stock distribution by a parent company of a controlled subsidiary is taxable at the parent-company level if the distribution is part of a plan (or series of related transactions) in which the following is true: one or more persons acquires stock representing a 50% or greater interest in either the distributing corporation, the controlled subsidiary, or any successor company.
The rules are a bit different in Canada, however, where if the transaction is classified as an amalgamation, it may qualify for tax-free treatment. The example case laid out below is based on the finding in Husky Oil Ltd. v. Her Majesty The Queen, 2010 FCA 125 (FCA 2010). Since the case is complicated, the steps are broken down into bullet points.
• MuCorp owns all the stock of Lambda Corp. MuCorp’s ownership structure is as follows: Mr. Sigma owns 42% of the company, the public owns 35%, and Beta Corp. owns 23%. All of the companies are taxable Canadian corporations.
• H Corp., also a taxable Canadian corporation, expresses an interest in acquiring the stock of MuCorp, but does not want to acquire Lambda.
• However, Beta is interested in acquiring Lambda, and both goals are accomplished through a complicated series of transactions that are ruled to be tax-free to MuCorp.
• The fundamental transaction went as follows. The shares of MuCorp owned by Beta had a value of $20,693,436. The Lambda stock owned by MuCorp was valued at $15,500,000. Through a series of transactions, Beta’s stock in MuCorp was, in effect, “redeemed” for the balance — $5,193,436 in cash — plus all the shares of Lambda owned by MuCorp.
• H Corp. initiated a tender offer for all of the MuCorp stock owned by shareholders other than Beta. The tender offer was successful, and H Corp. acquired direct control of MuCorp. Accordingly, each member of the H Corp. group became related to each member of the MuCorp group.
• Beta then “sold” all of its MuCorp shares to H Corp. for cash, a note, and common shares of H Corp.
• MuCorp and Beta entered into an agreement for amalgamation, while Lambda and a subsidiary of Beta, 347 Corp., were amalgamated in a transaction that was subject to the Canadian Income Tax Act’s subsection 87(4). The resulting corporation was named LA.
• Before the amalgamation, Beta owned all the stock of 347, and MuCorp owned all the stock of Lambda. After the amalgamation, Beta owned one common share of LA, and MuCorp owned 15,500,000 shares of LA’s preferred stock.
It is important to note that subsection 87(4) is a “rollover” provision that applies to the amalgamation of two or more taxable Canadian corporations. The general rule, found in paragraph 87(4)(a), states: When two corporations are amalgamated, a shareholder of a predecessor corporation, who receives nothing except new shares of the amalgamated corporation, is deemed to have disposed of the shares of the predecessor corporation for proceeds equal to their “adjusted cost base,” and to have acquired the shares of the amalgamated corporation at a cost equal to the same amount.
However, under subsection 87(4)(b), no rollover is available to a shareholder of a predecessor corporation if (1) the fair-market value of the old shares immediately before the amalgamation exceeds the fair-market value of the new shares immediately after the amalgamation, and (2) it is reasonable to regard all or a portion of the excess as a benefit that the shareholder desired to have conferred on a person related to the shareholder.
In such a case, the shareholder generally is treated as having realized a capital gain on the disposition of the old shares. The amount of the capital gain is typically equal to the “gift portion” of the transaction; that is, the amount by which the value of the old shares exceeds the value of the new shares.
In the example case, the Canadian authorities argued that there were several reasons the 87(4) exception applied to MuCorp on the amalgamation. For example, the fair-market value of the Lambda shares immediately before the amalgamation was $15.5 million, none of the preferred shares of LA issued on the amalgamation had any value, the $15.5 million difference in value represented a benefit MuCorp wished to confer on H Corp., and MuCorp was related to H Corp. at the time of the amalgamation.
However, the Federal Court of Appeal disagreed with the Canadian tax authorities. In Husky Oil Ltd., the court noted the basis for the 87(4) exception. Basically, the exception is intended to deter a taxpayer from using amalgamations to shift part or all of the value of a predecessor corporation to the amalgamated corporation, if — but only if — a person related to the taxpayer has a direct or indirect interest in the amalgamated corporation that will be enhanced by the shift in value.
In the example case, the supposed shift in value accrues to the benefit of Beta through its ownership of the only common stock of LA. There is no person related to MuCorp who stands to benefit from the shift in value to Beta. Therefore, the 87(4) exception cannot apply.
In an amalgamation to which 87(4) applies, the shareholders of each of the predecessor corporations dispose of their shares in exchange for shares of the amalgamated corporation. Subsection 87(4) deems the proceeds of disposition to be equal to their adjusted cost base unless the 87(4) exception applies. Here, the exception does not apply, and the court concluded that the specific provisions of 87(4) must trump the more general rule found in 69(4). As a result, the Canadian Minister of Taxation’s fallback position was also rejected.
In the United States, a split-off is taxable because the distributed stock forfeits its status as “qualified” property for the reasons described above. In the example case, the distribution by MuCorp of its Lambda stock to Beta was part of a plan pursuant to which one or more persons (the shareholders of H Corp.) acquired (indirectly) a greater than 50% interest in MuCorp. That means that in the United States, MuCorp would have been taxed on the disposal of its Lambda stock. However, in Canada, such a transaction, so long as it is implemented by means of an amalgamation, can, apparently, be accomplished without unfavorable tax consequences.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.