Economic optimism and strong corporate balance sheets continue to fuel an increase in merger-and-acquisition activity. In many cases, a rollover equity transaction, where the seller retains a portion of the equity in the acquired business or acquiring business, is the primary deal structure used. Buyers often prefer these types of deals because they allow target company owners to retain a certain percentage of equity, and they help ensure responsibility to facilitate a seamless and successful transition. This is especially the case with private-equity buyers, who are not as familiar with the inner workings of the business. From the seller's perspective, retaining equity in a sale transaction allows him or her to cash out of the business while still maintaining some of the future potential upside.
Successfully structuring a rollover equity transaction involves balancing buyer and seller objectives with tax considerations. Stock sales are usually more tax-advantaged to the seller; however, buyers typically prefer asset purchase treatment because, for tax purposes, they can depreciate or amortize a portion of the purchase price. Tax-efficient structuring can lower a buyer's cost of capital and maximize the net cash received by the seller.
When a rollover equity transaction crosses U.S. borders, the level of tax complexity increases. For many U.S. buyers, Canada's welcoming business environment, which offers market access, geographic convenience, and cultural similarities, is a popular place to search for attractive acquisition targets. While cross-border deals always present additional tax considerations, these issues often can be further complicated when the goal is to preserve a portion of the selling shareholder's equity stake in the Canadian target company. Three options can be pursued to achieve rollover equity when purchasing a Canadian company, each with its own merits and issues to consider: a stock purchase, a new corporation formation, and a Canadian unlimited liability company (ULC) dropdown strategy.
Stock purchase
Perhaps the most straightforward way to roll over equity in a Canadian company is for the U.S. buyer to purchase less than 100% of the outstanding shares of the Canadian target company. One of the reasons sellers typically prefer stock sales is the possibility of favorable tax treatment for the resulting gain. This is no different for Canadian sellers. A Canadian resident seller (corporation or individual) is taxable on only 50% of any capital gains on the sale of shares under Section 38(a) of the Canadian Income Tax Act, R.S.C., ch. 1 (1985, 5th Supp.). Furthermore, individual shareholders can shelter gain through their lifetime Canadian capital gains exemption. If a Canadian resident individual sells qualified small business corporation shares for a gain, the first CAD 835,716 of capital gain is potentially tax-free under Section 110.6 of the Canadian Income Tax Act.
To qualify for this exemption, three tests must be met:
- The corporation must be a "small business" corporation at the time of sale—it must be a Canadian-controlled private corporation, and it must use all or substantially all of its assets principally in an active business carried on primarily in Canada. The Canada Revenue Agency (CRA) has interpreted "all or substantially all" to mean at least 90% of the fair market value (FMV) of all corporate assets (including off-the-books assets such as goodwill);
- Throughout the 24 months immediately before the sale, the shares were not owned by anyone other than the individual or a person or partnership related to the individual; and
- Throughout the 24 months immediately before the sale, the corporation must have used more than 50% of its assets (by FMV) principally in an active business carried on primarily in Canada.
Effective use of these Canadian exemptions can maximize the seller's after-tax proceeds. This can lower the buyer's purchase price.
From the U.S. buyer's perspective, the biggest tax drawback to a stock purchase may be the inability to step up the tax basis of the acquired assets to FMV; instead, the assets will retain a carryover basis. Sec. 338(g) permits a corporate buyer to make a unilateral election to treat a qualified stock purchase (of 80% or more of the target's stock by voting power or value) as a deemed asset purchase. If this election is made, the transaction will be treated as a hypothetical asset deal for tax purposes, meaning the buyer's basis will be revalued to reflect the deemed purchase price, with the buyer bearing the incremental tax burden from the deemed gain.
In domestic acquisitions, Sec. 338(g) elections are rare, as the current tax cost of the recognized gain typically exceeds any future benefits. But in the case of a foreign target, the deemed asset sale typically does not create immediate or future gain recognition. However, because a foreign corporation's income and losses are generally not subject to U.S. taxes, the step-up in basis of these assets typically will not create immediate U.S. tax benefits. Despite this, since it results in the closing of the foreign target's tax year (for U.S. tax purposes), it may affect the earnings and profits, possible Subpart F inclusions, and foreign tax credit calculations. Tax planning for acquisitions of Canadian corporations should carefully include consideration of the U.S. tax effects of a Sec. 338 election.
Regardless of whether it makes a Sec. 338(g) election, the U.S. buyer will have several post-deal tax issues to consider. If a U.S. person purchases over 50% of a Canadian corporation, the company will be considered a controlled foreign corporation (CFC) for U.S. tax purposes. U.S. owners of CFCs must contend with a variety of international tax provisions, including Subpart F's anti-deferral regime and the mechanics of the foreign tax credit, which can often provide significant challenges, especially to noncorporate U.S. buyers.
New corporation formation
Rollover equity in a Canadian company also can be achieved through forming a new corporation in which the buyer invests. The formation of a new Canadian corporation may be attractive to a U.S. buyer concerned about target company liabilities. Unlike a direct purchase of stock, this allows for a partial step-up in the basis of assets.
The Canadian seller can contribute the target company's assets to a new Canadian company in exchange for stock (the individual owners of the Canadian target could also subscribe for shares of the new entity if so desired). The U.S. buyer will contribute cash (and potentially other assets), also receiving stock in exchange. The buyer's cash then will be distributed to the target shareholder corporation (subject to other tax matters and issues being addressed), and the resulting corporation will be owned by both parties.
Canadian income tax rules provide that business assets may be transferred to a newly incorporated Canadian entity on a tax-deferred basis, provided the transferor receives stock in exchange for the property transferred. If a transferor receives cash (i.e., boot) in excess of the tax basis of the assets transferred, it must recognize a gain (and possibly recapture). That transfer of property will be treated as a sale of the assets being transferred, which will allow a step-up in basis of those assets if a gain is recognized by the transferor. The stepped-up basis will result in an increase in future depreciation/amortization, which will provide current Canadian tax benefits but will not affect the U.S. owner's current U.S. tax situation.
From a U.S. perspective, Sec. 351 would generally allow nonrecognition treatment for the U.S. transfer to a Canadian corporation, provided its requirements were met. The U.S. buyer's contribution would be considered an outbound asset transfer, meaning that Sec. 367 could apply to trigger gain recognition on any appreciated assets transferred, potentially including goodwill. In most cases, the U.S. buyer would be transferring cash, which would make Sec. 367 inapplicable.
Post-transaction tax considerations are similar to those of the direct sale of corporate stock. The Canadian seller's tax situation would remain largely unchanged. If the U.S. buyer owns over 50% of a Canadian corporation, the CFC tax provisions would apply, as discussed earlier.
ULC dropdown
Domestic rollover equity transactions are often structured using a limited liability company (LLC) dropdown technique. This usually involves the seller's contributing target assets and liabilities to a newly formed, single-member LLC. The buyer then purchases LLC units, which Rev. Rul. 99-5 treats as the purchase of a proportionate ownership interest in each LLC asset, effectively stepping up this portion of assets. This is followed by the deemed contribution of each owner's asset interests to a "new" partnership. The resulting structure is a U.S. LLC (tax partnership) owned by both the target company shareholder and buyer.
These same results can be accomplished for a Canadian target through the use of a ULC, which is a Canadian corporate entity in which shareholders have unlimited liability with respect to company liabilities. The Canadian provinces of Alberta, British Columbia, and Nova Scotia allow for the creation of ULCs under their respective statutes. For tax purposes, a ULC is considered a hybrid entity because it is treated differently for Canadian and U.S. tax purposes. ULCs are considered regular corporations for Canadian purposes. For U.S. purposes, these entities are either treated as disregarded entities (if they have one owner) or partnerships (if they have more than one owner). This disparity in tax treatment between countries can provide unique planning opportunities as well as challenges.
The disparate tax treatment of these hybrid entities is highlighted by the treatment of the purchase of ULC shares by a U.S. person. For Canadian purposes, this is considered a stock sale, which will generally allow a Canadian seller to include only 50% of such gain as income. The lifetime Canadian capital gains exemption may also be available if the seller is a Canadian-resident individual. For U.S. purposes, a properly structured transaction will result in asset sale treatment, allowing a step-up in the basis of assets.
The mechanics of the step-up depend on whether the ULC is 100%-owned or owned by more than one shareholder. Since a 100%-owned ULC is treated as a disregarded entity for U.S. tax purposes, the purchase of ULC units will be treated similarly to the purchase of wholly owned LLC units and will be governed by Rev. Rul. 99-5. Alternatively, a multimember ULC is treated as a foreign partnership for U.S. tax purposes, meaning a U.S. buyer of ULC shares could make a Sec. 754 election. This would step up that buyer's share of company assets to FMV and allow for increased depreciation and/or amortization that would be allocated to the U.S. partner going forward.
Even though the above treatment is reserved for ULCs, Canadian corporations can undergo restructuring prior to the deal to become a ULC. One option is for the Canadian corporation to drop down its assets and liabilities into a newly formed ULC. Another is for the Canadian corporation to amalgamate into a ULC. While various issues must be considered and managed regardless of the option chosen, either way generally can be pursued without incurring current income tax in Canada.
As part of deal planning, U.S. buyers should consider the tax efficiency of repatriating future Canadian profits. Since a ULC is considered a regular corporation for Canadian tax purposes, a U.S. shareholder is subject to a 25% statutory withholding tax on interest, dividends, royalties, and other payments. The United States-Canada Income Tax Convention historically has maintained tax efficiency by reducing or eliminating such withholding taxes on many types of payments to U.S. recipients. However, since Jan. 1, 2010, the fifth protocol of the treaty has restricted the reduced withholding rate on payments made by a Canadian ULC to a U.S. recipient when the ULC is treated as a fiscally transparent entity for U.S. tax purposes (see Sardella, "Commentary on the Canada-U.S. Tax Treaty's Fifth Protocol," The Tax Adviser (March 2008)).
Distributions of ULC profits will be considered dividends for Canadian income tax purposes and subject to the requisite dividend withholding tax. However, for U.S. purposes, these distributions will be considered foreign partnership distributions. These typically would not be taxable in the United States. Article IV, Paragraph 7(b), of the treaty provides that ULC dividends paid to U.S. LLCs are subject to a 25% withholding tax in Canada (instead of the reduced rate of 5%) and creates the possibility of an excess foreign tax credit position in a year of profit repatriation.
The CRA has published a series of advance income tax rulings and technical interpretations that allow for the use of various repatriation strategies to avoid the application of the anti-hybrid rule in certain situations, including when the owner is a U.S. S corporation. However, the CRA accepts these repatriation strategies only in certain circumstances—these are not available when the owner is a U.S. LLC. The denial of treaty benefits for payments of dividends, interest, and other payments by ULCs to U.S. LLCs can make ULCs tax-inefficient and even punitive vehicles for U.S. investors.
The desire to roll over equity will add complexity to almost any deal. Rolling over equity in a cross-border context provides even further challenges and tax considerations. When structuring a deal involving a Canadian target company, taxpayers and their practitioners should carefully consider all possible deal structures to achieve the desired results for both the buyer and the seller.
EditorNotes
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.
