Exchangeable shares have long been used to effect tax-deferred share transactions involving Canadian resident vendors and foreign purchasers. Briefly, certain rollover provisions of the Act permitting tax-deferred share-for-share exchanges require that, where the shares being sold are shares of a Canadian corporation, the shares issued to a Canadian resident vendor must also be shares of a Canadian corporation.
To get around this limitation, the share-for-share exchange is generally structured in a manner such that Canadian resident vendors receive exchangeable shares of Canadian target (or other Canadian corporation owned directly or indirectly by foreign purchaser) in the course of a share sale to a foreign purchaser with the result that the taxation of any gain realized on the disposition of Canadian target shares is deferred until such shares are exchanged for shares of foreign purchaser. This type of planning provides a practical option where the consideration to be received by Canadian resident vendors on the sale of shares would include shares in the foreign purchaser. There are various possible structures involving the use of exchangeable shares, but the underlying principle is that the shares received by the Canadian resident vendor have an exchange right which entitles the holder thereof to exchange the shares of the Canadian target at some point in the future for shares of the foreign purchaser at a pre-determined ratio.
A typical structure involving exchangeable shares is as follows. The Canadian target will amend its articles to create a new class of exchangeable shares, as well as a new class of preferred shares. The exchangeable shares of Canadian target will generally be non-voting with a right of retraction at the option of the holder, subject to a call right by the foreign purchaser, which entitles the holder thereof to receive shares of foreign purchaser in exchange for shares of Canadian target. A number of voting rights of foreign purchaser equivalent to the number of issued and outstanding exchangeable shares of Canadian target are generally exercisable by a trustee for the benefit of all exchangeable Canadian resident vendors. The foreign purchaser receives one preferred share from the Canadian target in exchange for one common share of the foreign purchaser, and the Canadian shareholders then exchange their common shares of Canadian target for the exchangeable shares of Canadian target at negotiated ratios. Finally, the foreign purchaser exchanges its preferred share in the Canadian target for a common share of Canadian target.
Such structures have not historically been challenged by CRA, and indeed there have been suggestions in the Canadian federal budgets over the past decade that the rules governing tax-deferred share-for-share exchanges would eventually be extended to cross-border exchanges. Nonetheless, for the time being, exchangeable share transactions remain a valuable tool for effecting tax-deferred share purchase of Canadian targets by foreign purchasers.
In 10737 Newfoundland Ltd. v. R. (2011 D.T.C 1255) (“10737 Newfoundland”), the Tax Court of Canada recently addressed the issue of whether a Canadian resident taxpayer should be entitled to claim a capital loss realized on the exchange of Canadian target exchangeable shares for shares of foreign purchaser as a result of a subsequent decline in value. 3507271 Canada Inc. and 100935 Canada Inc. were Canadian resident shareholders of Newbridge Networks Corporation (“Newbridge”), which on February 23, 2000 entered into a merger agreement with Alcatel, a corporation resident in France. The merger was completed on May 25, 2000 pursuant to a court-approved plan of arrangement. Shareholders of Newbridge were given the option to receive either Alcatel American Depositary Shares (“Alcatel ADS”) or Newbridge exchangeable shares in consideration for their Newbridge common shares. The receipt of Alcatel ADS as consideration for Newbridge common shares was a taxable event for Canadian resident shareholders while the receipt of Newbridge exchangeable shares as consideration for Newbridge common shares was not a taxable event for such shareholders. The particular Canadian resident shareholders described above elected to receive Newbridge exchangeable shares.
The Newbridge exchangeable shares were intended to be economically equivalent to the Alcatel ADS, except that holders of Newbridge exchangeable shares were not entitled to attend or vote at meetings of Alcatel shareholders. The holders of Newbridge exchangeable shares were entitled at any time, subject to the exercise by Alcatel of its retraction call right, to require Newbridge to redeem their Newbridge exchangeable shares in exchange for Alcatel ADS.
Shortly after the merger became effective, 10737 Newfoundland Ltd. purchased the exchangeable shares from the two numbered companies mentioned above. More than two years later, after the Newbridge exchangeable shares had declined sharply in value, 10737 Newfoundland Ltd. exercised its retraction right to require Newbridge to redeem a portion of its Newbridge exchangeable shares in consideration for Alcatel ADS. 10737 Newfoundland Ltd. reported a significant capital loss on its disposition of the Newbridge exchangeable shares. The Minister of National Revenue (the “Minister”) reassessed 10737 Newfoundland Ltd. to disallow the capital loss on the basis of certain “stop-loss” rules under the Act.
The stop-loss rules in question are contained in subsections 40(3.3) and 40(3.4) of the Act and generally deem a capital loss realized on a disposition of property to be nil where all of the following conditions are met: (a) a corporation, trust or partnership (the “transferor”) disposes of a particular capital property (other than depreciable property of a prescribed class); (b) during the period that begins 30 days before and ends 30 days after such disposition, the transferor or a person affiliated with the transferor acquires a property (the “substituted property”); and (c) at the end of the period described in paragraph (b) the transferor or a person affiliated with the transferor owns the substituted property.
Finally, for the purposes of the aforementioned stop-loss rules, a right to acquire a property is deemed to be a property that is identical to the property itself pursuant to subsection 40(3.5) of the Act. Thus, the Minister reassessed 10737 Newfoundland Ltd. on the basis that the exchangeable shares were in effect merely a right to acquire Alcatel ADS, such that this right was deemed to be identical to the newly acquired Alcatel ADS with the result that no capital loss could be claimed until the eventual disposition of Alcatel ADS.
The Tax Court of Canada allowed the taxpayer’s appeal. Chief Justice Rip identified the question at issue as whether the property disposed of by 10737 Newfound Ltd. was properly identified as the Newbridge exchangeable shares themselves or as a right to acquire Alcatel ADS. Central to Chief Justice Rip’s decision was his determination that the exchange rights attached to the Newbridge exchangeable shares were part of the “bundle of rights” attached to the shares. Citing prior case law, the Court noted:
[…] a share should be looked at as a composite of different rights. By emphasizing the retraction right, the respondent arguably is proposing the existence of a distinct and separate property that the taxpayer did not own. The respondent is trying to parcel out piecemeal what suits its case. […] (at para. 39)
The appellant was abona fide shareholder of Newbridge; it held Exchangeable Shares with all the rights and obligations attached to these shares. To say that the taxpayer disposed of “a right to acquire” Alcatel ADSs, ignoring that this right was attached to the Exchangeable Shares, would amount to a recharacterization of the legal relationship between the appellant as a shareholder of Newbridge and Newbridge itself. (at para. 42)
In essence, the Court held that particular rights attached to a share, in this case the right to exchange the Newbridge share, could not be separated from the overall bundle of rights attaching to the Newbridge share for the purposes of applying the above-noted stop-loss rules. The property disposed of by 10737 Newfoundland Ltd. was therefore Newbridge exchangeable shares which were different from the Alcatel ADS, and not merely rights to acquire Alcatel ADS which would have been deemed to be property identical to Alcatel ADS under the stop-loss rules. Thus, 10737 Newfoundland Ltd. was permitted to essentially crystallize the accrued capital loss in respect of its Newbridge exchangeable shares while retaining its interest in Alcatel ADS until such time as the Alcatel ADS are disposed of.
The decision in 10737 Newfoundland opens the door to the crystallization of capital losses where taxpayers have suffered a decrease in the fair market value of exchangeable shares received in similar transactions but wish to retain their economic interest in the foreign purchaser. One way of avoiding the application of the above-noted stop-loss rules would be for a taxpayer to wait 30 days after a particular disposition to reacquire identical property. Based on the findings in this decision, and subject to the application of the general anti-avoidance rule (“GAAR”) discussed below, it should not be necessary to resort to this more circuitous method to avoid the application of the stop-loss rules in the context of exchangeable shares.
It is noteworthy that the Crown did not raise GAAR in its argument against the crystallization of the capital loss. Taxpayers are left to speculate as to why GAAR was not raised at any stage in the proceeding, and whether in future cases GAAR may be invoked under similar circumstances involving loss crystallization where the taxpayer has arguably exchanged a right to acquire property for the property itself.
The circumstances in 10737 Newfoundland were unusual, in that they involved not only shares in a corporation which suffered a dramatic drop in value following an exchangeable share transaction, but also a shareholder who wished to retain the underlying shares of the foreign purchaser after crystallizing the capital loss in respect of the exchangeable shares. Nonetheless, the case is noteworthy for its support of the legal consequences of exchangeable share transactions in relation to their intended effect, as well as its more general implications for the interpretation of rights attaching to shares in a corporation and the application of the stop-loss rules. The Crown did not appeal the decision to the Federal Court of Appeal.