Reorganization Strategies for Proposed Paragraph 55(3)(a)

The 2015 budget proposals affecting section 55 have forced advisers and taxpayers to rethink many standard corporate distributions and reorganizations. The proposals are effective as of budget day (April 21, 2015). Although draft legislation has been released, many details are still under discussion between the government and tax practitioners. For non-pressing matters, the prudent strategy may be to defer action. However, because waiting may not be an option for some, this article discusses alternative means by which assets may be moved within a related corporate group on a tax-deferred basis.

Consider a corporate group comprising Parentco, Parentco’s subsidiary Holdco, and Holdco’s subsidiary Opco. The group intends to transfer one of Opco’s existing business lines to Newco, a new subsidiary of Holdco, in a way that results in a clean structure (such that Holdco is the only owner of shares or debt of Newco). The key goal of the structuring is to ensure that all dividends arise under subsection 84(3), so that proposed paragraph 55(3)(a) applies to exclude the transactions from the uncertainty associated with the application of proposed subsection 55(2). Thus, the series of transactions that includes one of the alternatives below must not include a triggering event involving a person unrelated to the dividend recipient.

The transfer can be accomplished using the following steps:

Alternative 1
  1. Holdco forms Newco.

  2. Opco transfers the relevant assets to Newco on a tax-deferred basis pursuant to subsection 85(1) in exchange for shares of Newco. (Preferred shares rather than common shares are typically used, largely to avoid valuation issues.)

  3. Newco redeems the shares transferred to Opco in step 2 in exchange for a note.

  4. Opco redeems a portion of its shares (with a value equal to the value of the Opco assets transferred to Newco in step 2) and transfers the Newco note to Holdco as an in-kind redemption payment.

  5. Holdco transfers the Newco note to Newco in exchange for shares or as a capital contribution (thereby cancelling the note).

Before the budget, step 4 may have consisted of Opco declaring a dividend in kind of the Newco note to preserve Holdco’s ACB of the Opco shares. This is no longer an effective strategy, however, because dividends in kind do not fall under the protective cover of proposed paragraph 55(3)(a).

If the redemption of the Opco shares will result in a capital gain (that is, if the ACB is less than the PUC), Opco may want to take the steps necessary to reduce the PUC in respect of those shares so that the ACB is greater than or equal to the PUC. Before doing so, Opco may want to exchange the shares that it will redeem for shares of a different class (for example, exchanging common shares for preferred shares pursuant to section 51, 85, or 86).

Some practitioners might consider another way of implementing the transfer, which differs in steps 3 through 6:

Alternative 2
  1. Holdco forms Newco.

  2. Opco transfers the relevant assets to Newco on a tax-deferred basis pursuant to subsection 85(1) in exchange for shares of Newco. (Preferred shares rather than common shares are typically used, largely to avoid valuation issues.)

  3. Holdco transfers shares of Opco (with a value equal to the value of the Opco assets transferred to Newco in step 2) to Newco in exchange for shares of Newco on a tax-deferred basis.

  4. Newco redeems the shares that it issued to Opco in step 2 and issues a note to Opco as an in-kind redemption payment for the redeemed shares.

  5. Opco redeems the shares that Newco received in step 3, and issues a note to Newco as an in-kind redemption payment for the redeemed shares.

  6. The notes issued in steps 3 and 4 are offset and cancelled.

The two alternatives differ in their final outcomes with respect to Holdco’s ACB of the Newco shares:
  • In alternative 1, the ACB is the FMV of the Newco note (plus the nominal incorporating amount).

  • In alternative 2, the ACB is Holdco’s ACB of the Opco shares that Holdco transferred to Newco in step 3 (plus the nominal incorporating amount).

The two ACB amounts could be the same, but in most circumstances the first amount will be greater. Accordingly, it is likely that alternative 1 will be the preferred approach.

Carla Hanneman
KPMG Law LLP, Toronto
[email protected]

Canadian Tax Focus
Volume 5, Number 3, August 2015
©2015, Canadian Tax Foundation


  • Michael Atlas 8/16/2015 12:46:07 PM +4

    Another dose of unwarranted alarmism from a tax law relation to the proposed changes to 55(2)/55(3)(a)!

    This alarmism is not quite as all-encompassing as in the article on section 55 in the July issue of Tax for the Owner-Manager, on which I commented several times (note to readers whose sensitivities seemed to offended by my frank, Donald Trump style, comments there, that I have, in deference to them, reluctantly softened my comments here). In this case, the end result is the development of solutions for a problem that does not really exist! This, in turn, will needlessly increase professional fees.

    Having been involved with similar reorganizations on dozens of occasions over many years, I would never for a moment have looked to paragraph 55(3)(a) as providing “protective cover”, (even though it may have been available) for the actual dividend that would be paid to transfer the note receivable from Newco to Holdco. (Off course, it would have been vitally important in relation to the deemed dividend on the redemption of the Newco shares).
    Instead, I would have had total comfort in relying on the purpose test found in the opening words of 55(2), as they, until now, applied to actual dividends.
    The sole purpose of the dividend is to achieve the desired corporate structure, and certainly it is not part of any series of transactions aimed at reduce any gain or value as a result of that dividend. That is, as indicated in the article, the desire is to have a “clean structure” under which Newco has the business and its sole share and debt holder is Holdco.

    Tax advisors engaged to develop a reorganization will know full-well what the purpose is for any dividend.

    The purpose test is fully alive and well in the revised version of 55(2) that is proposed, and in fact, is easier to apply, since it only looks to the purpose of the dividend itself, and not the whole series of transactions.

    The fact that an increase in the net tax values is added as a purpose that can bring subsection 55(2) into play changes nothing in this type of scenario-although that, just like a decrease in the fair market value of shares, may be a result-it is certainly not a purpose.
    The only way that the actual dividend could reasonably be viewed as having a purpose which could bring subsection 55(2) into play would be if, somehow, it were seen as being part of a plan to stage an (outside) sale of the shares of Opco under circumstances that the capital gain is reduced. Nothing suggests that, and, if that were the case, tax advisors would be aware of that fact. Furthermore, if that were in the works, how would paragraph 55(3)(a) offer any “protective cover”, since at least one of the five prohibitions therein would be violated?

    The real losers here as a result of this unwarranted fear will be the public at large, in that this quest for the “protective cover” of paragraph 55(3)(a) will likely needlessly add professional fees to the cost of many corporate reorganizations-on a collective basis, that could be millions each year. Similarly, such muddled thinking regarding subsection 55(2) will likely result in many corporations spending thousands of dollars to perform SIOH calculations which were not really needed.

    The tidal wave of this alarmist thinking regarding subsection 55(2) is even growing to the point where some advisors fear that it can even apply to a dividend paid from a subsidiary to its parent corporation strictly for the purpose of creditor proofing. Often, the amount of such dividend would exceed SIOH, since the subsidiary will hold assets with unrealized gains, such as real estate or goodwill, which will be secured by a note payable to the parent. In no way, shape or form could the purpose of such dividend reasonably be viewed as being within the scope of subsection 55(2) under either the old or new rules. Yet, many advisors will no doubt succumb to the alarmist narrative and opt for (what they believe to be) the “protective cover” of paragraph 55(3)(a) by implementing steps to turn what would otherwise be an actual dividend into a deemed dividend under subsection 84(3). Ironically, I predict that this switch, will, on a number of occasions, result in situations where the exact opposite results. Namely, subsection 55(2) will apply when it would not have otherwise been applicable. This is because of the fact that there is an insidious “flip side” of this approach: once one moves from an actual dividend to a subsection 84(3) dividend, one forfeits all ability to rely on the purpose test. If a wheel falls off of the paragraph 55(3)(a) bus, the taxpayer will be rendered totally defenseless. The application of paragraph 55(3)(a) requires strict and careful adherence to five complex rules-violate one of them and you are toast! In addition, extra care is required because each of the tests will look to the entire “series of transactions or events” as part of which the deemed dividend was paid (which, based on subsection 248(10), can be interpreted quite broadly). Even seemingly innocuous events can put one offside. Mistakes are bound to happen from time to time, especially if such deliberate switching to 84(3) dividends becomes de rigeuer. As this procedure moves “down the food chain” to professional firms with less real knowledge of paragraph 55(3)(a), the potential for being tripped-up by one or more of the five prohibitions dramatically increases. On the other hand, avoiding the application of subsection 55(2) with an actual dividend, assuming one’s purpose is pure, is a process that is basically “idiot proofed”.

    As these self-imposed subsection 55(2) screw-ups inevitably happen, and if I am still around, please let me know-I can always use a good laugh!

  • Hugh Neilson 8/21/2015 7:47:20 PM +3

    Like Mr. Atlas, I also believe the purpose test mitigates many issues related to the amendments to Section 55. As he notes, we normally have a pretty good idea of our clients' purposes.

    However, the CRA does not share that insight into our clients' purposes, nor do they always place significant trust in the word of the practitioner representing his client, or that of the client themselves, as to what the purpose was.

    A client emerging from a battle before CRA's Appeals division (much less the Tax Court, Federal Court of Appeal or Supreme Court) looking at his positive ruling, along with his bill for professional services rendered, might be forgiven for seeing the result as somewhat less than a clear victory.

    We've all seen provisions introduced with the assurances of Finance and/or CRA that they will be applied in only the most egregious of circumstances. Has that promise been maintained as these provisions’ history has grown? Is the proportion of technical interpretations which suggest GAAR might be applied, for example, truly indicative of the proportion of issues appropriately described as "the most egregious"?

    If I were confident the proposed changes to Section 55 would be applied as sparingly as, say, third party penalties, and not as broadly as the GAAR now seems suggested to apply, I might be more supportive of the changes. Perhaps Mr. Atlas' experience differs from my own, such that he has such confidence the provisions will not be applied overly broadly by the many CRA auditors in practice. I lack that confidence. I am not even confident that their success in Guindon will not spur the CRA to broader application of those civil penalties.

    In my view, we should not have to accept broad assurances that a provision will be applied narrowly, to egregious situations. Rather, I believe the legislation itself should be drafted in a manner making it applicable only narrowly, and only to those egregious situations which it is intended to frustrate.

    The fact that a large number of professionals, including the joint committee of CPA Canada and the Canadian Bar Association, are concerned about the possible breadth of application of these amendments suggests, at least to me, that these concerns are real and valid.

    Concerns were raised that Synthetic Equity Arrangements might encompass routine purchase and share agreements. The new draft legislation addresses these concerns. Even the concern that the new S 55 provisions might cause the same receipt to be taxed as a capital gain twice has been addressed. The remaining concerns also need to be addressed. It isn’t enough for the technical notes to say that the amendments “are intended to facilitate bona fide corporate reorganizations”. They must actually achieve this result, without reliance on CRA applying the provisions sparingly and judiciously.