CORPORATE SPIN-OFF: Achieving a Tax-Free Corporate Reorganization
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Undertaking a domestic corporate spinoff involves highly complex tax planning to ensure the transaction is completed on a tax-deferred basis for both the corporation and its shareholders. The primary goal is to structure the distribution of the subsidiary's shares without triggering an immediate, often significant, tax liability. The overarching strategy typically revolves around a statutory corporate reorganization known as a "butterfly" transaction, which must adhere strictly to the rules outlined in the Income Tax Act (Canada), principally section 55.
The central tax planning strategy for a corporate spinoff is to qualify the transaction as a "butterfly" reorganization under the Income Tax Act. This is a highly technical, multi-step process that allows a corporation (the distributing corporation) to transfer property to a subsidiary (the spun-off corporation or "SpinCo") and then distribute the shares of the SpinCo to its own shareholders, all without triggering corporate-level tax on the disposition of the assets or tax on the inter-corporate dividend used to facilitate the reorganization. This complex process often requires obtaining an Advance Income Tax Ruling (AITR) from the Canada Revenue Agency to confirm the tax consequences before proceeding, although some practitioners may proceed without one in certain circumstances.
A critical aspect of the tax planning is avoiding the application of the anti-surplus stripping rules in subsection 55(2) of the Income Tax Act. These rules are designed to prevent the tax-free extraction of corporate surplus by re-characterizing certain tax-free inter-corporate dividends as a capital gain. To secure the tax-deferred treatment necessary for a successful butterfly, the transaction must satisfy the exception provided in paragraph 55(3)(b), which is specifically for qualifying "butterfly" reorganizations. This exception requires meticulous adherence to prescribed property division rules (in Regulation 5501) and ensuring that the transaction is not part of a series that involves the acquisition or disposition of property or shares by an unrelated person, thus preserving the economic interests of the shareholders.
For the shareholders receiving the shares of the spun-off company (SpinCo), a key planning goal is to avoid having the distribution treated as a taxable dividend. In the context of a successful butterfly, the mechanics of the reorganization (typically involving an exchange of shares) result in the shareholders being deemed to have disposed of a portion of their original shares and acquired the new SpinCo shares on a tax-deferred basis. The tax cost, or Adjusted Cost Base, of the original shares is allocated between the retained shares and the new SpinCo shares. This deferral is crucial, as a taxable dividend would result in immediate taxation at the shareholder's marginal rate, which can be significant, especially for individuals.
Detailed tax planning is required to strategically allocate and preserve corporate tax attributes. For instance, non-capital loss carryforwards, scientific research and experimental development pools, and other tax balances must be reviewed and allocated between the Distributing Corporation and SpinCo based on rules in the Income Tax Act. The allocation of these attributes is critical to the future tax efficiency of both entities. Furthermore, the calculation and preservation of the Capital Dividend Account and Paid-Up Capital for both entities must be managed throughout the multi-step reorganization to ensure that subsequent post-spin transactions can also be executed efficiently.
Before the final spin-off, the tax planner must address the separation of assets and liabilities. The most common tool for the tax-deferred transfer of assets from the parent to the new subsidiary is the section 85 rollover, which allows the transferring corporation to elect a transfer price between the asset's tax cost and its fair market value, thereby deferring any accrued capital gains. Furthermore, any pre-existing inter-corporate debt or creation of new inter-corporate debt between the companies during the reorganization must be carefully managed. The retirement of such debt in a butterfly transaction is often structured to utilize the inter-corporate dividend deduction under section 112, while ensuring that the section 55 anti-avoidance rules are not inadvertently triggered.
The integrity of the butterfly transaction is highly dependent on both pre-transaction and post-transaction compliance. The entire series of transactions must be viewed as a single, integrated plan. Tax planning must ensure that no non-permitted transactions occur in contemplation of or as part of the series of transactions. This includes prohibitions on the acquisition of shares of the Distributing Corporation or the disposition of assets from the Distributing or SpinCo to unrelated persons for a period following the distribution. Any such transaction, if deemed part of the series, could retroactively disqualify the butterfly, causing the inter-corporate dividends to be taxed and potentially resulting in significant unforeseen tax liabilities.
Our law firm strives to provide strategic tax-driven legal advice and direction to Calgary businesses looking to optimize their business structures and corporate transactions. Contact our law firm at Chris@NeufeldLegal.com or 403-400-4092 to schedule a confidential initial consultation for your business' tax structuring and tax planning initiatives.
