Exchangeable share structures have been a fixture in structuring cross-border share exchange mergers and acquisitions involving Canadian corporations for decades. Although the Canadian government previously announced plans to introduce a rule to allow Canadian shareholders to exchange Canadian shares for shares of a foreign corporation on a tax-deferred rollover basis, that proposal was subsequently abandoned. Nevertheless, exchangeable share structures may still be a viable alternative to achieve a similar result – despite their decreased popularity in recent years. The primary benefit of exchangeable share structures is that they allow Canadian shareholders to achieve full or partial deferral of Canadian taxes on capital gains which otherwise would be payable when a non-Canadian corporation acquires the shares of a Canadian corporation where the consideration consists, in whole or in part, of the acquirer’s own shares.
The Basic Structure of an Exchangeable Share Transaction
A common structure for an exchangeable share transaction involving a foreign (e.g. U.S.) acquiring corporation (Acquireco) is outlined in the chart below.
Incorporation of Exchangeco and Canco
Acquireco will incorporate two Canadian corporations: a direct subsidiary of Acquireco (Canco) and a direct subsidiary of Canco (Exchangeco). Canco is incorporated to exercise the “call rights” described below, while Exchangeco is incorporated to acquire the shares of the target Canadian corporation (Canadian target) from its Canadian shareholders (Canadian Shareholders) for exchangeable shares issued by Exchangeco to the Canadian Shareholders.1 (Other shareholders of Canadian target may prefer to receive Acquireco shares in exchange for their Canadian target shares.) Future exchanges of exchangeable shares for shares of Acquireco will be a taxable event for Canadian purposes to the holder of exchangeable shares.
For Canadian tax purposes the use of a separate Canco is generally preferable to maximize cross border paid-up capital (PUC) – which represents the amount that can generally be distributed free of Canadian withholding tax. Specifically, use of Canco generally allows PUC to be determined based on the value of exchangeable shares at the time of exchange, rather than based on the historic PUC in the exchangeable shares (which will generally not exceed the historic tax cost of the Canadian target shares to the Canadian Shareholders).
Creation of Exchangeable Shares
The exchangeable shares are structured to provide the Canadian Shareholders with the same economic rights and benefits as holders of the Acquireco shares into which the exchangeable shares are exchangeable. The share terms of exchangeable shares generally have the following attributes:
Retraction: Canadian Shareholders have a “retraction right”, which means that Canadian Shareholders can require that Exchangeco redeem exchangeable shares held by a Canadian Shareholder. The consideration on a retraction would be the same as in the event of redemption, described below.
Redemption: Exchangeco has a “redemption right”, which means that it can redeem all of the exchangeable shares for Acquireco shares on a one-for-one basis (plus any declared but unpaid dividends), in certain limited circumstances.
Dividends/Distributions: In order to maintain economic equivalence, if a dividend is declared on Acquireco shares, an equivalent dividend must be declared on the exchangeable shares, and vice versa. On the liquidation or dissolution of Exchangeco, Canadian Shareholders are entitled to receive Acquireco shares.
Voting: The exchangeable shares are typically non-voting. In addition, Canadian Shareholders are not legally shareholders of Acquireco and therefore are not entitled to vote at meetings of Acquireco shareholders. To allow the Canadian Shareholders to vote at the Acquireco level, Acquireco may issue shares of special voting stock to the Canadian Shareholders or to a voting trustee if permitted under its applicable law. However, it is not always necessary to provide voting rights to the Canadian Shareholders, and often voting rights are not provided where the Acquireco is a private company in order to simplify the structure. If voting rights are provided, the intent is to provide Canadian Shareholders with the same amount of votes that they would have had if they held ordinary Acquireco shares.
Liquidation/Dissolution: On a liquidation or dissolution (and subject to the overriding call right), exchangeable shares entitle the holder the right to receive shares of Acquireco on a one for one basis plus an additional amount for declared but unpaid dividends.
Term: If desired, the exchangeable shares could have a sunset clause triggering an automatic exchange after a period of time (such as 10 years). The exchangeable share terms may also provide for an automatic exchange in various circumstances such as where only a nominal number of exchangeable shares remain outstanding, on a liquidation event, as a result in adverse change in tax laws, or prior to an initial public offering.
Support & Exchange Agreement
Acquireco enters into a support agreement with the Canadian Shareholders pursuant to which Acquireco agrees to (a) provide Exchangeco with sufficient funds to pay dividends to Canadian Shareholders in an amount equal to dividends (if any) paid on Acquireco shares, and (b) issue Acquireco shares to the Canadian Shareholders to support Exchangeco’s redemption of the exchangeable shares or Canco’s exercise of its call right, discussed below.
Canco is granted a call right whereby it may purchase the exchangeable shares from the Canadian Shareholders for Acquireco shares (the call right). The purpose of the call right is to allow Canco to “purchase” the exchangeable shares rather than having Exchangeco redeem the shares (on a redemption or retraction or in connection with a liquidation event) thus avoiding the adverse deemed dividend tax consequences that may arise from a redemption/retraction of exchangeable shares.
Canadian shareholders are generally taxed more advantageously on dividends received from Canadian corporations as compared to those received from foreign corporations. In particular, dividends received on shares of Acquireco will not be eligible for the “gross-up” and “dividend tax credit” regime applicable to certain dividends, or the reduced tax rate applicable to designated “eligible dividends” received by individuals from taxable Canadian corporations. However, dividends received on exchangeable shares will generally result in certain Canadian preferred share tax rules applying to the issuer – which may discourage paying dividends on the exchangeable shares. In addition, foreign tax considerations may also discourage paying dividends on the exchangeable shares (such as the potential risk of foreign withholding taxes). The impact of the Canadian preferred share tax rules may be mitigated where the issuer is otherwise taxable – but that may not always be sufficient, particularly in the exchangeable share context since the quantum of dividends is in part dependent on non-Canadian operations.
The 2013 Federal Budget proposed new rules that would affect the character of gains and losses in respect of capital property sold or received under certain forward sale agreements, deeming such gains and losses to arise on income, rather than capital, account. We understand that these rules were not intended to apply to typical exchangeable share structures – but legislation to implement these rules (expected to be released in draft form later in 2013) will need to be carefully reviewed to confirm this result.
1 Canadian Shareholders may generally also take back cash or other consideration on the transaction on a tax-deferred basis provided that such cash or other consideration does not exceed the Canadian Shareholder’s tax cost in the Canadian target shares.