2017-0735771I7 Application of paragraph 40(3.5)(c)

Principal Issues: Whether the term “merger” as used in subparagraph 40(3.5)(c)(i) may include a winding-up.

Position: Yes.

Reasons: Based on the various Canadian legal definitions of the term “merger”, such term may be broadly interpreted so as to include a winding-up. Furthermore, had Parliament intended to exclude a winding-up from the reference to “merger” in subparagraph 40(3.5)(c)(i) it would have specifically done so by incorporating exclusionary wording to that effect, as was done in subsections 87(1), 87(8.1), 87(8.2) and 128.2(3). Furthermore, based on the text, context and purpose of paragraph 40(3.5)(c) the tax deferred liquidation of CCo should not result in the suspended loss becoming available, as such liquidation should fall within the ambit of “merger” in subparagraph 40(3.5)(c)(i).

Author: Patel, Komal
Section: 40(3.3), 40(3.4), 40(3.5), 95(2)(e), 87(1), 87(8.1), 87(8.2), 89(1) and 128.2(3)

                                                                                                                      January 26, 2018

Elizabeth Manning                                                                                         Income Tax Rulings Directorate
a/Manager Legislative Application Section                                                    K. Patel
Large Business Audit, ILBIB, CRA                                                                 (416) 973-2418
610 – 344 Slater Street, Ottawa, ON

                                                                                                                       2017-073577

Re:   XXXXXXXXXX (“ACo”) – TYE XXXXXXXXXX

Application of paragraph 40(3.5)(c) to the capital loss realized on the internal reorganization of equity interest in a foreign affiliate

We are writing in response to the November 24, 2017 referral from the Legislative Applications Section requesting the Income Tax Rulings Directorate’s (ITRD’s) opinion on the interpretation of subparagraph 40(3.5)(c) of the Income Tax Act (the “Act”) to the XXXXXXXXXX reorganization steps outlined below (the “Reorganization”).

All amounts referred to herein are in XXXXXXXXXX.

FACTS & ASSUMPTIONS

1.    ACo is a public corporation, the shares of which are traded on the XXXXXXXXXX Stock Exchange. ACo is a taxable Canadian corporation and a resident of Canada for purposes of the Act.

2.    BCo is a corporation formed under the laws of XXXXXXXXXX and a resident of XXXXXXXXXX. ACo owns XXXXXXXXXX% of the common shares of BCo.

3.    CCo is a corporation formed under the laws of XXXXXXXXXX and a resident of XXXXXXXXXX. CCo is a XXXXXXXXXX for XXXXXXXXXX tax purposes. CCo is a wholly-owned subsidiary of ACo.

4.    DCo is a XXXXXXXXXX formed under the laws of XXXXXXXXXX and a XXXXXXXXXX for XXXXXXXXXX tax purposes. DCo is a wholly-owned subsidiary of ACo.

5.    ECo is a XXXXXXXXXX formed under the laws of XXXXXXXXXX and a XXXXXXXXXX for XXXXXXXXXX tax purposes. ECo is a wholly-owned subsidiary of DCo.

6.    FCo is a corporation formed under the laws of XXXXXXXXXX and is a resident of XXXXXXXXXX. FCo is a holding company with subsidiaries that operate XXXXXXXXXX. The shares of FCo were excluded property (footnote 1) for Canadian income tax purposes at the time of the Reorganization. FCo has Class A and B common shares outstanding. (footnote 2) Immediately before the Reorganization ECo held XXXXXXXXXX Class B common shares of FCo which had an accrued loss in the amount of $XXXXXXXXXX. Immediately before the Reorganization CCo held XXXXXXXXXX Class B common shares of FCo which had an accrued loss in the amount of $XXXXXXXXXX.

7.    Immediately before the Reorganization the shares of CCo held by ACo had an accrued loss in the amount of $XXXXXXXXXX.

8.    Immediately before the Reorganization, BCo, CCo, DCo, ECo and FCo were controlled foreign affiliates (“CFAs”) (footnote 3) of ACo.

9.    Immediately prior to the liquidation of CCo in step 3 of the Reorganization, ACo had a surplus entitlement percentage in respect of CCo of at least XXXXXXXXXX%, making the liquidation a designated liquidation and dissolution (“DLAD”). (footnote 4)

REORGANIZATION STEPS

Step 1: On XXXXXXXXXX, ECo transferred all of its shares of FCo to BCo in exchange for XXXXXXXXXX Class B common shares of BCo that track to ECo’s indirect interest in FCo.  The FMV of the shares of FCo that were transferred by ECo was equal to the FMV of the shares of BCo received by ECo as consideration.

XXXXXXXXXX (footnote 5)

Step 2: On XXXXXXXXXX, ACo transferred, in aggregate, XXXXXXXXXX shares of CCo, being all of the outstanding shares of CCo to BCo as a contribution of capital, with no additional shares being issued.

XXXXXXXXXX

ACo reported a capital loss of $XXXXXXXXXX (“the Suspended Loss”) in respect of the disposition of the shares of CCo. The loss was initially suspended pursuant to subsection 40(3.4) since the CCo shares were disposed of to BCo, which was affiliated with ACo.

XXXXXXXXXX (footnote 6) XXXXXXXXXX

Step 3: On XXXXXXXXXX, BCo passed a resolution to dissolve and liquidate CCo.  CCo was liquidated on XXXXXXXXXX.  On liquidation, CCo distributed all of its property to BCo including its Class B shares of FCo and some nominal cash.

XXXXXXXXXX

As a DLAD, the liquidation of CCo occurred on a tax deferred basis pursuant to paragraph 95(2)(e).

XXXXXXXXXX

ISSUE

Whether the liquidation of CCo results in the Suspended Loss becoming available pursuant to subparagraph 40(3.4)(b)(i).

ANALYSIS

Part I: Subparagraph 40(3.5)(c)(i) and the meaning of “merger”

Corporate Law

The term “merger” is not defined in the Act nor has such meaning been the subject of any tax court cases.

Barron’s Canadian Law Dictionary, 6th Edition, defines “merger” as:

“The amalgamation of one thing into another; a consolidation.

1. In the law of corporations, the terms merger and amalgamation are often used interchangeably, although only the latter has a specific legal meaning. AMALGAMATION is the fusion of two or more corporations and their continuance as one corporation. Such an amalgamation, or, popularly, a merger, is accomplished in several ways: (1) A sale of the assets of one (or more than one) corporation to an existing corporation in consideration of the issuance of paid-up shares or securities of the latter. The vendor corporation will then pay its liabilities and distribute its assets among its own shareholders and surrender its charter or in some other manner be dissolved; (2) a lease of the whole or a substantial part of the assets and business of one or more corporations to another corporation. In this case the lessor corporation remains in existence and distributes, by way of dividends among its shareholders, the rentals paid by the lessee corporation; (3) acquisition of shares of two or more corporations by a new corporation or by an existing corporation; (4) amalgamation by agreement between the corporations pursuant to special statutory provisions. This last-named method of effecting amalgamations is governed by both federal and provincial companies legislation.”

Black’s Law Dictionary 8th Edition defines “merger” as: “The act or instance of combining or uniting”. It then details additional meanings depending on the context. In the corporate context it states: “The absorption of one organization (esp. a corporation) that ceases to exist into another that retains its own name and identity and acquires the assets and liabilities of the former. Corporate mergers must conform to statutory formalities and usu. must be approved by a majority of the outstanding shares.”

The definition then goes on to further define a number of subsets of “mergers”. Of note is the definition of De facto merger: “A transaction that has the economic effect of a statutory merger but that is cast in the form of an acquisition or sale of assets or voting stock. Although such a transaction does not meet the statutory requirements for a merger, a court will generally treat it as a statutory merger for purposes of the appraisal remedy.”

In contrast, a winding-up is defined (footnote 7) simply as: “The process of settling accounts and liquidating assets in anticipation of a partnership’s or a corporation’s dissolution.”

Based on the above definitions, it appears that from a corporate law perspective, the term “merger” is broader and more encompassing in comparison to a “winding-up”.

In The Queen v. Black and Decker Mfg. Co., 43 D.L.R. (3d) 393, at pages 399–400, (“Black and Decker”), which is a decision concerning the meaning of “amalgamation” under old Canadian corporate law, the Supreme Court of Canada indicated that:

“There are various ways in which companies can be put together. The assets of one or more existing companies may be sold to another existing company or to a company newly-incorporated, in exchange for cash or shares or other consideration. The consideration received may then be distributed to the shareholders of the companies whose assets have been sold, and these companies wound up and their charters surrendered. In this type of transaction a new company may be incorporated or an old company wound up but the legal position is clear. There is no fusion of corporate entities. Another form of merger occurs when an existing company or a newly-incorporated company acquires the shares of one or more existing companies which latter companies may then be retained as subsidiaries or wound up after their assets have been passed up to the parent company. Again there is no fusion. But in an amalgamation a different result is sought and different legal mechanics are adopted, usually for the express purpose of ensuring the continued existence of the constituent companies. The motivating factor may be the Income Tax Act or difficulties likely to arise in conveying assets if the merger were by asset or share purchase. But whatever the motive, the end result is to coalesce to create a homogenous whole. The analogies of a river formed by the confluence of two streams, or the creation of a single rope through the intertwining of strands have been suggested by others.” [Emphasis added]

Based on the above statement, the Court contemplated a number of different ways that a merger could be effected, supporting the notion that a merger at law is broad and encompassing.

Tax Law

A review of a number of provisions in the Act supports the view that the term “merger” used in subparagraph 40(3.5)(c)(i) is broad and encompassing such that it may also include a winding-up.

For instance, subsection 87(1) reads as follows: “In this section, an amalgamation means a merger of two or more corporations each of which was, immediately before the merger, a taxable Canadian corporation (each of which corporations is referred to in this section as a "predecessor corporation") to form one corporate entity (in this section referred to as the "new corporation") in such a manner that……..otherwise than as a result of the acquisition of property of one corporation by another corporation, pursuant to the purchase of that property by the other corporation or as a result of the distribution of that property to the other corporation on the winding-up of the corporation.”

This exclusionary language is also mirrored in subsection 87(8.1) which deals with foreign mergers and subsection 87(8.2) which deals with absorptive mergers. The exclusionary language found in each of these provisions supports that a merger is broad enough to include a winding-up, hence the specific carve-out of a winding-up noted. This drafting style is also evident in proposed subsection 87(8.4), which lays out the conditions required to be met in order to obtain a rollover (under proposed subsection 87(8.5)) on the disposition of taxable Canadian property that occurs as part of a foreign merger.

Proposed subsection 87(8.4) provides that, “Subsection (8.5) applies at any time if (a) there is at that time a foreign merger of two or more predecessor foreign corporations (within the meaning assigned by subsection (8.1), if that subsection and subsection (8.2) were read without reference to the expression "otherwise than as a result of the distribution of property to one corporation on the winding-up of another corporation")…”. Proposed subsection 87(8.4) is comparatively broader in its application as it removes from the definition of “foreign merger” the exclusion for wind-ups. Such carving out of wind-ups in the definition of “foreign merger” in 87(8.1) is only necessary because, in our view, a “merger” otherwise includes a wind-up.

In addition to subsections 87(1), 87(8.1) and 87(8.2), the exclusionary language used therein is also noted in subsection 128.2(3) which deals with cross-border mergers and in the definition of a “Canadian corporation” in subsection 89(1). Given that these provisions when making reference to a “merger” found it necessary to carve out a winding-up, it follows that the term “merger” generally includes a winding-up. As it relates to the stop loss rules, in our view, had Parliament intended to exclude a winding-up from the reference to “merger” in subparagraph 40(3.5)(c)(i), it would have specifically done so by incorporating exclusionary wording to that effect, as was done in a number of other provisions.

A review of the exclusion in subparagraph 40(3.5)(c)(i) to transactions that fall within paragraph 40(3.5)(b) provides additional support for the broadness of the term “merger” as used in subparagraph 40(3.5)(c)(i).

Subparagraph 40(3.5)(c)(i) reads:

(c) if subsections (3.3) and (3.4) apply to the disposition by a transferor of a share of the capital stock of a particular corporation and after the disposition
(i) the particular corporation is merged or combined with one or more other corporations, otherwise than in a transaction in respect of which paragraph (b) applies to the share, then the corporation formed on the merger or combination is deemed to own the share while the corporation so formed is affiliated with the transferor,

Generally speaking, paragraph 40(3.5)(b) provides that a share of the capital stock of a corporation that is acquired (i.e., new share) in exchange for another share (i.e., old share) in a transaction is deemed to be a property that is identical to the other share (i.e., old share) if section 51, 86, 87 or 85.1 applies to the transaction. Accordingly, in addition to a winding-up, transactions that fall within sections 51, 86, 87 or 85.1 may also fall within the ambit of a “merger” for purposes of subparagraph 40(3.5)(c)(i). This provides further support for the broadness of the term “merger” as used in subparagraph 40(3.5)(c)(i).

In addition, we note that the current version of paragraph 40(3.5)(c) (applicable after August 19, 2011) incorporated the words “or combined” immediately after the word “merger”. In this respect, it appears that the addition of the words “or combined” to “merged” broadens the potential scope of subparagraph 40(3.5)(c)(i).

Part I: Conclusion

Based on legal definitions of the term “merger” as well as the scope of that term described by the Supreme Court of Canada in the Black and Decker case, it is evident that such term is broad and encompassing and may include a winding-up. Furthermore, as mentioned above, had Parliament intended to exclude a winding-up from the reference to “merger” in subparagraph 40(3.5)(c)(i), it would have specifically done so by incorporating exclusionary wording to that effect, as was done in subsections 87(1), 87(8.1), 87(8.2), 89(1) (footnote 8) and 128.2(3). Given that these provisions, when making reference to a “merger”, found it necessary to carve out a winding-up, it follows that the term “merger” generally includes a winding-up. Lastly, the various provisions referred to in paragraph 40(3.5)(b) and the carve-out of these provisions in the context of the term “merger” in subparagraph 40(3.5)(c)(i), lends additional support for the broadness of that term as used in the context of subsection 40(3.5).

Part II: Subparagraph 40(3.5)(c)(i) and the use of the word “formed”

Subparagraph 40(3.5)(c)(i) makes reference to a corporation “formed” on the merger or combination. Under most corporate statutes, where a corporation is wound-up into another, there is no formation of a corporation in the traditional sense.

In our view, although no corporation is “formed” on a winding-up, this does not preclude the application of subparagraph 40(3.5)(c)(i). Above, it was noted that transactions that fall within sections 51, 86, 87 or 85.1 are carved out of a “merger” in subparagraph 40(3.5)(c)(i). Accordingly, the term “merger” as used therein is broad enough to capture a subsection 86(1) reorganization of capital, as one example. The rollover provisions of subsection 86(1) apply where all of the shares of the capital stock of a particular class are exchanged for new shares in the course of a reorganization of the corporation’s capital. In such a transaction there is no corporation “formed” in the traditional sense. The same can be said for transactions that fall within sections 51 and 85.1. Consequently, the use of the word “formed” in subparagraph 40(3.5)(c)(i) does not, in our view, preclude a merger from including a winding-up.

In addition, it is helpful to revisit subsection 87(8.1) and the definition of foreign merger: “For the purposes of this section, "foreign merger" means a merger or combination of two or more corporations each of which was, immediately before the merger or combination, resident in a country other than Canada …. to form one corporate entity resident in a country other than Canada … in such a manner that, and otherwise than as a result of the distribution of property to one corporation on the winding-up of another corporation…”. The above wording supports that a wind-up could fall within the ambit of a merger that results in the “formation” of a corporation entity. The same can be inferred from the winding-up carve outs found in subsections 87(1) and 128.2(1).

Lastly, the wording in subsection 128.2(1) is particularly notable in respect of the current discussion around the word “formed”: “Where a corporation formed at a particular time by the amalgamation or merger of, or by a plan of arrangement or other corporate reorganization in respect of 2 or more corporations….”. The wording of this provision supports that the use of the word “formed” may be broad enough to include more than just a straight amalgamation of corporations and may also include “other corporate reorganizations” such as a wind-up or liquidation.

Part II: Conclusion

Based on the wording of subparagraph 40(3.5)(c)(i) and the specific carve out of a number of transactions in paragraph 40(3.5)(b) that do not result in a corporation being “formed” in the traditional sense, it is evident that the use of the word “formed” should be broadly interpreted within the context of the provisions at hand. This is further evidenced by the use of the word “formed” in subsections 87(1), 87(8.1) and 128.2(1). Accordingly, in our view the use of the word “formed” in subparagraph 40(3.5)(c)(i) does not preclude a merger from including a winding-up.

Part III: Interpretation of subparagraph 40(3.5)(c)(i) in light of subparagraphs 40(3.5)(c)(ii) and (iii)

In the analysis above we conclude that the term “merger” as used in subparagraph 40(3.5)(c)(i) is broad enough to include a wind-up. Turning our attention to subparagraphs 40(3.5)(c)(ii) and (iii), we observe that these subparagraphs make reference to certain wind-ups (i.e., subsection 88(1) wind-ups as well as a QLAD (footnote 9) or DLAD where the transferor of the loss shares is a foreign affiliate). This introduces a level of ambiguity and leads to the question that if subparagraph (i) includes a wind-up, what is the purpose of subparagraphs (ii) and (iii)? It follows then that the words of paragraph 40(3.5)(c) appear to support more than one meaning and as such, emphasis must be placed on the text, context and purpose of the rules in arriving at an appropriate interpretation thereof. This method of interpreting the Act was espoused by the Supreme Court of Canada in Her Majesty the Queen v. Canada Trustco Company, 2005 DTC 5523 (“Canada Trustco”), (as quoted in Her Majesty the Queen v. Imperial Oil Limited, 2006 DTC 6639 (“Imperial Oil”), para. 10:

“The interpretation of a statutory provision must be made according to a textual, contextual and purposive analysis to find a meaning that is harmonious with the Act as a whole. When the words of a provision are precise and unequivocal, the ordinary meaning of the words play a dominant role in the interpretive process. On the other hand, where the words can support more than one reasonable meaning, the ordinary meaning of the words plays a lesser role. The relative effects of ordinary meaning, context and purpose on the interpretive process may vary, but in all cases the court must seek to read the provisions of an Act as a harmonious whole.”

Context

Subparagraphs 40(3.5)(c)(ii) and (iii) cover a limited number of wind-up transactions, however all such transactions involve a wind-up that occurs on a tax deferred basis. It appears that Parliament wanted to ensure that, pursuant to the deemed continuity rules, a suspended loss does not become available where the transferred corporation is subsequently wound-up on a tax deferred basis. This makes sense given that the wound-up corporation’s assets continue to be held within the affiliated group and the wind-up was not subject to Canadian tax. In other words, where shares are transferred at a loss to an affiliated party, there is no economic loss realized by the affiliated group and when such shares are subsequently wound-up in a tax deferred manner, there continues to be no economic loss or cost realized by the affiliated group. Accordingly, such circumstances should not, from a tax policy perspective, warrant the availability of a capital loss.

The above interpretation is further supported by looking at the context of subsection 40(3.5) from a macro perspective. It is notable that all of the reorganizations mentioned in paragraph 40(3.5)(b) (i.e., sections 51, 86, 87 and 85.1) allow transactions that fall within those provisions to occur on a tax deferred basis. Given that the deemed continuity rules apply to such transactions, this informs us that the legislators intended that tax deferred transactions should not result in a previously suspended loss becoming available.

Purpose

The Federal Court of Appeal in Cascades c. R., 2009 DTC 5093, made the following comments regarding the overall scheme of the legislation and subsections 40(3.3), 40(3.4) and 40(3.5), at paragraph 34:

“[…] in light of the overall scheme of the legislation and of the provision in question, they should be seen as establishing a stop-loss rule. As Gerald D. Courage points out in his article Utilization of Tax Losses and Debt Restructuring, 2006 Ontario Tax Conference, (Toronto; Canadian Tax Foundation, 2006), 9:1-86, at page 2:

[…] the Act contains a number of so called “stop-loss rules” where there has been a transfer of property with an accrued loss within a statutorily defined closely held group. While the transfer might otherwise be treated as a sufficient realization so as to permit recognition of the loss, nevertheless the loss is denied until the property (or, in some cases, property received in exchange on the transfer) is transferred out of the group, at which point there is effectively a “true” realization by the group of the loss for tax purposes.”

The purpose of subsections 40(3.3), (3.4) and (3.5) was also summarized by Justice Lamarre of the Tax Court of Canada in Cascades Inc. v. Majesty the Queen, 2008 DTC 2387, as follows, para. 22:

“These rules are aimed at preventing a corporation (in this case, the appellant) from recognizing a capital loss on capital property for as long as the property or identical property (the substituted property) is held by the transferor (the appellant) or a person affiliated with the transferor. The respondent relied on paragraph 40(3.5)(c) to argue that the corporation formed on the merger of PII and 371, namely 384894-9 Canada Inc. (PII Fusionco), was deemed to hold the share of PII (sold by the appellant and given rise to the loss at issue) as long as it was affiliated with the appellant. The presumption in paragraph 40(3.5)(c) of the ITA is that when a transferor (the appellant) disposes of a share of the capital stock of a corporation (PII) that is then merged with one or more other corporations (371), the corporation formed on the merger (PII Fusionco) is deemed to own the share as long as it is affiliated with the transferor. […]”

It is evident from statements made by the court as well as the relevant explanatory notes that at large, the purpose of the stop-loss rules in subsections 40(3.3), 40(3.4) and 40(3.5) is to defer the recognition of losses incurred in an affiliated-party. Such purpose becomes especially evident or useful in circumstances that reveal there to be no true economic loss incurred by the transferor or by the affiliated group as a whole. Absent the existence of such rules, the recognition and use of losses on transfers within an affiliated group would erode the Canadian tax base.

Part III: Conclusion

A textual, contextual and purposive interpretation of the rules in paragraph 40(3.5)(c) lead to the conclusion that the deemed continuity rules are intended to capture tax deferred wind-ups, whether it be through the specific mechanics of subparagraphs 40(3.5)(c)(ii) and (iii) or the broader more general provisions of subparagraph 40(3.5)(c)(i) by virtue of the term “merger” used therein.

OVERALL CONCLUSION

Based on the foregoing analysis, the tax deferred liquidation of CCo into BCo should not result in the Suspended Loss becoming available, as such liquidation should fall within the ambit of “merger” in subparagraph 40(3.5)(c)(i). Accordingly, BCo should be deemed to own the shares of CCo as long as BCo and ACo are affiliated.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. A severed copy will also be distributed to the commercial tax publishers, following a 90-day waiting period (unless advised otherwise), for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this version should be e-mailed to: ITRACCESSG@cra-arc.gc.ca.

We trust our comments will be of assistance, and thank you for your enquiry.

Yours truly,

Yves Moreno
Section Manager
for Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

c: XXXXXXXXXX – Large File Case Manager, XXXXXXXXXX TSO

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1  As defined in subsection 95(1).
2  Class A shares are entitled to XXXXXXXXXX per share and Class B shares are entitled to XXXXXXXXXX per share.
3  As defined in subsection 95(1).
4  As defined in subsection 95(1).
5  XXXXXXXXXX
6  XXXXXXXXXX
7  Black’s Law Dictionary 8th Edition.
8  Definition of Canadian corporation.
9  Qualifying liquidation and dissolution as defined in subsection 88(3.1).

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