The Implications of Spin-off Reorganizations by U.S. Public Companies for Canadian Residents

It is very common for U.S. public corporations to “spin-off” their holdings in other US corporations, so that their shareholders own such holdings directly.

If properly implemented, a reorganization of this nature should be tax-free for US tax purposes as result of the application of IRC Sec. 355.

The Canadian Income Tax Act (“the Act”) has its own system for allowing “divisive reorganizations” to be implemented on a tax-free basis. In this country, they generally have to be structured as a “butterfly reorganization” under complex rules in paragraph 55(3)(b) of the Act, and related section. The shares to be spun-off would not be directly transferred to the shareholders of the distributing company. Instead, a more complex series of transactions would be implemented involving the creation of another corporation-those steps need not be detailed here.

But what if a shareholder receiving the distribution from a US Pubco is a Canadian resident? How is the distribution treated in Canada?

Unfortunately, in Canada the distribution would normally be treated as a dividend in kind of the distributed stock, and the shareholder would be fully taxable on the fair market value of the stock.

This is extremely unreasonable, since all that is really happening, from an economic perspective, is that the shareholders’ equity in the distributing company is divided into two parts: one that represents the distributed stock, and one that represents what is left.

To address the fact that it is inappropriate to tax the spin-off as a dividend in kind in Canada, section 86.1 was added to the Act in 2001.

Under this provision, if stock is received by a Canadian resident as part of a US section 355 spin-off reorganization of a US public company, and certain other requirement are met, the stock will not be treated as a dividend in kind.

Instead, a portion of the cost base of shares in the distributing corporation will be transferred to the shares that were received as part of the spin-off, based on relative fair market value at the time of the distribution.

However, there are certain complex conditions that must be met in order for section 86.1 to apply for any particular Canadian shareholder:

(a) Within six months following the distribution, the distributing corporation must provide various required information to the Canada Revenue Agency, including information about the distribution, values of shares, and the name and addresses of each Canadian resident who received a distribution, and a statement that the distribution is not taxable in the US.

(b) That Canadian shareholder must include an election, in the tax return filed for the taxation year that includes the time of the distribution, in which various information is provided regarding number of shares owned, values, cost base, etc.

Unfortunately, if the distributing corporation does not co-operate and provide the required information to the CRA within six months, there would not seem to be any way that a Canadian shareholder who receives the distributed shares could avoid being taxable on a dividend in Canada.

In certain cases, if the shareholder does not expect that the distributing corporation will be accommodating in this regard, and the distribution has not yet occurred, it might be preferable for the shareholder to sell his or her shares into the market prior to the distribution. If desired, the shares of the distributing corporation and/or the spun-off corporation could be purchased after that time.

In accordance with Circular 230 Disclosure

Mr. Atlas is a Toronto-based Chartered Accountant who practices as an independent consultant on a wide-range of international and domestic tax issues. Most of his practice consists of advising accounting and law firms on high-level tax issues. Prior to forming an independent tax practice in 1991, was Partner in charge of tax practice of major independent accounting firm in Toronto. Advises clients worldwide. Author of leading book, Canadian Taxation of Non-Residents, considered one of the few Canadian tax professionals, outside of the big accounting and law firms, who is an expert on high-level international tax matters.

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