Income tax issues.

• Position: TEI-Canada Dept. of Finance; follow-up on 1998 questions and responses.

QUESTION

IV. Section 85 "Triangular Merger" with a Foreign Target Company

Canadian shareholders of an U.S. Company (Target) are unable to effect a tax-free rollover where a Canadian publicly held taxable corporation (Canco) acquires Target in certain transactions that permit U.S. shareholders of Target to obtain tax-free treatment. The steps in the transaction are, as follows. Canco incorporates Subco, an U.S. corporation. Subco merges with Target, also an U.S. company. Subco ceases to exist and Target, the same legal entity as existed before the merger, remains (New Targetco). All the issued and outstanding shares of Target owned by its shareholders before the merger are cancelled and converted to a right to receive shares of Canco. New Targetco issues common shares to Canco in consideration for Canco issuing its common shares to Targetco shareholders.

The purpose of structuring the acquisition in this fashion is to facilitate the acquisition of Target by Canco by means of a "triangular merger," which minimizes or even eliminates the U.S. tax effect for U.S. shareholders of Target. The outcome of the transaction is an acquisition of Target without a direct disposition to Canco of Target shareholders' shares. From the perspective of Target's shareholders, however, the transaction is equivalent to a direct share-for-share exchange, which is accorded tax-free rollover treatment under the Act. We believe that equivalent transactions should be taxed in a consistent fashion and, hence, recommend that the Department of Finance amend the Act to accord "triangular merger" transactions tax-free rollover treatment. We invite the Department's comments.

RESPONSE

Although there is no longer work currently underway on this issue, the Department of Finance may in the future review the treatment of Canadian shareholders in the context of a "triangular U.S. merger" with a view to determining what, if any, amendments should be made to the Act. Any proposed amendment allowing for rollover treatment to the Canadian shareholders of course would have to ensure, amongst other things, that all appropriate downward adjustments were made to Canco's adjusted cost base in its shares of Target to reflect any rollover to the Canadian shareholders.

QUESTION

XII. Part VI.1 Tax Creditable Against Part I and Part VI Tax

In reviewing the preferred shares legislation, we note what appears to be an inconsistency between the treatment of shareholders with a substantial interest (25-percent ownership) in the preferred-share dividend-paying corporation and the transfer of the Part VI.1 tax under subsection 191.3(1) where dividends are paid to a related party (i.e., a greater than 50-percent owner). Under the definition of "excluded shares," dividends paid to a shareholder with a substantial interest in the payer corporation are not subject to the Part VI.1 tax. The preferred shares rules also permit taxpayers to enter...