Navigating the bump rules

ADVICE FOR THOSE TAX ADVISERS WHO DESIGN AND IMPLEMENT TRANSACTIONS TO USE THE BUMP

There are many reasons why corporations merge. Such a move may enable the losses of one to be used against the profits of the other. A merger may also facilitate combining the business operations of an acquired corporation (Targetco) with those of the acquiring corporation (Buyco). Tax planning for this latter type of combination may also involve the use of the "bump" provisions in section 88 of the Income Tax Act to increase the adjusted cost base of the nondepreciable capital property of Targetco. In order to achieve this objective, it will be necessary to complete a vertical amalgamation or a windup of Targetco into Buyco.

The act recognizes each of these legal mechanisms to effect a vertical merger of two taxable Canadian corporations on a tax-free basis. On an amalgamation, generally the rights, obligations and property of each of the amalgamating corporations become the rights, obligations and property of the amalgamated corporation and there is no need for a separate assignment or conveyance of assets to the corporation created on the amalgamation. All types of amalgamation require that each predecessor corporation must be incorporated within the same jurisdiction. Generally, continuation by one corporation into another provincial jurisdiction or continuation to become a federally incorporated corporation is permitted, with the notable exception of corporations incorporated in Quebec.

Where one wholly owned taxable Canadian corporation is voluntarily wound up into its parent corporation, the liquidators of the estate of the corporation must ensure that the corporation's obligations are appropriately discharged and that the remaining property of the corporation is distributed to its shareholder. Ultimately, the subsidiary corporation will cease to exist and will be granted Articles of Dissolution. Unlike with an amalgamation, in a windup, the property and liabilities of the subsidiary corporation do not automatically become such of the parent corporation. That is why there must be a conveyance of assets from the subsidiary to the parent. Most intangible property must be assigned and registered to the parent and liabilities must be satisfied or assumed by the parent. However, the parent and the subsidiary need not be incorporated under the same corporate statute in order to effect a windup. Legal counsel should be sought to deal with the corporate and regulatory requirements related to winding-- up and amalgamation transactions.

While both a windup and an amalgamation may generally be completed on a tax-deferred basis, in order to achieve the bump on an amalgamation, the parent corporation immediately before the amalgamation must own all the shares of the subsidiary. In the case of a winding-up, at least another taxable Canadian corporation immediately before the windup must own 90% of the issued shares of each class, and persons dealing at arm's length with the parent immediately before the windup must own any shares not owned by the parent.

On a winding-up to which subsection 88(1) applies, or on a vertical amalgamation, there is, generally, no gain on the deemed disposition of the subsidiary's shares by the parent unless the paid-up capital of such shares exceeds their adjusted cost base. Generally, a subsidiary's property that is distributed to the parent on a winding-up is deemed to be disposed of at its cost amount and this becomes the cost to the parent of the property. On an amalgamation, there is a continuity of the tax history of each predecessors based on the rules in Section 87, many of which also apply in the case of a winding-up.

The notable exception to these rules is the bump to the adjusted cost base of certain property of the subsidiary that may be increased to an amount not greater than its fair market value at the time that the parent last acquired control of the subsidiary. (Property must meet certain conditions to be eligible for the bump: see story on www.CAmagazine.com.)

To illustrate the mechanics of the bump, suppose Targetco owns nondepreciable capital property with an adjusted base cost of $100 and a fair market value of $600 at the time Buyco acquired control of Targetco. The adjusted cost base of Targetco's shares is $500 to the parent. Targetco's tax balance sheet at the time of windup is: cash, $100; assets, $1,500 (including the nondepreciable property described above); reserves, $900; liabilities, $300; dividends paid, $0; for a total in equity of $400 (assume retained earnings of $300 and capital stock with $100 of paid-up capital).

Based upon the figures in the table on page 35, the maximum allowable increase to the adjusted cost base of Targetco's nondepreciable capital property is $100, which will result in a new adjusted cost base of $200.

The bump is most often used as a method to dispose of Targetco's redundant assets or transferring assets within Buyco's corporate group following an acquisition transaction. For example, assume Targetco owns the shares of two operating companies, Keepco and Sellco, and that Buyco wishes to acquire only Keepco. Another party, however, is interested in purchasing the shares of Sellco. But the shareholder of Targetco is only interested in selling all the Targetco shares to Buyco. Accordingly, Buyco arranges to acquire all the shares of Targetco, following which Buyco windups or vertically amalgamates with Targetco. As part of the windup or vertical amalgamation, Buyco is able to bump the adjusted cost base of the Selco shares to their fair market value. Buyco then sells the Sellco shares to the third party.

If Keepco and Sellco were divisions of Targetco, and not separate legal entities, it would be necessary for Targetco to transfer Sellco's business assets to a newly incorporated company (Newco) prior to Buyco acquiring Targetco. The very same series of transactions occur, as mentioned earlier, ending with Buyco selling the Newco shares for no capital gain. By using this buy, bump and sell technique, Buyco has effectively been able to achieve its business objective of retaining Keepco while divesting itself of Sellco on a tax-effective basis. Buyco should be aware, however, of the significant complexities inherent in the bump denial rules.

The bump denial rules start from the position that all property is eligible for the bump except ineligible property, which includes:

* depreciable property;

* property transferred to the parent on the winding-up where the transfer is part of a paragraph 55(3)(b) (butterfly) reorganization;

* property (or property acquired in substitution thereof) acquired by the subsidiary from the parent (or a person not dealing at arm's length with the parent) in the same series of transactions or events in which the parent last acquired control of the subsidiary;

* property distributed to the parent on the winding-up, where, as part of the series of transactions or events that includes the winding-up, the parent acquired control of the subsidiary, and any of such property (or property acquired in substitution thereof) is acquired by certain persons who had an interest in the subsidiary before the acquisition of control occurred.

The first three categories of ineligible property are relatively straightforward. That is, no bump is allowed to depreciable property, property acquired as part of a butterfly transaction or property transferred to the subsidiary by the parent (an anti-stuffing provision) as part of the series of transactions. The fourth type of property is more complex. A person described in this category includes one who was or was deemed to be a specified shareholder of the subsidiary at any time during the course of the series of transactions and before the acquisition of control of the subsidiary was last acquired. The definition of specified shareholder is a taxpayer who owns, directly or indirectly at any time in the year, 10% or more of the issued shares of any class of a corporation or one related to that corporation. A specified shareholder does not include a specified person - that is to mean the parent (at the time of windup) or a person related to the parent. There is also the concept of an extended deemed ownership.

This rule is intended to ensure that a bump cannot be obtained where certain shareholders of Targetco reacquire an interest in Targetco's property as part of a series of transactions that includes a disposition of their Targetco shares. If Targetco's property or property that is substituted therefore is acquired in these circumstances, none of Targetco's property may be bumped.

Without the bump, a disposition by Buyco of the Sellco shares would result in corporate income taxes on any gain that were realized based on the historic adjusted cost base of the Sellco shares. Consider this situation. Keepco and

Sellco are wholly owned by Targetco and Targetco is owned equally by 100 shareholders (vendors). Buyco, a wholly owned subsidiary of a nonresident corporation Foreignco, acquires Targetco and offers the vendors 50% cash consideration and the balance of the consideration consists of shares of Foreignco. Buyco then winds up Targetco and intends to bump the adjusted cost base of Keepco's and Sellco's shares and sells Sellco to a third party thinking it has no capital gain on the sale because of the bump. Wrong.

For the purposes of the bump denial rules, the vendors are considered to be specified shareholders of Targetco, after that acquisition, which collectively own substituted property whose fair market value is partly or wholly attributable to Targetco's property that was distributed to Buyco on the windup. As a result, the bump to any of Targetco's property is denied. However, if the vendors were offered Buyco shares as consideration for Targetco, then the bump to Targetco's otherwise eligible property should be preserved. This is because the shares received by the vendors were shares of the parent corporation (Buyco) that was a taxable Canadian corporation.

This is but one example of the complexities with the bump denial rules. There are numerous practical difficulties in interpreting the legislation - one example is the meaning of the phrase "series of transactions.' In addition, there are numerous technical glitches with the legislation that make the bump denial rules among the most challenging provisions in the act to interpret. Tax advisers should exercise extreme care in designing and implementing a transaction to use the bump given these complexities.

[Author Affiliation]

Greg C. Boehmer, CA, is partner and national director of mergers and acquisitions tax practice with Ernst & Young LLP, in Toronto. Manu Kakkar, CGA, CA, MTax, is manager in the core Canadian consulting practice with Ernst & Young LLP, in London, Ont.

[Author Affiliation]

Technical Editor: Michel Lanteigne, FCA, managing partner tax for Canada Ernst & Young LLP