Chapter 15



Chapter Fifteen Lecture Notes

Acquisition of Control Rules and Use of Corporate Losses

David Christian Spring Term 2013

Thorsteinssons LLP UBC Faculty of Law

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Notes

“All the Congress, all the accountants and tax lawyers, all the judges, and a convention of wizards all cannot tell for sure what the income tax law says.”

Walter B. Wriston

Ordinary Rules on Use of Losses[1]

1. A “non-capital loss” (ordinary business or property loss) incurred in a year may be applied to reduce the corporation’s income for the three immediately preceding taxation years and for the twenty subsequent taxation years (s.111(1)(a)). A corporation's net capital loss (generally one-half of capital losses) incurred in a year may be carried back three years and forward indefinitely to be applied against the amount of taxable capital gains in those years (s.111(1)(b)).

2. The corporate “loss-utilization rules” arising on an “acquisition of control” of the corporation are designed to prevent persons from “trading in loss companies”. Although rules restricting the utilization of losses on an acquisition of control had existed for many years, they had little effect on the trading in losses. This necessitated changes in 1981, 1983, and (most significantly) in 1987.

“Acquisition of Control”

3. We examined this concept, in part, in Chapters 2 and 3. What must be determined in this context is whether there has been an acquisition of legal control. Subsection 256(5.1), which deals with the concept of de facto control, is not relevant for the purposes of the loss-limitation rules found in section 111 and discussed below.

4. To recap briefly, for the purposes of testing the availability of loss carry-forwards under the rules in this Chapter, the word "control" means the right of control that rests in ownership of a sufficient number of shares (referred to as "controlling shares") to confer the majority of the voting power in the corporation and to allow for an election of a majority of the board of directors. Direct control of a particular corporation is the ownership of its controlling shares; indirect control includes the ownership of the controlling shares of an intermediary corporation that owns the controlling shares of the particular corporation.

5. Once it has been determined that there has been a change of control, it must be determined whether any person or group of persons has actually acquired control. The answer is not always clear in the case of a “group”. Recall Chapter 3 and the notion of a “group of persons” discussed in the case of Silicon Graphics.

Deeming Rules

6. Subsections 256(6) and (7) contain the acquisition-of-control tests relevant to these rules in relation to the carry-forward of tax losses. Recall s.256(6) from Chapter 3, which applies for all purposes of the Act. The rule deems control not to have changed if temporary control is acquired primarily for the purpose of safeguarding a loan made to, or an investment made in, the controlled corporation.

7. Subsection 256(7) applies only for specific provisions of the Act, including ss.88(1.1) and (1.2), 111, and 249(4) (all discussed below). Subsection 256(7) specifies certain situations in which control is deemed not to have been acquired, and also deems a change of control to have occurred in some other circumstances.

8. Paragraph 256(7)(a) provides that where shares of a corporation were acquired by a person, that person is deemed not to have acquired control of the particular corporation by virtue of such share acquisition if:

• that person was “related to” the person from whom the shares were acquired (other than by virtue of a right referred to in s.251(5)(b)) – recall Chapter 3 and the notion of “related persons”;

• that person and the acquired corporation were related (other than by virtue of a right referred to in s. 251(5)(b));

• that person was an executor, administrator, or trustee of an estate who acquired the shares by virtue of the death of any other person; or

• that person acquired the shares by way of a distribution from an estate arising on the death of another person to whom that person was related.

9. Note that s.256(7)(a) applies to redemptions, cancellations, and changes in the rights, privileges, restrictions, or conditions attaching to shares as well as to acquisitions of shares. Where any of these events occurs and the person or group of persons that controlled the corporation after the event was related to the corporations before the event, there is no acquisition of control. Consider a simple example.

[pic]

10. There are two deeming rules in the context of an amalgamation. First, s.256(7)(b)(ii) provides that where a person or group of persons controls the amalgamated corporation, and did not control a predecessor corporation, that person or group is treated as having acquired control of that predecessor corporation, and of any corporation it controlled before the amalgamation. An exception provides that this deemed acquisition of control will not apply if, had the person or group acquired all the shares of the predecessor before the amalgamation, the person or group would not have acquired control of the predecessor. This ensures that s.256(7)(b)(ii) does not deem an acquisition of control in amalgamations of corporations in a related group of corporations.

11. The second rule, in s.256(7)(b)(iii), deals mainly with widely-held corporations. The rule deems control of a predecessor corporation, and of each corporation controlled by it before the merger, to have been acquired by a (hypothetical) person or group of persons as a result of the amalgamation unless:

• the predecessor corporation was related, immediately before the merger, to each other predecessor corporation – for example:

[pic]

or

• if one person had (again, hypothetically) acquired all the shares of the new corporation received by shareholders of the predecessor corporation (or of another predecessor that controlled that predecessor) on the merger in consideration for their shares of the predecessor corporation (or the other predecessor, as the case may be), that person would have acquired control of the new corporation, for example:

[pic]

or

• s.256(7)(b)(iii) would otherwise deem control of every predecessor to have been acquired, in an amalgamation of two corporations and their controlled subsidiaries, as it would, for example, if two corporations of equal value amalgamated, with the shareholders of each taking back half the shares of the new corporation:

[pic]

12. Paragraph 256(7)(c) deals with “reverse takeovers”. Consider this example. A widely held public company acquires the shares of a “loss company”. The acquisition-of-control rules for losses would clearly apply. However, what if the public company shareholders exchange their shares of that company for shares of the loss company? The acquisition-of-control rules would likely not have applied before enactment of s.256(7)(c) - no “group” acquired control of the loss company. Paragraph 256(7)(c) deems an acquisition of control to occur where shareholders, if they were hypothetically treated as one person, would have acquired control of the loss company in this example. (As with many of the rules designed to limit losses, these rules can also apply to transactions that are not undertaken for the purpose of acquiring losses.)

13. Subsection 256(8) is also best illustrated by example. Take a potential purchaser of the shares of a corporation that discontinued a business with a loss carry-forward available from prior years. The purchaser could acquire effective, but not legal, control over the corporation by acquiring, for example, an option to purchase the shares of that company. A new, profitable business might then be transferred into the corporation, the losses utilized, and then later the option might then be exercised to take legal control. Subsection 256(8) now deems the acquisition of any right (for example, the option described) referred to in s.251(5)(b) with respect to shares (discussed in Chapter 2 and 3) to be equivalent to the acquisition of the shares if “one of the main purposes of” the acquisition of the right was to avoid the loss limitations set out in section 111 below.

Effect of Acquisition of Control on Losses (and Other Rules)

Deemed Year-End

14. A deemed year-end occurs when there is an acquisition of control (s.249(4)). The deemed year-end triggers all the normal administrative requirements of a regular year-end. Corporate tax returns must be filed, final tax payments must be submitted, and income tax elections that are due within a specified period of a fiscal year-end must be made. Where the normal year-end occurs within seven days of the change of control, it may be extended by election, thus avoiding a short taxation year.

Timing of Acquisition of Control

15. Subsection 256(9) provides that, regardless of the time at which control is acquired, control is deemed to have been acquired at the beginning of the day unless the corporation elects that subsection 256(9) will not apply. This rule can be a significant trap if the acquisition is part of a series of staged steps in an acquisition.

Carryover of Net Capital Losses

16. Pursuant to s.111(4), net capital losses will expire on an acquisition of control. Post-acquisition capital losses cannot be carried back to the pre-acquisition period. Realized net capital losses and capital losses unrealized immediately before an acquisition of control cannot be carried forward. All non-depreciable capital property must be valued immediately before an acquisition of control occurs. To the extent that such capital property has declined in value below the original cost (ACB), the excess must be deducted from the ACB of the property, and a capital loss is deemed to be realized (s.111(4)(c) and (d)).

17. Under s.111(4)(e), a corporation can elect to have any capital property (including depreciable property) that has appreciated in value deemed to be disposed of for any amount between the ACB and the fair market value. The property is then deemed to be reacquired at the designated amount. The s.111(4)(e) election was designed to allow a corporation to avoid the expiry of net capital losses on an acquisition of control to the extent of accrued but unrealized capital gains.

Carry-over of Non-Capital Losses

18. Subsection 111(5) limits the ability of a corporation to use its non-capital losses once control of the corporation has been acquired. The limitations created by this subsection can be summarized as follows:

• Only non-capital business losses are potentially available for carry-forward. Non-capital losses that arise from property are not available.

• Non-capital business losses are deductible only if the business that gave rise to the loss is carried on throughout the year in which the deduction is claimed, and that business is carried on in that year for profit or with a reasonable expectation of profit.

19. Once it is determined that a non-capital loss can be carried forward, the loss can be used only against income from that business, and income from any other business if substantially all of the income of the other business is derived from the sale, leasing, rental, or development of properties or rendering of services similar to the properties sold, leased, rented, or developed or services rendered by that business.

Depreciable Property

20. Subsection 111(5.1) provides that where, at any time, control of a corporation has been acquired and the undepreciated capital cost (UCC) of the depreciable property of a prescribed class immediately before that time would have exceeded the fair market value of all the property of that class, the excess capital cost is deemed to have been claimed as CCA for the taxation year ending before the acquisition of control. This calculation is made on a class-by-class basis, not on an aggregate basis. The CCA may increase the non-capital losses of a business, which would then be subject to the carry-over rule above.

Effect on GRIP/LRIP

21. When a corporation becomes or ceases to be a Canadian-controlled private corporation in a year, the status of its GRIP and LRIP accounts will change. A corporation that becomes a CCPC will have an addition to its GRIP account; a corporation that ceases to be a CCPC will have an addition to its LRIP account. Note that the timing of becoming or ceasing to be a CCPC is not the same as the timing of an acquisition of control. Recall paragraph 251(5)(b): if a person has a right in respect of shares of a corporation that allows the person to acquire the shares of the corporation, the person is deemed, for purposes of the definition of CCPC in subsection 125(7), to be in the same position in relation to control of the corporation as if the person owned the shared. This means that a corporation may become or cease to be a CCPC prior to the time control of a corporation is acquired, at the time an agreement for an acquisition is made, rather than when the transaction closes. There is no relieving rule like that in paragraph 110.6(14)(b), which protects CCPC status for purposes of the capital gains exemption.

Amalgamations and Liquidations (Losses)

22. As we saw in an earlier Chapter, where two or more corporations amalgamate, the amalgamated corporation is deemed to be a new corporation. Notwithstanding that a new corporation is created, subsection 87(2.1) provides that, on an amalgamation, the net capital and non-capital losses of the predecessor corporation flow-through to the amalgamated corporation as if the amalgamated corporation is a continuation of each of its predecessors. This rule applies for the ordinary rules for carry-over of losses and the rules that apply where there is an acquisition of control of one of the amalgamating (predecessor) corporations as discussed above.

23. On the wind-up of a taxable Canadian corporation, ss. 88(1.1) and (1.2) allow the effective transfer of its non-capital losses and net capital losses to the parent company. The flow-through of losses is permitted only where subsection 88(1) applies, i.e., immediately before the wind-up, at least 90 percent of the issued shares of each class of the subsidiary are owned by the parent company, and all shares that were not owned by the parent were owned by the persons with whom the parent was dealing at arm's length. The subsidiary's loss is deemed to be the parent's loss for the parent's taxation year in which the subsidiary's loss year ended. The subsidiary's losses are available for the use of the parent only in its taxation year beginning after the start of the wind-up, which is generally the date on which the shareholders resolve to wind-up the company.

24. Certain conditions must be met for the losses to qualify for transfer to the parent company: (1) the losses must not have been deducted by the subsidiary in any taxation year, and (2) the losses must otherwise have been deductible in computing the taxable income of the subsidiary for its first taxation year commencing after the wind-up has begun, on the assumption that it had such a taxation year and that it had sufficient income and/or taxable capital gains for that year.

25. If there is an acquisition of control of the parent or the subsidiary after the year in which the losses were sustained, the usual rule limiting the availability of non-capital losses applies if the business transferred to the parent is discontinued. In the case of net capital losses, any change in control will prevent such losses from being available for the carry-forward. Subsection 88(1.1) is in conformity with subsection 111(5). It restricts the deduction by the parent of any unused non-capital losses of the subsidiary where there has been a change of control. A non-capital loss incurred by a subsidiary from the carrying on of a particular business is deductible by the parent only with certain limitations where control of the parent or subsidiary changes. The limitations are the same as those in subsection 111(5).

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[1] I am indebted to Kellough, H., and McQuillan, P., for their discussion of these concepts in their work TAXATION OF PRIVATE CORPORATIONS AND THEIR SHAREHOLDERS, Third Edition. Much of this Chapter is taken from the discussion in Chapter 13 of their work.

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(Before)

Son

Father

Opco

(After)

Father

Son

Opco

Sale

Public

Parent

Sub

amalgamate

Public A

Pubco A

Pubco B

amalgamate

Public B

60%

40%

Public A

Pubco A

Pubco B

amalgamate

Public B

50%

50%

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