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Using Exchangeable Shares inInbound Canadian Transactions

by Steve Suarez and Pooja Samtani

Reprinted from Tax Notes Int’l, December 24, 2007, p. 1281

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Using Exchangeable Shares in InboundCanadian Transactions

by Steve Suarez and Pooja Samtani

This article reviews the concept of exchangeableshares, which are often used in cross-border

mergers and acquisitions involving Canadian corpo-rations. A significant number of large, high-profiletransactions have been effected using exchangeableshares, including Vivendi’s acquisition of the Sea-gram Co. Ltd. in 2000 and the combination of AdolphCoors Co. and Molson Inc. in 2005, forming MolsonCoors Brewing Co. Exchangeable share transactionshave occurred in both public company and privatecompany transactions, and the exchangeable sharestructure has been used in a variety of circum-stances to optimize the Canadian tax consequencesof cross-border mergers and acquisitions involvingCanadian corporations.

Exchangeable Shares

Exchangeable shares are used in cross-bordermergers and acquisitions because Canada’s incometax regime currently does not allow for a nonrecog-nition transaction, or rollover, when shares of aCanadian corporation are exchanged for shares of aforeign corporation; on such an exchange, the holderof the Canadian shares will realize any accruedgains on those shares based on the fair market valueof the foreign shares received.1 Conversely, a roll-over generally is available for Canadian tax pur-poses on the exchange of shares of a Canadian

corporation for shares of another (or the same)Canadian corporation, such that any accrued gainon the old shares is not realized but instead ‘‘rollsover’’ into the new shares.2 This puts potentialforeign acquirers or merger partners of a Canadiancorporation at a competitive disadvantage relativeto their Canadian counterparts, in that they canonly offer their own shares to the Canadian corpo-ration’s shareholders on a taxable-transaction basis(that is, with the Canadian corporation’s share-holders realizing any accrued gains on their shares),whereas the Canadian corporation’s shareholderscan exchange their shares for shares of a Canadianacquirer or merger partner on a rollover basis.

This inability to provide Canadian target share-holders with a tax-deferred exchange can oftenhinder foreign corporations hoping to use their ownshares as currency to acquire or merge with Cana-dian corporations. Exchangeable share structuresare designed to minimize this disadvantage for for-eign acquirers as much as possible.

What Are Exchangeable Shares?An exchangeable share can be described most

simply as a share of a Canadian corporation (Ex-changeco) that, together with some ancillary rights,replicates as closely as possible the economics (andto some extent the legal rights enjoyed by holders) ofa share of another corporation. In a typical ex-changeable share structure, all the common sharesof Exchangeco are owned directly or indirectly bythe foreign acquirer (Foreign Parent), and an ex-changeable share issued by Exchangeco (togetherwith some ancillary rights) will replicate the eco-nomics of, and entitle the holder to exchange theexchangeable share for, a common share of ForeignParent. Shareholders of the Canadian target corpo-ration in the projected cross-border merger or acqui-sition (Canco) will exchange their Canco shares forshares of Foreign Parent or (for those wanting arollover) exchangeable shares of Exchangeco. Theresult (see Figure 1) is that Canco shareholders endup holding either Foreign Parent common shares or

1In the October 18, 2000, Economic Statement and BudgetUpdate, Canadian Minister of Finance Paul Martin an-nounced an intention to develop a rollover rule for cross-border share-for-share exchanges. The minister’s statementprovided no details of the circumstances in which suchtax-deferred share-for-share exchanges could occur, butrather indicated that these rules would be developed inconsultation with the private sector and would not take effectbefore the release of draft legislation for public discussion.However, no formal proposal or draft legislation has ever beenreleased, and it seems doubtful that this will occur in theforeseeable future.

2Expressed another way, the result of a rollover is that theexchanging shareholder realizes no gain on the disposition ofthe old shares and, for tax purposes, has a cost in the newshares equal to the holder’s previous cost of the old shares.

Steve Suarez is a partner and PoojaSamtani is an associate with Osler, Hoskin &Harcourt LLP in Toronto.

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exchangeable shares of Exchangeco. The holder ofan exchangeable share can either sell it to a thirdparty for cash or exchange it for a Foreign Parentcommon share (both actions will cause any accruedgains to be realized for Canadian tax purposes), andall exchangeable shares will eventually be acquiredby Foreign Parent or a subsidiary for Foreign Parentcommon shares. Canco will effectively become awholly owned subsidiary of Foreign Parent, andCanco’s shareholders will be equity holders of For-eign Parent (either directly or indirectly via ex-changeable shares).

In the Canadian tax regime, transactions aretaxed primarily based on their legal substancerather than on their economic substance. The keyelement of the exchangeable share is that it is, inlaw, a share of a Canadian corporation, and that theexchangeable share is designed to replicate theeconomic attributes of a different security is gener-ally not relevant for Canadian income tax purposes.Exchangeable share structures have been employedfor many years, and to date, Canadian tax authori-ties have not challenged (or indicated any intentionof challenging) the status of exchangeable shares asbona fide shares of Exchangeco, a Canadian corpo-ration.

Key Attributes

The objective of an exchangeable share is to givethe holder a security that is a share of a Canadiancorporation but that replicates (to the extent pos-sible) the attributes of a share of the Canadiancorporation’s ultimate foreign parent. The primaryfeatures of an exchangeable share that achieves thisresult are described below:

• Dividends. Whenever a dividend is paid on theForeign Parent common shares, Exchangecopays a corresponding dividend on the exchange-able shares.

• Exchange Rights. Holders of exchangeableshares typically have the right to exchangethem on demand for a fixed number of ForeignParent common shares. Usually the exchangeratio is one Foreign Parent common share foreach exchangeable share, and this discussionproceeds on that premise. This exchange occursprimarily via a right in the exchangeable shareitself (the retraction right), empowering theholder to require Exchangeco to purchase theshare and deliver a Foreign Parent commonshare in payment.3 Some events (such as theliquidation of Foreign Parent) may trigger anautomatic exchange of exchangeable shares forForeign Parent shares, and in most cases, theexchange of all remaining exchangeable shareswill occur after an agreed-on number of years.Thus, over time all exchangeable shares areeventually exchanged for Foreign Parentshares.

• Liquidation Rights. On the liquidation of Ex-changeco, a holder of exchangeable shares re-ceives a Foreign Parent share for each ex-changeable share and does not receive anyother property.

• Voting Rights. In many cases, mechanisms areput in place to allow holders of exchangeableshares to vote on matters that Foreign Parentshareholders vote on, as if they actually heldForeign Parent shares. To the extent legallypossible, holders of exchangeable shares aregenerally given no rights to vote as holders ofExchangeco shares.

3In practice, the actual exchange is, for reasons explainedin the text below, usually made by having another corporationexercise a call right to purchase the exchangeable share anddeliver a Foreign Parent share, but the holder’s retractionright is what typically initiates the exchange process. In thisarticle, ‘‘retraction’’ refers to the holder of a share initiating aprocess by which the issuer repurchases the share, and‘‘redemption’’ refers to the issuer of the share initiating thatprocess.

100%common

Some formerCanco

shareholders

Foreign Parentshareholders

Canco

Some formerCanco

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Exchangeco

Exchangeableshares

ForeignParent

Figure 1. Simplified ExchangeableShare Structure

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These results are achieved through a combinationof the terms of the exchangeable shares themselvesand other legal mechanisms.

Benefits

There are two principal benefits to using ex-changeable shares in a cross-border merger or ac-quisition such as described in the example above:

• Gain Deferral. Canco shareholders can deferthe realization of the accrued gains on theirCanco shares for Canadian tax purposes byreceiving shares of a Canadian corporation(that is, exchangeable shares) instead of For-eign Parent shares. This deferral lasts until theexchangeable shares are exchanged for sharesof Foreign Parent or are sold.

• Dividend Taxation. Canadian residents aregenerally taxed more advantageously on divi-dends received on shares of a Canadian corpo-ration than on dividends received on shares of a

foreign corporation.4 Accordingly, to the extentthat Foreign Parent pays dividends followingthe exchange, Canadian-resident Canco share-holders prefer to receive those amounts in theform of dividends on the exchangeable sharesrather than as dividends on the Foreign Parentshares.

In many cases, particularly when Canco’s sharestrade on a designated stock exchange, nonresidentsof Canada are not subject to Canadian tax on gainsrealized on their Canco shares. Nonresidents alsogenerally do not benefit from receiving Canadian-source dividends. It is therefore common to seeexchangeable shares offered only to Canco share-holders who are Canadian residents. Tax-exempt

4For a discussion of recent changes in the taxation ofCanadian-source dividends, see Manjit Singh and SteveSuarez, ‘‘Canada Issues Revised Dividend Tax Credit Legis-lation,’’ Tax Notes Int’l, Oct. 30, 2006, p. 331.

Molson Coors Brewing Company was formed using exchangeable shares.

Richard B. Levine/Levine Roberts Photography

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entities (for example, pension funds) are also some-times excluded from receiving exchangeable shareson the basis that they are not materially disadvan-taged by receiving Foreign Parent shares.

When Are Exchangeable Shares Used?Exchangeable shares are most likely to be useful

in the following circumstances:• when Foreign Parent wishes to offer its own

shares (rather than exclusively cash) as all orpart of the consideration to be received byCanco shareholders; and

• when a significant portion of Canco’s share-holder base consists of Canadian residents whoare not exempt from Canadian tax and havematerial accrued gains on their Canco sharesfor Canadian income tax purposes, such thatdeferring the realization of gains benefits asignificant number of persons.

Also, since Canadian-source dividends are taxedadvantageously for Canadian residents, exchange-able shares are likely to be an especially attractiveoption for Canco shareholders when Foreign Parentwill be paying significant dividends in the yearsimmediately following the transaction.

There are two principal benefits tousing exchangeable shares in across-border merger oracquisition.

Depending on the circumstances, exchangeableshares may also be useful in other situations (forexample, when Canco shareholders resident outsideCanada could be subject to Canadian tax on Cancoshares, as may be the case when Canco shares arenot traded on a designated stock exchange).5 How-ever, as a general rule, exchangeable shares are ofgreatest use in a cross-border merger or acquisitionwhen there are existing accrued gains to be deferredor future dividends to be paid, and when there is asignificant Canadian shareholder base that wouldthereby benefit from the two principal advantages ofexchangeable shares.

Foreign Parent must weigh a variety of factors inchoosing what form of consideration to offer toCanco shareholders and, if shares, whether to useexchangeable shares. For example, there may benontax reasons why Foreign Parent would not wantexternal shareholders (even ones holding exchange-

able shares) below the Foreign Parent level in itsparticular circumstances. Moreover, a foreign ac-quirer often wishes to use the 88(1)(d) step-up toincrease the cost (for Canadian tax purposes) ofCanco’s property following the acquisition of Canco’sshares.6 The use of Foreign Parent shares (eitherdirectly or indirectly in the form of exchangeableshares) as consideration will generally disentitleForeign Parent from using the 88(1)(d) step-up.Foreign acquirers therefore must often choose be-tween competing priorities in structuring cross-border transactions into Canada.

Principal Tax IssuesWhen exchangeable shares are being used, the

Canco shareholders and Foreign Parent must con-sider several Canadian tax issues. Some of theseissues relate to Foreign Parent’s initial acquisitionof Canco shares and delivery of exchangeable sharesto Canco shareholders, while others relate to thesubsequent period during which the exchangeableshares are outstanding, and to the ultimate ex-change of exchangeable shares for Foreign Parentshares that will eventually occur.

Canco ShareholdersIn the vast majority of cases, the primary reason

for using exchangeable shares is to defer the real-ization for Canadian tax purposes of any accruedgains on Canco shares. As noted earlier, since non-residents are usually not subject to Canadian tax ontheir Canco shares,7 deferral is typically most rel-evant for Canadian-resident shareholders.

Structure of Initial ExchangeThe initial exchange of Canco shares for ex-

changeable shares can be structured in a number ofways (discussed below), some of which may be moredesirable than others for Canco shareholders (andfor Foreign Parent). As such, choosing the steps bywhich the exchangeable shares are actually deliv-ered (as distinct from the decision to offer exchange-able shares at all) can be a further tax issue ofrelevance to shareholders of Canco interested inreceiving exchangeable shares. While the differentways of structuring the initial exchange of Cancoshares for exchangeable shares have some differ-ences, broadly all of them limit tax deferral to anexchange of Canadian shares for Canadian shares.

5Exchangeable shares are also sometimes used when aCanadian corporation wishes to raise money in foreign equitymarkets and the cost of migrating the corporation into theforeign jurisdiction would be prohibitive (as is often the case).

6For a discussion of this issue, see Steve Suarez, ‘‘Canada’sTax Cost Step-Up: What Foreign Purchasers Should Know,’’Tax Notes Int’l, Dec. 4, 2006, p. 779.

7Shares listed on a designated stock exchange are gener-ally not included in the type of property that nonresidents aresubject to capital gains tax on in Canada, and even in the caseof unlisted shares, Canadian taxation of nonresidents willoften be precluded under a relevant tax treaty.

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To the extent that a Canco shareholder receivessomething other than exchangeable shares (non-share consideration), there is the potential for real-ization of accrued gains. For this reason and becauseit is generally not possible to put all of the rights ofthe holder of exchangeable shares in the exchange-able shares themselves, Canco shareholders lookingfor gains deferral are typically interested in limitingthe amount and value of nonshare considerationreceived.8

Dividend Treatment

As noted, Canadian-resident shareholders benefitfrom advantageous tax treatment of dividends onexchangeable shares, relative to receiving dividendson shares of a foreign corporation. That advanta-geous treatment can take different forms dependingon the shareholder: Canadian-resident corporationscan often obtain a 100 percent dividends receiveddeduction for Canadian-source dividends, whileCanadian-resident individuals may be eligible for aparticularly low rate of tax on a Canadian-sourcedividend, depending, in each case, on certain fac-tors.9 Canco shareholders interested in receivingexchangeable shares will want to ensure that thenecessary steps are taken to achieve these results tothe greatest degree possible, and they will also wantto satisfy themselves that they will not be subject toany special taxes sometimes applicable to sharesthat fall within Canada’s preferred share tax re-gime.10

Structure of Subsequent Exchange

Ultimately, exchangeable shares will be ex-changed for Foreign Parent shares. The manner inwhich this occurs is highly relevant to the holder ofthe exchangeable share, because if the exchangeableshare is sold to its issuer Exchangeco (for example,via an exercise of the retraction right of the holder ofthe exchangeable share) rather than some other

entity, the excess of the value of the Foreign Parentshare received over the paid-up capital (PUC) of theexchangeable share will generally be characterizedas a deemed dividend for tax purposes — that is, asa distribution of corporate surplus rather than acapital gain.11 Because the PUC of the exchangeableshare is often significantly less than the share-holder’s cost for tax purposes of the exchangeableshare, the amount of any such deemed dividend isoften larger than the accrued gain on the share. Asale to Exchangeco may therefore produce a materi-ally worse tax result for the holder of the exchange-able share than a sale of the exchangeable share tosome other entity.12

On an exchange, most holders of exchangeableshares want to receive their Foreign Parent sharesfrom an entity other than Exchangeco. For thisreason, Canco shareholders will typically want theexchangeable share structure to include a mecha-nism whereby someone other than Exchangecoeventually acquires their exchangeable shares anddelivers their Foreign Parent shares. As noted be-low, this is usually effected by establishing a sepa-rate Foreign Parent subsidiary (Callco) that exer-cises a call right to acquire exchangeable shares inany situation in which Exchangeco would otherwiseacquire them.

FIE Rules

For the past several years, Canada has beenproposing to enact a new system of taxing foreign-source passive income earned by Canadian resi-dents. These rules (the foreign investment entityregime) are highly complex and difficult to apply, butconceptually they target portfolio investment in for-eign entities earning predominantly passive formsof income. Canco shareholders will want to ensurethat exchangeable shares (and shares of ForeignParent) are not subject to these rules.

Listing of Exchangeable Shares

Finally, in most transactions in which Canco is apublic corporation, the exchangeable shares willthemselves be listed for trading on a designatedstock exchange. Exchangeable share transactionshave been effected using unlisted exchangeableshares, but these can give rise to a number of

8In situations when exchangeable shares are made avail-able to tax-exempt entities, nonshare consideration is typi-cally not the type of property that tax-exempts are permittedto own, creating another reason to minimize the amount ofnonshare consideration.

9It may also be observed that having Canadian share-holders receive dividends from a Canadian entity prima facieeliminates any leakage that would otherwise arise fromwithholding tax imposed by Foreign Parent’s home jurisdic-tion on Foreign Parent dividends paid to Canadian residents(although, as noted below in the case of the U.S., there is someresidual concern).

10A more detailed discussion of this issue is beyond thescope of this article; however, it is sufficient for currentpurposes to be aware that better or worse dividend treatmentfor holders of exchangeable shares can result depending onthe details of the legal agreements that create the exchange-able share structure.

11In such circumstances, a capital gain (or loss) is alsoproduced, calculated as the amount by which the value of aForeign Parent share, net of any deemed dividend, exceeds (isless than) the holder’s cost of the exchangeable share. De-pending on the circumstances, it is thus possible to realizeboth a deemed dividend and a capital gain.

12Although it is possible that deemed dividend treatmentcould produce a better tax result for some taxpayers in somecircumstances, this is generally not the case.

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incremental tax and nontax issues. When exchange-able shares are unlisted, this makes a sale of ex-changeable shares to a third party for cash lesslikely and makes the retraction right the share-holder’s principal exit mechanism. From a Canadiantax perspective, using unlisted shares can raiseseveral potential issues, although these mostly af-fect nonresidents of Canada and tax-exempt organi-zations (who are often not given the option of receiv-ing exchangeable shares on the initial exchange inany case). It is nonetheless important to be aware ofthe point.

Foreign ParentUsing an exchangeable share structure raises tax

issues for Foreign Parent as well. Some of the moresignificant of these are described below.

Structure of Initial ExchangeOn the initial exchange of Canco shares for ex-

changeable shares, giving Canco shareholders arollover reduces the cost to Foreign Parent of theacquired Canco shares for Canadian tax purposesbelow what would otherwise be the case. Althoughthe initial acquisition transaction can be structuredto mitigate some of the effects of this, a reduced taxcost at the Canco share level is generally disadvan-tageous to some extent, and as a result, ForeignParent typically seeks to limit the tax deferral tothose shareholders who truly need it.13 ForeignParent may also have a preference for one of thedifferent provisions offering tax deferral to Cancoshareholders over others (described below). Finally,it is generally useful for Canadian tax reasons toemploy a Canadian acquisition vehicle to carry outthe acquisition of Canco, rather than have ForeignParent do so directly.14

Structure of Subsequent ExchangeEven though the holder of the exchangeable

share’s formal legal mechanism for initiating anexchange of exchangeable shares for Foreign Parentshares is the use of the retraction right in theexchangeable shares to require Exchangeco to ac-quire them, in practice Exchangeco virtually neveracquires the exchangeable shares. As noted earlier, adeemed dividend results when Exchangeco acquiresits own shares, which is usually disadvantageous for

both the holder of the exchangeable share andExchangeco. Under Canada’s preferred share rules,which apply to equity shares with debtlike features,a dividend on the exchangeable shares usually givesrise to a special tax (Part VI.1 tax) on Exchangeco.This tax is effectively refundable against Exchange-co’s ordinary income tax and so may not pose aninsurmountable barrier for those corporations thatare paying enough corporate income tax to com-pletely offset any Part VI.1 tax, but even so, it isclearly desirable to avoid it.

Accordingly, it is typical for Foreign Parent to usea Canadian subsidiary (Callco) to effect any ex-changes of exchangeable shares for Foreign Parentshares. Callco is often the same Canadian entityalready used in the acquisition structure on theinitial exchange to acquire the Canco shares of thosepersons not receiving exchangeable shares.15 On theinitial exchange, Canco shareholders receiving ex-changeable shares grant Callco a call right to pur-chase their exchangeable shares in the event thatthey would otherwise be acquired by Exchangeco.Holders of exchangeable shares can normally rely onCallco to exercise that call right whenever an ex-change of exchangeable shares for Foreign Parentshares occurs since avoiding a deemed dividend isgenerally beneficial for both Exchangeco and hold-ers of exchangeable shares.

Foreign Tax Issues

Finally, there will often be tax issues or opportu-nities in Foreign Parent’s home jurisdiction createdby the exchangeable share structure. These mayaffect how the initial transaction issuing the ex-changeable shares is structured, the ongoing opera-tion of the exchangeable share structure, or thesubsequent exchange of exchangeable shares forForeign Parent shares. For example, when ForeignParent is a U.S. corporation, some U.S. practitionershave been concerned that the IRS would seek toapply U.S. withholding tax on exchangeable sharedividends on the basis that exchangeable shares arein substance shares of a U.S. corporation.16 On someCanada-U.S. exchangeable share transactions, theinitial exchange has been structured in such amanner as to entitle the U.S. acquirer to make anelection under IRC section 338. This can have thebenefit of eliminating Canco’s earnings and profitsfor U.S. tax purposes, facilitating a subsequent

13This is a reason nonresidents of Canada and tax-exemptentities are often excluded from being able to acquire ex-changeable shares on the initial acquisition transaction.

14Maximizing the PUC of the shares of the top-tier Cana-dian entity in the structure is typically the principal taxbenefit of using a Canadian acquisition vehicle. The use of aseparate acquisition corporation is discussed in greater detailin Nathan Boidman et al., ‘‘Role of a Target Country Acqui-sition Corporation (Special Purpose Vehicle),’’ Tax Notes Int’l,Feb. 21, 2005, p. 663.

15See the previous discussion under ‘‘Structure of InitialExchange.’’

16One commentator has suggested that a recent IRSprivate letter ruling indicates that exchangeable sharesshould be treated as Foreign Parent stock. See Willens, ‘‘IRSRuling Clarifies Status of ‘Canadian Exchangeable Stock,’ ’’BNA Daily Tax Report, No. 96, May 18, 2007.

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extraction of assets out of the Canco structure. Insome circumstances, a section 338 election may alsogenerate deductions or foreign tax credits in theUnited States. While a discussion of foreign taxissues is beyond the scope of this article, the inter-play of Canadian law with that of Foreign Parent’shome country may be an important element ofdeciding whether to use exchangeable shares, and ifso, how to structure the acquisition.

Structure Details

Attempting to create a share of one entity thatreplicates the entitlements of a share of a differententity in another country is not a simple task. Notsurprisingly, the process necessary to make thishappen is somewhat complex, and achieving thisresult requires a number of different legal mecha-nisms. Although the final product is relativelysimple for the exchangeable share holders them-selves, the underlying legal machinery is somewhatmore complicated.

There will often be tax issues oropportunities in Foreign Parent’shome jurisdiction created by theexchangeable share structure.

Also previously described, the tax deferral soughtby Canco shareholders receiving exchangeableshares makes it desirable to minimize the value ofany nonshare consideration (property other thanshares of Exchangeco) received in exchange for theholder’s Canco shares. For this reason, the ex-changeable share structure puts as many of therights of the holders of the exchangeable shares aspossible in the exchangeable shares themselves.Since holders of exchangeable shares must haverights against and obligations toward persons otherthan Exchangeco to make the exchangeable sharesas equivalent as possible to Foreign Parent shares,and since it is generally not possible to endow anExchangeco share with rights that are legally en-forceable against persons other than Exchangeco,the exchangeable share structure contains multiplelegal instruments:

• the exchangeable shares themselves, issued byExchangeco;

• call rights granted by the holders of the ex-changeable shares to Callco;

• a support agreement entered into among For-eign Parent, Callco, and Exchangeco, wherebyForeign Parent generally agrees to do suchthings as are necessary to ensure that Callcoand Exchangeco carry out their obligations, and

the equivalence of exchangeable shares andForeign Parent shares is maintained;17

• a voting and exchange trust agreement betweenForeign Parent, Exchangeco, and a trustee ap-pointed to act on behalf of holders of exchange-able shares (the trustee); and

• a Foreign Parent special voting share, issued tothe trustee.

In transactions involving a publicly held Canco, itis common to employ a corporate law process knownas a plan of arrangement to effect the implementa-tion of the exchangeable share structure, whereby acourt supervises the transaction and issues an orderdeeming various elements of the transaction to haveoccurred on particular terms. The plan of arrange-ment can also be a useful source of legal rights inmaking the exchangeable share structure functionsmoothly, particularly when the exchangeableshares will be widely held.

It is perhaps most useful to set out the primaryobjectives that the exchangeable share structuretries to accomplish and then describe the mecha-nisms employed to achieve them.

Liquidation Entitlement

The terms of the exchangeable shares providethat on the liquidation or windup of Exchangeco,each exchangeable share entitles the holder to re-ceive a Foreign Parent common share. The holder ofexchangeable shares does not otherwise receive anyof Exchangeco’s property. As such, exchangeableshares derive their value from, and depend on thefortunes of, Foreign Parent shares rather than thevalue of Exchangeco’s assets.

Holder Retraction on Demand

Holders of exchangeable shares invariably wantthe right to exchange those shares for Foreign Par-ent shares on demand. Without this right, exchange-able shares lack the economic equivalence withForeign Parent shares that is the essential elementof the transaction. This is achieved primarilythrough the terms of the exchangeable shares them-selves, which give the holder the right (called theretraction right) to require Exchangeco to acquirethe holder’s exchangeable shares in exchange for anequal number of Foreign Parent common shares —that is, the same consideration that would be re-ceived on a liquidation or windup of Exchangeco.

17Holders of exchangeable shares are generally not partiesto this agreement out of concern that the rights they wouldobtain if they were parties would be valuable nonshareconsideration that (as discussed earlier) could adversely af-fect their ability to exchange their Canco shares for exchange-able shares on a tax-deferred basis.

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Trustee Exchange on Extraordinary Event

While each holder of exchangeable shares canexercise her retraction rights on demand, in somehighly unusual circumstances, it will be necessaryfor all holders of exchangeable shares to exchangetheir exchangeable shares for Foreign Parent sharesto achieve the intended economic result. These cir-cumstances include the insolvency of Exchangeco(since Exchangeco becoming insolvent would impairits ability to respond to retractions) and the liquida-tion of Foreign Parent (since there would be noForeign Parent shares left to exchange for exchange-able shares were this to occur). These mandatoryexchanges are generally provided for in the votingand exchange trust agreement, whereby if suchevents are imminent, Foreign Parent agrees to pur-chase all outstanding exchangeable shares for con-sideration consisting of a corresponding number ofForeign Parent common shares (that is, the sameconsideration as on a retraction or Exchangeco liqui-dation). The trustee (acting on behalf of the holdersof exchangeable shares) will exercise this rightshould one of these events become imminent.

These undertakings made by Foreign Parent (of-ten referred to as ancillary rights) to holders ofexchangeable shares (via the trustee) constitutenonshare consideration that must be taken intoaccount in determining the tax consequences of theinitial exchange to Canco shareholders receivingexchangeable shares. Numerous public transactionshave proceeded on the premise (often supported byvaluation advice) that these ancillary rights (includ-ing the voting rights described below) have onlynominal value when they are received, because inmost cases, the likelihood of these events occurringis remote.

Exchangeco-Initiated Exchanges

Foreign Parent will generally want some limita-tion on how long the exchangeable share structuremust stay in place. To accomplish this, the ex-changeable share terms usually have a redemptionright that allows Exchangeco to redeem any out-standing exchangeable shares once a set period oftime has passed since the exchangeable shares werefirst issued. That length of time is established aspart of the bargain between Foreign Parent and theCanco shareholders on the initial acquisition ofCanco, but most often, in public transactions, it runswithin a 5- to 10-year time frame (Molson-Coorswould appear to be the high-water mark at 40years). As with other exchanges, the redemptionprice is one Foreign Parent common share for eachexchangeable share.

It is also common for some other events to triggerExchangeco’s redemption right to have all remain-ing exchangeable shares exchanged. Again, theseevents are defined in the terms of the exchangeable

shares and are usually negotiated between Cancoand Foreign Parent as part of the initial acquisition(assuming that the transaction is a friendly one). Anexample would be the right to redeem the exchange-able shares if the number of remaining outstandingshares (ignoring any held by Foreign Parent or itsaffiliates) falls below a specified level.

Capital Gains Treatment

As discussed previously, most holders of ex-changeable shares that exchange their exchange-able shares for Foreign Parent shares want to re-ceive their Foreign Parent shares from someoneother than Exchangeco to avoid the deemed divi-dend that arises if Exchangeco repurchases its ex-changeable shares. Foreign Parent wants the samething — to avoid Part VI.1 tax. Since it is generallyundesirable to give holders of exchangeable sharesnonshare consideration18 and it is difficult to giveholders of exchangeable shares a right containedwithin an Exchangeco share that will be legallyeffective against someone other than Exchangeco,this means that holders of exchangeable sharesgenerally do not have a right to require anyone otherthan Exchangeco to purchase their exchangeableshares on demand.

Instead, exchangeable share structures are typi-cally set up such that Callco has the right (but notthe legal obligation) to acquire any exchangeableshares that would otherwise be acquired by Ex-changeco, whether on the liquidation of Exchangeco,the exercise of a retraction right by the holders ofthe exchangeable shares, or the exercise of Ex-changeco’s redemption right. This is achieved by theholders of exchangeable shares granting Callco aright to allow Callco to purchase any exchangeableshare that would otherwise be purchased from themby Exchangeco. The amount payable by Callco is thesame as would otherwise be paid by Exchangeco: oneForeign Parent share for each exchangeable share.Although the call right mechanism does not give theholder of the exchangeable share absolute certaintyof avoiding deemed dividend treatment on the ex-change of his exchangeable share,19 he can be rea-sonably confident that Foreign Parent will causeCallco to exercise the call right since deemed divi-dend treatment on the exchange is generally unde-sirable for Exchangeco too.

18As noted earlier, on the initial exchange of Canco sharesfor exchangeable shares, it is desirable to put as much of thevalue as possible to be received by holders of exchangeableshares in those shares themselves, since too much nonshareconsideration may cause a recognition of accrued gains on theCanco shares.

19This is because the shareholder cannot force Callco toexercise the call right.

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In any event, Foreign Parent shares must beobtained by whichever entity (Exchangeco or Callco)is acquiring the exchangeable shares from time totime so that they can deliver them to holders ofexchangeable shares receiving Foreign Parentshares. There are different possible procedures formaking this happen, but quite often, the recipient(usually Callco) issues shares of itself to ForeignParent to pay for the required Foreign Parentshares, which are then delivered to the holder ofexchangeable shares in exchange for his exchange-able shares. If structured correctly, this process willoccur in such a manner as to maximize the cross-border PUC of the newly issued Callco shares andensure that Callco has full tax cost in the ForeignParent shares acquired. Foreign Parent’s homecountry tax law may also have specific issues requir-ing attention (for example, ensuring that it has fulltax cost in the Callco shares it acquires).

Voting Rights in Foreign ParentIn many cases, Canco shareholders being offered

exchangeable shares desire the same voting rightsaccorded to holders of Foreign Parent shares. Thisdesire is typically satisfied by causing Foreign Par-ent to issue a single special voting share to thetrustee who periodically acts on behalf of the holdersof exchangeable shares. The special voting sharecarries a number of votes at Foreign Parent share-holder meetings equal to the number of exchange-able shares outstanding at that time, with eachholder of exchangeable shares (other than ForeignParent or its affiliates) being entitled to instruct thetrustee to cast as many of those votes as she hasexchangeable shares. Procedures for effecting thisare set out in the voting and exchange trust agree-ment. As with other ancillary rights, these votingrights constitute nonshare consideration received bythe holder of exchangeable shares on the initialexchange of Canco shares for exchangeable shares.

Since Foreign Parent shareholders have no votingrights at the Exchangeco level, the exchangeableshare terms provide that holders of exchangeableshares similarly have no right to vote at meetings ofExchangeco shareholders. Canadian corporate law,however, gives the holders of each class of a corpo-ration’s shares the right to vote on some fundamen-tal transactions whether or not the terms of theshares provide for voting rights. The result is thatthere will still be some instances in which holders ofexchangeable shares as a class can vote at Ex-changeco shareholder meetings. This can prove in-convenient for Foreign Parent, and it is one reasonwhy it will want to ensure that the exchangeableshares have a finite lifespan.

Dividend Equivalence

Although not all Foreign Parents are regulardividend payers, many are, and in any case, whether

or not regular dividends are expected to be paid,holders of exchangeable shares will want to be surethat they will receive equivalent amounts shouldany Foreign Parent dividends occur. This is providedfor in the terms of the exchangeable shares them-selves. The support agreement essentially obligatesForeign Parent to do what is necessary to ensurethat Exchangeco pays corresponding dividends onthe exchangeable shares whenever a Foreign Parentdividend is paid.

When the usual legal mechanisms (for example, asupport agreement) are employed, dividends on ex-changeable shares will trigger the Part VI.1 issuertax on Exchangeco (described above). As discussed,this tax is effectively refundable to Exchangeco if it(or a related Canadian corporation) is paying suffi-cient corporate income tax.

The rights and obligations of the various partiesin the exchangeable share structure are summa-rized in Figure 2. (This diagram reflects the share-for-share exchange version of the exchangeableshare structure, described in the next section.)

Implementing the StructureThe last portion of this article describes the

different methods by which Canco shareholders ex-change their Canco shares for exchangeable sharesand by which the exchangeable share structure isput in place. The differences between the methodsare essentially based on which Income Tax Actprovision is used to achieve a rollover for Canadiantax purposes.

Exchangeable share transactions are typicallystructured in one of three ways to achieve thedesired tax efficiencies: (i) a reorganization of capi-tal of Canco in which Canco issues the exchangeableshares (that is, Canco and Exchangeco are the sameentity); (ii) a share-for-share exchange (an exchangeof Canco shares for exchangeable shares of Ex-changeco or Foreign Parent shares); or (iii) an amal-gamation20 of Exchangeco and Canco followed by areorganization of capital. These alternative struc-tures are illustrated and discussed below. The selec-tion of which structure to use is generally influencedby a combination of tax, corporate, and securitieslaw considerations, depending on the particular cir-cumstances of each case.

All of the structures involve entities other thanForeign Parent delivering Foreign Parent commonshares to Canco shareholders. Further, such deliv-eries occur after the initial exchange, when holders

20An amalgamation is the merger of two corporations toform a single entity that is a continuation of both predeces-sors.

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Figure 2. Summary of Rights and Obligations

Some Former Canco Shareholders

- transfer Canco shares to Callco orExchangeco for Foreign Parent shares

- receives call rights from Cancoshareholders receiving exchangeableshares on initial exchange

- executes support agreement with ForeignParent and Exchangeco

- will eventually acquire all exchangeableshares on call right exercise by deliveringForeign Parent shares

Foreign Parent

Exchangeco

ExchangeableShare Trustee

- executes voting and exchange trust agreementwith Foreign Parent

- holds and votes Foreign Parent special votingshare on behalf of holders of exchangeable shares

- holds extraordinary event exchange rights onbehalf of holders of exchangeable shares

Exchangeable Shareholders

- transfer Canco shares to Exchangeco forexchangeable shares with retraction rights vs.Exchangeco, plus ancillary rights

- grant call rights on exchangeable shares to Callco

Specialvotingshare

- issues Foreign Parent shares to Callco orExchangeco as necessary, on initialexchange and ongoing exchangeable shareexchanges

- issues special voting share to Trustee

- grants extraordinary event exchange rightsto Trustee

- executes voting and exchange trustagreement with Trustee and Exchangeco

- executes support agreement with Callcoand Exchangeco

- acquires Canco shares from and delivers exchangeableshares and ancillary rights to those Canco shareholdersreceiving exchangeable shares on initial exchange

- has limited exchangeable share redemption rights in certaincases (negotiable)

- executes support agreement with Foreign Parent and Callco

- executes voting and exchange trust agreement with ForeignParent and Trustee

Commonshares

Exchangeableshares

Callco

Canco

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of exchangeable shares begin to exercise their re-traction rights. There are different ways of ensuringthat Exchangeco, Callco, or any other affiliate ofForeign Parent gets the Foreign Parent shares itneeds to deliver them to Canco shareholders orholders of exchangeable shares in a tax-efficientmanner (for example, maximizing cross-border PUCor ensuring full tax cost).

The Capital Reorganization

When an exchangeable share structure is imple-mented by way of a capital reorganization of Canco,the issuance of exchangeable shares is accomplishedin reliance on subsection 86(1) ITA. This provisiongives a shareholder a tax-deferred exchange when,in the course of a reorganization of a corporation’scapital,21 that corporation acquires all of the sharesof any class of its shares owned by a shareholder andin exchange issues new shares (with or withoutnonshare consideration) to that shareholder. Anexample of an exchangeable share transaction usinga reorganization of capital under subsection 86(1)ITA is the acquisition of Newbridge Networks Corp.(Canada) by Alcatel in 2000, implemented under aplan of arrangement.

Exchangeable share transactionsare typically structured in one ofthree ways to achieve the desiredtax efficiencies.

While there are different variations on the capitalreorganization structure, the principal steps areessentially as follows:

1. Foreign Parent incorporates a Canadiansubsidiary (Callco).

2. Canco amends its articles of incorporation toauthorize the issuance of an unlimited numberof exchangeable shares.

3. All Canco common share holders transfertheir shares to Canco for a number of Cancoexchangeable shares (and the ancillary rightsdescribed above) based on the negotiatedCanco share/Foreign Parent share exchangeratio. This exchange occurs on a tax-deferredbasis under subsection 86(1) ITA. Simulta-neously, Canco issues one voting common shareto Callco for nominal consideration, leavingCallco as the sole common share holder.

4. Holders of Canco exchangeable shares whochoose not to (or are not permitted to) retaintheir exchangeable shares transfer them toCallco in exchange for Foreign Parent shareson a one-for-one basis. This exchange is ataxable event, although most nonresidentswould typically be excluded from Canadiantaxation on any accrued gains.

5. Any Canco exchangeable shares owned byCallco are exchanged for more common sharesof Canco.

6. Foreign Parent issues a special voting shareto the trustee, and the support, voting, andexchange trust agreements are entered into.

The result is illustrated in Figure 3. There aredifferent variations of this structure, depending onwhether exchangeable shares are to be limited toonly some types of Canco shareholders (for example,taxable Canadian residents).

In step 3, subsection 86(1) ITA allows the ex-changing shareholder to receive nonshare consider-ation without any capital gain or deemed dividendbeing realized, as long as the value of that nonshareconsideration does not exceed either the PUC or theholder’s cost of the shares being exchanged; non-share consideration is applied first as a reduction ofthe PUC and basis of the newly issued shares. This

21The reorganization of capital requirement is typicallysatisfied through an amendment to the share terms andclasses set out under the articles of incorporation of Canco.

Figure 3. Capital Reorganization

Commonshares

Some formerCanco

shareholders


Canco/Exchangeco

Some formerCanco

shareholders

Callco

Exchangeableshares

ForeignParent

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means that if the value of the nonshare consider-ation received by a Canco shareholder (that is, theancillary rights, plus any cash received in lieu of afractional exchangeable share) is kept below thePUC and holder’s tax cost of his Canco shares, nocapital gain or deemed dividend will occur and theexchange can be made on a complete rollover basis.As noted earlier, exchangeable share transactionsusually proceed on the basis that the value of theancillary rights described above is nominal (profes-sional valuation advice on this point is desirable),and as a result, the exchangeable shares can bedelivered to Canco shareholders on a nonrecognitionbasis.

The Share-for-Share Exchange

Another Canadian rollover provision often usedin exchangeable share transactions is subsection85(1) ITA. Like subsection 86(1) ITA, this provisionallows nonshare consideration to be received up tothe holder’s tax cost of the disposed share withoutany gain being realized (that is, boot to basis),thereby accommodating the receipt of ancillaryrights. Whereas subsection 86(1) ITA applies only ifshares are disposed of to the corporation that issuedthem, subsection 85(1) ITA may apply to shares (ormost other property) disposed of to any taxableCanadian corporation (whether or not the issuer ofthe shares) for consideration that includes shares ofthe corporation. Two important differences are thatsubsection 85(1) ITA requires both the buyer of theshare and the seller to file a joint election in orderfor the provision to apply (which can entail someadministrative cost when Canco is widely held), andit allows the seller to choose to recognize proceeds ofdisposition essentially anywhere between her cost ofthe shares and their FMV.22 Examples of exchange-able share transactions effected using a subsection85(1) share-for-share exchange are the combinationof Molson Inc. and Adolph Coors Co. in 2005 andVivendi’s acquisition of the Seagram Co. Ltd. in2000.

A number of variations of share-for-share ex-changes are possible, depending on the particularobjectives being sought (in particular any foreign taxconstraints). However, a relatively straightforwardversion of the share-for-share exchange would workas follows:

1. Foreign Parent incorporates a Canadiansubsidiary (Callco).

2. Callco creates Exchangeco as a new Cana-dian subsidiary.

3. Those Canco shareholders who want (or arerequired) to receive Foreign Parent shares onthe initial exchange deliver them to Callco inexchange for Foreign Parent shares based onthe negotiated exchange ratio. This exchange isa taxable event, although most nonresidentswould typically be excluded from Canadiantaxation on any accrued gains.

4. Those Canco shareholders receiving ex-changeable shares transfer their Canco sharesto Exchangeco for exchangeable shares issuedby Exchangeco (and ancillary rights).

5. Foreign Parent issues a special voting shareto the trustee, and the support and voting andexchange trust agreements are entered into.

The result is illustrated at Figure 4. While thisshows Canco’s shares being held partially by Ex-changeco and the remainder by Callco, Callco maychoose to transfer its Canco shares to Exchangecofor more Exchangeco common shares.

On the exchange of Canco shares for exchange-able shares and ancillary rights in step 4, a rolloverfor Canadian tax purposes will occur if the partiesfile a joint subsection 85(1) ITA election within therequired time and the value of the ancillary rightsdoes not exceed the holder’s cost of the Canco sharesfor tax purposes. Notwithstanding the proceduralformalities required under subsection 85(1) ITA,many public transactions have been structured us-ing this share-for-share exchange model.

22Recognizing part of the gain might be desirable, forexample, to use available losses from other sources.

Figure 4. Share-for-Share Exchange

Some formerCanco shareholders

Commonshares


Canco

Some former Cancoshareholders

Callco

Exchangeableshares

Foreign Parent

Exchangeco

Commonshares

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Amalgamation

It is also possible to implement an exchangeableshare structure by way of an amalgamation of Cancowith either Exchangeco or a Canadian subsidiary ofExchangeco (Subco), whereby both corporationsamalgamate into a single entity (Amalco) that is thesuccessor of both predecessors. Nonrecognitiontreatment is possible for both the predecessor corpo-rations and their shareholders on the amalgationunder section 87 ITA.

The key difference between nonrecognition treat-ment under section 87 ITA and the other rolloverprovisions previously discussed is the treatment ofnonshare consideration. To qualify for a rolloverunder section 87 ITA, shareholders of the amalga-mating corporations (Canco and either Exchangecoor Subco) cannot receive any consideration for thedisposition of the old shares on the amalgamationother than shares of the amalgamated company (orits postamalgamation Canadian parent). Even a

nominal amount of nonshare consideration wouldcompletely taint the rollover (both for shareholdersand the amalgamating corporations).

Since exchangeable share structures routinelyinclude ancillary rights (even if only of nominalvalue) for Canco shareholders receiving exchange-able shares, amalgamations are not, on their own,sufficiently accommodating. Exchangeable sharetransactions structured in reliance on section 87 ITAwill therefore virtually always proceed in twostages: an amalgamation followed by another formof tax-deferred transaction in which the ancillaryrights are delivered. The Uniphase Corporation-JDSFitel combination of 1999 is an example of one suchexchangeable share structure, and took the follow-ing form:

1. Foreign Parent incorporated a new Cana-dian subsidiary (Callco).

2. Callco incorporated Exchangeco as a newCanadian subsidiary.

3. Exchangeco incorporated Subco as a newCanadian subsidiary.

4. Subco and Canco amalgamated to formAmalco, with Canco shareholders receivingspecial shares of Exchangeco (Subco’s parent)23

and Exchangeco (the only Subco shareholder)receiving Amalco common shares.

5. Those Canco shareholders who were to re-ceive Foreign Parent shares delivered theirExchangeco special shares to Callco in ex-change for Foreign Parent shares.24 This ex-change was a taxable event, although mostnonresidents would typically be excluded fromCanadian taxation on any accrued gains.

6. Canco shareholders to receive exchangeableshares transferred their Exchangeco specialshares to Exchangeco in exchange for ex-changeable shares and ancillary rights. Thisqualified as a capital reorganization of Ex-changeco eligible for rollover treatment undersubsection 86(1) ITA (described above).

7. Foreign Parent issued a special voting shareto the trustee, and the support, voting, andexchange trust agreements were entered into.

Because the amalgamation itself did not accom-modate the delivery of ancillary rights, these wereinstead distributed to holders of exchangeable

23This form of merger, whereby shareholders of a partici-pating corporation receive shares of Amalco’s postamalga-mation parent corporation (Exchangeco) instead of Amalco, iscalled a triangular amalgamation.

24Callco would later exchange these special shares formore Exchangeco common shares.

Commonshares

Some formerCanco

shareholders


Amalco(formerly

Canco/Subco)

Some formerCanco

shareholders

Exchangeco

Exchangeableshares

ForeignParent

Callco

Figure 5. Amalgamation andCapital Reorganization

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shares on the subsequent capital reorganization.The result is depicted in Figure 5.

ConclusionAs long as the Canadian tax system does not

provide for a deferral of tax on the exchange of ashare of a Canadian corporation for a share of aforeign corporation, exchangeable share structureswill continue to be used. The gain deferral andfavorable dividend treatment they offer represent

meaningful benefits to Canadian shareholders. Thismakes them a useful tool for foreign entities seekingto acquire or combine with a Canadian corporationthat has a significant Canadian shareholder base ina transaction that is not all cash. This is particularlyso when the foreign acquirer may be competing witha Canadian corporation for the Canadian target,since exchangeable shares help to level the playingfield in terms of the Canadian tax implications toshareholders. ◆

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