Corporate reorganizations are valuable weapons in a firm's strategic armory. Employed for a variety of business purposes, they exist in numerous forms, including amalgamations, share-for-share exchanges, divisive reorganizations, and liquidations. Yet, regardless of differences in motivation and mechanics, corporate reorganizations are almost always characterized by a transfer of property between taxpayers, a transfer which is generally caught by the deemed disposition rule of the Income Tax Act (the "Act").(1) This principle holds that where a taxpayer disposes of property to a person with whom he or she does not deal at arm's length, the taxpayer is deemed to have received proceeds of disposition equal to the fair market value of the property.(2) Therefore, the application of the deemed disposition rule to a reorganization of business affairs has the potential to generate taxable gains. Such a result may be both punitive and unjust, however, particularly in circumstances where the transferor and the transferee are effectively the same party, as in the example of when a sole proprietor creates a corporation and subsequently transfers his/her assets to it. In such an instance, since the change in business structure would merely constitute a legal rather than a fundamental economic change in ownership, a deemed disposition which created serious tax consequences would be inappropriate.
To prevent such injustices, the federal government introduced the concept of rollovers to the Act, provisions which allow taxpayers in controlled situations to dispose of property without recognizing any immediate gain or loss from the disposition. Instead, the property is rolled over at its cost amount to the transferee, and the gain or loss deferred until the property is subsequently resold in an unprotected transaction.(3) One of the most significant forms of corporate reorganization safeguarded by these rollovers is the "winding-up" or liquidation of a subsidiary corporation into its parent company. Since the parent typically transfers property to the baby upon its creation, the parent would generally expect that upon its dissolution the subsidiary would be allowed to transfer its remaining property back to the parent without significant tax implications. Subsection 88(1) of the Act governs such a situation, permitting the winding-up of a subsidiary into its parent corporation company on a tax-free rollover basis, if certain pre-requisite conditions are satisfied. The intent of this report is two-fold:
The paper is divided into six sections, including this introduction. Part II addresses the corporate law issues attached to the winding-up of a corporate subsidiary into its parent; Part III examines the substantive provisions of the rollover and the related corporate tax implications thereof, with particular emphasis on the "bump" rules; Part IV reviews the newest and proposed amendments to subsection 88(1); Part V evaluates the extent to which the rollover achieves three principal objectives, and proposes a number of reforms for improving subsection 88(1); and Part VI provides a conclusion to the paper.
Before discussing the tax implications of winding-up a subsidiary corporation into its parent, it is necessary to first review the corporate law considerations relating to dissolutions. As such, the relevant provisions of the Canada Business Corporations Act(4) ("CBCA"), the corporate legislation governing federally-incorporated companies, will be discussed.
Generally, a corporation can only be dissolved under the guise of the authority of the jurisdiction in which it was incorporated.(5) A dissolution can be achieved in various fashions, including voluntarily, involuntarily, and by means of court order. However, because of the unique complications involved in applying subsection 88(1) to involuntary or court order dissolutions, this paper will generally assume that the subsidiary is being wound up under the voluntary dissolution provisions of the CBCA.
The CBCA provides several methods by which a company may be voluntarily dissolved. Section 210 of the CBCA provides for voluntary dissolution in three sets of circumstances. For example, if the company has not yet issued any shares, then it may be dissolved at any time by a simple resolution passed by all of its directors. If the corporation has issued shares but lacks both property and liabilities, then it may be dissolved by a special resolution of its shareholders. On the other hand, if it does have property or liabilities, then it may be dissolved by special resolution of the shareholders of each of its classes of issued shares, so long as it discharges its liabilities prior to dissolution. The special shareholders' resolution required above must usually be approved by two-thirds of the shareholders of a particular class, and must resolve that: the company be dissolved, its liabilities and obligations settled, and its property distributed to its shareholders.
Section 211 of the CBCA is a more complex provision which provides that either the directors or the shareholders may submit at their annual meeting a proposal for the voluntary liquidation and dissolution of the corporation. Once the proposal is approved by a special resolution of the shareholders of each class of shares, a statement of intent to dissolve the corporation is sent to the Director of the Corporations Branch.
Regardless of the exact route taken by a corporation to achieve voluntary dissolution, once the prescribed procedure has been completed, including the filing of articles of dissolution with the Director, the Director is obligated to send to it a certificate of dissolution.(6) The corporation ceases to exist on the date shown on this certificate.(7)
The following analysis of the tax implications of subsection 88(1) is organized into seven parts: eligibility for rollover, general rules, shares of the subsidiary, property of the subsidiary, liabilities of the subsidiary, losses of the subsidiary, and minority shareholders.(8)
The opening words of subsection 88(1) reveal that there are four primary requirements that must be satisfied in order for the rollover provision to apply: taxable Canadian corporations, wind-up of subsidiary, 90 percent ownership and arm's-length requirement.
i) Taxable Canadian Corporations
The first requirement is that both the parent and the subsidiary corporations be "taxable Canadian corporations." Thus, according to the Act, both corporations must be resident in Canada at the time of the winding-up, and either incorporated or resident in Canada continuously since June 18, 1971.(9) As well, neither the parent nor the subsidiary can be exempt from tax under part I of the Act.(10)
ii) Winding-up of Subsidiary
In order for subsection 88(1) to apply, there must also be a winding-up of the subsidiary.(11) According to Interpretation Bulletin IT-126R2, Revenue Canada considers a company to be wound up if it has followed the procedures for winding up and dissolution as set out by the appropriate winding-up or companies Act, or if the company has concurred with the dissolution requirements under its incorporating statute.(12) This suggests that a formal dissolution procedure such as those provided in sections 210 and 211 of the CBCA must have been completed by the subsidiary corporation before the rollover will take effect. However, it is common for the final certificate of dissolution to not be obtained until after the subsidiary's business has effectively been terminated. To resolve this potential uncertainty, Revenue Canada issued a statement indicating that it considers a corporation to be wound up for the purpose of subsection 88(1) without the completion of the formal dissolution of the corporation, so long as there is "substantial evidence that it will be dissolved within a short period of time."(13)
Revenue Canada will also accept that subsection 88(1) applies where a corporation is not dissolved in a particular year because of the existence of outstanding litigation, provided that four conditions are met. All the corporation's assets and liabilities must have been distributed or assumed by the shareholders, excluding those that cannot be transferred as a result of the litigation. As well, the outstanding litigation must be the only reason for the delay in obtaining a formal dissolution. The winding-up corporation must not undertake any activities or acquire any property while awaiting the formal dissolution. Finally, the corporation must be dissolved formally shortly after the conclusion of the litigation.(14)
iii) 90 Percent Ownership
A third requirement for the application of the rollover is that the parent corporation must have owned 90 percent or more of the issued shares of each class of the subsidiary corporation's capital stock, immediately before the winding-up. The most controversial element in this test is the timing issue. Specifically, what is the meaning of immediately before the winding-up? Revenue Canada has interpreted this phrase to mean that point in time directly preceding the implementation of winding-up procedures which would normally mean the date of the shareholders' resolution authorizing the winding-up.(15) As has already been discussed, the CBCA considers the commencement of these procedures to occur with the passing of a special shareholders' resolution to that effect. Therefore, the 90 percent threshold test should be applied immediately prior to the passing of such a resolution.(16) Based on this interpretation of the timing issue, however, it is conceivable that a parent corporation could own 90 percent of a subsidiary's shares immediately prior to the commencement of the winding-up, and then reduce its level of ownership below 90%, without disqualifying itself from the application of subsection 88(1).(17)
Furthermore, Revenue Canada has interpreted the ownership of 90 percent of the subsidiary's shares to mean beneficial ownership.(18) This is an important element since it effectively means that individual shareholders will not be able to trigger subsection 88(1) by combining their shareholdings together in order to reach the 90 percent threshold.
iv) Arm's-length Requirement
The fourth and final requirement of subsection 88(1) is that all of the subsidiary's shares that are not owned by the parent corporation immediately before the winding-up must be owned at that time by "persons with whom the parent was dealing at arm's length." Subsection 251(1) provides that "related persons shall be deemed not to deal with each other at arm's length," and that "it is a question of fact whether persons not related to each other were at a particular time dealing with each other at 'arm's length.'" Therefore, to ensure that the rollover applies, the parent must make two determinations. The first is whether any minority shareholder is "related" to the parent, according to the definition in subsection 251(2). The second is whether the parent and minority shareholder do not deal at arm's length in fact.(19) This consideration is required because it is possible for unrelated parties to be in fact dealing with each not at arm's length. Once these four conditions precedent have been met, the subsection 88(1) rules operate automatically; no election is required.
Prior to examining the structure and mechanics of subsection 88(1) in detail, it is helpful to first furnish a broad overview of its key provisions. The rules of the rollover are designed to help corporations that wish to merge its assets, liabilities and business operations by winding-up a subsidiary into its parent, without incurring adverse tax consequences. Paragraph 88(1)(a) deems that the property distributed by the subsidiary to the parent upon its dissolution was disposed of for proceeds equal to the cost amount of such property to the subsidiary.(20) Paragraph 88(1)(b) generally allows the parent corporation to dispose of its shares in the subsidiary on a tax-free basis. Paragraphs 88(1)(c) and (d), containing the most complex rules in the subsection, provide that generally, on a winding-up of a subsidiary corporation, the parent may designate an amount (the "bump") to increase the cost to it of certain non-depreciable capital property owned by the subsidiary, where the adjusted cost base of the parent's shares in the subsidiary exceeds the net assets of the subsidiary. Furthermore, subsections 88(1)(e.1) through (i) generally provide for the flowthrough of various tax attributes and accounts of the subsidiary to the parent, while subsections 88(1)(1.1) and (1.2) provide for the flowthrough to the parent of the subsidiary's non-capital and net capital loss carryforwards.
Having briefly highlighted the components of subsection 88(1), the next step is to conduct a thorough examination of the rollover's integral provisions and of their major tax implications.
When a subsidiary is dissolved into its parent, one of the fundamental problems that arises is determining how to deal with the subsidiary's shares. Paragraph 88(1)(b) has resolved this question by providing that upon the winding-up of the subsidiary, all subsidiary shares owned by the parent corporation are deemed to have been disposed of by the parent. To determine the amount at which these proceeds should be valued, the Act holds that it is equal to the greater of:
This prescribed treatment of the disposition of the parent's subsidiary shares leads to two important tax implications for the parent with respect to capital gains (or losses). First of all, since the above formula guarantees that the parent's proceeds of disposition will always be at least equal to its adjusted cost base of the shares, then the parent corporation will never be in a situation of recognizing a capital loss on the disposition of these shares.(22) Yet, the parent may be forced to realize a capital gain in the event that the adjusted cost base of the parent's shares of the subsidiary is less than both the paid-up capital thereof and the aggregate of the cost amounts of the subsidiary's net assets plus its cash. This, in turn, raises a second tax consideration for the parent.(23) Rather than choosing to recognize such a capital gain, the parent may pursue other avenues by which it could be reduced or eliminated. For instance, the parent company could have the subsidiary, prior to the commencement of winding-up, declare and pay a taxable dividend to its shareholders. Alternatively, again prior to the start of liquidation procedures, the subsidiary could consider reducing the paid-up capital of its shares.(24) In either case, the undesirable capital gain could be avoided by the subsidiary upon its winding-up. On the other hand, both of these options have the potential of violating the anti-avoidance rules of the Act.
The Act contains a number of provisions which are aimed at preventing or discouraging taxpayers from artificially converting fully taxable income into income that is either non-taxable or taxable at a lower rate. Most pertinent to this discussion are the rules outlined in subsection 55(2) and section 245. Subsection 55(2) is designed to prevent companies from reducing capital gains by the payment of a tax-free intercorporate dividend which reduces the value of the shares in anticipation of their sale. If applicable, then the dividend recommended above would be deemed to be proceeds of disposition.(25) Similarly, either the dividend or the paid-up capital reduction could be caught by section 245's general anti-avoidance provision ("GAAR") and labeled an "avoidance transaction." Academics, however, have argued strongly that neither action should be barred by the GAAR on the ground that neither would constitute an abuse of the Act as a whole, since the Act does provide for a tax-deferred winding-up of a subsidiary.(26) It has been further contended that subsection 88(1) falls within the confines of the comments of the Department of Finance in the technical notes to Bill C-139 (which enacted GAAR) which held that section 245 was not intended to apply to transactions that are primarily tax motivated but that come within the description of provisions that either contemplate or encourage transactions that are primarily tax motivated.(27) Since the courts have yet to provide guidance on this controversy, any subsidiary contemplating either of the moves detailed above would be wise to first conduct a review of the Act's anti-avoidance laws.
At the heart of the analysis of the subsection 88(1) rollover is its prescribed tax treatment of the property transferred from a subsidiary to its parent upon winding-up. This area is by far the rollover's most complex and controversial, outlining a wide assortment of rules which vary according to the particular class of property involved. Subparagraph 88(1)(a)(iii) provides that the general rule of the rollover is that the property distributed by the subsidiary to its parent on winding-up is deemed to be transferred at its cost amount. Thus, the subsidiary does not recognize a gain or loss on the transfer. In turn, the parent corporation is deemed to acquire each of the subsidiary's assets at a cost equal to the subsidiary's deemed proceeds of disposition.
A more detailed examination of these rules is arranged according to the specific categories of the subsidiary's property: non-depreciable capital property, depreciable property, eligible capital property, and other property.
i) Non-Depreciable Capital Property - The "Bump"
The non-depreciable capital property of a corporation includes such items as real property, bonds, and debentures.(28) Paragraph 88(1)(c) essentially provides that the cost to the parent of non-depreciable capital property transferred from the subsidiary will be the adjusted cost base to the subsidiary, plus an amount (the "bump") computed under paragraph 88(1)(d). This bump is important in two main scenarios. The first is where the parent originally purchased the subsidiary's shares at a premium to reflect the excess of the fair market value of the subsidiary's assets over their tax values. While this excess purchase price would otherwise be lost when the subsidiary is wound-up into the parent, the bump provisions allow the parent to preserve a significant portion of the tax basis associated with the premium by raising the cost basis of certain non-depreciable capital property.(29) The second scenario is where the subsidiary incurred losses while the parent was in control. While ordinarily these losses would lead to a capital loss to the parent on the disposition of its subsidiary shares, the rollover denies recognition of such losses. Instead, according to paragraph 88(1)(d), the parent is permitted to convert the capital loss into a bump which is used to increase the adjusted cost base of the non-depreciable capital property transferred from the subsidiary.(30)The ultimate effect of this "bump" is to either increase the parent's capital loss or decrease its capital gain when the property is subsequently resold. The bump therefore compensates the parent for its losses.
The bump is available only in relation to non-depreciable capital property that was owned by the subsidiary when the parent last acquired control and which has been owned without interruption since then.(31) Paragraph 88(1)(d.2) imposes special rules to determine when this acquisition of control occurs, specifying that where control of a company is acquired by a parent corporation from a party with whom the parent was not dealing at arm's length, the parent corporation is deemed to have last acquired control of the subsidiary at the earlier of two times: when the selling corporation last acquired control, or when the selling corporation was deemed by paragraph 88(1)(d.2) to have last acquired control.(32)
As well, to be qualified bump property it must be non-depreciable capital property at the time the parent acquired control. However, property that was capital when in the possession of the subsidiary may be non-capital inventory once transferred to a parent who intends to sell it immediately following the winding-up.(33) To avoid confusion, the Act will only look to whether the property is capital in the hands of the subsidiary.
The size of the bump is defined as the amount by which the parent's adjusted cost base of its shares in the subsidiary, immediately before the winding-up, surpasses the aggregate of:
The resulting bump amount is a global figure which may then be designated to any non-depreciable capital property held by the subsidiary continuously from the time the parent corporation last acquired control until the time of the transfer, subject to the limitations contained in subparagraphs 88(1)(d)(ii) and (iii).(35) Subparagraph 88(1)(d)(ii), for instance, provides that the amount of the bump designated to a particular capital property may only raise the cost of the property to the parent up to the fair market value of the property at the time the parent acquired control. As well, a maximum limit is imposed on the amount of the bump.(36) Thus, the parent may not employ the entire available bump if the excess of the fair market value of the eligible property over the cost base of the property is less than the total bump available.
Having outlined the technical procedure by which the bump functions, the next step is to evaluate it on a public policy basis. The first consideration is its scope. As we have already seen, the bump applies only to non-depreciable capital property. However, this means that any premium paid by the parent on shares of the subsidiary relating to goodwill, unrealized inventory gains, and resource property will go unrecognized in their cost basis when the assets are transferred to the parent on the subsidiary's winding-up.(37) The obvious explanation for Revenue Canada restricting the bump to non-depreciable capital property is that it minimizes the present value of tax savings for the parent since an increase in the cost basis of such property will only reduce future capital gains realized when the property is subsequently sold.(38) No savings are realized in the present. In contrast, if the bump could be applied to depreciable property, then the bump could be amortized against income much sooner, leading to tax gains having greater present values.(39) This distinction seems badly flawed if one remembers that the purpose of the bump in the first place was to allow the parent to preserve some of the premium paid by the parent on the acquisition of the subsidiary's shares. It should not matter whether this premium derives from depreciable assets or non-depreciable capital property.
A second policy consideration is the appropriate legislative treatment of deliberate attempts by a parent to inflate its potential available bump. A bump inflation may theoretically be accomplished by any device which reduces the subsidiary's net assets such that the difference between the tax value of the subsidiary's net assets and the parent's adjusted cost base -- the bump -- is maximized.(40) While the most obvious method is for the parent to instruct the subsidiary to pay dividends to its shareholders prior to the winding-up, this is caught and forbidden by subparagraph 88(1)(d)(i.1)(A) which reduces the bump to the parent by the amount of the dividend paid on the shares of the subsidiary disposed of by the parent on or in contemplation of the winding-up.
However, there are a number of problems with this anti-avoidance provision. To begin with, while paragraph 88(1)(d) prohibits artificial increases in the bump achieved via dividend payments, it does nothing to address more subtle forms of manipulation. For example, other techniques for raising the bump include winding-up the subsidiary as early as possible if it is expected to be profitable in the future, or delaying the winding-up until later if the subsidiary is expected to face losses in the near future.(41) Yet, both of these strategies, despite being solely motivated to inflate the bump, are perfectly acceptable from the perspective of the subsection 88(1) rollover. It is recognized that these tactics may be more difficult to pigeon-hole as avoidance measures than dividends, and that they may fall within the ambit of the general anti-avoidance provisions of the Act. However, it is highly desirable that paragraph 88(1)(d) attempt to control even these more subtle moves so as to provide greater consistency to the legislation.
As well, there is the potential for great injustice to be inflicted by subparagraph 88(1)(d)(i.1)(A) in certain circumstances. For example, take the case of where Company A, having a less than a controlling interest in Company B, receives a dividend from Company B during its period of ownership, and then subsequently acquires the whole of Company B's shares. If Company A liquidates Company B pursuant to subsection 88(1) in the future, subparagraph 88(1)(d)(i.1)(A) will, at that time, interpret the dividend to be an avoidance attempt and, as a result, reduce the amount of Company A's bump by the amount of the dividend. This anomaly occurs because the provision does not specify that the "dividend grind to the bump is with respect to dividend payments received by the parent while it was a parent; [it] simply refers to dividends received by the parent on shares disposed of on the winding up."(42) Legal analysts have questioned whether the Act intended for this type of dividend payment to be caught by the avoidance rule.(43) As long as the dividends paid to Company A prior to it becoming a parent were not made with the intention of inflating the future bump, then the policy rationale underlying the provision is not violated and the bump should not be reduced.
In sum, while the bump rules provide a valuable service by allowing a parent to retain some of the tax benefits related to a premium paid by it in the process of purchasing the shares of its subsidiary, there is considerable room for improving the anti-avoidance clause to ensure that it operates with greater consistency and practical fairness.
ii) Depreciable Property
Another important group of property affected by subsection 88(1) is depreciable capital property, or capital property in respect of which a portion of the capital cost may be deducted.(44) All such property transferred to the parent by a subsidiary on its winding-up is deemed to have been disposed of at its undepreciated capital cost.(45) Furthermore, paragraph 88(1)(f) formulates a rule by which the parent is intended to be placed in the exact situation with respect to the depreciable property as that of the subsidiary immediately prior to winding-up. It sets out that the parent is deemed to have acquired the depreciable property capital cost to the subsidiary at its original capital cost, and is deemed to have claimed a capital cost allowance with respect to the property equal to the margin by which this original cost exceeds its proportional undepreciated capital cost, provided that this amount is less than the original capital cost of the property. In this way, the parent is guaranteed to "inherit any recapture potential attributable to capital cost allowance previously claimed on the property."(46)
iii) Eligible Capital Property
"Eligible capital property" is also encompassed by the rollover regime. Essentially it is capital property that, before 1971, failed to generate entitlement to a current deduction, capital cost allowance, or any other concessionary allowance.(47) The Act deems the subsidiary on winding-up to have disposed of its eligible capital property for proceeds equal to its cost amount, or four-thirds of the subsidiary's cumulative eligible capital. Given that the cumulative eligible capital amount is reduced by three-quarters of the deemed proceeds, then the result is a complete rollover.(48) The main role served by this provision is to simply preserve adjustments to the cumulative eligible capital account so as to recognize the increase in eligible capital expenditures' inclusion rate from one-half to three-quarters.
iv) Other Property
Other types of property which are transferred from the subsidiary to its parent on winding-up include accounts receivable and inventory. Accounts receivable are deemed by paragraph 88(1)(a) to have been disposed of by the subsidiary and, by paragraph 88(1)(c) to have been acquired by the parent, at an amount equal to their cost base in the hands of the subsidiary immediately before the winding-up.(49) This cost amount is specified by subsection 248(1) to be the cost to the subsidiary as determined for the purposes of computing income.(50) Essentially, it means that a receivable is transferred at its face amount.
The liabilities of the subsidiary are another major area for discussion in an analysis of subsection 88(1). In fact, the discharging of a subsidiary's obligations is a pre-requisite to its legal dissolution. The rollover makes a distinction between the subsidiary's settlement of a debt owing to the parent, and of one owing to a third party. With respect to the parent-as-creditor situation, a subsidiary may discharge any indebtedness to its parent either by payment in cash or by transferring assets of equivalent value to the parent.(51) However, the subsection 88(1) rollover applies only in respect of the transfer of assets in the context of liquidation proceedings. Where a subsidiary fails to fully satisfy a debt owing to the parent, the parent corporation has the option of electing to assume the outstanding debt at its cost amount. If the parent chooses this route, then the subsidiary is deemed to have paid an amount equal to the cost amount of the debt to the parent.(52)
To determine the cost amount of the debt, one must reference subsection 248(1) which defines it as the adjusted cost base of the debt to the creditor. If, however, the debt involves inventory instead of capital property, then subsection 10(1) sets out that the cost is equal to the lower of its cost and fair market value.(53)
Turning now to the third party-as-creditor situation, the subsidiary may discharge the obligation either by paying cash or by transferring assets to the third party having a value equivalent to the debt.(54) Subsection 88(1) is primarily concerned with the latter case since such a transfer may result in a variety of tax effects to the subsidiary, including capital gains, taxable income and recapture of capital cost allowance. In an effort to respond to this problem, paragraph 88(1)(e.2) in coordination with subsection 87(7) now allow the parent to assume the debt on the subsidiary's behalf and avoid triggering any immediate tax consequences, given that two conditions are satisfied.(55) First, the assumption of the indebtedness must be part of the distribution of the subsidiary's assets on liquidation. Second, the amount payable by the parent on the maturity of the debt must be the same would have been payable by the subsidiary had the transfer not taken place. The net result of the satisfaction of these provisions is that the parent is able to step into the shoes of the subsidiary as if it had issued the debt from the outset, thus entitling the parent to any deduction for deep or shallow discounts to which its subsidiary was entitled, while allowing the parent to delay negative tax consequences into the future.(56)
Another major consideration during the winding-up of a corporate subsidiary is the status of the losses previously incurred by the subsidiary. Prior to March 31, 1977, the transfer of a subsidiary's non-capital and net capital losses was strictly forbidden.(57) However, since that time the Act, by means of the subsection 88 rollover, has permitted limited transfers of a subsidiary's losses to its parent, provided that certain general criteria are met. The following analysis of these criteria will focus first on non-capital losses, followed by net capital losses.
With respect to non-capital losses, paragraph 88(1.1)(b) explicitly holds that the loss is deductible by the parent corporation only if it has not already been deducted in computing the taxable income of the subsidiary, and would otherwise be deductible by the subsidiary for any taxation year beginning after the commencement of the winding-up procedures.(58) The fallout from this rule is that non-capital losses of the subsidiary that are in their last year of carryforward eligibility will not be available to the parent upon winding-up; rather, they will simply expire, unused. It is important to note as well that a parent who receives transfer of its subsidiary's losses must satisfy all of the usual limitations otherwise applicable to the deductibility of losses and the loss carryforward periods, including those contained in paragraphs 111(1)(a), (c), (d), and (e), and subsection 111(3).(59)
Furthermore, whether they arose from carrying on the "subsidiary's loss business," or from any other source, the parent corporation is deemed by paragraph 88(1.1)(c) to have experienced these non-capital losses in the parent's taxation year in which the subsidiary's year ended.(60) Since it is forbidden that the loss in question have been deductible by the parent for the purposes of computing its taxable income for any taxation year beginning prior to the commencement of the winding-up, it is therefore necessary that the parent's identifies the taxation year in which the subsidiary's loss is deemed to have been incurred, and to determine the number of the parent's taxation years that have elapsed since then.
The rollover sets out additional restrictions on the transfer of non-capital losses when there has been an acquisition of control of either the parent or the subsidiary. Specifically, paragraph 88(1.1)(e) provides that the parent is not permitted to deduct any non-capital losses of the subsidiary if control of the parent or subsidiary has been acquired, prior to the conclusion of the parent's taxation year in which the deduction is sought to be used, by a person who did not possess control of the subsidiary at the end of the subsidiary's loss year.(61)
An analogous set of rules are provided in subsection 88(1.2) in respect of the net capital losses of the subsidiary. The only major distinction from the regime described above involves the requirement that the net capital loss be deemed to have been incurred by the parent in its taxation year in which that taxation year of the subsidiary ended.(62) This is of little concern since there are no limitation periods for the carryforward of net capital losses.
A final major area of discussion of the tax implications of the subsection 88 rollover is the impact which it inflicts upon the minority shareholders of the subsidiary. These shareholders face one of two options. First, the parent has the choice of purchasing their shares, in which case the minority owners will realize a capital gain or loss based on the difference between the proceeds received for the shares and the tax basis of the shares in their hands.(63)
On the other hand, the subsidiary may choose to redeem the shares of the minority shareholders. If this is accomplished prior to the commencement of the winding-up, then it falls within the usual rules of redemption contained in subsection 84(3).(64) As a result, the shareholders receive proceeds of redemption equal to the fair market value of the shares, with the amount by which they exceed the paid-up capital of the stock resulting in a taxable deemed dividend (unless subsection 84(8) applies).(65) As well, where there is a difference between the proceeds of disposition of the shares (deemed to be equal to the paid-up capital of the shares) and the tax basis of the shares to the shareholders, then a taxable gain or loss is recognized.
However, if the stock redemption follows the winding-up resolution, then no dividends are deemed to be paid to the minority shareholders. Rather, the proceeds of redemption are entirely proceeds of disposition on the stock, and the shareholders realize a capital gain or loss equal to the difference between the proceeds on the redemption and the tax basis of the stock in their hands.(66)
A large number of new and proposed amendments to subsection 88(1) have recently arisen. A sample of these actual and proposed legislative changes will now be examined.
First of all, paragraph 88(1)(a) was amended by adding a new provision (a.3) which relates to financial institutions. It basically provides that where the parent and the subsidiary were both financial institutions in their respective taxation years in which the winding-up took place, then each specified debt obligation of the subsidiary distributed to the parent on the winding-up is deemed not to have been disposed of.
Another recent addition to the subsection 88(1) rollover regime is paragraph 88(1)(i), applying to mark-to-market property. Mark-to-market property is deemed to have been disposed of by a financial institution at the end of each year for proceeds equal to its fair market value and to have reacquired it at a cost equal to those proceeds. The new paragraph 88(1)(i), added in 1995, basically provides that for purposes of the mark-to-market requirement in subsection 142.5(2) only, the subsidiary's taxation year in which its assets were distributed under a winding-up procedure is deemed to have ended immediately prior to the transfer of these assets.(67)As a consequence, the subsidiary's property will be marked to market just prior to its distribution and then distributed to the parent for the same amount.
Two proposed amendments relating to the bump provisions were contained in the June 20, 1996 Notice of Ways and Means motion from the Department of Finance.(68)The first is an amendment to paragraph 88(1)(c.2)(vi). The new provision sets out that all of the property of a subsidiary distributed to its parent on winding-up will be considered ineligible for the bump if persons, who had a significant interest in the subsidiary before the time the parent last acquired control, acquire a significant interest in that property after the winding-up.(69) Prior to this, only property which was actually disposed of to such persons was considered ineligible for the bump.
The second proposed amendment is outlined in paragraph 88(1)(c.3). According to its technical notes, it provides that for the purposes of determining whether property of the subsidiary or property substituted for that property has been acquired by a person having a significant interest in the subsidiary, substituted property includes property whose value is wholly or partly attributable to property of the subsidiary or proceeds of disposition derived from the sale of such property. It also provides that property that is money received as consideration for the disposition of particular property will not be considered as property acquired by any person in substitution for the particular property.(70)
Kopstein has concluded that the net result of these proposed amendments is that the subsidiary's shareholders can receive money received by the parent on the sale of property which was distributed to it by the subsidiary, without offending the rule. However, if the money had actually been transferred by the subsidiary to the parent as part of the winding-up, then the acquisition of any of that money by a person described in subparagraph 88(1)(c)(vi) would cause all of the property distributed to the parent on the winding-up to be considered ineligible property.(71) Kopstein also observed that these amendments would lead to a strange policy result since "the amount of money which would have been distributed to the parent on the winding-up would have reduced the amount of the available bump under paragraph 88(1)(d).(72)
Overall, the modifications described above mostly serve to fine-tune the subsection 88(1) rollover rather than to implement any fundamental alterations thereof.
Having completed a substantive review of the subsection 88(1) rollover, the paper will now assess its effectiveness in the context of three principal objectives:
In response to question one, subsection 88(1) is overall quite successful at achieving extensive rollover treatment for both the parent and the subsidiary corporations. The provisions reflect an understanding of the fact that businesses often change their legal forms without altering their economic ownership, and, as a result, generally permit neutral restructuring transactions to proceed with few adverse tax consequences. For example, when a subsidiary transfers its property to its parent as part of an eligible winding-up, rather than being obligated to recognize any tax gains that may have developed on the assets, the parent is usually deemed to have purchased them for proceeds which are equivalent to their cost amount to the subsidiary. The net result is that any taxable gains that may exist can be deferred until the parent sells the items in the future in a non-protected sale. There are, however, some deviations from this in practice. The most notable is with respect to the deemed disposition upon winding-up of a parent's subsidiary's shares. There are occasions where the procedure set out by subsection 88(1)(a) results in the parent incurring a non-sheltered taxable gain on the shares.
Turning to the second question, subsection 88(1) is relatively successful at promoting tax neutrality in the sense that it strives to help companies to achieve an equivalent change in economic ownership of their assets with the same tax consequences, regardless of the legal form in which the transactions are implemented. One significant area where this neutrality is violated is with respect to the bump provisions. For instance, in a corporate takeover, the predator firm often plans to sell one or more of the target firm's business units. If these sub-companies are contained in separate subsidiaries, then the predator may be able to achieve its objective on a tax-free basis by liquidating the subsidiaries following the takeover, and bumping the tax basis of the shares to be sold to fair market value. As a result, the subsidiaries will then be able to be sold without triggering any tax liability under the Act. In contrast, if the unwanted business units are contained within different divisions of the parent corporation, then the predator will be unable to dispose of the units without triggering tax, unless cooperation is offered by the target. For example, the target, may, if it desires, undertake to incorporate these units into subsidiaries before completion of a takeover bid so that the successful acquirer will be able to sell off the unwanted units on a more tax-efficient basis. However, the target, by extending cooperation to the more favored bidder, places the other offerors at a disadvantage in that the tax savings that the favored bidder is bound to receive could allow it to make a higher share price bid to the target's shareholders.(74) The legislation should discourage these types of situations.
With respect to the third and final question, the majority of the rollover's rules are relatively straightforward, leading to tax consequences that are reasonably clear and certain. Unfortunately, the bump provisions found in paragraphs 88(1)(c) and (d) are very complicated, consisting of a variety of intricate formulae and procedures intended to safeguard against abuse. In particular, the clauses pertaining to the calculation of the amount of the bump and the determination of eligible property are complex and difficult to follow.
Overall, the success of subsection 88(1) in fulfilling these three objectives is a strong indicator that the rollover manages corporate winding-ups in a manner which integrates the interests and objectives of taxpayers as well as Revenue Canada.
ii) Proposals for Reform
While subsection 88(1) is admittedly well constructed, this paper as a whole has revealed certain areas where reform could be beneficially implemented. For instance, some consideration should be given to expanding the scope of eligible property under the bump rules to include other capital such as goodwill and inventory. To do so would be in greater harmony with the goal of the bump to allow the parent to preserve some of the premium paid by the parent on its acquisition of the subsidiary's shares.
An amendment to subparagraph 88(1)(d)(i.1)(A) would also be valuable. As it is presently worded, on the winding-up of its subsidiary the parent company's bump is reduced by the amount of any dividends received from the subsidiary both before and after acquiring a controlling interest in it. However, this result lacks any connection with the underlying rationale of the provision which is to prohibit transactions deliberately aimed at inflating the bump. To overcome this problem an amendment could be made to specify that the dividend grind to the bump only applies to payments received by the parent while it was a parent.
Further changes could also be contemplated which provide for enhanced tax neutrality. As we have seen in the context of a corporate takeover, the legal form used in a restructuring can sometimes be critical to whether or not a particular change in ownership may be achieved with minimal adverse tax consequences. It may be advantageous to the pursuit of simplicity and greater certainty if subsection 88(1) was modified to be less concerned with the legal structures involved in a winding-up, and more focused on the economic arrangement.
A final general proposal for reform is that Parliament take steps to make the provisions of subsection 88(1) more intellectually accessible to the average business person. As of now, business leaders unnecessarily incur extensive time and expense in attempting to predict the consequence of a proposed subsidiary dissolution on its bump amount. Thus, the benefits of simplification and streamlining would be that corporations would be able to, as a result, conduct its restructuring decisions in an environment of enhanced certainty, efficiency and cost effectiveness.
If corporate reorganizations are weapons in a firm's strategic armory, then rollovers are its complementary shields. Frequently employed to achieve business and tax objectives, business restructurings, even where lacking any significant economic changes, have the potential to generate adverse and premature tax consequences. Fortunately, rollovers, such as subsection 88(1), have evolved within the Act to help defer the majority of these tax effects until a time when they more closely reflect substantive ownership revisions in a corporation. Given the wide-spread popularity of subsidiary winding-ups in our present world, the importance of subsection 88(1) in introducing fairness and economic consciousness to the Act is considerable. Already a solid if somewhat complex set of provisions, Parliament must continue to modify subsection 88(1) of the Act over time in order to ensure that it remains a comprehensive and practical tool of business, and hopefully, a clearer, more precise one as well.
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1. R.S.C. 1985, c. 1 (5th Supp.) [hereinafter the "Act']. Unless otherwise stated, all statutory references in this paper are to the Act.
2. Paragraph 69(1)(b).
3. V. Krishna, The Fundamentals of Canadian Income Tax, 5th ed. (Toronto: Carswell, 1995) at 877.
4. R.S.C. 1985, c. C-44 [hereinafter CBCA].
5. Krishna, supra note 3 at 1002. See also generally, Russian Commercial & Indust. Bank v. Comptoir d'Escompte de Mulhouse  AC 112 (H.L.); Re Russian Bank for Foreign Trade  Ch. 745.
6. ss. 210(5) and ss. 211(15) of the CBCA.
7. ss. 210(6) and ss. 211(16) of the CBCA.
8. See generally D.M. Williamson, "Checklists: Corporate Reorganizations, Amalgamations and Wind-ups," in Report of Proceedings of the Thirty-Ninth Tax Conference, 1987 Conference Report (Toronto: Canadian Tax Foundation, 1988), 29:1-65.
9. Subsection 89(1).
11. Interpretation Bulletin IT-126R2, March 20, 1995, paragraph 3.
13. Ibid. at paragraph 5.
15. Ibid. at paragraph 7.
16. S.J. Roberts and M.E. Briggs, "The Taxation of Corporate Reorganizations: Winding Up: Part 1" (1996) 44:2 Can. Tax. J., 533 at 537.
17. J. Shafer, "Liquidation," in Report of Proceedings of the Forty-Third Tax Conference, 1991 Conference Report (Toronto: Canadian Tax Foundation, 1992), 10:1 at 21.
18. Interpretation Bulletin IT-488R2, June 24, 1994 at paragraph 3.
19. Shafer, supra note 16 at 22.
20. This treatment does not apply to partnership interests; rather, they are deemed not to have been disposed of by the subsidiary, except for the purposes of subsection 98(5)(g). Note that paragraph 88(1)(a.3) does not apply for the purpose of the anti-avoidance rule in subsection 69(11).
21. Paragraph 88(1)(d)(i).
22. A capital gain or loss on shares is calculated by subtracting the adjusted cost base of the shares from the proceeds of disposition.
23. Roberts, supra note 15 at 546. See also T.G. Duholke, "Section 88-Wind-ups," in 1992 British Columbia Tax Conference (Vancouver: Canadian Tax Foundation,1992), tab 4 at 24.
25. Shafer, supra note 16 at 26.
28. Ibid. at 29.
29. T. Pister, "Paragraph 88(1)(d) Bump on the Winding Up of a Subsidiary-Part 1" (1990) 38:2 Can. Tax. J., 148 at 149.
31. D.S. Ewens, "Corporate Dissolutions" (1985) 33:6 Can. Tax. J., 1246 at 1249.
32. IT-488R2, supra note 17 at paragraph 30.
33. See, for example, Hickman Motors Limited v. The Queen, 95 DTC 5575 (FCA); and The Queen v. Mara Properties Limited, 95 DTC 5168 (FCA).
34. Roberts, supra note 15 at 549.
35. Pister I, supra note 28 at 152.
37. Ibid. at 153.
38. Ibid. at 154.
39. Ibid. at 154.
40. Roberts, supra note 15 at 554.
42. T. Pister, "Paragraph 88(1)(d) Bump on the Winding Up of a Subsidiary-Part 2" (1990) 38:2 Can. Tax. J., 426 at 427-28.
43. Ibid. at 428.
44. Shafer, supra note 16 at 38.
45. Roberts, supra note 15 at 547.
47. Shafer, supra note 16 at 41.
49. Krishna, supra note 5 at 1006.
50. Shafer, supra note 16 at 41.
51. Ibid. at 27.
52. C.R. Plume, Rollovers and Elections Under the Income Tax Act (Toronto: Canadian Institute of Chartered Accountants) (looseleaf), S88-1 at 4033.
53. Shafer, supra note 16 at 41.
54. Roberts, supra note 15 at 543.
55. Plume, supra note 51 at 4043.
56. Roberts, supra note 15 at 557-58.
57. Shafer, supra note 16 at 43. See also, generally E.C. Harris, "Utilization of Losses and Deductions After a Change in Corporate Control" in Report of Proceedings of the Thirty-Fourth Tax Conference, 1982 Conference Report (Toronto: Canadian Tax Foundation, 1992), pp. 356-401.
58. Ibid. at 45.
59. Roberts, supra note 15 at 555-57.
61. Shafer, supra note 16 at 44-45.
62. Roberts, supra note 15 at 557.
63. IT-488R2 supra note 17 at paragraph 46.
64. Roberts, supra note 15 at 538.
67. Roberts, supra note 15 at 542.
68. Kopstein, "Updates on 1995-1996 Developments and Tax Planning Strategies," in 1996 British Columbia Tax Conference (Vancouver: Canadian Tax Foundation, 1996) at 7.
70. See Canada, Department of Finance, Explanatory Notes Relating to Draft Legislation (Ottawa: the Department, April 1995); and Canada, Department of Finance, Explanatory Notes Relating to Draft Legislation (Ottawa: the Department, June 1996).
71. Kopstein, supra note 67 at 8.
73. D.T. Tetreault and R.F. Lindsay, "The Taxation of Corporate Reorganizations: How Are We Doing So Far?" (1995) 43:5 Can. Tax. J., 1441 at 1442.
74. Ibid. at 1453-54.