When is "Loss Trading" Permissible: A Purposive Analysis of Subsection 111(5)

Transcription

1 When is "Loss Trading" Permissible: A Purposive Analysis of Subsection 111(5), Bennett Jones LLP 67 th Annual Tax Conference 67e Conférence fiscale annuelle 2015 "The general policy of the Act is against the trading of noncapital losses by corporations, subject to specific limited circumstances." OSFC Holdings Ltd. v. The Queen, 2001 FCA 260 " there is nothing evil or immoral about trafficking in loss carryovers as such; indeed unfettered trafficking is a positive good, serving to distribute tax benefits where they belong." American Law Institute (1980) 2

2 CONTEXT Losses may be a significant asset of an operating corporation (a "Lossco") Questions as to whether monetization of losses is possible Assume an acquisition of control of Lossco Goal: to articulate policy rationale for allowing loss trading in limited circumstances and to provide a framework for the analysis 3 AGENDA Overview of Subsection 111(5) Discussion of Legislative Policy Specific Requirements of Loss Streaming Rules Transactional Issues 4

3 SUBSECTION 111(5) Once a corporation is subject to an actual or deemed acquisition of control, pre-acquisition non-capital losses can be deducted only if: i. the losses may reasonably be regarded as arising from the carrying on of a business (the "loss business"); and ii. the loss business is carried on, throughout the tax year in which the deduction is claimed, by the corporation for profit or with a reasonable expectation of profit 5 If and only if these requirements are satisfied, losses can be deducted against income from: i. loss business, or ii. where properties were sold, leased, rented or developed or services rendered in the course of carrying on the loss business, from any other business substantially all of the income of which was derived from the sale, leasing, rental or development, as the case may be, of similar properties or rendering similar services 6

4 All or nothing approach no losses carryforward unless loss business is continued post-acquisition during all tax years in which the losses are claimed No actual "trading" of losses losses continued to be claimed by corporation Indirectly permits a transfer of non-capital losses to a purchaser through the acquisition of equity interest in a Lossco WHY IS THIS PERMITTED? 7 LEGISLATIVE POLICY Subsection 111(5) should be interpreted according to a unified textual, contextual and purposive approach Necessary to understand legislative purpose and context of loss business continuity requirement 8

5 LEGISLATIVE POLICY Policy themes: i. Denial of refundability or transferability of losses generally refundability is conceptually pure, but cost to fisc is too high ~ $206 billion of unutilized capital losses ii. Prima facie entitlement of a corporate taxpayer to loss carryovers Landrus general policy of Act to allow the loss, subject to limited exceptions paragraph 111(1)(a) provides relief to taxpayers whose income or loss fluctuates year to year 9 LEGISLATIVE POLICY iii. iv. Only person who suffered economic loss should be entitled to benefit of tax loss (outdated) notion that corporation is intermediary of its shareholders on acquisition of control, losses should be limited since former shareholders, who bore economic loss, are no longer participants Tax avoidance concerns preclude acquisitions that are motivated primarily for tax, rather than business, advantages 10

6 LEGISLATIVE POLICY Each of foregoing could be satisfied by a strict denial of loss carryforwards after an acquisition of control or use of a purpose test But subsection 111(5) does not preclude use of losses post-acquisition of control losses can be utilized if loss business is continued 11 LEGISLATIVE POLICY Designed to encourage profitability and growth Fiscally desirable to encourage the revitalizing of a loss business, including through an acquisition and replacement of management Department of Finance "single major exception" to the policy against loss-trading, an attempt to support the recovery of unprofitable enterprises Confirmed in OSFC Holdings, Garage Montplaisir, and Manac 12

7 LEGISLATIVE POLICY Subsection 111(5) is an express recognition by Parliament that economic growth is enhanced by providing incentives to sustain or revive a failing business Incentive to combine Lossco with a profitable corporation, as combination increases likelihood of future profits Losses should be able to be utilized post-acquisition if the transaction fulfils purpose of invigorating loss business 13 LOSS STREAMING RULES Subsection 111(5) test can be difficult to apply Thirty-five or so cases, but few definitive guidelines Purposive analysis would give rise to a more principled approach and also illustrates logic that runs through the cases 14

8 LOSS STREAMING RULES Step #1: Identification of Loss Business Focus on defining characteristics of loss business not on any particular component of its operations Crystal Beach Park determine "essence" of the business Gaz Métropolitain determine "primary purpose" of corporation's activities 15 Step #1: Identification of Loss Business Will depend on industry in which Lossco operates and qualifications of its principals real estate may be described broadly (Crystal Beach Park, Wigmar Holdings, and S.T.B. Holdings) production may extend to products in a generic industry, rather than particular product (No. 717, E.P. Martin & Co.) industry practice critical to whether or not location is important (Canadian Dredge Dock, E.P Martin & Co.) 16

9 Step #1: Identification of Loss Business Advantageous to define loss business expansively broad description in public disclosure and in income tax and financial records adduce evidence of breadth of activities and overall business plan show that broad definition is consistent with the industry demonstrate that Lossco principals (both pre- and post- acquisition) have expertise and knowledge to pursue a wide range activities 17 LOSS STREAMING RULES Step #2: Confirm Continuity of Loss Business Pre- Acquisition Focus on degree and nature of activity once a business ceases, it cannot be revived Issue can arise in situations of financial distress where steps taken to circumscribe Lossco's operations creditor protection under CCAA or BIA Avoid sale of substantially all assets and termination of most employees Lossco should remain in position to execute and complete contracts consistent with historical practice 18

10 LOSS STREAMING RULES Step #3: Confirm Continuity of Loss Business Post-Acquisition Must be "exact same business" not just same type of business (Eastern Textile Products, Waldman's) Business is subject to constant evolution fulfilling legislative purpose requires that new management has flexibility to alter aspects of business Not all changes will be fatal some are practically necessary. Per Crystal Beach: " the changes effected demonstrate its efforts to enhance those aspects of the business that has been successful while improving those that had not." 19 Step #3: Confirm Continuity of Loss Business Post-Acquisition Jurisprudence has focused on evidence of interconnection, interlacing or interdependence of various business elements pre- and post-acquisition Demonstrate overlap between operations pre-and postacquisition 20

11 Step #3: Confirm Continuity of Loss Business Post-Acquisition Critical factors: Nature of business activity Continuity of services/products/customer relationships Scale of business Continuity of income-producing assets Location of operations Change of name Allocation of time and financial resources 21 LOSS STREAMING RULES Step #3: Confirm Continuity of Loss Business Post-Acquisition Post-acquisition, the focus should be on whether there are sufficient indications that: Core essence of business continues Most significant alterations were commercially reasonable in a bona fide effort to make the loss business profitable 22

12 LOSS STREAMING RULES Step #4: Loss business continued with a Reasonable Expectation of Profit NRT Technology confirms REOP is alive and well in context of subsection 111(5) Must be grounded in economic reality Factors include: factors causing losses and changes therein background and experience of principals operational plan good faith and reputation time and energy devoted to endeavour 23 LOSS STREAMING RULES Step #5: "Same or similar" business Similar means "of the same nature or character" Requires an analysis of two similar activities (Manac) Need: i. a commercial activity ii. similar properties iii. substantially all income Where loss business is not in a separate division, this is evidence of similarity (Gaz Métropolitain) 24

13 TRANSACTIONAL ISSUES Value of losses Anecdotal evidence $0.03 to $0.10 per dollar of losses significant discount to full post-acquisition value Depends on: ability to verify loss balances and analysis of factors giving rise to losses predicted post-acquisition revenues availability risk and risk of change of law 25 TRANSACTIONAL ISSUES Representations as to tax attributes Should a specific representation as to quantum of noncapital losses be sought? tension between ensuring the parties obtain what they bargain for versus drawing attention to any tax motivations behind transaction Drafting challenges clarity that representations deal with numerical loss balances as of a time immediately prior to the acquisition of control but no warranty as to ability to use losses following acquisition of control 26

14 TRANSACTIONAL ISSUES Survival period Normal reassessment periods do not start until loss is claimed New St. James CRA can assess to deny loss in future year loss is claimed Reliance on normal reassessment period as survival period for representation on loss balances can amount to open-ended representation Anecdotal evidence suggests 6-7 years is the "norm" 27 TRANSACTIONAL ISSUES Damages and Indemnities What is appropriate measure of damages if breach of representation as to quantum of tax pools effective tax rate x shortfall in represented non-capital loss balances, or reference to purchase consideration Stand alone indemnity specifying a specific methodology as to value of shortfall 28

15 CONCLUSIONS Loss trading through the acquisition of equity interests in a Lossco is not prohibited in all circumstances Subsection 111(5) provides a specific circumstance that of continuity of the loss business in which indirect of transfer of losses is permitted A transaction which is structured to utilize Lossco's losses post-acquisition should not be viewed as aggressive or abusive so long as requirements of subsection 111(5) are satisfied 29