Bumps on the Road to the Bump: Deficiencies in the Specified Property Exception. by Geoffrey S. Turner, of Davies Ward Phillips & Vineberg LLP*

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1 Bumps on the Road to the Bump: Deficiencies in the Specified Property Exception by Geoffrey S. Turner, of Davies Ward Phillips & Vineberg LLP* *I would like to acknowledge the helpful comments on this article from my partners Stephen Ruby, Siobhan Monaghan and Raj Juneja. December 2005 Citation: Geoffrey S. Turner, "Bumps on the Road to the Bump: Deficiencies in the Specified Property Exception" vol. IX No. Corporate Structures and Groups (December 2005) The tax cost bump permitted under the rules in paragraphs 88(1)(c) through (d.4) of the Income Tax Act (Canada) 1 is a key feature of many takeover bid acquisitions of public Canadian target companies. 2 The specified property relieving rule in paragraph 88(1)(c.4) is necessary to preserve the bump that would otherwise be tainted in many routine acquisition structures because of the very broad reach of the substituted property deeming rules in paragraph 88(1)(c.3). A number of recent Department of Finance comfort letters contemplate further expansion of the scope of specified property relief. This article considers some of the circumstances contemplated by these comfort letters, and suggests several principles for the drafting of appropriate amendments to the specified property rules. In particular, the article reviews possible bump denial issues under the current definition of specified property that arise in the following circumstances: (i) where there is a post-bid amalgamation squeeze-out in which target shareholders receive redeemable preferred shares redeemable for non-cash consideration, or the squeeze-out is achieved through a triangular amalgamation; (ii) where employees holding target stock options exchange them for options under the bidder s stock option plan, or the bidder grants them new equity-based employee incentive rights; and (iii) where one or more lenders to the bidder are also shareholders of target. In addition, the article makes several observations regarding the requirement that any bidder shares or debt issued to target shareholders as bid consideration must be securities of a Canadian (not foreign) corporation. Purpose of the Bump Rules -- Specified Property in Context In very general terms, the bump is intended to allow a Canadian corporate bidder to effectively "push down" its cost of the shares of a newly acquired Canadian target corporation to similar assets of the target (i.e., non-depreciable capital property), in order to increase or "bump" the cost of this underlying property acquired on the tax-deferred winding-up or vertical amalgamation of 1 2 R.S.C. 1985, c. 1 (5 th Supplement), as amended, hereinafter referred to as the "Act". Unless otherwise stated, statutory references in this article are to the Act. Of course the bump also can be and frequently is applied to an acquisition of a private Canadian target company, but this article will focus on common issues faced in a public company takeover bid context.

2 - 2 - the target into the bidder. 3 From a policy perspective, among other things the bump facilitates the efficient functioning of the Canadian capital markets by removing tax constraints that might otherwise impede a bidder's ability to acquire a target corporation or unduly increase the costs of the acquisition. For example, the bump permits a "buy, bump and sell" acquisition strategy that may make some takeover bids more attractive and less costly to execute. The bump also facilitates tax consolidation by allowing the target to be merged with the bidder (perhaps in order to shelter target income with bidder financing expenses) in a manner that preserves the bidder's high basis in the target assets. For foreign bidders who employ a Canadian acquisition company, the bump can facilitate post-bid reorganizations to eliminate costly "sandwich" structures where the Canadian target owns foreign affiliates. However, in order to preserve the integrity of the corporate tax base and the "butterfly" rules in section 55, the bump is not intended to be used to achieve the same result as a prohibited "purchase butterfly". 4 As a result, the bump is generally precluded where significant shareholders of the target retain a continuing economic interest in the target assets as part of the series of transactions. The limited exceptions are available where the continuing interest of the significant shareholders (the specified property, as discussed below) is acquired in circumstances where it is clear the bump is not being used to effect a "backdoor purchase butterfly", namely a tax-deferred disposition of some subset of target assets to arm's length persons. The breadth and technical specificity of the resulting bump denial rules enacted to achieve these policy objectives have given rise to the need for numerous subsequent relieving rules and Finance comfort letters, in order to allow the bump to operate as intended by its policy rationale in many essentially routine acquisition transactions where the bump would otherwise be inappropriately denied. As a very brief summary, the bump is denied under subparagraph 88(1)(c)(vi) where, as part of the series of transactions that includes the bidder's acquisition of control of target and the subsequent winding-up or vertical amalgamation of target into bidder, any property actually distributed to the bidder on the winding-up or vertical amalgamation (generally referred to as "distributed property"), or any property acquired in substitution for distributed property (generally referred to as "substituted property"), is acquired by a prohibited "specified shareholder" of target. Generally, a prohibited specified shareholder includes a single person who owned (or is deemed to have owned) 10% or more of the shares of any class of target before 3 4 Among numerous other restrictions, the cost of a particular non-depreciable capital property of target that is distributed to bidder on the winding-up or vertical amalgamation may be bumped only up to its fair market value at the time bidder acquired control of the target, and the aggregate application of the bump is constrained by the total bump room determined in accordance with paragraph 88(1)(d). The principal policy concern of the bump denial rules is perhaps best illustrated by the example provided in the Finance explanatory notes that accompanied the draft legislation released with the February 22, 1994 federal budget. The "backdoor purchase butterfly" example involves Ms A who owns all the shares of Opco that owns assets she wishes to keep, and assets she wishes to sell to an arm's length Buyco. Since a purchase butterfly is prohibited, Opco drops the assets Ms A wishes to keep to a Subco and Ms A sells the Opco shares to Buyco. Buyco winds-up Opco and bumps the cost of the Subco shares to their fair market value, and sells the Subco shares back to Ms A realizing no gain because of the bump. Ms A has effectively sold the Opco assets she wished to sell but has retained the Opco assets she wished to keep. No corporate tax has been realized by Opco, though Ms A has realized shareholder level tax on her sale of the Opco shares. This backdoor purchase butterfly would achieve effectively the same results as a prohibited purchase butterfly transaction, but is now precluded by the bump rules that deny the bump to Buyco in these circumstances.

3 - 3 - the bidder acquired control of target and during the course of the series (generally referred to as a "single specified shareholder"), and in addition, a group of persons who would have been a single specified shareholder if all of their shares of target had been owned by a hypothetical single person (generally referred to as a "group specified shareholder"). However, a prohibited specified shareholder does not include a "specified person", namely the bidder and any person related to bidder. For these purposes substituted property has both its ordinary meaning and an expanded meaning. The real problem with the bump rules in practice is the extremely broad expanded meaning of substituted property in paragraph 88(1)(c.3), and the narrowly formulated exceptions to substituted property contained in subparagraphs 88(1)(c.3)(iii) to (v) (and (vi) and (vii) as proposed by the July 18, 2005 draft legislation). Subparagraph 88(1)(c.3)(ii) includes as substituted property any property (generally referred to as "determinable property") owned by a person after the acquisition of control of target the fair market value of which is determinable primarily by reference to distributed property, or to proceeds of disposition of distributed property. Subparagraph 88(1)(c.3)(i) is even broader, including any property (generally referred to as "attributable property") owned by a person after the acquisition of control of target the fair market value of which is wholly or partly attributable to distributed property. However, to provide some relief from the otherwise overreaching attributable property component of substituted property, "specified property" as defined in paragraph 88(1)(c.4) is excluded from attributable property, though not from determinable property. Specified Property The Current Law By subparagraphs 88(1)(c.4)(i) and (iii), specified property includes a share of a taxable Canadian corporation received as consideration for the acquisition of a share of target by the issuing Canadian corporation or by a "specified subsidiary corporation". 5 This aspect of specified property preserves the bump on conventional share exchange transactions, for instance where a Canadian public corporation bidder either itself or through a special purpose acquisition corporation acquires a target and the bid consideration includes shares of the public corporation. But for the specified property relief, the shares issued to a single or group specified shareholder of target on the share exchange transaction would be substituted property (and in particular, attributable property) because their value will be partly attributable to target assets distributed on the winding-up or vertical amalgamation of the target (either into the special purpose acquisition corporation or the public corporation itself). However, the bump would be preserved because those shares would be "received as consideration" for the target shares acquired by the public corporation bidder or its special purpose subsidiary, and would therefore qualify as specified property. Similarly, by subparagraphs 88(1)(c.4)(ii) and (iv), specified property includes an indebtedness issued by a taxable Canadian corporation as consideration for the acquisition of a share of target by the issuing Canadian corporation or by a "specified subsidiary corporation". Again, this rule 5 A specified subsidiary corporation in respect of a particular bidder corporation is defined in paragraph 88(1)(c.5) effectively to mean a corporation in which the bidder corporation holds shares that meet a 90% of votes and value test. Thus a wholly owned special purpose acquisition corporation established to acquire target shares under the takeover bid would qualify.

4 - 4 - can preserve the bump in some circumstances where the bid consideration offered by a Canadian bidder or its special purpose acquisition subsidiary includes debt of the Canadian bidder. While the value of this debt might be considered to be partly attributable to distributed property, due perhaps to the credit enhancement arising from the target assets, the debt would be issued "as consideration" for the target shares acquired by the bidder or its special purpose subsidiary and therefore would be specified property. Finally, by subparagraphs 88(1)(c.4)(v) and (vi), specified property includes a share issued on certain amalgamations in exchange for a share of a predecessor corporation, where the share is redeemed, acquired or cancelled immediately after the amalgamation for money. These rules permit a bidder to effect a conventional amalgamation squeeze-out transaction in order to acquire remaining target shares not tendered to the original bid, but only where the redeemable preferred shares that otherwise would be attributable property are redeemed solely for cash. It is apparent that specified property as currently defined is too narrow and does not adequately overcome the otherwise very broad scope of the attributed property component of substituted property. As a result, a number of common takeover bid circumstances may result in acquisitions by a single or group specified shareholder of property that is attributable property but not specified property, and therefore substituted property, thereby precluding a bump when arguably the continuing economic interest in target assets is not one that for policy reasons should warrant denial of the bump. Three of these typical scenarios are addressed below. Amalgamation Squeeze-Outs As noted above, current subparagraphs 88(1)(c.4)(v) and (vi) provide that redeemable preferred shares issued on a conventional amalgamation squeeze-out will be specified property only if they are redeemable solely for cash. Yet there are many takeover bids where the bid consideration includes shares, debt or other non-cash consideration. The overly restrictive conditions for specified property treatment effectively prevent the use of this amalgamation squeeze-out technique in those circumstances. Moreover, an amalgamation squeeze-out transaction can be accomplished using a triangular amalgamation without the issuance of redeemable preferred shares. However, the shares of the parent issued on such a triangular amalgamation squeeze-out will not clearly qualify as specified property under the current restrictive wording. By way of background, the relevant corporate and securities law applicable to a "going-private transaction", which includes a post-bid amalgamation squeeze-out, generally requires a formal valuation of the relevant shares and "majority of the minority" approval, where votes associated with the bidder's shares are excluded. Relief is available (i.e., no valuation of the minority target shares is required, and the bidder may include its shares in the majority of the minority vote, thereby ensuring approval of the going-private transaction) where the consideration offered for target shares in the post-bid squeeze-out transaction is at least equal in value to, and in the same form as, the consideration paid pursuant to the original bid. Bidders invariably are compelled to structure the going-private transaction so as to qualify for this corporate and securities law relief. Where a conventional amalgamation squeeze-out is the preferred technique, the redeemable preferred shares received by minority target shareholders are immediately redeemed for consideration identical to that offered in the bid. Under the current

5 - 5 - specified property rules, if that consideration includes shares or debt of the bidder, the bump would be denied. Any bidder offering shares or debt as bid consideration and wishing to preserve the bump would be precluded from using this conventional amalgamation squeeze-out technique and would be forced to complete the going-private transaction in an alternative manner. One such alternative is a court-approved plan of arrangement in which the minority target shares are directly exchanged for the same consideration as offered under the bid, so that any shares or debt of the bidder delivered to the minority target shareholders under the arrangement would be received or issued as consideration for the target shares acquired by the bidder or its special purpose acquisition subsidiary, and would thus qualify as specified property under the applicable rules in subparagraphs 88(1)(c.4)(i) to (iv). However, for commercial reasons a plan of arrangement may be less desirable than a conventional amalgamation squeezeout because, for example, the required court hearing may afford disgruntled target shareholders and other stakeholders an opportunity to voice dissent and delay or even block the squeeze-out transaction. 6 There is no apparent policy reason to justify restricting the redemption consideration to cash. So long as all of the property received by the minority target shareholders on the redemption of the preferred shares would be specified property if it were received directly as consideration for the target shares, then that property, and the redeemable preferred shares themselves, should all be treated as specified property. This circumstance was addressed by Finance in its comfort letter dated May 2, In the particular facts disclosed in that letter, the bid consideration offered by the bidder consisted exclusively of common shares of the bidder. After the bidder directly (not through a special purpose acquisition corporation) acquired more than 66-2/3% of the target shares, the bidder proposed to effect a conventional amalgamation squeeze-out in which the target minority shareholders would receive redeemable preferred shares that would be immediately redeemed for bidder common shares. Finance gave comfort that it would recommend the Act be amended such that the redeemable preferred shares received on the amalgamation, and the bidder common shares received upon the redemption of those shares, would be considered specified property, applicable to windings-up that begin after An alternative form of amalgamation squeeze-out not involving the issuance of redeemable preferred shares was considered in the Finance comfort letter dated April 15, In that situation, the taxpayer contemplated a triangular amalgamation squeeze-out to be completed under a plan of arrangement. 7 Bidder together with its special purpose acquisition company acquired more than 80% of the target shares. Bidder intended to cause a winding-up of the special purpose acquisition company, followed by an amalgamation of target with a new special 6 7 This is not merely an idle concern. For example, in the recent acquisition by CNPC International Ltd. of PetroKazakhstan Inc. which occurred by plan of arrangement, a dissenting stakeholder appeared at the court hearing to give submissions opposing the going-private transaction. The court reserved judgement and the effect was to delay the closing of the transaction by over a week. In a typical triangular amalgamation, the parent issues shares to the target shareholders as consideration for the cancellation of the target shares on the amalgamation of the target with another special purpose subsidiary of the parent. The target shares are not acquired by the parent on a direct exchange, which gives rise to the specified property issue addressed in the comfort letter.

6 - 6 - purpose subsidiary of bidder. On the triangular amalgamation, the bidder would receive all of the common shares of the target amalco and minority target shareholders would receive shares of bidder as consideration for the cancellation of their target shares on the triangular amalgamation. The bidder shares would not clearly have satisfied the restrictive conditions of subparagraph 88(1)(c.4)(i) because they would not have been received strictly as consideration for the acquisition of target shares by the bidder or by a specified subsidiary corporation. Finance gave the requested comfort that the amendment contemplated in the May 2, 2002 comfort letter would ensure that the bidder shares issued on the triangular amalgamation squeeze-out would be specified property, to be applicable to windings-up that begin after It is evident from the foregoing that the relieving amendment contemplated by Finance needs to be broadly drafted to accommodate all possible forms of amalgamation squeeze-out transactions. The relief should apply regardless whether there is a special purpose acquisition subsidiary, whether the bid consideration includes shares or debt or any other non-cash consideration or any combination thereof, or whether the squeeze-out is achieved in a conventional manner involving the issuance of redeemable preferred shares or using a triangular amalgamation. Provided that what target shareholders ultimately receive on the squeeze-out transaction would be specified property (or put another way, not substituted property), the specific mechanics of achieving that result should be largely irrelevant. Each takeover bid or other acquisition will engage different commercial considerations depending on the applicable corporate and securities law jurisdictions and the particular factual circumstances and acquisition strategy of the bidder. Where there is no compelling policy reason to interfere, the bump rules should neither restrict nor encourage a bidder from utilizing any particular squeeze-out technique. This is currently not the case under the overly restrictive specified property rules. Employee Stock Options Another common bump problem with no policy rationale involves the treatment of stock options held by target employees that are exchanged for stock options in respect of the bidder. It is often commercially desirable for a bidder to cause the conversion of target employee stock options into the bidder's existing stock option plan by replacing target stock options with new bidder options under a subsection 7(1.4) exchange. However, the bidder stock options acquired by former target optionholders will be attributable property because their value will be at least partly attributable to target assets distributed on the winding-up or vertical amalgamation into bidder. Moreover, the bidder stock options will not qualify as specified property under the existing statutory provisions. Accordingly, if the target optionholders exchange target stock options for bidder stock options as part of the series of transactions and such optionholders would constitute a single or group specified shareholder of target before the acquisition of control, the bump will be denied to bidder. This is not an uncommon factual circumstance, since senior management employees typically hold both stock options and significant shareholdings such that their collective ownership of target shares may well reach the 10% threshold. 8 The April 15, 2005 comfort letter also addressed options and warrants to acquire target shares that would be exchanged on the triangular amalgamation for options and warrants to acquire bidder shares. This is discussed below.

7 - 7 - The employee stock option exchange situation has been addressed by Finance comfort letters dated April 22, 2002 and June 24, 2003, and in the April 15, 2005 letter discussed above. In the 2002 and 2003 letters, Finance indicates that it is prepared to recommend amendments to ensure that rights to acquire bidder shares in the context of a stock option exchange (including, in the case of the April 22, 2002 letter, option rights to acquire bidder shares held in a subsection 7(6) trust) will not be substituted property under subparagraph 88(1)(c.3)(i). In the 2005 letter Finance indicates that the new bidder stock options received on the exchange will be specified property under paragraph 88(1)(c.4). In each case, the recommended amendments would be applicable to windings-up that occur after Using the words in the April 22, 2002 comfort letter, the stock option exchange is simply a proxy for an exchange of the underlying shares, which themselves would qualify as specified property. 9 Perhaps an alternative policy justification for this relief in the context of section 7 options is that the new stock options are acquired by the employees of target in their capacity as employees, not as shareholders. Currently unaddressed by Finance comfort letters, but equally problematic for the bump, are grants by bidder of new employee stock options or other "phantom unit" or share-based incentive rights to target employees as part of the series. For example, in addition to a customary stock option plan, many bidders will have deferred share unit or restricted share unit plans entitling employees to cash or share payments based on the value of a notional number of bidder shares. Bidder may wish to act quickly following the acquisition of control of target to retain valued target employees by issuing those employees rights under these incentive plans. These entitlements arguably will be attributable property because their value will be at least partly attributable to the target assets distributed on the winding-up or vertical amalgamation, but they will not qualify as specified property. If the employees who receive these entitlements as part of the series of transactions that includes the acquisition of control of target and its subsequent winding-up or vertical amalgamation constitute either a single or group specified shareholder, the bump may be denied to bidder. The rights acquired from bidder by a single or group specified shareholder of target in respect of employee stock options or other equity-based incentive plans do not represent the type of continuing economic interest in the target assets that should warrant denial of the bump. Generally, these rights are granted to persons in their capacity as employees, not as shareholders. It is difficult to see how an equity-based employee incentive right issued to a person as an employee could be used to facilitate a backdoor purchase butterfly. A rule analogous to subsection 7(5) could provide appropriate relief by including in specified property an employee stock option or other incentive right acquired in respect of the person's employment. Moreover, if the acquisition of bidder shares would not result in the bump being denied, the acquisition of rights to acquire shares or rights to cash payments computed by reference to the value of such shares should not result in the bump being denied. 9 The April 15, 2005 comfort letter also appears to have used this justification appropriately to confirm specified property treatment for the warrants to acquire bidder shares that were to be issued on the triangular amalgamation squeeze-out in exchange for target warrants.

8 - 8 - Cash Lenders to Bidder Many bidders borrow the cash they require to purchase the target shares. The lenders in turn acquire a receivable owing by bidder, and this property would appear to be acquired as part of the series of transactions that includes the acquisition of control of target by bidder. The receivable would arguably be attributable property, since the rights of the lenders to enforce the receivable would derive their value at least in part from the target assets insofar as they form part of the bidder's asset pool supporting the covenant to repay and thereby contribute to the creditworthiness of the bidder. The receivable will not qualify as specified property under the current rules in paragraph 88(1)(c.4), and therefore, if any one or more of the lenders to bidder constitute a single or group specified shareholder of target, the bump would be denied to bidder. The possibility of lenders to bidder constituting a group specified shareholder of target may be a realistic concern in more circumstances than might at first be apparent. Financial institutions often hold significant positions of "in-play" target companies, whether through direct equity investments, index and other arbitrage activities, hedging transactions, securities lending and borrowing, and so forth. Particularly where a bidder borrows from a group of financial institutions such as in a syndicated credit facility, there may be uncertainty whether the lenders collectively are a group specified shareholder such that the borrowing by bidder might inadvertently taint the bump. A similar factual concern was addressed in a May 31, 2004 Finance comfort letter. The bidder proposed to finance the acquisition of target by issuing non-participating, interest-bearing debt in the U.S. and Canadian capital markets. Target had a substantial shareholder who could potentially have been a specified shareholder of target. The substantial shareholder intended to purchase some of the debt to be issued by the bidder, and the bidder requested comfort from Finance that the bump would not be denied. Finance replied with what must be described generously as very soft comfort, stating merely that "[W]e understand your concerns regarding the denial of the bump in the circumstances described in your letter and we do not dispute that the result appears to be inconsistent with the policy underlying subparagraph 88(1)(c)(vi)". The letter contains no customary undertaking to recommend a suitable relieving amendment. Finance arguably could have been more definitive in this comfort letter. The potential specified shareholder would acquire the bidder debt on a fully taxable basis using cash to purchase the receivable, and the property interest would be that of a creditor, not a shareholder. It is difficult to see how the receivable would represent a continuing interest in the target assets that should potentially disqualify the bump. Moreover, as the comfort letter notes, Finance has already proposed to amend subparagraph 88(1)(c.4)(i) to include as specified property a share of bidder that is issued for consideration that consists solely of money. 10 The same policy rationale should apply equally to a debt of bidder (whether it is participating or non-participating) issued for 10 This amendment to expand the subparagraph 88(1)(c.4)(i) category of specified property was most recently included in the July 18, 2005 draft legislation, and stems from a September 28, 2000 Finance comfort letter. Inexplicably, the same amendment is not currently proposed to be made to the subparagraph 88(1)(c.4)(iii) category of specified property. If not changed, the relief for bidder shares issued solely for cash will apply only where the target is wound up or vertically amalgamated directly into the bidder itself, and not into a special purpose acquisition subsidiary of bidder. There is no apparent policy justification for this distinction.

9 - 9 - consideration that consists solely of money. A simple amendment to this effect to both subparagraphs 88(1)(c.4)(ii) and (iv) would provide appropriate relief. 11 A related but much more inadvertent and technical problem arises where the target has debt obligations outstanding at the time of its winding-up or vertical amalgamation that are assumed by the bidder. The rollover and continuity rules in subsections 87(6) and (7) are intended to be relieving in this circumstance for both the amalgamated corporation and the holders of the debt that is assumed as a result of the amalgamation. These relieving rules apply also to windings-up by virtue of subsection 88(1)(e.2). In particular, subsection 87(6), if it applies, 12 would deem the holder of debt of a predecessor to have disposed of the old debt for proceeds equal to its adjusted cost base, and to have acquired the new debt of the amalgamated corporation at a cost equal to those same proceeds. It is the latter part of this rule, namely the deemed acquisition of a new debt of the bidder, that will be problematic for the bump if any of the debt holders of target constitute a single or group specified shareholder of target. This could be unverifiable in any case where the target debt consists of widely held bonds or debentures how can bidder determine the aggregate target shareholdings of persons who hold publicly traded or otherwise widely held debt? Again, there is no policy reason for the bump to be denied as a result of the operation of these relieving deeming rules, and indeed there is no suggestion that the Canada Revenue Agency or any commentator has ever seriously argued that this technical issue should be a legitimate concern. An amendment of the nature discussed above in the context of the May 31, 2004 Finance comfort letter, namely an expansion of specified property to include any debt obligation that was issued (or exchanged) for consideration that consists solely of money, would and should eliminate this unintended bump denial issue provided it is worded sufficiently broadly. At this point it is worth noting the relevance of a more recent Finance comfort letter dated September 22, It dealt with unusual proposed facts where the bidder would acquire the first target from a vendor corporation in exchange for cash consideration and would seek the bump on the subsequent winding-up of the first target into bidder. Yet as part of the same series of transactions, the parent of bidder would also acquire a second target (a Canadian corporation that was a sister to the first target before its acquisition by the parent of bidder) from the vendor in exchange for consideration consisting of cash and shares of the parent of bidder. The concern was that the shares of the parent of bidder received by the vendor derive their value in part from In addition, analogous relief for debt-like financing securities is already available with respect to holders of a "specified class" of non-voting, non-participating preferred shares described in paragraph 88(1)(c.8). By virtue of subparagraph 88(1)(c.2)(iii), ownership of a specified class of preferred shares of target is disregarded for purposes of determining whether a person is a specified shareholder of target. Just as debtlike interests received on a preferred share financing of target are ignored, so too should debt-like interests (or indeed actual debt interests) received on a debt or preferred share financing of bidder be ignored. A threshold issue is whether subsection 87(6) would apply to a debt obligation of target that is assumed by bidder by operation of the relevant corporate law pursuant to the vertical amalgamation or winding-up. Subsection 87(6) requires that a taxpayer who owned a debt obligation of a predecessor as capital property receive no consideration for the disposition of the debt obligation on the amalgamation other than a debt obligation of the amalgamated corporation with the same principal amount. The question is whether the amalgamation or winding-up results in a disposition of the old debt obligation that is required for subsection 87(6) to apply.

10 the assets of the first target, and that they would be acquired as consideration for the shares of the second target, not the first target as required to qualify them as specified property. Finance gave comfort it would recommend an amendment to ensure that the shares of the parent of bidder acquired by the vendor would be specified property. This appears to have been based on the facts that the first target shares would be acquired solely for cash consideration in the first transaction, and that the shares of the parent of bidder issued in the second transaction would be issued in consideration for property that does not derive its value from distributed property. This is appropriate because any transaction intended to use the bump to avoid the butterfly restrictions would generally involve a direct or indirect transfer of distributed property in exchange for substituted property. That was not the case in the proposed facts and the acquisition of the shares of the parent of bidder (attributable property) by the vendor (a single specified shareholder) could not have been objectionable from a policy perspective indeed those shares if issued in exchange for the shares of the first target would have been specified property. The suggestion following from the September 22, 2005 comfort letter is that the existing amendment proposed to subparagraph 88(1)(c.4)(i) under the July 18, 2005 draft legislation (to include bidder shares issued solely for money, which should also be extended to subparagraph (iii)), and the analogous amendments to subparagraphs 88(1)(c.4)(ii) and (iv) (to include any debt obligation issued solely for money) advocated for in this article, should be further broadened to include a bidder share or debt, as the case may be, issued solely for money or for property that does not derive its value from distributed property at any time during the series. Foreign Bidder Shares or Debt To qualify as specified property under current subparagraphs 88(1)(c.4)(i) to (iv), the shares or debt received as consideration for the acquisition of target shares must be shares or debt of a taxable Canadian corporation. 13 These restrictions effectively preclude a foreign bidder from obtaining the bump following the acquisition of a Canadian target where shares or debt of the foreign bidder are offered as bid consideration only on an all-cash bid would a foreign bidder be able to access the bump. While the foreign bidder's special purpose Canadian acquisition corporation could itself issue shares or debt, these shares or debt would presumably be determinable property and therefore substituted property the specified property exception from attributable property would not be sufficient. Alternatively, the special purpose Canadian acquisition corporation could issue exchangeable shares which would be exchanged into shares of the foreign bidder at the option of the holder. However, while the exchangeable shares would not be attributable property because of the specified property exception, they would possibly be determinable property, 14 and the foreign bidder shares into which they are exchangeable would be attributable property. It is generally understood that the subsequent exchange into the foreign bidder shares would occur as part of the series of transactions contemplated at the time of the This is because the shares or debt must be issued either by the "parent" in subparagraphs 88(1)(c.4)(i) and (ii), which by virtue of the preamble to subsection 88(1) must itself be a taxable Canadian corporation, or by a taxable Canadian corporation in the circumstances described in subparagraphs 88(1)(c.4)(iii) and (iv). Because the exchangeable shares are exchangeable for shares of the foreign bidder and their fair market value accordingly is a function of the fair market value of the foreign bidder shares, it is not clear whether they would necessarily be determinable property, even if the target shares were the only asset of the Canadian issuer of the exchangeable shares.

11 acquisition of control of target, and those foreign bidder shares would not be specified property. 15 As a result, it is generally considered that the issuance of exchangeable shares is incompatible with the bump. This aspect of the specified property limitations is of more than mere passing interest due to a number of recent high profile takeover bids by Canadian bidders for large Canadian target companies where there is speculation whether a foreign bidder will launch a competing bid. 16 The inability of a foreign bidder to access the bump (other than in an all-cash bid that might be prohibitively expensive, or at least more challenging to finance, given the substantial market capitalization of the Canadian target companies) is thought to give a potential strategic advantage to the Canadian bidders who can access the bump using share consideration. Does restricting specified property to shares or debt of a Canadian corporation in fact give an advantage to Canadian bidders where the Canadian target is perhaps too large for an all-cash bid, and is this an intended or desirable result? It is possible to envision circumstances where a foreign bidder would value the bump and would be prejudiced by its denial, although it would depend very much on the foreign bidder's intentions with respect to the Canadian target assets. For example, without the bump, a foreign bidder might be unable to tax-efficiently execute a "buy, bump and sell" strategy, or reorganize the target assets to eliminate a "sandwich" structure where the Canadian target has foreign subsidiaries. On the other hand, if a foreign bidder is content to retain all of the target assets in their existing holding structure, the denial of the bump might not be a significant concern and would not necessarily deter the foreign bidder from making a bid using share or debt consideration. Although it is not at all clear that the specified property restrictions were intended to confer a tax advantage on domestic Canadian bidders competing with possible foreign bidders to acquire a large Canadian target company, that appears to be their effect in at least some circumstances. This begs the question whether from a policy perspective there is any justification for the continued limitation of specified property relief to shares and debt of a Canadian corporation. This article has argued in favour of expansion of the scope of specified property in several contexts should specified property be further expanded to include shares and debt of a foreign corporation? On the one hand, if the policy concern is to prevent stripping of target assets (in particular, its foreign affiliates) out of Canada (i.e., a "buy, bump and run"), this is already possible in an allcash bid by a foreign bidder that would enable it to utilize the bump and distribute the foreign Most exchangeable share arrangements include a sunset provision, or a date at which the issuer may redeem the shares and force an exchange. Even if an optional exchange at the election of the holder is not considered part of the series of transactions, generally the exchange at the issuer's option after the sunset date is thought to be part of the series because it is "hardwired" into the share terms at the time the shares are issued. For example, Inco Limited has bid for Falconbridge Limited, and Barrick Gold Corporation has bid for Placer Dome, in each case offering a combination of bidder shares and cash. At the time of writing, no competing bid for either target has been announced, but in both cases the most frequently mentioned potential competing bidders are foreign companies.

12 affiliates to the foreign parent without incurring Canadian tax. 17 Any policy concern with this outcome should be mitigated somewhat by the fact that the sale of target shares on the cash bid would be fully taxable to the selling target shareholders. Expanding specified property to allow the bump where the bid consideration includes foreign bidder shares or debt would give rise to exactly the same results a taxable sale of the target shares under the bid, followed by a bump that would enable a distribution of foreign affiliates to the foreign parent and a removal of those assets from the Canadian tax system. The existing specified property limitation does not prevent a stripping of assets out of Canada; it merely makes that result somewhat more difficult to achieve by requiring a foreign bidder to offer all-cash consideration. On the other hand, one could argue in favour of the current restrictions on the grounds of "economic nationalism", i.e., that the bump provisions do give a possible tax advantage to domestic bidders over foreign bidders for large Canadian target companies where an all-cash bid is prohibitive, and that may be a desirable outcome to promote Canadian ownership of large Canadian target businesses. The practical reality is that any proposal to relax the current restrictions on specified property would appear to benefit foreign bidders at the expense of Canadian bidders, and there is little political or economic advantage in promoting the interests of foreign taxpayers. Of course, other beneficiaries of an expansion of specified property would include shareholders (both resident and non-resident) of Canadian target companies, who might receive a higher price for their shares if foreign bidders are more easily able to compete with Canadian bidders. In the end, there does not appear to be a compelling argument either way. However, it is not unrealistic to expect that a proposal to expand specified property to assist foreign bidders at the expense of Canadian bidders could become politicized. In the current Canadian political environment, this suggests that no such proposal will be made, and accordingly, specified property is likely to remain limited to Canadian shares and debt. Summary -- Recommended Principles for the Expansion of Specified Property The bump rules ultimately are intended to facilitate takeover bids and promote the efficiency of Canadian capital markets. They cannot fully achieve this objective if they are available in excessively restrictive circumstances that require bidders to deviate from their commercially preferred bid structures solely to fit within the tightly constrained technical bump requirements. The bump should of course be denied where there is a legitimate policy concern with a continuing interest in the target assets retained by the target shareholders that is inconsistent with the butterfly rules and achieves a backdoor purchase butterfly. But no such policy concern generally exists when target shareholders receive attributable property either as a consequence of a squeeze-out transaction in which they dispose of their target shares, in their capacity as 17 For example, the foreign bidder could establish a Canadian special purpose acquisition company and finance it with cash paid as the subscription price for common shares with high paid-up capital. After the acquisition of 100% of the target shares, target would be wound-up or vertically amalgamated into the special purpose acquisition company and the cost of the target's directly owned foreign affiliates would be bumped to their fair market value at the time of the acquisition of control. The Canadian acquisition company would then distribute the foreign affiliate shares to the foreign bidder as a return of paid-up capital, free of Canadian withholding tax and with no gain realized on the deemed disposition of the distributed shares at fair market value due to the bumped cost of those shares.

13 employees who acquire bidder stock options or other equity-based incentive rights, or as cash lenders to bidder (or more generally where target shareholders receive a share or debt of bidder in exchange for property which does not derive its value from distributed property). Various Finance comfort letters have addressed aspects of these bump issues, and amendments are accordingly expected to expand the specified property definition in paragraph 88(1)(c.4). The concern is that the draft legislation to implement the commitments made in the comfort letters will adopt a piecemeal approach that targets the specific factual circumstances addressed in each comfort letter but goes no further. By way of illustration, this appears to have been the approach adopted in the July 18, 2005 draft legislation to expand subparagraph 88(1)(c.4)(i) to include shares of bidder that are acquired for consideration that consists solely of money. Why is that relieving amendment not extended to shares issued for money in circumstances covered by subparagraph 88(1)(c.4)(iii)? It should not matter from a policy perspective whether the bump is sought on a winding-up or vertical amalgamation into a special purpose acquisition subsidiary rather than the Canadian bidder itself. Similarly, why is that amendment not extended to debt issued for money? With respect to the comfort letters dealing with amalgamation squeeze-outs, employee stock options and lenders to bidder, this article has described some circumstances beyond the particular facts addressed in those letters that should also be covered by the amendments. For example, the amalgamation squeeze-out relief should be available regardless of whether a special purpose acquisition subsidiary is employed, regardless of whether the bid consideration delivered on the amalgamation squeeze-out includes shares, debt or other non-cash consideration, and regardless of whether the amalgamation squeeze-out is implemented using redeemable preferred shares or a triangular amalgamation. Broad relief should be available for any attributable property acquired in a person s capacity as an employee, regardless whether it is a conventional employee stock option or another form of equity-based incentive. Finally, attributable property that is a debt (whether participating or non-participating) received by a lender of cash to the bidder or received by a person in consideration for property that does not derive its value from distributed property at any time during the series should be included in specified property, and this should include any such debt deemed to be acquired by virtue of subsection 87(6). The purpose of amendments to broaden specified property should be to make the bump more accessible in circumstances where there is no policy concern with the nature of attributable property acquired by former target shareholders. It would be unfortunate if the draft legislation provides only narrowly focused relief that merely adds to the complexity and apparent arbitrariness of the bump rules that are already riddled with technical exceptions and constraints.