Exchangeable share structures (also known as mirror share or dividend access share structures) are often used in cross-border acquisitions where the consideration for the shares of a Canadian target company consists, in whole or in part, in the shares of a foreign acquiror. Under such circumstances, Canadian tax law does not permit a “roll-over” or deferral of the capital gain that would otherwise be payable by Canadian resident shareholders of the target on that portion of the consideration that is made up of shares of the foreign acquiror.
However, Canadian tax law does permit a roll-over where the consideration consists in shares of a Canadian company. In order to accommodate Canadian resident shareholders, therefore, a foreign acquirer will often form a Canadian subsidiary which will issue to those shareholders (at their option) shares that are exchangeable into shares of the foreign acquirer. This exchangeable share structure will normally delay the taxation of the capital gain until the shareholder exercises the exchange right, allowing Canadian resident shareholders to achieve a tax roll-over.
In 2000, the Government of Canada announced its intention to allow a roll-over to Canadian target shareholders in the case of a direct acquisition by a foreign acquiror. However, the required legislation has never been passed and this proposal has been absent from recent federal budgets (as of 2012). Note that, even if such legislation does come into force, exchangeable share structures will continue to offer some significant benefits – for example, Canadian target shareholders under such a structure receive shares of a Canadian corporation, which makes them eligible for the dividend tax credit applicable to Canadian corporations.
Although exchangeable shares can be used in both a public company and private company cross-border M&A context, the description that follows is primarily focused on public company transactions.
Elements of the Structure
The exchangeable share structure is designed to achieve, as nearly as practicable, the same result as a pure share-for-share exchange involving two Canadian companies. Exchangeable shares of a Canadian company are designed, in all material respects, to be the functional and economic equivalent of the common shares of a foreign acquiror. That is, exchangeable shares are designed to mirror the voting, dividends and return of capital rights inherent in the foreign acquiror’s listed common shares. The principal characteristics of exchangeable share structures are as follows:
The holders of the exchangeable shares typically have the right to exchange such shares for the listed common shares of the foreign acquiror on a one-to-one basis (with an adjustment for dividends payable, if any). A mandatory exchange is provided after (i) some negotiated “sunset” period (typically 5‑10 years) or (ii) if the number of outstanding exchangeable shares falls below a specified threshold.
The value of the exchangeable shares is kept the same as that of the foreign acquiror’s common shares typically through a one-to-one exchange ratio and through extensive anti-dilution provisions. Dividends are identical and, among other things, there is an equal right in favour of the holders of exchangeable shares to participate with the foreign acquiror’s shareholders in a liquidation, dissolution or other winding-up of the foreign acquiror (the medium for this liquidation right is a mandatory exchange of the exchangeable shares for the foreign acquiror’s common shares).
Typically (through the medium of special voting share(s) in the foreign acquiror’s capital or through a voting trust) the holders of exchangeable shares are given voting rights equivalent to those they would have had had they held actual shares in the foreign acquiror (although this right is occasionally omitted, particularly if the aggregate vote attributable to the exchangeable shares is very small).
The structure can achieve a number of objectives for the foreign acquiror, the Canadian target company, and their shareholders.
By being able to issue common stock equivalents as the merger consideration, the foreign acquiror avoids cash and financing requirements and, in addition, increases its capital base. The foreign acquiror is also able to issue shares into Canada without complying with Canadian tender offer rules, and without itself becoming a “reporting issuer” in Canada, subject to Canadian ongoing disclosure requirements (although typically the foreign parent company will agree to file its domestic disclosure documents in Canada).
An exchangeable share transaction can also be structured to permit the foreign acquiror to extract cash from the Canadian target on a tax-effective basis. At the corporate level, an exchangeable share transaction is neutral, although it will create one or more subsidiaries.
An exchangeable share transaction is generally completely neutral to shareholders of the foreign acquiror, other than the economic effects of the fully-diluted per share calculations.
An exchangeable share transaction allows a public Canadian target to “de‑register” – that is, it eliminates the target’s separate target reporting requirements under applicable securities rules (replaced by the foreign acquiror reporting on a consolidated basis in accordance with its usual requirements).