Cross-Border Counselor

Readers listed on the NYSE will want to note a recent rule change. Effective immediately, notification of public announcements regarding dividends or stock distributions must be provided to the NYSE at least ten minutes prior to public release, even after market close. Read more in the post from our partner Jason Brenkert here: https://governancecomplianceinsider.com/nyse-rule-change-requires-ten-minutes-advance-notice-of-public-announcement-of-dividends-or-stock-distributions/

This week the SEC Division of Economic and Risk Analysis published a new report including a wealth of data regarding recent trends in public offerings and private placements of securities. The report includes a number of interesting facts about U.S. private placement practice, including: In the last few years, issuers have raised 2-3 times more capital through Regulation D than through Rule 144A. Rule 506(b) remains the most popular way to raise capital under Regulation D, with 97% of all funds raised under Rule 506 being raised under Rule 506(b), rather than the newer Rule 506(c), with issuers choosing not to take the additional steps required by Rule 506(c) to generally solicit investors. Only 6% of Rule 506(b) offerings in the most recent years have contemplated sales to non-accredited investors. Brokers are more likely to be used in Rule 506(c) generally solicited offerings, at 33% of new offerings compared with only 17% of new offerings under Rule 506(b). The issuer fails to file a Form D in as many of 10% of all unregistered offerings eligible for the Rule 506 exemption. The number of Regulation A offerings qualified by the SEC has taken off, from less than 10 per year before the “Regulation A+” amendments (which increased the maximum offering amount to $50 million) to more than 80 in 2016; however, Regulation A still represents a small fraction of the funds raised under Regulation D or Rule 144A. This is consistent with what we are seeing from our Canadian clients who conduct private placements in the United States. Most issuers that rely on a safe harbor are continuing to rely on Rule 506(b), limiting their offering to accredited investors with no general solicitation, or relying on Rule 144A, to allow for a quicker and more streamlined approach. However, Regulation A+ offerings are becoming more popular where the benefits warrant the extra time and expense. The complete SEC report is available at: www.sec.gov/files/access-to-capital-and-market-liquidity-study-dera-2017.pdf.

Canadian companies and their outside counsel occasionally ask about the ability to grant early exercise incentive stock options (“ISOs”) to limit the impact of the U.S. alternative minimum tax (“AMT”) to their U.S. employees. However, due to fairly counterintuitive U.S. federal tax regulations, structuring options in this manner may expose optionees to negative tax consequences in the event of a disqualifying disposition (defined below). This post reviews the tax effects of early exercise ISOs and compares the tax results to alternative structures. Early Exercise ISO Tax Consequences With any early exercise option, the optionee is permitted to initially exercise their entire stock option by paying the full option exercise price, but will receive back restricted stock with the same vesting schedule as the original option. Employees will usually file a Section 83(b) election as permitted within 30 days following the transfer of the restricted stock. In 2004, final ISO regulations clarified that Section 83(b) elections filed on restricted shares acquired via early exercise ISOs are only effective for AMT purposes and not for ordinary compensation tax purposes. In the best case where both ISO holding periods are met (the shares acquired via ISO are held at least two years from the date of grant and at least one year from the date of exercise, prior to sale), the entire spread between the sale price and the exercise price paid will be taxed as long-term capital gain. However, if either holding period is not met, a “disqualifying disposition” occurs. Assuming that an 83(b) election was timely filed within 30 days following exercise, then upon a disqualifying disposition, the difference between the fair market value of the shares on the date the underlying restricted stock vests less the exercise price paid for the shares is compensation income that will be reported on the employee’s Form W-2 in the year of sale (or if less, the amount realized in the sale less the exercise price).[1] In addition, the capital gains holding period will only begin on the date the underlying restricted stock vests.[2] To the extent the stock price increased or decreased from the date of restricted stock vesting, such change will be short-term or long-term capital gain or loss, as applicable. This tax result means that early exercise ISOs become risky to an optionee in the event of a disqualifying disposition. While reducing AMT income is a positive result, a disqualifying disposition results in a potentially large amount of compensation income and/or short-term capital gain. The optionee often has little control over whether a disqualifying disposition will occur, such as if all shares are sold in connection with an acquisition of the issuer or if the optionee’s shares are repurchased following termination from employment. Early Exercise NSO Tax Consequences As compared to an ISO, the exercise of a non-qualified stock option (“NSO”) is not a preference item for AMT purposes. If an optionee early exercises a NSO, an 83(b) election will be respected for compensation purposes and the optionee will only recognize compensation income equal to the fair market value of the shares on the date of exercise less the option’s exercise price. This income will be subject to applicable withholding for federal and state payroll taxes, including FICA. However, if the option is early exercised shortly following the option grant date, as is often the case, there is typically minimal (or zero) spread to recognize as compensation up front. The 83(b) election also starts the capital gains holding period. Thereafter, the vesting of the underlying restricted stock received upon the early exercise will not result in any further compensation income to the optionee. Upon disposition of the stock, capital gain or loss will be recognized in the year of sale, which will be long-term if the stock is held at least one year from the date of early exercise. Therefore, in contrast to early exercise ISOs, early exercise NSOs can reduce the exposure to gain being characterized as short-term capital gain to the one year after the early exercise, provided the 83(b) election is timely filed. In addition, by exercising and filing an 83(b) election shortly following grant, recognition of compensation income may be limited or eliminated. Early exercise ISOs have an overhang for up to two years following the date of grant where a disqualifying disposition could result in both compensation income and short-term capital gain recognition. For these reasons, as illustrated in the examples below, we find early exercise NSOs to be preferable to early exercise ISOs in most cases. This is especially true with respect to companies where (i) there is a possibility of acquisition within two years following the date of grant, (ii) the optionees have sufficient capital to early exercise the awards, and (iii) the optionees see a meaningful upside for the company at the time of early exercise (or the amount needed to early exercise is relatively small). Example 1 A startup company grants early exercise ISOs for 1000 shares to an employee at $0.05 per share on June 1, 2017, subject to a vesting schedule where 50% vests on June 1, 2018, and the remaining 50% vests on June 1, 2019.  Participant early exercises on June 5, 2017 while shares are still worth $0.05 per share and files an 83(b) election recognizing $0 in income, which is effective only for AMT purposes. Upon exercise, the participant receives restricted shares with the same two-year vesting schedule. When 50% of the shares vest on June 1, 2018, the fair market value has risen to $5 per share. On March 1, 2019, the company is sold via a stock purchase agreement for $10 per share. All unvested equity awards are accelerated and the shares held by the participant are sold in the deal, resulting in a disqualifying disposition, as both ISO holding periods were not met. Participant recognizes compensation income equal to the spread between FMV on the date the restricted stock vested less the exercise price paid: For the 500 shares that vested on June 1, 2018, 500 x $(5.00 - .05) = $2,475. For the 500 shares that vested in connection with the March 1, 2019, transaction, 500 x $(10.00 - .05) = $4,975. Total compensation income recognized due to disqualifying disposition is $2,475 + $4,975, or $7,450. The capital gains holding period begins on the date of restricted stock vesting. Because both tranches of restricted stock vested less than a year prior to the March 1, 2019, transaction, the $10,000 received in the stock sale less (i) $7,450 previously recognized as compensation income and (ii) $50 in total exercise price paid, or $2,500, is short-term capital gain. Example 2 Assume the same facts as Example 1, but with an early exercise NSO instead: The 83(b) election on June 5, 2017, results in $0 in compensation recognition and also begins the capital gains holding period. No compensation income is recognized with the vesting of the underlying restricted shares, as there is no disqualifying disposition concept applicable, and the 83(b) election was effective for compensation tax purposes. Upon the sale of the company on March 1, 2019, the entire $10,000 received minus the $50 amount paid in exercise price, or $9,950, will be recognized as long-term capital gain. Example 3 Assume the same facts as Example 1, but with a regular ISO grant (without the early exercise feature) that is exercised immediately prior to the March 1, 2019, transaction: No compensation income recognized at the time of exercise under the ISO rules. The March 1, 2019, sale of the shares will be a disqualifying distribution, characterizing the full $10,000 received minus the $50 amount paid in exercise price, or $9,950, as compensation income.   [1] U.S. Treas. Reg. Sec. 1.422-1(b), Ex. 2. [2] Id.

As a reminder to all foreign issuers that have a December 31 fiscal year end, the upcoming end of their second fiscal quarter, June 30, 2017, will be the calculation date for their status as a foreign private issuer (“FPI”) for purposes of both the United States Securities Act of 1933, as amended (the “Securities Act”) and the United States Securities Exchange Act of 1934, as amended (the “Exchange Act”). We recommend that issuers begin the analysis early to determine whether actions should be taken prior to the June 30th date to avoid an unintentional loss of FPI status. An early determination of the business nexus test (as described below) is also needed to know whether the issuer needs to request that their transfer agent and depositories provide U.S. resident beneficial shareholder information as of June 30, 2017. As detailed below, the definition of an FPI has two parts, one based on the percentage of the issuer’s U.S. resident shareholdings (the shareholder test), and the other based on its connections with the United States (the business nexus test). As an issuer must meet both of the two parts of the test to lose FPI status, it is often beneficial for an issuer to consider the business nexus test prior to considering the shareholder test. Because many issuers will not meet any of the three elements of the business nexus test (as discussed below), there would be no need to go through the time-consuming and often difficult process of determining the percentage of voting shares held by U.S. resident shareholders. The term “foreign private issuer" is defined by Rule 3b-4 under the Exchange Act and Rule 405 under the Securities Act as any non-U.S. issuer, other than a foreign government, except any issuer meeting the following conditions: (a)   more than 50% of the outstanding voting securities of such issuer are, directly or indirectly, held of record by residents of the United States; and (b)   any one of the following: (i)    the majority of the executive officers or directors are U.S. citizens or residents, or (ii)   more than 50% of the assets of the issuer are located in the United States, or (iii)  the business of the issuer is administered principally in the United States. While the FPI test is a seemingly straightforward calculation, the application of the test in certain circumstances can be challenging. The SEC staff has recently issued guidance that clarifies the application of the tests in certain circumstances and provides comfort for the application of reasonable methodologies that are consistently applied. Our prior blog post on the clarifications can be found here: crossbordercounselor.com/sec-provides-clarification-of-foreign-private-issuer-calculation/. In evaluating the citizenship and residency of executive officers and directors, each test must be separately applied to executive officers as a group and directors as a group. In determining the location from which a business is administered, an issuer must assess, on a consolidated basis, the location from which the issuer’s officers, partners, or managers direct, control, and coordinate the issuer’s business activities. Issuers may look to the geographical segment information determined in the preparation of financial statements for purposes of calculating the location of assets. Alternatively, an issuer may apply any other reasonable methodology on a consistent basis to determine location of assets. If an issuer fails one of more of the business nexus tests, a calculation of the issuer’s U.S. shareholdings is required. For purposes of the shareholder test, each holder identified on the record of security holders counts as a record holder. However, the issuer must look through the record ownership of institutional custodians, such as Cede & Co, CDS, and other commercial depositories, by obtaining the list of accounts for which the securities are held by the depository. In addition, under applicable SEC rules, an issuer must “look through” the record ownership of brokers, dealers, banks, or nominees to the beneficial holders who hold securities through such institutions. The “look through“ provisions of these rules are limited to three jurisdictions: (1) the United States; (2) the foreign company’s home jurisdiction; and (3) the primary trading market for the foreign company’s securities, if different from the foreign company’s home jurisdiction. Foreign private issuer status is of considerable benefit to foreign issuers that access the U.S. markets. Issuers that are in danger of a change in status may find that the recent SEC guidance gives them some additional flexibility in satisfying the FPI test. For those issuers, careful advance planning may make it possible to avoid the loss of the FPI benefits.

If a non-U.S. corporation (the “Company”) is a “passive foreign investment company” or “PFIC” for any tax year during which a U.S. shareholder owns shares in the Company, certain adverse U.S. federal income tax consequences of the acquisition, ownership, and disposition of shares will generally apply to such U.S. shareholder. A U.S. shareholder will be subject to the rules of Section 1291 of the Internal Revenue Code (described below) with respect to (a) any gain recognized on the sale or other taxable disposition of shares and (b) any “excess distribution” received on the shares. A distribution generally will be an “excess distribution” to the extent that such distribution (together with all other distributions received in the current tax year) exceeds 125% of the average distributions received during the three preceding tax years (or during a U.S. shareholder’s holding period for the shares, if shorter). Under Section 1291 of the Code, any gain recognized on the sale or other taxable disposition of shares, and any “excess distribution” received on shares, must be ratably allocated to each day in a U.S. shareholder’s holding period for the respective shares. The amount of any such gain or excess distribution allocated to the tax year of disposition or distribution of the excess distribution and to years before the entity became a PFIC, if any, would be taxed as ordinary income (and not eligible for certain preferred rates applicable to capital gains). The amounts allocated to any other tax year would be subject to U.S. federal income tax at the highest tax rate applicable to ordinary income in each such year, and an interest charge would be imposed on the tax liability for each such year, calculated as if such tax liability had been due in each such year. A U.S. shareholder that is not a corporation must treat any such interest paid as “personal interest,” which is not deductible. For a U.S. shareholder who is an individual that invests in stock of a corporation and holds such stock for more than 12 months, any gain on the sale of such stock is generally subject to a 20% tax rate applicable to long-term capital gains. However, if the stock held is stock in a PFIC, any gain on the sale or other disposition of such PFIC stock is generally taxed at the highest ordinary income tax rate of 39.6%, plus the applicable interest charge, which is not deductible. In addition, in most cases, a Medicare tax of 3.8% on investment income will apply to certain individuals, estates and trusts. Certain elections may be available to U.S. shareholders in certain situations to mitigate such adverse tax consequences.

A Canadian company that proposes to grant stock options or other types of equity compensation to persons in the United States must comply with the securities laws of the state in which the recipient is located, unless the type of equity being issued (e.g., the underlying common shares, in the case of options to purchase common shares) is listed on a “national securities exchange” such as the NYSE, Nasdaq, and NYSE MKT. This means that private companies, Canadian public companies that are not listed in the United States, and Canadian companies that are listed in the United States only in over-the-counter markets such as the OTCQX, OTCQB, or Pink Sheets, are required to comply with state securities laws. Canadian companies should not assume that because they have taken the requisite steps under U.S. federal laws, such as registering the underlying securities by filing a Form S-8 with the SEC or complying with an exemption from registration under SEC Rule 701, that no further actions are required. While some states’ laws do not require additional actions to be taken, many states impose requirements that differ from federal laws. For example, Some states require that an application for exemption be filed and accepted by the state, or another type of notice be filed, and a fee be paid, prior to making the first equity award in that state. Some states’ exemptions from registration requirements restrict the types of awards that can be made, the types of persons that can receive awards, and the types of companies that can rely on the exemption. For example, some states’ exemptions are unavailable for awards to consultants and non-employee directors, are subject to bad boy disqualifications, are available only for certain types of equity plans, or are unavailable for awards made on an SEC-registered basis. Some states have no specific exemption for equity-based compensation, and a company seeking to make equity-based awards in those states must either register the plan or comply with another type of exemption, such as an exemption that might be available for a private placement to a limited number of persons satisfying certain investment criteria. The State of California imposes substantive requirements on the plan itself, including terms related to the number of securities to be issued, minimum vesting criteria, minimum post-termination exercise periods, information delivery requirements, and shareholder approval requirements, in addition to the requirement to file a notice and pay a fee.

On April 10, 2017, the SEC’s Division of Enforcement brought enforcement actions against 27 individuals and entities behind various alleged stock promotion schemes. These actions arose when public companies, through promoters or communications firms, hired newsletter writers to generate publicity for their securities without publicly disclosing that the writers were being paid. While it is not illegal to hire newsletter writers, Section 17(b) of the Securities Act of 1933 (Securities Act) requires that newsletter writers fully disclose both the amount and the nature of the compensation received, including the dollar amount of a cash payment, the number of shares issued, or any other compensation. Additionally, newsletter writers and persons who adopt, approve or authorize the content of a publication may be liable for untrue statements of material facts or omissions for misleading investors. The Internet provides a ready means for fraudulent promotion of securities though social media, newsletters, chat rooms, emails, online blogs, press releases, and other media. The SEC’s Division of Enforcement is focusing attention on companies using stock promotion schemes that lead investors to believe that they were reading independent, unbiased analyses in newsletters, social media, stock forums, or other media when writers are secretly compensated for promoting a company’s securities. The SEC can bring charges against companies and promoters for these types of violations under various provisions of the Securities Act and Securities Exchange Act of 1934 (Exchange Act), including: Securities Act Section 17(a)/ Exchange Act Section 10(b) and Rule 10b-5: For, directly or indirectly, using interstate commerce to offer or sale any securities by: - employing any device, scheme or artifice to defraud; or - obtaining money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or - engaging in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser. Section 17(b) of the Securities Act: For, directly or indirectly, using interstate commerce to publish, give publicity to, or circulate any notice, circular, advertisement, newspaper, article, letter, investment service, or communication which, though not purporting to offer a security for sale, describes such security for a consideration received or to be received, directly or indirectly, from an issuer, underwriter, or dealer, without fully disclosing the receipt, whether past or prospective, of such consideration and the amount thereof. Exchange Act Section 20(b):  For aiding and abetting violations of Section 17(a) and Section 17(b) of the Securities Act and Section 10(b) and Rule 10b-5 of the Exchange Act. In addition, violations of securities laws may result in criminal prosecution. Allegations of securities law violations or association with firms that are charged with securities law violations may cause liability and embarrassment to a company and its officers, directors and employees. These violations may result in penalties, fines, imprisonment, or sanctions, including barring persons from serving as an officer or director of a public company or participating in certain securities offerings. Companies may be ultimately responsible for the investor relations work performed by investor relations, communication, social media, marketing, and other firms. Companies can take steps to avoid securities law violations by: Completing due diligence and selecting only reputable investor relations, communication, social media, marketing, and other firms to engage in investor relations activities. Limiting the use of paid newsletter writers and making sure that any compensation paid is properly disclosed. Adopting public communications policies that require authorization of company communications prior to dissemination. Carefully reviewing all materials for accuracy to ensure that the disclosure does not contain untrue statements of a material fact or omissions. Making sure that all content is consistent with the company’s public disclosures filed with regulatory agencies. Including forward looking statement and other disclaimers in all materials that are promotional in nature. Involving legal counsel, auditors and other professionals in the review of investor relations materials. Note: This post was originally published on Dorsey’s Governance & Compliance Insider blog here. 

We get asked from time-to-time whether it is advisable for issuers to pay fees to unregistered “finders” for introducing potential investors in the United States to the issuer in connection with securities offerings. The short answer is “no.” Most finders are engaged by issuers under finder’s, advisory, or other arrangements, which typically require payment of “success fees” upon completion of a financing transaction. While these arrangements are sometimes structured to try to hide or disguise the true intent of the arrangement, payment of transaction-based compensation is treated by U.S. securities regulators as a nearly-conclusive indication that a person is engaged in the securities business and should be registered as a broker-dealer. The relevant U.S. federal broker-dealer laws that should be of concern to an issuer using an unregistered finder include: Section 15(a)(1) of the Securities Exchange Act of 1934 (Exchange Act), which makes it unlawful for a person to “effect a transaction in securities” or “attempt to induce the purchase or sale of, any security” unless they are registered as a broker or dealer under the rules and regulations of the Financial Industry Regulatory Authority, Inc. (FINRA). FINRA is the regulatory organization designated by the Securities and Exchange Commission (SEC) to license and regulate broker-dealers. Section 29(b) of the Exchange Act, which provides that every contract made in violation of any provision of the broker-dealer registration requirements “shall be void” as to rights of persons who made or engaged in the performance of such contract. It results in the underlying purchase of securities becoming a voidable transaction that gives the investor a right of rescission, effectively granting a put right to the investor or purchaser. Section 20(e) of the Exchange Act, under which the SEC may impose aiding-and-abetting liability on any person that knowingly or recklessly provides substantial assistance in a violation of the Exchange Act. The theory behind broker-dealer registration is to provide a gatekeeper to protect investors in the marketplace. FINRA members are required to “observe high standards of commercial honor and just and equitable principles of trade” in the conduct of its business, including determining if an investment is "suitable" for its customer. Finders assisting in transactions rarely make such determinations and view themselves simply as middlemen in making introductions to potential investors. Because unregistered broker-dealers may not adhere to these high commercial standards, the SEC broadly construes the broker-dealer laws and narrowly construes the few permitted exceptions. Under SEC guidance derived from no-action letters, the SEC requires all intermediaries effecting transactions in securities to be licensed, subject to a few limited exceptions. Effecting a securities transaction may include, among other factors, receiving transaction-based compensation, recommending a company or the purchase of its securities, negotiating terms of a securities offering or purchase, attending meetings or presentations where the merits of the investment are discussed, performing or accommodating due diligence efforts, providing valuations or estimates of value, and other activities that facilitate a securities transaction. The consequences of engaging an unlicensed finder can be troublesome: Finder Risks:  Any unlicensed person engaging in activities designed to effect a transaction in securities may violate broker-dealer laws. The SEC or state securities regulators may seek to enjoin the unlawful activities or seek monetary penalties or criminal sanctions. Issuer Risks:  Retaining and permitting an unlicensed intermediary to effect a securities transaction may be a violation of federal and many state laws, and may subject the issuer to possible civil and criminal penalties. Any person that knowingly or recklessly provides substantial assistance in a violation of the Exchange Act may be subject to aiding-and-abetting liability. Rescission Risks:  A violation of broker-dealer laws creates a right of rescission under federal and/or state securities law. The SEC or state securities regulators may require the issuer to offer investors rescission rights, and the issuer may be required to return the investment. State Securities Violations:  Many states have begun reviewing state notice filings on Form D (which report transactions exempt from registration under Regulation D) and actively monitoring finder’s fees paid in connection with securities transactions. Some states have required issuers to provide additional information related to unlicensed broker-dealers and, in some cases, to certify that finder’s fees or commissions have only been paid in compliance with broker-dealer laws. Accounting Liability Risk:  Auditors may raise accounting issues resulting from paying finder’s fees to unregistered broker-dealers and may require an issuer to account for potential liability arising from rescission rights. Bad Actor Consequences:  An issuer or finder that is convicted of any felony or misdemeanor, is subject to any order, judgment, or decree of any court, or is subject to any order of certain regulators may be ineligible to participate in certain types of securities offerings, including Rule 506 of Regulation D offerings and Regulation A offerings. Using an unlicensed finder can result in broker-dealer law violations. Many times the issue arises in the context of state notice filings and direct inquiries from state securities regulators where finder’s fees or commissions are paid in connection with an offering. Other times, they arise from a failed investment where the investor may assert claims related to broker-dealer law violations to establish a right of rescission. Issuers should use caution in determining whether to engage a finder to assist in financing transactions.   Note: This post was originally published on Dorsey's Governance & Compliance Insider blog here. 

This week, the SEC approved a rule that would require broker-dealers to settle most securities transactions on a T+2 basis (shortening the current regime from T+3), effective September 5, 2017. See additional information in the post from our partner Jason Brenkert here. Will Canadian regulators follow suit?

On March 1, 2017, the United States Securities and Exchange Commission (SEC) published the taxonomy for the eXtensible Business Reporting Language (XBRL) for financial statements prepared in accordance with International Financial Reporting Standards, as issued by the International Accounting Standards Board (IFRS). Accordingly, foreign private issuers that prepare their financial statements in accordance with IFRS may immediately begin submitting their financial statements in SEC filings in the XBRL format. While Rule 405 of Regulation S-T would require foreign private issuers that prepare their financial statements in accordance with IFRS to submit financial data in XBRL upon publication of the taxonomy, the SEC has stated that such foreign private issuers are only required to submit financial data in XBRL with their first annual report on Form 20-F or 40-F for a fiscal period ending on or after December 15, 2017. Therefore, foreign private issuers who prepare their financial statements in accordance with IFRS are not required to submit XBRL data for the fiscal year ended December 31, 2016. The full text of the SEC’s release can be found at the following link: https://www.sec.gov/rules/other/2017/33-10320.pdf See our previous postings on the topic here: SEC delays XBRL compliance for foreign private issuers that prepare their financial statements in accordance with IFRS SEC Mandates Use of XBRL for Financial Statements

A Canadian corporation will generally be a passive foreign investment company or “PFIC” if, for a tax year, (a) 75% or more of its gross income is passive income (the “PFIC income test”) or (b) 50% or more of the value of its assets either produce passive income or are held for the production of passive income, based on the quarterly average of the fair market value of such assets (the “PFIC asset test”). Gross income generally includes all sales revenues less the cost of goods sold, plus income from investments and from incidental or outside operations or sources, and passive income generally includes, for example, dividends, interest, certain rents and royalties, certain gains from the sale of stock and securities, and certain gains from commodities transactions. Cash and cash equivalents are generally treated as assets held for the production of passive income. For purposes of the PFIC income test and PFIC asset test described above, if the Canadian corporation owns, directly or indirectly, 25% or more of the total value of the outstanding shares of another corporation, such Canadian corporation will be treated as if it (a) held a proportionate share of the assets of such other corporation and (b) received directly a proportionate share of the income of such other corporation. In addition, for purposes of the PFIC income test and PFIC asset test described above, and assuming certain other requirements are met, passive income does not include certain interest, dividends, rents, or royalties that are received or accrued from certain related persons (as defined in Internal Revenue Code Section 954(d)(3)), to the extent such items are properly allocable to the income of such related person that is not passive income. Canadian corporations that are in the development or exploration stage commonly constitute PFICs under the PFIC income test because their only source of gross income is interest income and other investment income earned on their cash balances. The same rules apply for other non-U.S. corporations.

Canadian miners and oil & gas companies should be aware that on February 14, 2017, President Trump approved a joint resolution of Congress that disapproved a recent SEC rule requiring specific disclosure by resource extraction issues. The obligation to report was imposed by Rule 13q-1 under the Exchange Act. The rules would have required resource extraction issuers to disclose payments made to the U.S. federal government or foreign governments, including foreign subnational governments, for the commercial development of oil, natural gas or minerals. See the full discussion from our partner Kimberley Anderson here.

In December 2015, the Canadian Securities Administrators (CSA) announced an amended regime for a prospectus-exempt rights offering in Canada. This amended regime allows certain public companies in Canada to conduct a prospectus-exempt rights offering without prior CSA review of the rights offering circular, and using a greatly simplified rights offering circular that assumes, without incorporation by reference, that the shareholder is familiar with the issuer’s other continuous disclosures. While the new regime revitalized the market in Canada for rights offerings, it raised several questions regarding the extension of the rights offering to U.S. shareholders. Form F-7 under the Multi-Jurisdictional Disclosure System (MJDS) has historically provided a means for eligible Canadian issuers to register securities issued in a rights offering under the U.S. Securities Act of 1933, as amended (the 1933 Act). Based on the SEC’s determination that Canadian disclosure requirements are adequate, Form F-7 allows the offering document (whether prospectus or rights offering circular) to comply principally with Canadian requirements, imposing only a few additional SEC requirements. Unlike most SEC registration forms, conducting an offering on Form F-7 does not subject the issuer to ongoing SEC reporting requirements. However, because the securities are treated as having been issued in a registered offering, the issuer is liable under the 1933 Act for any material misstatement or omission in the offering document, as it is in other registered public offerings. Following the passage of the December 2015 amendments, it was unclear whether the SEC would allow the use of Form F-7 under the new, abbreviated Canadian regime. Preliminary verbal guidance received from the SEC’s staff suggested that the staff was not, at that time, sufficiently comfortable with the new regime to give any assurance of Form F-7’s availability in such circumstances. It was also unclear how, if such registration was permitted, an issuer would protect itself from liability under the 1933 Act for material misstatements or omissions, given the limited amount of disclosure that is required or permitted under the new Canadian regime. As a result, since December 2015, Canadian issuers have not extended rights offerings under the new regime into the United States on Form F-7, and have often prevented U.S. shareholders from participating in the rights offering. Last week, the SEC published a no action letter allowing the use of Form F-7 for rights offerings by eligible Canadian issuers under NI 45-106, as amended by the CSA. The no action letter was issued following the receipt of an acknowledgment from the law firms submitting the request that: “When so registering securities on Form F-7, an issuer would need to assure that the registration statement and the prospectus satisfied the antifraud and liability provisions under the [1933 Act]”, and assurances that: “To do so, for purposes of the offering materials made available to U.S. holders, the issuer could provide a brief description of its business, risk factors, discussion of results of operations and capital resources and such other matters as it deemed material or otherwise in the offering circular.” Therefore, it appears that the SEC will allow the use of Form F-7 for rights offerings extended under NI 45-106, as amended by the CSA; however, a Canadian issuer taking advantage of this form of registration must include in the offering document sufficient information to protect itself from liability under the 1933 Act for material misstatements or omissions. It remains to be seen how the market will react to the SEC’s no action letter, including (1) the amount of disclosure that issuers will be comfortable including, and omitting, from a rights offering circular that is filed on Form F-7, knowing that the offering will be subject to U.S. prospectus liability, and (2) how frequently issuers will decide to follow this approach.

In recent years, many Canadian companies have sought to create a U.S. market for their shares by listing on the OTCQX. Qualifying Canadian companies that have their primary listing on the Toronto Stock Exchange, the TSX Venture Exchange or the Canadian Securities Exchange may generally obtain a quotation on the OTCQX or the next lower tier of the OTC Markets, the OTCQB, without filing a registration statement with, or becoming subject to ongoing reporting requirements with, the U.S. Securities and Exchange Commission. During 2016, the initial listing requirements for OTCQX included a minimum share price of US$0.25, a minimum market capitalization of US$10 million, an operating business, no current bankruptcy or reorganization proceedings, at least 50 beneficial round lot shareholders, an exemption from SEC reporting, and an exemption from penny stock status (typically satisfied through net tangible assets of at least US$2 million, or US$5 million if the company has been in operations for less than three years). A company obtaining an OTCQX quotation was also required to retain an attorney or broker approved by the OTC Markets to serve as the company’s Principal American Liaison, or PAL.  PALs were tasked with confirming the company’s compliance with OTCQX listing qualifications, delivering a letter of introduction to the OTC Markets, and providing an annual letter to the OTC Markets confirming the company’s continued satisfaction of the OTCQX continued listing qualifications. Effective January 1, 2017, the OTCQX has eliminated the requirement for an annual PAL letter. Approved attorney or broker PALs, now referred to as “Sponsors,” will only be required to provide an initial letter of introduction, thereby reducing the ongoing cost of an OTCQX listing. Dorsey has assisted more than 80 Canadian clients in obtaining OTCQX quotations, and is an approved Sponsor (previously, an approved PAL).

A Canadian SEC reporting company that looks to acquire a company with outstanding equity grants in the United States will frequently need to address the question: What alternatives are available for the assumption of the target’s outstanding options or other equity-based compensatory awards? Under U.S. law, both the grant of the equity award and the exercise or conversion of the equity award must be registered under the 1933 Act or satisfy an available exemption. For Canadian issuers that are SEC reporting companies, the alternative approaches available to satisfy the 1933 Act requirements for the exercise or conversion of the assumed awards were formerly restricted to (i) an S-8 registration statement (either existing or newly filed) or (ii) an alternative exemption, such as Rule 506 of Regulation D, which would typically be available only in limited circumstances. Under recent SEC guidance, however, SEC reporting issuers may now also rely on Rule 701 for the exercise of outstanding equity awards of the target that are assumed by the issuer if the target relied upon Rule 701 for the original issuance. Rule 701 is commonly used by U.S. private companies and Canadian and other foreign public companies that aren’t subject to SEC reporting obligations to structure their compensatory equity programs. Greatly simplified, Rule 701 is available to issuers that do not report with the SEC in connection with offers and sales of securities pursuant to written compensatory benefit plans to employees, officers and directors, and certain limited types of consultants and other persons, subject to limits on the amount of awards and, in certain cases, the need to deliver specified disclosures. Notwithstanding the express language in Rule 701 that the exemption is available only to an issuer that is not subject to SEC reporting requirements, an SEC reporting issuer may rely upon Rule 701 for the exercise of the assumed awards, provided that the target satisfied the requirements of 701 at the time of the original grant. Issuers should note that this change in guidance does not provide an exemption for the issuance of the acquiror options or other securities in connection with the assumption or exchange of the target options. For purposes of that transaction, the acquiror must rely upon (i) another exemption (such as Rule 3(a)(10) in a typical plan of arrangement) or (ii) a “no sale” position, which would be available if the terms of the target compensatory plan, at the time of the original grant, permitted the assumption of the options without the consent of the option holders. This new guidance will provide issuers with additional flexibility in structuring acquisitions of companies that aren’t SEC reporting companies. Due to the technical nature of the 701 exemption, however, an acquiror and its advisors should carefully review the target company’s compliance with Rule 701 to satisfy themselves that the exemption was available to the target at the time of original issuance.

For Canadian issuers and their advisers, compliance with U.S. securities laws generally begins with the question: Is the issuer a “foreign private issuer”? The FPI definition, which is set out in Rule 405 under the Securities Act and 3b-4(c) of the Exchange Act, involves the following four inquiries: Are more than 50% of the issuer’s outstanding voting securities held of record, directly or indirectly, by residents of the United States? Are a majority of the issuer’s executive officers and directors citizens or residents of the United States? Are a majority of the issuer’s assets in the United States? Is the issuer’s business principally administered from within the United States? While the FPI test is a seemingly straightforward calculation, the application of the test in certain circumstances can be challenging.  The SEC staff has recently issued guidance that clarifies the application of the tests in certain circumstances and provides comfort for the application of reasonable methodologies that are consistently applied. Multiple Classes of Voting Securities.  Issuers that have multiple classes of outstanding voting securities with different voting rights may choose to make the calculation on the basis of voting power or the number of outstanding securities, provided that the methodology is applied on a consistent basis. United States Residency.  A person who has permanent resident status in the United States (a “Green Card” holder) is presumed to be a U.S. resident.  For purposes of other holders, an issuer may select other reasonable criteria, and apply them consistently, such as tax residency, nationality, mailing address, physical presence, location of financial or legal relationships, or immigration status. Officers and Directors.  In evaluating the citizenship and residency of executive officers and directors, each test must be separately applied to executive officers as a group and directors as a group. Administration of Business.  No single factor or group of factors is determinative of the location from which a business is administered.  An issuer must assess, on a consolidated basis, the location from which the issuer’s officers, partners or managers direct, control and coordinate the issuer’s business activities.  Absent other factors, shareholder meetings or occasional meetings of the board of directors in the United States would not indicate that the issuer’s business was administered in the United States. Location of Assets.  Issuers may look to the geographical segment information determined in the preparation of financial statements for purposes of calculating the location of assets.  Alternatively, an issuer may apply any other reasonable methodology on a consistent basis to determine location of assets. Foreign private issuer status is of considerable benefit to Canadian issuers that access the U.S. markets.  Issuers that are in danger of a change in status may find that the recent SEC guidance gives them some additional flexibility in satisfying the FPI test.  For those issuers, careful advance planning may make it possible to avoid the loss of the FPI benefits.

Being a “foreign private issuer” is very important to a Canadian company’s treatment under U.S. securities laws.  If a Canadian company ceases to qualify as a foreign private issuer under the rules of the U.S. Securities Exchange Commission (SEC), it must generally: Change the way in which it offers and sells its own securities to persons in Canada and other non-U.S. jurisdictions, including the imposition of U.S. legends regardless of the jurisdiction of the purchaser, Begin reporting with the SEC unless its securities are held by a sufficiently small number of persons, and Report with the SEC on U.S. domestic forms rather than the more liberal forms that apply to most Canadian companies that report with the SEC. In addition, its directors, executive officers and 10% shareholders may become subject to the reporting and liability provisions of Section 16 of the U.S. Securities Exchange Act, which is a significant inconvenience and may require restructuring some of the company’s benefit plans and practices. A company incorporated under the laws of Canada or any Canadian province will be a foreign private issuer unless, as of the last business day of its most recently completed second fiscal quarter: More than 50% of the outstanding voting securities of the company are directly or indirectly owned of record by residents of the United States (Part 1), and Any of the following (Part 2): The majority of the company’s executive officers or directors are U.S. citizens or residents, More than 50% of the assets of the company are located in the United States, or The business of the company is administered principally in the United States. Because the result under Part 2 is often easier to determine, many companies will first assess the results of Part 2 in order to determine whether analysis of security ownership under Part 1 is necessary.  If analysis under Part 1 is necessary, a company may generally rely on the address of a securityholder as set forth in properly maintained securityholder records; however, it must generally “look through” the ownership of commercial depositaries such as CDS and Cede & Co., and other nominees such as brokers and banks that hold securities for the account of their customers.  In addition, it must generally take into account information set forth in beneficial ownership reports, and cannot give credence to a structure established to evade the U.S. securities laws.  The test set forth in Part 1 therefore generally requires, for a publicly traded company, a review of beneficial ownership reports and the company’s securityholder records and the commissioning of a beneficial ownership search through a service such as Broadridge. Companies that determine they are majority owned by U.S. residents may find themselves able to maintain foreign private issuer status by ensuring that they do not satisfy any of the criteria in Part 2 – by ensuring that their board and executive officers include a sufficient number of persons that are not U.S. citizens or residents, that their business is primarily administered outside the United States, and that a majority of their assets are located outside the United States. We frequently assist Canadian companies with assessing and maintaining their status as a foreign private issuer and, where appropriate, complying with the new regulations to which they are subject when they lose such status.

Most non-underwritten private placements of securities by Canadian companies to U.S. investors are made in reliance upon Rule 506 of Regulation D. Since September 2013, this exemption has been subject to “bad boy disqualifications.” Generally speaking, a company is prohibited from relying on Rule 506 if the company, any of its predecessors, any of its affiliated issuers, or any of its directors, officers, general partners, managing members or promoters has been subject to certain convictions, orders, judgments, decrees in the United States or suspension or expulsion of membership from certain organizations in the United States. In addition, if any person has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in the Rule 506 offering, then the offering will generally not qualify for Rule 506 if the person being paid, any general partner or managing member of such person or any director or officer of any of the foregoing has been subject to any such disqualifying events. A limited exception exists if the event occurred prior to September 2013 and is appropriately disclosed to prospective purchasers prior to the sale. Canadian companies that want to ensure the availability of Rule 506 should ask their directors, officers, 20% beneficial shareholders, general partners, managing members and promoters to periodically complete an appropriate Rule 506 bad boy questionnaire. We recommend that companies obtain a completed questionnaire from such persons at least annually, and that a questionnaire be completed by any person who newly becomes subject to the requirements (e.g., a newly appointed officer or a shareholder who first becomes a 20% beneficial shareholder). An appropriate form of questionnaire is available to clients upon request. In addition, Canadian companies should not agree to pay any person any remuneration or commission (directly or indirectly) for soliciting purchasers in a Rule 506 offering (e.g., an underwriter, agent or “finder”), unless it is first confirmed that the person is a U.S. registered broker-dealer that is legally permitted to receive such a commission and the parties enter into an appropriate contract in which the person confirms that no bad boy disqualifications are applicable. Companies should seek U.S. counsel’s advice on the appropriate language.

You’re a Canadian public company with no U.S. operations.  You don’t file reports with the SEC.  You plan to merge with another Canadian public company in a share-for-share exchange, structured as a Canadian plan of arrangement.  Do you need to hire U.S. counsel to assist on this Canadian deal? Yes. Canadian public companies invariably have shareholders resident in the United States.  If the acquirer will issue shares to the target shareholders, or if there will be an amalgamation in which shareholders of both companies receive shares of amalco, the transaction will be deemed to involve the offer and sale of securities to the U.S. shareholders.  This requires either registration with the SEC and applicable states, or an exemption.  The good news is that the U.S. requirements for a plan of arrangement are relatively manageable, and exemptions are available in most states.  New York likely requires an advance filing. Other reasons to involve U.S. counsel include: The acquirer is required to analyze the U.S. tax treatment to U.S. shareholders, and disclose this in a specific tax form; Securities registration or exemptions will be required for the future exercise or conversion of any stock options, warrants or other convertible securities outstanding and held by U.S. residents; If there are any U.S. executives, the tax consequences of the transaction to them and to the company should be analyzed; and A compliance review with respect to U.S. securities and other laws, especially if a party has U.S. investors, business activities, contracts, subsidiaries, regulatory filings or is listed on any U.S. market.