Debt Restructuring. 17th Taxation of Corporate Reorganization Conference January 22, 23 & 24, 2013 Kathleen S.M. Hanly and Kevin H.

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1 Debt Restructuring 17th Taxation of Corporate Reorganization Conference January 22, 23 & 24, 2013 Kathleen S.M. Hanly and Kevin H. Yip

2 Debt Restructuring Legislative framework for insolvency proceedings Debt forgiveness rules Debt for debt restructuring Equity for debt restructuring Debt parking rules Acquisition of control planning Non-resident creditors Convertible debt 2

3 Legislative Framework Restructuring Plan of arrangement under Companies Creditors Arrangement Act ( CCAA ) Proposal under Bankruptcy and Insolvency Act ( BIA ) Plan of reorganization under Chapter 11 of US Bankruptcy Code Liquidation Bankruptcy under BIA Plan of liquidation under Chapter 7 of US Bankruptcy Code 3

4 CCAA Restructuring Process Governs most complex debt restructurings in Canada, particularly cross-border restructurings Not detailed code, discretion in presiding judge flexible solutions Initiated by debtor applies to Court for initial order on notice to key stakeholders seeks protection from creditors Initial order stays legal proceedings against debtor i.e. creditors can t enforce claims 4

5 BIA Restructuring Use BIA proposal for smaller and less complex restructurings (now used mainly for personal debt) Must file BIA proposal within 6 months of initiating process (no Court stay after that date) Liquidation Typically creditors petition debtor into bankruptcy liquidation under BIA Assets vest in trustee in bankruptcy who, subject to rights of secured creditors, distributes assets to unsecured creditors in accordance with priorities 5

6 Debt Forgiveness Rules Commercial debt obligation incurred to earn income Debt settled for less than principal amount Forgiveness not otherwise included in income 6

7 Debt Forgiveness Rules (cont d) Section 80 forgiven amount reduces tax attributes in specified order: losses tax bases of assets Once tax attributes exhausted 50% income inclusion, subject to insolvency deduction 7

8 Transfer of Forgiven Amount Debtor can transfer forgiven amount to eligible transferee, including related Canadian corporation, under section Debtor jointly and severally liable for transferee tax up to 30% of transferred forgiven amount for 4 years Reduction of related company ACB (shares and debt) under subsection 80(11) avoids 50% income inclusion under subsection 80(13) only if related company tax attributes exhausted 8

9 Pre-Forgiveness Planning Transfer of Assets CREDITOR Debtor Debtor Lossco $100 FORGIVENESS Debtor does not want to lose UCC Depreciable Assets with UCC of $100 $100 ACB Newco Transfer of depreciable assets to Newco Depreciable Assets with UCC = $100 Section transfer of $100 forgiven amount $100 Losses (Lossco can t use) 9

10 Intercompany Debt Eliminated on Amalgamation X Co Amalco X Co and Y Co amalgamate to form Amalco NOTE Y Co Note deemed settled on amalgamation at cost amount under subsection 80.01(3) Debtor has no forgiven amount under section 80 provided that cost amount = principal amount 10

11 Foreign Currency Debt and Amalgamation Tech. Interpretation No E5 Y Co issues USD Note to X Co when US$1 = CDN$1.50 USD NOTE PRINCIPAL AMOUNT = US$1,000 X Co Amalco X Co and Y Co amalgamate to form Amalco when US$1 = CDN$1 Y Co ACB of USD Note = Principal Amount of USD Note = Amount for which USD Note issued = CDN$1,500 USD Note deemed settled on amalgamation at CDN$1,500 ACB under subsection 80.01(3) Neither creditor nor debtor has gain or loss under subsection 39(2) and debtor has no forgiven amount under section 80 11

12 Equity for Debt Restructuring Amount paid = fair market value of issued shares PLUS increase in value of existing shares Therefore, no forgiveness if e.g. issue preferred shares with fair market value equal to principal amount of debt, or 100% parent receives no shares but existing shares go up in value by principal amount No relief on subsequent redemption of deficient value preferred shares 12

13 Equity for Debt Restructuring (cont d) Parent US advisors wanted to issue single common share to Creditor in satisfaction of Note and then have Creditor acquire Canco shares from Holdco Holdco HOLDCO has 5,000,000 COMMON SHARES worth $5M 1 COMMON SHARE = $1 Value Creditor NOTE = $10M Principal Amount If issue single common share (worth $1 in this example) for $10M Note trigger $10M debt forgiveness 13 Canco ASSETS = $15M Value

14 Equity for Debt Restructuring (cont d) Parent Reordered to transfer Canco shares to Creditor first and did not have to issue any shares Holdco Creditor Able to rely on paragraph 80(2)(g.1) to ensure no forgiveness rather than having to address value of shares issued for Note 5,000,000 COMMON SHARES worth $15M 14 Canco ASSETS = $15M Value

15 Equity for Debt Restructuring (cont d) USco Non-Resident Parent Principal amount of debt to NRO was greater than value of Canco and greater than ACB of debt to NRO CAPITAL CONTRIBUTION UNITED STATES CANADA Canco DEBT REPAYMENT NRO 15

16 Equity for Debt Restructuring (cont d) CRA Document No : technical interpretations should not be provided in respect of GAAR CRA Document No clarifies CRA s GAAR position where cash is circled to avoid paragraph 80(2)(g) Whether GAAR applies will be assessed based on facts and circumstances in context of ruling application Negative GAAR Committee response on transaction on prior Slide when ruling sought 16

17 Equity for Debt Restructuring Ruling No R3 LossCo Lender (same group) LossCo Shareholder SUBORDINATED DEBENTURES NON-VOTING CLASS A PREFERENCE SHARES LossCo 17

18 Equity for Debt Restructuring (cont d) Ruling No R3 LossCo Lender 3. LossCo repays subordinated debentures using funds received on LossCo Shareholder subscription LossCo Shareholder 1. ProfitCo loans $X to LossCo Shareholder 2. LossCo Shareholder subscribes for $X (loan proceeds from ProfitCo) + $XX (its own $) Class A shares of LossCo 4. On the day before step 5., ProfitCo buys LossCo shares held by LossCo Shareholder for $X, which is satisfied through set-off against $X loan LossCo 5. LossCo and ProfitCo amalgamate ProfitCo 18

19 Equity for Debt Restructuring (cont d) Ruling No R3 Rulings: Amalco is carrying on Lossco business Amalco s income derived from sale, leasing, rental or development of similar properties of rendering of similar services Amalco can use LossCo losses GAAR applies to loan to LossCo Shareholder, subscription for LossCo shares and repayment of LossCo subordinated debentures repayments of debentures considered settlement of debt for no consideration for purposes of section 80 19

20 Equity for Debt Restructuring (cont d) Ruling No R3 Other Shareholders Parent PARENT DEBT LossCo ProfitCo 20 KEY FACT: Realizable value of LossCo s assets less than amount owing under Parent Debt LossCo under water

21 Equity for Debt Restructuring (cont d) Ruling No R3 KEY FACT: Immediately before Parent s subscription for additional common shares, Amalco has positive value Other Shareholders Parent 1. Amalco redeems Other Shareholder shares for cash NON-VOTING REDEEMABLE SHARES 3. Amalco repays Parent Debt 2. Parent subscribes for common shares for Parent Debt amount Amalco 21

22 Debt for Debt Restructuring Often preferable to issue debt rather than equity since value of debt is irrelevant to forgiveness: no forgiveness if same principal amount can use low-interest or non-interest bearing debt need to check foreign jurisdiction accrual rules if have non-resident holder 22

23 Debt for Debt Restructuring (cont d) May have combination of: forgiveness of some debt replacement debt (interest-bearing) equity kicker 23

24 Debt for Debt Restructuring (cont d) Interest Deductibility CRA has stated that taxpayer can deduct, under paragraph 20(1)(c), interest on loan used to pay tax-deductible interest on another loan Subsection 20(3) generally permits deduction of interest on money borrowed to repay loan obtained for income-producing purpose E.g. CRA has stated that interest deduction permitted under subsection 20(3) on loan used to repay interest-free loan used to earn active business income CRA has stated that whether debtor can deduct interest in context of CCAA filing depends on whether debtor has legal obligation to pay CRA: CCAA eliminates legal obligation to pay interest unless there is a court order to the contrary query whether correct 24

25 Debt Parking Rules Rules ensure can t avoid debt forgiveness by parking debt instead of settling it Parked obligation if: (1) specified obligation, AND (2) held by non-arm s length or significant interest holder Significant interest = shares with 25% votes or value include non-arm s length shareholdings when determining whether at 25% threshold 25

26 Debt Parking Rules (cont d) Specified obligation at previous time holder of debt dealt at arm s length with and did not have significant interest in debtor, OR at previous time holder purchased debt from unrelated person, OR holder claimed a bad debt loss under subsection 50(1) Order irrelevant: debt holder becomes significant interest shareholder, OR significant interest shareholder becomes debt holder 26

27 Debt Parking Rules (cont d) Safe harbour: 20% Debt becomes parked AND tax cost to holder < 80% principal amount debt deemed settled at tax cost forgiven amount = principal amount - tax cost Deduction of 50% of subsequent payment on account of parked debt previously subject to forgiveness rules under subsection 80.01(10) anti-avoidance restriction Consider partial settlement vs. purchase by shareholder at discount E.g. instead of having debtor pay third party creditors 50 on dollar, debtor s parent purchases debt from those creditors for 50 on dollar 27

28 Sale of Shares and Debt - Debt Parking Canadian Vendor Purchaser Purchase triggers debt forgiveness DEBT SHARES DEBT SHARES Non-Capital Losses Target Target DEBT FMV = $1M DEBT PRINCIPAL AMOUNT = $100M Debt = Parked Debt $99M Debt Forgiveness 28

29 Sale of Shares and Debt (cont d) ATR-66 TYPE TRANSACTION Canadian Vendor Canadian Vendor Paragraph 40(2)(e.1) denies loss on transfer of debt Paragraph 53(1)(f.1) adds denied loss to ACB of Debt to Newco Debt transferred to Newco DEBT Target Newco Target Deemed settlement of debt at ACB on winding-up of Newco (subsection 80.01(4) election) 29 NOTE: Canadian Vendor forgoes loss on debt as trade-off for eliminating debt forgiveness

30 Acquisition of Significant Interest Existing Shareholder Creditor Creditor has acquired debt at discount DEBT ACB < 80% OF PRINCIPAL AMOUNT 100% 75% COMMON SHARES 0 25% COMMON SHARES 30 Debtor may not know forgiven amount avoid 25% equity in creditor Debtor

31 Acquisition of Control Acquisition of control triggers year-end, crystallization and streaming of non-capital losses, crystallization and disappearance of net capital losses Creditors often become new shareholders and debt holders of ongoing entity Ordering may determine whether there is acquisition of control May be able to effect debt restructuring in manner that avoids acquisition of control Sometimes acquisition of control desirable: (1) changes accrued losses into non-capital loss carryforwards, and/or (2) minimizes debt forgiveness consequences 31

32 Triangular Restructuring Old Debtor REDUCTION OF DEBT BY CREDITORS Creditors TRANSFER OF SUBSIDIARIES FROM OLD DEBTOR TO NEW DEBTOR New Debtor ISSUANCE OF SHARES AND NEW DEBT TO CREDITORS New Debtor may be Newco (acquisition of control) or existing corporation in group (possibly change, but not acquisition, of control) 32

33 Non-Resident Creditors Domestic Withholding Tax Exemption Under domestic exemption in paragraph 212(1)(b), interest paid or credited to non-resident not subject to withholding tax provided: arm s length recipient not participating debt interest Participating debt interest is defined as (subsection 212(3)): Interest [other than fully exempt interest ] that is paid or payable on an obligation, other than a prescribed obligation, all or any portion of which interest is contingent or dependent on the use of or production from property in Canada or is computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion or by reference to dividends paid or payable to shareholders of any class of shares of the capital stock of a corporation. 33

34 Non-Resident Bank Financing 34 How to structure bank debt where non-resident bank providing new financing to corporate group as part of debt restructuring? If non-resident parent borrows from bank and finances Canco internally by making loan to Canco with proceeds from bank loan, there is withholding tax on interest paid by Canco Unless Canada-US Tax Treaty ( US Treaty ) exempts interest on related party loan (see Slide 36) If, instead, Canco borrows directly from non-resident bank (e.g. with appropriate parent guarantee, if necessary), interest paid by Canco to bank should be exempt from withholding tax under domestic exemption Thin capitalization rules generally N/A to loan from bank because arm s length lender, whereas apply to loan from parent (now 1.5:1 debt-to-equity ratio)

35 Non-Resident Creditors Ordering No Longer Required On debt restructuring where new debt/equity issued for old debt, previously would order to principal first and have the interest forgiven to avoid withholding tax Now no longer necessary if all non-resident creditors are arm s length (and no participating debt interest ) since neither principal nor interest triggers withholding tax 35

36 Non-Resident Creditors Canada-US Tax Treaty Under US Treaty, where US resident receives Canadiansource interest: Not related: Exempt from withholding tax on interest since February 1, 2009 assuming not participating interest for US Treaty purposes (largely redundant due to domestic exemption that took effect in 2008) Related: Nil withholding tax on interest as of 2010 assuming not participating interest Note that this assumes that US resident is (1) beneficial owner of interest; and (2) entitled to benefits under US Treaty under limitation on benefits ( LOB ) provisions Note hybrid rules in Article IV(7) that deny US Treaty benefits 36

37 US Treaty Benefits LOB Provisions in Liquidation Assume that: USco and subsidiary Canco are in liquidation USco owned by private equity investors in US USco not qualifying person for purposes of LOB provision in US Treaty USco will receive payments of interest and dividends on liquidation of Canco Can USco rely on Article XXIX-A(3) for US Treaty benefits even though business not currently actively carried on? LOB requires (in simplified terms) that: USco engaged in active conduct of trade or business in US Cdn-source income derived in connection with that business US business substantial in relation to activity generating Cdnsource income If not, can USco apply for Competent Authority relief under Article XXIX-A(6)? no treaty shopping 37

38 Insolvency Proceedings and Cross-Border Trade Receivables E.g. USco in Chapter 11 proceedings and Chapter 11 filing date (petition date) amounts owed by USco to Canco remain outstanding because of US proceedings Deemed dividend under subsection 15(2) and 212(2) and paragraph 214(3)(a) if debt not repaid within one year after end of Canco taxation year in which debt arose (subsection 15(2.6)) BUT: Is subsection 15(2) N/A to trade receivables under subsection 15(2.3)? Subsection 15(2.3) applies where debt arose in ordinary course of business and bona fide arrangements made for repayment within reasonable time Section 17 deems interest accrual where interest on upstream outbound intercompany debt less than reasonable rate Does section 17 apply in respect of non-interest bearing petition date trade receivables is zero a reasonable rate of interest in these circumstances? 38

39 Insolvency Proceedings and Outbound Loan Assume have outbound loan that has triggered deemed dividend under subsection 15(2) and paragraph 214(3)(a) Can loan be repaid to get withholding tax refund under subsection 227(6.1)? Subsection 227(6.1) provides for refund of deemed dividend withholding tax where debt repaid (not as part of series etc.) Refund at withholding rate applicable to hypothetical dividend paid by Canco at time of repayment May be able to obtain withholding tax refund by having USco repay Canco via (cashless) set-off against pre-existing inbound financing from USco Does tax have to be paid and refund sought under subsection 227(6.1) or will CRA apply administrative set-off? 39

40 Insolvency Proceedings and Outbound Loan (cont d) Want to eliminate outbound loan from Canco to USco to recover deemed dividend withholding tax under 15(2) and 214(3)(a) $5M OUTBOUND LOAN USco $5M LOAN USCO IN CHAPTER 11 PROCEEDINGS Transfer of loan to Canco UNITED STATES CANADA Holdco repays its $5 million loan from USco by transferring to USco Holdco s $5M loan to Canco (cash in Canco at least $5M) Holdco Canco $5M LOAN HOLDCO AND CANCO IN LIQUIDATION Subsection 227(6.1) withholding tax refund at 15% on repayment of outbound loan by way of setoff against inbound loan 40

41 Non-Residents Holding Convertible Debt Uncertainty re: whether conversion premium and regular periodic interest payments on convertible debt are subject to withholding tax Recent convertible debt deals have eliminated issue mainly by: Ensuring that have traditional convertible debenture within CRA administrative position (see Slide 44) Structuring debt so complies under old subparagraph 212(1)(b)(vii) 41

42 Non-Residents Holding Convertible Debt (cont d) Subsection 214(7) deems payment of interest where: Holder of convertible debenture transfers it to Canadian resident; and Price for which obligation assigned exceeds price for which obligation issued (the excess ) Subsection 214(14) deems debt conversion to be assignment Subsection 214(7) N/A to excluded obligation as defined in subsection 214(8) Excluded obligation includes debt that qualifies under old subparagraph 212(1)(b)(vii) 42

43 Non-Residents Holding Convertible Debt (cont d) If conversion premium is deemed interest under subsection 214(7) and is considered participating debt interest (see definition on Slide 33) because (among other things) quantum of conversion premium is dependent on issuer s share price, concern is that conversion premium as well as regular interest payments could be subject to withholding tax under Part XIII From policy perspective seems anomalous that still have to rely on subparagraph 212(1)(b)(vii) criteria after repeal of that provision 43

44 Non-Residents Holding Convertible Debt (cont d) At 2009 IFA Conference CRA stated: Conversion of traditional convertible debenture by its original holder for common shares of issuer generally, no excess under subsection 214(7) Thus conversion premium not deemed interest for Part XIII purposes Traditional convertible debenture (CRA Doc No C6) concept is somewhat narrow: Public corporation issuer No original issue discount Debentures Cdn dollar denominated, unsecured and subordinated, bear interest at fixed rate, have fixed conversion price or ratio etc. 44

45 Non-Residents Holding Convertible Debt (cont d) Significant uncertainty remains: CICA/CBA Joint Committee made submission May 2010 and outlined a number of scenarios for CRA to consider suggested broader standard convertible debenture concept See also Income Tax Technical News ( ITTN ) 41 (Dec 2009) and ITTN 44 (April 2011) At 2011 CTF Annual Conference Roundtable, CRA was asked about status of its review and responded as follows: The Joint Committee outlined a number of convertible debenture scenarios for consideration with a number of scenarios The types of issues vary and the interpretation and policy is very different depending upon the scenario Rulings Directorate has started an analysis of the technical and policy considerations and is targeting completing work in 2012; but given the nature of the issues, may not be able to determine definitive policies in this time frame 45

46 Presenters Kathleen S.M. Hanly Fasken Martineau DuMoulin LLP 333 Bay Street, Suite 2400 Toronto, Ontario M5H 2T6 Tel: Fax: Kevin H. Yip Fasken Martineau DuMoulin LLP 333 Bay Street, Suite 2400 Toronto, Ontario M5H 2T6 Tel: Fax:

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