1 This article was originally published in the Journal of International Taxation in February 2011 Debt restructuring in Canada Domestic and U.S. cross-border case studies (Part 1) Steven Hurowitz (KPMG), Ron Maiorano (KPMG), and Carrie Smit (Goodmans LLP) 1 The tax rules affecting debt restructuring are complicated and the interaction of several countries rules and tax treaties adds to the complexity. *42 In light of the global financial crisis and economic downturn in 2008 and 2009, debt restructuring has again become a very relevant topic for Canadian taxpayers. This article discusses, in the form of two case studies, selected Canadian and cross-border tax issues arising in the context of debt restructuring. Case study #1 below discusses the Canadian issues. Case study #2 in a forthcoming issue will address selected U.S. tax considerations. Case Study #1 The relevant facts are as follows: 1 A Canadian public corporation ( Pubco ) is a taxable Canadian corporation the shares of which are listed on the Toronto Stock Exchange ( TSX ). 2 Pubco has a wholly owned Canadian subsidiary ( Canco ) that is a taxable Canadian corporation. Canco operates an active business in Canada and currently has non-capital loss carryforwards ( NOLs ), capital loss carryforwards ( CLs ), and undepreciated capital cost ( UCC ). 3 Canco has issued U.S. dollar-denominated interest-bearing promissory notes ( Notes ) to a group of arm s-length nonresident noteholders ( Noteholders ). The Notes are commercial debt obligations for purposes of section 80 of the Income Tax Act (Canada), as amended (the Act ). 2 4 Canco has a wholly owned Canadian subsidiary ( CanSub ) that is a taxable Canadian corporation. CanSub has issued a non-interest-bearing promissory note to Canco ( CanSub Note ). The CanSub Note is a commercial debt obligation for purposes of section 80 of the Act. 5 Canco has a wholly owned U.S. resident subsidiary ( US Sub ). 6 Pubco has a wholly owned Canadian subsidiary ( CanSister ) that is a taxable Canadian corporation. CanSister has NOLs (which arose prior to a previous acquisition of control of CanSister) and CLs. 7 The adjusted cost base ( ACB ) of (a) the shares of CanSub and US Sub held by Canco and (b) the shares of Canco and CanSister held by Pubco, exceeds the fair market value ( FMV ) of the shares. *44 See Exhibit 1 for the corporate structure of Pubco. Canco is in financial difficulty and can no longer meet its obligations under the Notes. As a result, the Pubco group is to be restructured (through a statutory plan of arrangement or a filing under the Companies Creditors Arrangement Act ( CCAA ). Under this restructuring, it is proposed that the 1 STEVEN HUROWITZ and RON MAIORANO are with KPMG and CARRIE SMIT is with Goodmans LLP. The authors acknowledge the invaluable assistance of Bob Lorence, Mimi Duong, and Benoit Lacoste Bienvenue, KPMG, and Marisa Wyse, Goodmans LLP. Mr. Maiorano has written previously for the Journal. 2 Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended. Unless otherwise indicated, section references herein are to the Act.
2 2 Noteholders will effectively exchange their Notes for (1) new interest-bearing promissory notes ( New Notes ) of Canco and (2) shares in the capital stock of Pubco. Receipt of New Notes. As partial consideration for the settlement of the Notes, Noteholders will receive New Notes issued by Canco. Pursuant to paragraph 80(2)(h), Canco will be considered to have paid an amount equal to the principal amount of the New Notes for purposes of determining the forgiven amount in respect of the Notes. Unlike paragraph 80(2)(g), which applies in the context of share consideration, this provision does not refer to value, so that (subject to the discussion below) the value of the New Notes is irrelevant to the determination of the forgiven amount. Accordingly, to determine the forgiven amount in respect of the Notes, the principal amount of the New Notes must be determined. Subsection 248(1) defines principal amount as the maximum amount... payable on account of the obligation by the issuer thereof, otherwise than as or on account of interest. The Technical Notes respecting paragraph 80(2)(h) reiterate that it is this definition of principal amount that is relevant for purposes of paragraph 80(2)(h), adding that [i]n particular, the principal amount of an obligation issued by a debtor does not include amounts that are considered to be payable on account of interest. In many instances, the New Notes will be commercial instruments that bear interest at a reasonable rate and have commercial covenants and other terms. In that situation, the principal amount of the New Notes should equal their face amount, even if the New Notes may have a value at issuance that is less than their stated face amount. In Interpretation Bulletin IT-533, the Canada Revenue Agency ( CRA ) confirmed that where money is borrowed with a stated interest rate and in consideration for a promise to pay a larger amount, such a discount is generally not interest. 3 It should be considered, however, whether Canco can issue a long-term promissory note (e.g., 30-year maturity) having a relatively high principal amount (significantly in excess of value) and bearing interest at a nominal or nil rate ( Deferred Term Note ). If paragraph 80(2)(h) applies, the forgiven amount can be reduced or eliminated, at least until this Deferred Term Note is itself settled or extinguished. However, it must be determined whether the full face amount of the Deferred Term Note actually constitutes its principal amount for purposes of the Act. Given that the value of the Deferred Term Note will be significantly less than its face amount, could all or a portion of this difference be considered interest, either pursuant to the reasoning in Lomax 4 or under subsection 16(1)? However, it is not clear that it is appropriate to view the Deferred Term Notes as being issued at a discount; although the Noteholders have given up property (the original Notes) having a low value in consideration for the Deferred Term Notes, from Canco s perspective, it has relieved itself of an obligation equal to the full face amount of the original Notes. The issuance of a Deferred Term Note to defer a debt forgiveness also needs to be analyzed under the general an-tiavoidance rule ( GAAR ). The fundamental question is whether this transaction defeats or frustrates the object and spirit of paragraph 80(2)(h). Given that paragraph 80(2)(h) specifically looks to the principal amount and not value, and the debtor corporation is legally obligated to pay the full face amount under the terms of the Deferred Term Note, it could be argued that its issuance is not abusive. In a 2002 advance tax ruling, 5 an employee owed money to his former employers but was in financial difficulty and could not repay the loans. The loans were exchanged for new loans that had the same principal amounts but were not due until the day following the date of the employee s death. The CRA ruled that paragraph 80(2)(h) would apply so that no debt forgiveness arose on the exchange and that GAAR would not apply. However, in this situation the employee acquired life insurance sufficient to repay the loans, so it was reasonable to expect that the loans would be fully repaid on maturity. Would the same position on GAAR apply where there is no reasonable expectation that the new indebtedness will be repaid at its maturity? The question of interest deductibility in respect of the New Notes also needs to be addressed. Under paragraph 20(1) (c), interest is deductible only when it constitutes interest on borrowed money used for the purpose of earning income from a business or property or an amount payable for *45 property acquired for the purpose of gaining or producing income. The New Notes are arguably not an amount payable for property, as no property is acquired by the debtor (rather, a liability is extinguished). However, it appears that the CRA views the New Notes as borrowed money that is used to repay other borrowed money, so that the interest is deductible under a combination of paragraph 20(1)(c) and subsection 20(3). 6 The potential application of the thin capitalization rules must also be considered. The Noteholders are also acquiring shares of Pubco, such that if the New Notes become outstanding debts to specified nonresidents, the thin capitalization provisions of subsection 18(4) will apply; as there is no direct nonresident 3 Interpretation Bulletin IT-533, para. 37. See also subsection 16(1) and Lomax (HM Inspector of Taxes) v. Peter Dixon & Son, Ltd. (1943), 25 TC 353 (CA). 4 Id. See also Gestion Guy Menard Inc. v. MNR,  2 CTC 2793 (TCC). 5 Ruling Rulings and See also Ruling R3.
3 3 equity in Canco, deductibility of interest in respect of the New Notes may be denied. However, if a Noteholder holds Pubco shares representing 25% or more of the votes or value of Pubco, but otherwise deals at arm s length with Pubco, that Noteholder will not be considered a specified nonresident shareholder of Canco; the same conclusion would not result if that Noteholder directly held shares of Canco representing 25% or more of the votes or value of Canco. Another issue is withholding tax on the interest paid on the New Notes. If the Noteholders are considered not to deal at arm s length with Canco, or the interest is considered participating debt interest under subsection 212(3), withholding tax will apply under the Act (although relief may be available for U.S. Noteholders under the Canada-U.S. income tax treaty if the interest is not participating for purposes of Article XI(6)(b) of the treaty). It is a question of fact whether a Noteholder deals at arm s length with Canco; issues can arise where a group of Noteholders acquires more than 50% of the Pubco shares if those Noteholders may be considered to act in concert in respect of this shareholding. 7 Receipt of Pubco shares. As partial consideration for the settlement of the Notes, Noteholders will also receive shares in the capital of Pubco. These shares may be contributed by Pubco to Canco and then transferred by Canco to the Noteholders, or issued directly by Pubco to the Noteholders pursuant to an undertaking of Pubco to do so. 8 Regardless of the mechanics, if Canco provides the Pubco shares to the Noteholders in partial satisfaction of the Notes, the forgiven amount will be determined based on the FMV of the Pubco shares at the time that the Noteholders receive them. Where the Pubco shares are listed on a stock exchange, it *46 is unlikely that the FMV of those shares will be precisely determinable in advance, which may make it difficult to estimate the forgiven amount prior to closing and plan for its application. It should also be determined whether a portion of the Notes should be transferred by the Noteholders directly to Pubco in consideration for the Pubco shares. In this situation, the debtparking rules in section will apply, but a forgiven amount will arise only when the specified cost 9 of the transferred Notes to Pubco is less than 80% of the principal amount thereof. Accordingly, where the value of the Pubco shares is expected to equal or exceed 80% of the principal amount of the remaining unpaid Notes, a debtparking transaction with Pubco may be advantageous in comparison to a settlement with Canco itself. If the value of the Pubco shares to be issued to the Noteholders is less than 80% of the principal amount of the unpaid Notes, so that the debt-parking rules would apply on the transfer of the Notes to Pubco, it should be determined whether a portion of the Notes (pro rata across all Noteholders) could first be settled by Canco for no consideration, to cause the value of the Pubco shares to equal at least 80% of the principal amount of the remaining Notes. The transfer of the remaining Notes to Pubco may then not result in any further debt forgiveness. A further benefit of a debt-parking transaction may arise if a partial repayment of the Notes would give rise to a foreign exchange gain to the debtor. If the Noteholders transfer their foreign denominated Notes to Pubco, subsection 80.01(11) will apply and the inherent foreign exchange gain (or loss) will not be realized. 10 Only when the Notes (now owing by Canco to Pubco) are repaid or settled will any inherent foreign exchange gain or loss to Canco be realized for tax purposes. When the Notes are held by Pubco, it will likely be necessary to eliminate or reduce the interest otherwise accruing to Pubco. Care must be taken to avoid (1) any further debt forgiveness to Canco (particularly if the 80% threshold was met and no forgiven amount arose on the debt-parking); (2) the realization of a foreign exchange gain by Canco; or (3) the realization of a gain by Pubco. Accordingly, it may not be advisable to immediately capitalize or repay the Notes. However, it may be possible to amend the interest rate on the Notes, reducing it to a nominal 0.01% rate, without causing a novation or disposition of the Notes. 11 The possibility of a deduction under subsection 80.01(10) on a subsequent repayment of the Notes should also be considered. 12 Foreign exchange considerations. The Notes issued by Canco are denominated in U.S. dollars. Thus, Canco will need to consider the effects of foreign currency fluctuations on the calculation of the forgiven amount, as well as the foreign exchange consequences under subsection 39(2). There has been a fair amount of uncertainty as to the appropriate application of paragraph 80(2)(k) when 7 Interpretation Bulletin IT-419R2. See also Swiss Bank Corp. et al. v. MNR,  CTC 614 (SCC). 8 Rulings and R3. 9 Specified cost is defined in subsection 80.01(1) as cost amount, which is defined in subsection 248(1) as ACB in respect of capital property. 10 Technical Interpretation C6. 11 See, e.g., General Electric Capital Equipment Finance Inc. v. The Queen,  1 CTC 217 (FCA); Technical Interpretations I7 and ; Ruling ; Income Tax Technical News Nos. 14 and See Technical Interpretation (with respect to debtor, payment deemed made pursuant to paragraph 80(2)(h) will be considered a payment as contemplated by subsection 80.01(10)). Given that paragraph 80(2)(h) applies only for purposes of section 80, it is unclear if this is correct at law. See also Technical Interpretation
4 4 a foreign currency-denominated debt is settled. Paragraph 80(2)(k) provides that when an obligation is denominated in a foreign currency, the forgiven amount at any time in respect of the obligation will be determined with reference to the relative value of that currency and the Canadian currency when the obligation was issued. 13 The forgiven amount is defined in section 80 as (generally) the amount by which the principal amount of an obligation exceeds the amount, if any, paid in satisfaction of that principal amount. Accordingly, any payment by Canco in satisfaction of the Notes must be converted into its Canadian dollar equivalent using the rates applicable when the debt was issued. Example. Canco issued a US$1,000 Note when the exchange rate was at par. If the exchange rate is currently US$1 = Cdn$1.40, and Canco repays an amount in respect of the Note equal to US$700 (the equivalent of Cdn$980), the remaining unpaid balance of US$300 is forgiven. The forgiven amount should be calculated as follows: the US$700 payment is converted into Canadian dollars using the rate applicable when the Note was issued, which was par. The US$700 payment should then be considered a Cdn$700 payment. Because the principal amount of the Note was *47 Cdn$1,000 (the historical equivalent of US$1,000), 14 the forgiven amount should be Cdn$1,000 less Cdn$700, or Cdn$300. The foreign exchange gain or loss under subsection 39(2) must also be computed, although this gain or loss is realized only in respect of the portion of the Note that has been repaid. In the above example, US$700 was repaid; this amount was borrowed when the exchange rate was at par and repaid when the exchange rate was US$1 = Cdn$1.40, resulting in a foreign exchange loss of Cdn$280. As a result of the settlement of the US$1,000 Note for a US$700 payment, Canco has realized a forgiven amount of Cdn$300 and a foreign exchange loss of Cdn $280. If these items could be netted, they would come out to Cdn$20, which corresponds to Canco borrowing the equivalent of Cdn$1,000 and repaying only the equivalent of Cdn$980. In effect, the determination of the forgiven amount can be made and understood only in conjunction with the determination of the foreign exchange gain or loss. This methodology is consistent with the Technical Notes respecting paragraph 80(2)(k), as well as the relevant technical interpretations issued by the CRA. 15 The potential application of paragraph 80(2)(k) in the context of a debt-parking transaction has also been the subject of much discussion. 16 Paragraph 80(2)(k) is in subsection 80(2), which provides that it applies only for purposes of section 80. The debt-parking rules are in section 80.01, not section 80. However, subsection 80.01(8) simply provides that where the debt-parking rules apply, the forgiven amount will be determined as if the debtor had paid an amount in satisfaction of the principal amount of the debt equal to the specified cost of the debt to its holder. Further, because the definition of forgiven amount is in section 80 (and for the purposes of section 80.01, the definition of forgiven amount has the meaning assigned by subsection 80(1) subject to certain adjustments), it appears that paragraph 80(2)(k) should apply to that determination. The CRA recently issued a Technical Interpretation 17 clarifying this issue and confirming that paragraph 80(2)(k) of the Act applies for purposes of determining the forgiven amount that arises as a consequence of the application of the debt-parking rules in section of the Act. (The CRA also confirmed that a deemed settlement under the debt-parking rules would not trigger the recognition of any foreign currency gain or loss.) With respect to the interaction of the application of the debt-parking rules and the computation of the forgiven amount, situations may arise where the debt is acquired at an economic discount of greater than 20%, but the debt-parking rules do not apply. Example. The US$1,000 Note described above (which was issued when the currencies were at par) is transferred to Pubco for shares of Pubco having a value of US$700, or the current equivalent of Cdn$980. As the specified cost of the Note to Pubco is Cdn$980, 18 which is greater than 80% of the principal amount of the Note of Cdn$1,000, no debt-parking will arise. This occurs notwithstanding that Pubco paid only an amount economically equal to 70% of the amount owing, and the forgiven amount if computed under section 80 would have been Cdn$300. Conversely, debt may be acquired at an economic discount of less than 20% where the debt-parking rules do apply. Example. The current exchange rate is US$1 = Cdn$0.75, and Pubco acquires the US$1,000 Note for Pubco shares having a value of US$900. The specified 13 Subsection 261(2). 14 On principal amount of a foreign currency denominated debt reflecting exchange rate applicable when debt arose, see The Queen v. Imperial Oil,  1 CTC 41 (SCC); Tembec Inc. v. The Queen, 2008 DTC 3232 (TCC); Technical Interpretations , , and E5. 15 Technical Interpretations and See, e.g., Bauer, Restructuring Debt Obligations, Report of Proceedings of the Sixtieth Tax Conference, 2008 Tax Conference (Toronto: CTF, 2009), 37:1-30; Wortsman, Nesbitt, and Love, Recent Transactions in Cor-porate Finance: Assumption, Tender Offer and Other Secondary Market Transactions, id. 9: Technical Interpretation C6. See also Technical Interpretation E5. 18 See definition in note 8, supra. Under subsection 261(2), this should be computed using the current exchange rate.
5 5 cost of the Note to Pubco will be Cdn$675, which is less than 80% of the principal amount of the Note. This results in a debt-parking (and a forgiven amount of Cdn$100), notwithstanding that Pubco paid an amount economically equal to 90% of the amount owing. There may also be situations where the specified cost of a debt is less than 80% of its principal amount, but no forgiven amount will arise. Example. Debt-parking would arise if Pubco paid the full amount of US$1,000 for the Note when the exchange rate was US$1 = Cdn$0.75 (i.e., Cdn$750 is paid). However, when the forgiven amount is computed under section 80, paragraph 80(2)(k) should apply and no actual forgiven amount will arise. *48 These results are arguably inconsistent with the policy of the debt-parking rules, which is to cause debt forgiveness when the debt is transferred at a greater-than-20% economic discount. A more appropriate result would be obtained if principal amount for purposes of subsection 80.01(8) referenced the current Canadian dollar equivalent of the face amount of a foreign denominated debt obligation; perhaps this interpretation could be justified under a textual, contextual, and purposive interpretation of subsection 80.01(8). 19 Ordering steps to minimize the impact of a forgiven amount. If Canco will realize a forgiven amount as a result of its debt restructuring, opportunities to mitigate the impact of the debt forgiveness should be considered. These are discussed below, with examples involving various fact situations. To better understand these opportunities and examples, it is helpful to briefly review the ordering rules on application of a forgiven amount to the tax attributes of Canco. Ordering rules. The ordering rules are in subsections 80(3) to (13). In brief, these rules provide for the application of the forgiven amount to Canco s tax attributes in the following order: 20 Category 1: NOLs and CLs. The rules first provide for the automatic application of the forgiven amount to (1) Canco s NOLs 21 and (2) Canco s CLs. 22 For purposes of these rules, Canco s NOLs and CLs will generally include balances that were restricted or eliminated due to a prior acquisition of control, where certain conditions are met. In particular, pursuant to the definition of relevant loss balance, 23 the obligation being settled must have been issued before and not in contemplation of the prior acquisition of control or, if issued subsequent to that acquisition of control, the proceeds of the issuance must have been used to refinance such an earlier issued obligation. Category 2: depreciable and amortizable pools. If a balance remains after application of the forgiven amount to Category 1, the rules then provide for a discretionary application of the remaining unapplied portion of the forgiven amount to the following tax pools, to the extent designated by Canco: 1 Capital cost and UCC of Canco s depreciable property Cumulative eligible capital ( CEC ) of Canco in respect of each business of Canco Certain resource pools of Canco. 26 Although these designations are discretionary, the forgiven amount must be applied to these tax pools to the maximum extent possible if Canco intends to apply any remaining unapplied portion of the forgiven amount to the ACB of its capital properties or its current year CLs. Category 3: capital properties. If a balance remains after application of the forgiven amount to Category 2, the rules then provide for a discretionary application of the remaining unapplied portion of the forgiven amount to the ACB of the following capital properties, to the extent designated by Canco: 27 1 ACB of capital property, other than shares and debts of corporations of which Canco is a specified shareholder, provided maximum designations were made under Category ACB of shares and debts of nonrelated corporations of which Canco is a specified shareholder, provided maximum designations were made under Categories 2 and 3(1) ACB of shares and debts of corporations to which Canco is related, provided maximum designations were made under Categories 2, 3(1), and 3(2) However, see subsection 261(2). See also note 13, supra. 20 On the ordering rules, see Pickford and Tunney, The Tax Treatment of Forgiveness of Debt and Foreclosures, The Proposed New Rules, Report of Proceedings of the Forty-Sixth Tax Conference, 1994 Tax Conference (Toronto: CTF, 1995), 3:1-62; Baek, Tax Planning for Recessionary Times, Report of Proceedings of Fifty-Fifth Tax Conference, 2003 Tax Conference (Toronto: CTF, 2004), 53: Subsection 80(3), which applies to all NOLs (from both business and property). This provision also affects farm losses. 22 Subsection 80(4). This provision also affects ABILs (allowable business investment losses). 23 Subsection 80(1). 24 Subsection 80(5). 25 Subsection 80(7). 26 Subsection 80(8). 27 See also section 80.03, where a gain may be realized on the surrender of property that has been the subject of a subsection 80(9), (10), or (11) designation. 28 Subsection 80(9). 29 Subsection 80(10). 30 Subsection 80(11).
6 6 The amounts designated by Canco in Categories 2 and 3 are applied to reduce the relevant tax pool balance im-mediately after the time of the debt forgiveness. 31 Category 4: Current Year CLs. If Canco has made maximum designations under Categories 2 and 3(1) and a balance of the forgiven amount remains, Canco is effectively required under subsection 80(12) to apply this balance against current-year CLs (to the extent that they exceed current-year capital gains). 32 *49 Category 5: income inclusion. When Canco has made all of the automatic and discretionary applications of the forgiven amount to its tax attributes under Categories 1 to 4, an unapplied forgiven amount may still remain ( Remaining Amount ). If this occurs, subject to certain adjustments and designations, Canco will realize an income inclusion equal to 50% of the Remaining Amount. 33 To avoid or reduce the income inclusion, Canco could make a joint election under section ( Section Election ) with certain related Canadian parties, 35 such as CanSub, Pubco, and CanSister, to transfer all or a portion of the Remaining Amount to those parties. CanSub, Pubco, and CanSister could then apply the portion of the Remaining Amount transferred to them against their tax attributes. Canco will also have an income inclusion equal to 50% of the lesser of (1) any amount allocated to Category 3(3), and (2) the residual balance in respect of the settlement of the Notes. In brief, the residual balance 36 will be the amount by which the gross tax attributes of certain related Canadian parties exceed the Remaining Amount. 37 As a result, if Canco applies a portion of the forgiven amount to reduce the ACB of the shares of CanSub or US Sub, the application will in effect be wasted (i.e., 50% of that portion would still result in an income inclusion) to the extent that the gross tax attributes of certain related parties exceed the Remaining Amount. If Canco has an income inclusion in respect of the forgiven amount, it should be considered whether Canco could claim an insolvency deduction, if it is determined to be insolvent in accordance with the rules in subsection 61.3(1). Alternatively, Canco may be able to claim an insolvency reserve under section The ordering rules do not provide for an application of the forgiven amount against undeducted investment tax credits ( ITCs ), scientific research and experimental development ( SR&ED ) expenditures, 38 or financing expenditures (unamortized balance of paragraph 20(1) (e) expenditures). Accordingly, these pools, if any, could be used to shelter the income inclusion. Canco could also consider applying current-year losses and other deductions (such as interest expense and tax reserves) against the income inclusion. Planning opportunities to minimize the impact of a forgiven amount are discussed below. Minimize existing NOL balances. Canco should consider minimizing its existing NOLs at the time of the debt forgiveness, so that the forgiven amount can be applied against less valuable tax attributes, such as CLs or slow depreciating UCC or CEC balances. The following techniques could be used to reduce its NOLs: (1) refile its prior-year tax returns for loss years to reduce capital cost allowance (CCA) and CEC claims and increase its UCC and CEC pools; or (2) file (or refile) its tax returns for the tax year prior to the year in which the debt forgiveness occurs, so as not to claim discretionary reserves under paragraphs 20(1)(l), (m), or (n). The CRA has a longstanding administrative policy 39 of allowing a taxpayer to revise a claim for CCA and other permissive deductions in respect of a tax year for which a notification that no tax is payable ( nil assessment ) had been issued provided that: There is no change in the tax payable for the year or any other year filed for which the time has expired for filing a notice of objection. 31 Canco makes the designation to these tax pools on Form T2154 and files it with its income tax return for the tax year that includes the settlement of the Notes. If Canco is settling more than one commercial obligation at the same time, it must also complete and file Form T2153 with its income tax return for the tax year that includes the settlement of the Notes. 32 If for some reason Canco wants to avoid application of this rule, it can do so by not making maximum des-ignations under categories 2 and 3(1). However, this choice would be made only in unusual circumstances and, as will be discussed later in the article, it cannot be made to transfer a forgiven amount to a related party because maximum designations must be made under categories 2, 3(1), and 3(2) to make a section election. 33 Subsection 80(13). The inclusion rate is 100% in respect of a debtor that is a partnership. 34 Canco and the eligible transferee must file Form T2156 by the later of the due date of Canco s and the eligible transferee s income tax returns for the tax year that includes the settlement of the Notes. The election may also be filed within the period allowed for a notice of objection following a tax assessment for this year, and amended elections are possible. When a section election is made, the debtor corporation is jointly and severally liable for certain tax liabilities of the transferee for a period following the debt settlement. 35 Eligible transferee is defined in subsection 80.04(2). 36 Subsection 80(14). 37 Pursuant to subsection 80(14.1), the gross tax attributes of these related Canadian parties are in effect the total tax attributes of those persons (other than those described in Category 3(3)) before taking into account the results of a transfer of an amount through a Section Election. 38 Subsection 37(1). 39 Information Circular IC 84-1, paras. 1 and 10.
7 7 The CRA has not issued a notice of determination pursuant to subsection 152(1.1), unless the revision is re-quested within 90 days from the day of mailing of the notice of determination for that year. 40 *50 Once permissive deductions have been reduced, the impact on a later tax year should apply automatically. For instance, when CCA claims for a class for prior tax years have been reduced, the UCC balance of that class should be au-tomatically adjusted upward, as the balance E in the definition of UCC in subsection 13(21) will be automatically reduced. The impact on a later year should be automatic, provided there is no change in taxes payable for a year in which the time has expired for filing a notice of objection. Increase loss in year of debt forgiveness. In addition to minimizing its NOLs by amending prior-year tax returns, Canco should also consider increasing its non-capital loss for the year in which the debt forgiveness occurs by taking steps such as (1) claiming the maximum discretionary reserves allowed under paragraphs 20(1)(l), (m), and (n); (2) making pension contributions to settle pension liabilities; and (3) making deductible contract termination payments. The higher current-year noncapital loss would then be available to shelter any Remaining Amount (which is included in income at only a 50% rate). Take advantage of discretionary rules. Subsections 80(5), (7), and (8) provide that a forgiven amount is applied to a UCC class, CEC pool, and resource expenditures, respectively, to the extent designated. Accordingly, Canco can use its discretion to forgo applying a forgiven amount against high CCA-rate depreciable property and cumulative Canadian exploration expenses ( CCEE ). However, because Canco will not have made the maximum designations under Category 2, any remaining forgiven amount cannot be applied through Category 3 designations or to offset current-year CLs under subsection 80(12). Accordingly, a Remaining Amount may arise, although only 50% of this amount will result in an income inclusion. Canco could then shelter this *51 income inclusion by claiming, in the year of the debt forgiveness, the maximum CCA and CCEE amounts to which it is entitled. In effect, by including the forgiven amount in income at a 50% rate, Canco may be able to retain a greater amount of total tax attributes. Example 1. Canco s tax attributes are as follows: Forgiven amount of $75 million. NOLs of $75 million. CLs of $30 million. Depreciable property with a capital cost of $55 million and a UCC balance of $10 million. Canco claimed a paragraph 20(1)(m) reserve of $5 million in the tax year prior to the year in which the debt forgiveness occurred. In addition, Canco will realize a loss for the current tax year of $4 million (before claiming CCA but after the paragraph 12(1)(e) income inclusion). Absent any planning, the forgiven amount would be applied to reduce Canco s NOLs to nil, and its CLs, UCC balance, and current-year loss would remain at $30 million, $10 million, and $4 million, respectively. In summary, Canco would retain total tax attributes of $44 million. However, if Canco s CCA claims in prior years, and its paragraph 20(1)(m) reserve for the immediately prior year, were reduced to nil, Canco s NOL balance would be reduced to $25 million and its UCC balance would increase to $55 million. The forgiven amount would then be applied to reduce Canco s NOLs and CLs to nil and an unapplied forgiven amount of $20 million would remain. Canco could then designate the $20 million to be applied to its UCC balance, resulting in a remaining UCC balance of $35 million. Canco would also have a revised current-year loss (before CCA claim) of $9 million, as it would have no income inclusion under paragraph 12(1)(e). In summary, Canco would still retain total tax attributes of $44 million, although these attributes (current-year loss of $9 million plus UCC balance of $35 million) are more valuable. Alternatively, if Canco did not make a designation in respect of its UCC balance, but instead realized an income inclusion of $10 million (50% of $20 million) and retained the UCC balance of $55 million, it could then shelter this income inclusion with its current-year income loss (of $9 million) and CCA on the depreciable property of $1 million. Canco would now retain total tax attributes of $54 million, all in the form of UCC. Example 2. Canco s tax attributes are as follows: Forgiven amount of $30 million. No NOLs or CLs. Class 29 depreciable property with a UCC balance of $20 million. Canco has the ability to settle an onerous supply contract for a one-time deductible payment of $10 million. If Canco were to designate the forgiven amount to be applied against the $20 million UCC balance, at the end of the year it would have a UCC balance of nil and an income inclusion of $5 million (50% of the Remaining Amount of $10 million). If Canco settled the contract in the year of the debt forgiveness, it could generate a deduction of $10 million and an overall net loss for the year of $5 million. If Canco did not designate the unapplied forgiven amount against its UCC balance, it would realize an income in-clusion of $15 million (50% of $30 million). Canco could then offset the 40 The CRA has not publicly stated that it views the revision of prior-year permissive claims in order to mitigate the impact of a forgiven amount as abusive or otherwise inappropriate tax planning. 41 Paragraphs 111(4)(c) and (d) will result in a realization of the inherent CLs and a designation under paragraph 111(4)(e) will increase the tax cost of Canco s capital property.
8 8 income inclusion with a CCA claim of $10 million and the contract termination deduction of $10 million. Canco would have the same overall net loss for the year of $5 million but by eliminating the designation, a UCC balance of $10 million is retained. Transfer assets prior to debt forgiveness. Another technique to preserve high-value tax attributes is to transfer property to arm s-length or related arm s-length parties prior to the time of the debt forgiveness. If Canco owns capital property with an accrued capital loss, it may benefit from transferring this property to an arm s-length party in the tax year prior to the debt forgiveness and crystallizing the CL. (For this reason, it may be beneficial to time an acquisition of control or amalgamation before the debt forgiveness, to have a tax year-end before the debt forgiveness.) A forgiven amount arising in a subsequent tax year could then be applied against this CL. If the CL is not crystallized, Canco will be forced to apply the forgiven amount against its UCC, CEC, and resource pools to the maximum extent possible before it can apply any remaining portion against the ACB of its capital property (subject also to the residual balance rules discussed above). Canco should also consider transferring depreciable property to a related party prior to the debt forgiveness. For example, if Canco has NOLs, CLs, and depreciable property with a FMV greater than its UCC, it should consider realizing the inherent recapture by transferring the depreciable property to a related party for FMV proceeds. Provided that Canco has a tax year-end prior to the debt forgiveness, its NOLs can shelter this recapture. (Thus, here too it may be beneficial to time an acquisition of control or amalgamation before the debt forgiveness, to have a tax year-end before the debt forgiveness.) As a result, a portion of Canco s NOLs could be preserved in the form of the related party s higher UCC balance and the forgiven amount could be applied against lower-value CLs. In the context of an acquisition of control of Canco, all unrealized CLs will be realized, and Canco could achieve a similar result by filing a designation to realize the inherent recapture or gain in Canco s capital property. 41 Example 3. Canco s tax attributes are as follows: Forgiven amount of $100 million. NOLs of $60 million. CLs of $100 million. Depreciable property with a FMV of $100 million, capital cost of $160 million, and a UCC balance of $40 million. Absent any planning, the forgiven amount would be applied to reduce the NOLs to nil and the CLs to $40 million. Canco would retain CLs of $60 million and the UCC balance of $40 million. However, if the recapture inherent in the depreciable property were realized in a year prior to the year of the debt forgiveness, possibly by transferring the depreciable property to a related party (or filing a paragraph 111(4)(e) designation if there is an acquisition of control), Canco s NOLs could be used to shelter this recapture. The forgiven amount would then be applied to *52 reduce Canco s CLs to nil and the UCC balance would be $100 million. Similarly, if Canco has depreciable property with a FMV less than UCC, it should consider realizing the inherent terminal loss and reducing its UCC balance by transferring the depreciable property to a related party. 42 This opportunity is discussed in further detail below. It should also be considered whether Canco can amalgamate with any related corporations prior to the debt settlement. Certain lower-value tax attributes (such as CLs or low CCA-rate UCC) in the related corporation may then be available to offset the forgiven amount in the amalgamated corporation, thereby preserving the more valuable UCC in Canco. Plan for accrued CLs. If control of Canco is not acquired and no property is sold, the accrued but unrealized CLs in respect of related-party investments will not be realized. As a result, if a residual balance exists, Canco will not be able to apply the forgiven amount to the ACB of the relatedparty investments, such as its shares of CanSub and US Sub. Consequently, to avoid an income inclusion, Canco may be forced to use a Section Election to apply the forgiven amount against the tax attributes of Pubco, CanSub, and CanSister. Example 4. Canco s tax attributes are as follows: Forgiven amount of $200 million. NOLs of $40 million. Depreciable property with a FMV of $10 million and a UCC balance of $60 million. Shares of CanSub with an ACB of $80 million and a nominal FMV. Shares of US Sub with an ACB of $40 million and a nominal FMV. Also, CanSub has depreciable property with a UCC balance of $80 million and there is no acquisition of control of Canco. Canco must first apply $40 million of the forgiven amount against its NOLs and then can apply $60 million of the forgiven amount against its UCC balance. 43 A forgiven amount of $100 million would remain. If Canco applies an amount in excess of $20 million to reduce the ACB of its shares of CanSub or US Sub, it will have a positive residual balance. For example, if Canco applies $30 million to reduce the ACB of its shares of CanSub and also makes a Section Election for the Remaining Amount of $70 million, it will have a residual balance of $10 42 The terminal loss will not be suspended under subsection 13(21.2) if an acquisition of control of Canco occurs within 30 days of the transfer. 43 Pursuant to paragraph 80.04(4)(b), Canco must make the maximum designation to its UCC balance to make a Section Election.
9 9 million (gross tax attributes of CanSub of $80 million less Remaining Amount of $70 million). That is, Canco is effectively forced to limit application of the forgiven amount to the ACB of its shares of Cansub or US Sub to $20 million, and to make the Section Election for $80 million to avoid an income inclusion. CanSub could then designate the $80 million to be applied against its UCC to avoid an income inclusion. In summary, the only tax attributes that Canco and CanSub together would retain would be the remaining inherent capital losses in the shares of CanSub and US Sub of $100 million. However, an acquisition of control of Canco would provide easier access to the accrued CLs. 44 In particular, an acquisition of control of Canco that occurred prior to the debt settlement would allow Canco to crystallize the CLs inherent in its shares of CanSub *53 and US Sub. 45 If the debt forgiveness occurred in the following tax year, the forgiven amount could be automatically applied against Canco s CLs, 46 after application against the NOLs. (Where Canco has depreciable property with inherent recapture, it should also be considered whether Canco could file a paragraph 111(4)(e) designation to apply its NOLs to increase its UCC balance.) The results above are also consistent with a favorable tax ruling issued by CRA respecting a series of transactions similar to those described above. 47 In particular, the CRA ruled that the taxpayer could apply the forgiven amount arising on a debt forgiveness that was timed to occur after an acquisition of control to reduce the CLs that were deemed to be realized as a result of the acquisition of control. In addition to the specific technical rulings issued, the CRA ruled that GAAR would not apply to the proposed transactions. As a result of the acquisition of control, Canco will realize the accrued CLs on its shares of CanSub of $80 million and US Sub of $40 million. To avoid an income inclusion, Canco can apply the remaining forgiven amount of $40 million against its UCC balance. In summary, Canco and CanSub would retain total tax attributes of $100 million (UCC of $20 million in Canco and $80 million in CanSub). Alternatively, if Canco will realize a significant current-year non-capital loss, it may be beneficial to time the debt forgiveness to arise before the acquisition of control. Canco could then preserve the current-year loss by applying the forgiven amount to its NOLs, UCC balance, and the CLs realized on the acquisition of control in respect of its shares of US Sub and CanSub (through subsection 80(12)). Additional planning may include the prior application of the forgiven amount to NOLs and the transfer of Canco s depreciable property to a related party (as discussed above) to allow for the initial application of the forgiven amount to the CLs (through subsection 80(12)). Example 5. The facts are the same as in Example 4 except that the NOL of $40 million is incurred in the current year and an acquisition of control is anticipated. If the acquisition of control occurred after the debt forgiveness, Canco could apply the forgiven amount to its UCC balance of $60 million and the deemed CL of $120 million realized in the acquisition-ofcontrol year. This would leave a Remaining Amount of $20 million. Canco could then make a Section Election with CanSub for $20 million, and CanSub could apply this amount against its UCC balance. In summary, Canco and CanSub would retain total tax attributes of $100 million (a new NOL of $40 million in Canco and UCC of $60 million in CanSub). Subsection 256(9) Election. As a practical matter, debt settlements often occur on the same day as part of the closing steps for a distressed acquisition. Absent an election under subsection 256(9), the acquisition of control would be deemed to occur on the first moment of the day of closing, and accordingly, prior to the debt forgiveness arising later that day. However, it may be beneficial to make a subsection 256(9) election to time the acquisition of control to occur at its actual time. Provided that the debt is settled before the closing of the acquisition (as is typical), this election could be used to time the debt forgiveness to arise before the acquisition of control. The choice would depend on whether more tax attributes are preserved if the debt forgiveness occurs before or after the acquisition of control. Example based on recent CRA ruling. A recent advance tax ruling ( Ruling ) issued by the CRA 48 illustrates how the tax attributes of a distressed group can be preserved through a pre-closing transfer of depreciable property to a related party. Example. The facts are the same as in Example 4 above, plus (1) Pubco has accrued CLs in its shares of Canco and CanSister totaling $30 million; and (2) CanSister has CLs and streamed NOLs totalling $10 million. Absent planning, Canco would be required to apply the forgiven amount of $200 million first to its NOLs of $40 million, then to apply $60 million of the remaining forgiven amount to its UCC balance if it wanted to make a Section Election or use subsection 80(12). However, to preserve its UCC balance, Canco could transfer its depreciable property to a related corporation (or *54 possibly a newly formed operating partnership) prior to the debt forgiveness. 44 Consideration should also be given to subsection 256(8). Further, losses suspended under subsection 40(3.4) will become unsuspended on an acquisition of control, and available to offset a debt forgiveness. 45 Paragraphs 111(4)(c) and (d). 46 These CLs should be considered part of Canco s relevant loss balance. 47 Ruling Ruling R3. In addition to the specific technical rulings issued, the CRA ruled that GAAR would not apply to the proposed transactions.
10 10 Transaction steps. If Canco implemented steps conceptually similar to those in the Ruling, the following transactions would occur. Prior to the implementation of a plan of arrangement, a new successor public company would be formed ( New Pubco ) and it would subscribe for preferred and common shares of Pubco. The consideration for the subscription would be nominal cash and an undertaking ( Undertaking ) to deliver certain new common shares of New Pubco, as directed by Pubco. The share subscription would be designed so that it does not result in an acquisition of control of Pubco. Pubco would then subscribe for additional common shares of Canco and in consideration it would transfer a part of the Undertaking to Canco. The plan would then include the following key steps: 1 Canco would first transfer its depreciable property and related business assets to a related party for proceeds equal to the FMV of the property (satisfied through the issuance of equity and the assumption of liabilities). 2 Canco would settle the Notes at a discount at the time ( Settlement Time ) that is immediately before the time that is immediately before the time that control of Pubco is acquired by New Pubco (step 3 below). Payment would be in the form of the issuance of common shares by New Pubco to the Noteholders pursuant to the Undertaking. 3 New Pubco would then acquire control of Pubco by issuing its shares to the public shareholders of Pubco (also pursuant to the Undertaking) in satisfaction of the redemption of the Pubco common shares (other than those shares held by New Pubco). As a result, Pubco would become a wholly owned subsidiary of New Pubco. An election under subsection 256(9) would be filed. The significant tax consequences of these transactions are discussed below. Terminal loss on transfer of depreciable property. Generally, when depreciable property is transferred to an affiliated party, the stop-loss rules in subsection 13(21.2) will apply to suspend any inherent terminal loss. The suspended terminal loss is deemed to be depreciable property of the transferor ( Deemed DP ) until certain triggering events occur, including an acquisition of control. If an acquisition of control is the first triggering event, the Deemed DP is deemed to be owned until the time that is immediately before the time that is immediately before the acquisition of control. The Deemed DP is deemed to have a UCC equal to the suspended terminal loss. However, if the transfer of the depreciable property occurs within 30 days of the subsequent acquisition of control of Canco, the stop-loss rules would not apply and Canco would immediately realize its terminal loss of $50 million. 49 Regardless of whether the stop-loss rules apply, the transferee would have a UCC addition equal to the $10 million FMV of the depreciable property. Canco could also consider refiling its prior-year tax returns for loss years to reduce prior CCA claims and increase its UCC pools. This step should result in a lower NOL and a larger terminal loss in the acquisition-ofcontrol tax year. Acquisition of control of Pubco. When New Pubco acquires control of Pubco (which arises when the shares of Pubco are redeemed and shares of New Pubco are issued to the existing shareholders of Pubco), each of Pubco, Canco, CanSub, and CanSister would be deemed to have a tax year ending at the time immediately prior to the acquisition of control. 50 In the acquisition-of-control tax year (1) Pubco will realize the accrued CLs on its shares of Canco and CanSister; and (2) Canco will realize the accrued CLs on its shares of US Sub and CanSub. Canco can effectively apply a portion of the forgiven amount against its deemed-realized CLs under subsection 80(12). To do so, however, Canco must first apply the forgiven amount against its UCC balance immediately after Settlement Time. Preserving UCC. The debt forgiveness is timed to arise at Settlement Time. Absent the transfer of the depreciable property by Canco, any *55 unapplied portion of the forgiven amount would need to be applied against the UCC of Canco s depreciable property if Canco intended to apply (under subsection 80(12)) any portion of the forgiven amount against the CLs arising on its acquisition of control. However, by first transferring its depreciable property to a related party, this obstacle is avoided. If the depreciable property had been transferred by Canco more than 30 days prior to the acquisition of control, the stop-loss rules in subsection 13(21.2) would have applied, and Canco would have had UCC in relation to the Deemed DP. However, under clause 13(21.2)(e) (iii)(d), the Deemed DP is deemed to be owned by Canco only until the time that is immediately before the time that is immediately before control of Canco is acquired. This time is immediately after Settlement Time. Implied in the Ruling is the CRA s belief that owned until the time means not owned at that time. 51 Based on this interpretation, Canco would not have a UCC balance at the time that is immediately after Settlement Time. Rather, the Deemed DP would result in a terminal loss to Canco in its acquisition-of-control tax year. Accordingly, Canco would not be forced to first apply the unapplied portion of the forgiven amount against its UCC balance to be able to apply a portion against its current-year CLs. 49 Subsection 13(21.2) and paragraph (f) of the definition of superficial loss in section Subsection 249(4). 51 See Ruling D of Ruling R3.
11 11 Section Election. At this point, Canco would have a Remaining Amount of $40 million. 52 It could include 50% of this balance ($20 million) in its income under subsection 80(13). The income inclusion could then be sheltered with losses arising in the acquisition-of-control year, including business losses, interest expense, and the terminal loss arising on the transfer of Canco s depreciable property to the related party. Generally, however, the preferred approach would likely be to avoid an income inclusion. Accordingly, Canco could make a Section Election with Pubco to transfer $30 million of the Remaining Amount to Pubco. The $30 million transferred would then be excluded from the subsection 80(13) income inclusion. Pubco would be deemed to have issued a commercial debt obligation in the amount of $30 million that was settled at Settlement *56 Time. The $30 million would also be deemed a forgiven amount of Pubco arising at Settlement Time. Accordingly, this forgiven amount would arise in Pubco s acquisition-of-control tax year. Pubco could then choose to apply the $30 million forgiven amount under subsection 80(12) against the $30 million CLs realized on its shares of Canco and CanSister. Canco could also consider making a Section Election with CanSister for $10 million. However, pursuant to the definition of relevant loss balance, CanSister generally can apply the transferred forgiven amount against its streamed losses only if the deemed obligation had been issued before and not in contemplation of the prior acquisition of control. 53 In general, the deemed obligation will be deemed to have been issued at the same time that the Notes were issued. However, if control of CanSister was acquired after issuance of the Notes, and CanSister and Canco were not related to each other immediately before that acquisition of control, the deemed obligation will be deemed to have been issued after that acquisition of control. 54 In essence, this rule means that CanSister can apply the transferred amount against its streamed losses only if CanSister and Canco were sister companies prior to the time that control of CanSister was previously acquired. If CanSister was acquired by Pubco at the time that Canco was an existing subsidiary of Pubco, CanSister could not apply the transferred portion against its streamed losses. In summary, through these planning steps Canco should be able to apply the forgiven amount arising on the settlement of the Notes against low-value tax attributes, such as accrued CLs in the Pubco group (and potentially streamed losses of CanSister), instead of its more valuable tax attributes. Debt slide of CanSub Note. The CanSub Note is currently a noninterest-bearing note issued by CanSub to Canco that the parties want to eliminate. Because the value of the Cansub Note is significantly below its face amount, a debt forgiveness to CanSub would result if the note were capitalized into additional shares of CanSub (or contributed to the capital of CanSub). 55 ATR-66 transactions. To eliminate the CanSub Note in a tax efficient manner, the parties can undertake a debt-slide transaction similar to the transaction described in advance tax ruling ATR-66: 1 Canco would transfer the CanSub Note to a new Canadian subsidiary of CanSub ( Subco ) in consideration for a promissory note of Subco ( Subco Note ) having a principal amount equal to the FMV of the CanSub Note. 2 Subco would be wound up into CanSub under subsection 88(1), and the Subco Note would become a liability of CanSub on the wind-up. An election under subsection 80.01(4) would be filed in respect of this wind-up. The loss realized by Canco in step (1) above would be denied pursuant to paragraph 40(2)(e.1), but would be added to the tax cost of the CanSub Note to Subco under paragraph 53(1)(f.1). Accordingly, on the wind-up of Subco into CanSub, the CanSub Note would have full tax cost to Subco and no forgiveness would result under subsection 80.01(4). In addition, the face amount of the Subco Note would equal its value, such that the Subco Note could be capitalized into additional shares of CanSub (or contributed to the capital of CanSub) without resulting in a debt forgiveness. These *57 debt-slide transactions are generally acceptable to the CRA 56 because there is no doubling up of losses and the transactions are consistent with the policy on related-party loss trading; in particular, CanSub avoids a debt forgiveness but Canco forgoes its loss. Non-interest-bearing debt considerations. The CanSub Note is non-interest-bearing, so it must be considered whether subparagraph 40(2)(g)(ii) could apply to deny the loss realized on the transfer of the CanSub Note to Subco. If this provision applied first to deny the loss, there would be no loss to which paragraph 40(2)(e.1) could apply, 57 and the tax cost adjustment in paragraph 53(1)(f.1) would not apply. It is not clear which of paragraph 40(2) (e.1) or subparagraph 40(2)(g)(ii) should apply first; each refers to the taxpayer s 52 Forgiven amount of $200 million applied against NOLs of $40 million and CLs of $120 million. 53 See definition of relevant loss balance in subsection 80(1). This rule generally can also allow the forgiven amount to be applied against streamed losses if the obligation being settled was originally borrowed to refinance an obligation issued prior to the previous acquisition of control. 54 Paragraph 80.04(4)(h). Also, the refinancing provision in paragraph (e) of the definition of relevant loss balance will not apply. 55 Paras. 80(2)(g) and (g.1). 56 For advance tax rulings relating to debt-slide transactions, see Rulings , , R3, R3, R3, and R3. 57 Paragraph 40(2)(e.1) applies to a taxpayer s loss, if any (emphasis added). If subparagraph 40(2)(g)(ii) has already applied to eliminate the loss, there is no loss to which paragraph 40(2)(e.1) could apply. See Technical In-terpretation September
12 12 loss, if any and neither refers to the other. Under the rules of statutory interpretation, a more specific provision takes precedence over a more general one. 58 However, it is unclear which provision is more specific; although paragraph 40(2)(e.1) applies to any type of debt and subparagraph 40(2)(g)(ii) applies only to debts not acquired for an income-earning purpose, subparagraph 40(2)(g)(ii) applies to any disposition of such debt, whereas paragraph 40(2) (e.1) applies only to specific dispositions within related groups. Where the indebtedness in question is owed by a subsidiary to its parent corporation, the decision in Byram 59 should apply to render subparagraph 40(2)(g)(ii) inapplicable, on the ground that the parent corporation made the loan to facilitate the subsidiary s income-earning potential and increase the likelihood of future dividends. The CRA has accepted the decision in Byram and generally applies it when there is a clear nexus between the interest-free loan and the potential future income from the subsidiary. 60 Where subparagraph 40(2)(g)(ii) may apply (for example, the loan is between sisters, or from a subsidiary to its parent, so that the Byram decision is inapplicable), other transactions can be considered to avoid its potential application. In a 2008 advance tax ruling, 61 a subsidiary held a noninterest-bearing note issued by its parent. Before effecting a debt-slide transaction, the terms of the note were first amended to add a conversion feature, and the note was then converted into an interestbearing note under section Several months later, the new interest-bearing note was eliminated through a form of debt-slide transaction. Rulings were given that the amendment did not result in a novation or disposition of the note and that section 51.1 applied to the conversion of the note, such that the subsidiary was considered to have acquired the new note at the same (full) tax cost as the original note. Because the new note was issued as an interest-bearing note, subparagraph 40(2)(g)(ii) did not apply, and debt-slide rulings under paragraphs 40(2)(e.1) and 53(1)(f.1) were given. Shares vs. notes. The traditional debt-slide transaction includes the issuance of a new promissory note by a new subsidiary of the debtor, as described above. However, this structure may cause issues to arise where the value of the existing debt is unclear. For example, if the CanSub Note (face amount of $100) is estimated to be valued at $70, and is transferred to Subco for a Subco Note of $70, the tax cost of the CanSub Note to Subco will equal the $70 paid by Subco plus the amount of the paragraph 53(1)(f.1) adjustment. If the CanSub Note is actually determined to have a value of $80, paragraph 69(1) (b) may apply so that the denied loss will be only $20 and the paragraph 53(1)(f.1) adjustment will be limited to $20. As a result, Subco will not have full tax cost in the CanSub Note, resulting in a debt forgiveness on the wind-up of Subco to the extent of the deficiency. Where valuation may be an issue, the CanSub Note could be transferred to Subco for share consideration. For example, in a 2003 ruling, 62 Subco was *58 incorporated as a subsidiary of the creditor and the debt was transferred to Subco in consideration for common shares. A section 85 election was filed in respect of the transfer; under section 85, the agreed amount will always be adjusted to equal the value of the debt transferred to the subsidiary (assuming that the tax cost of the debt is greater than its FMV). 63 Alternatively, in the 2008 ruling discussed above, 64 Subco was established as a subsidiary of the debtor and the debt was transferred to Subco for preferred shares, subject to a price adjustment clause. No section 85 election was filed, as the price adjustment clause would automatically apply to cause the value of the preferred shares to always equal the value of the transferred debt, such that the tax cost of the acquired debt to Subco (after the application of paragraph 53(1)(f.11)) should always equal its principal amount. It may also be possible to have Subco pay for the transferred debt with its own promissory note, but to include a form of price adjustment clause in the terms of the note, whereby the principal amount of the note would automatically adjust to equal the value of the transferred debt. Tax cost of the debt. The debt-slide transactions are effective only where the tax cost of the debt to the original creditor is full; if the debt was issued at a discount or when it did not have full value (such that paragraph 69(1)(a) may have applied to reduce tax cost), the deemed loss to the creditor will be reduced and the tax cost of the debt to Subco will be less than its principal amount. In addition, care must be taken that any acquisition of control of the creditor does not take effect until after the debt-slide transactions to avoid a reduction of tax cost on the acquisition of control under paragraph 111(4)(c). 58 See MNR v. Chrysler Canada Ltd.,  2 CTC 95 (FCTD). 59 Edwin J. Byram v. The Queen,  2 CTC 149 (FCA). 60 Technical News No. 18 and Technical Interpretations and E5. Byram, id., may also apply where the lender is a minority shareholder of the borrower, if the future potential dividend stream from the shares could have been sufficient to recoup the loan. 61 Ruling R3. 62 Ruling Paragraph 85(1)(c) provides that the elected amount cannot be greater than the value of the transferred property, and paragraph 85(1)(c.1) says that it cannot be less than the lesser of the value of the transferred property and the cost amount of the transferred property. 64 Note 60, supra.
13 Alternative transactions. As an alternative to a debt-slide transaction, it should be considered whether the creditor and debtor could simply amalgamate (or effect a wind-up in a parent/subsidiary situation). Under subsections 80.01(3) and (4), no debt forgiveness will arise provided that the intercompany debt has full tax cost to the creditor; 65 the rationale behind these transactions is similar to that behind the ATR-66 transactions, in that the creditor forgoes the loss at the same time that the debtor avoids a forgiveness. It has been asserted that one of the reasons that a debt-slide transaction is considered acceptable to the CRA is that the same result could be achieved through an amalgamation or wind-up. In the 2008 ruling discussed above, 66 the CRA ruled that a debt-slide transaction was effective, even though the creditor and debtor could not have amalgamated in a tax-efficient manner. In the ruling, the creditor was a non- Canadian corporation that had moved its mind and management to Canada and thus became a resident of Canada. However, it was not a taxable Canadian corporation for purposes of the Act and so could not have amalgamated under section 87 with the debtor corporation. It should also be considered whether CanSub could simply repay the CanSub Note to Canco. In particular, Canco would capitalize CanSub with cash equal to the principal amount of the CanSub Note, and CanSub would then use these funds to repay the CanSub Note. Although the CRA sometimes views the circling of cash to repay underwater debts as abusive, 67 it should arguably be acceptable where Canco and CanSub are both Canadian corporations and the tax cost of the shares of CanSub only increases by an amount equal to the value of the CanSub Note. If so, the debt forgiveness to CanSub is avoided but Canco s loss is also eliminated. To ensure that the tax cost of the CanSub shares is increased only by an amount equal to the value of the CanSub Note (and not by the full amount of the cash contributed to CanSub), it may be necessary for Canco to first make a capital contribution to CanSub equal to the loss in the CanSub Note, followed by a second capital contribution (or share subscription) for the remainder. 68 Conclusion This article will conclude with Part 2 on Case Study #2 ( Selected U.S. Tax Consideration ). A recent CRA advance tax ruling illustrates how the tax attributes of a distressed group can be preserved through a pre-closing transfer of depreciable property to a related party. With planning, Canco may be able to apply the forgiven amount arising on the settlement of the Notes against lowvalue tax attributes instead of its more valuable tax attributes. 65 Any foreign exchange gain or loss inherent in the debt would not be realized on an amalgamation or wind-up. See Rulings R3 and R3 and Technical Interpretation E5. 66 Note 60, supra. 67 Technical Interpretations , , , and See also Interpretation Bulletin IT-293R, para See 1987 Revenue Canada Round Table Question 68 and 1988 Revenue Canada Round Table Question 36 (Canadian Tax Foundation Annual Tax Conference); Technical Interpretations and November Contact us Ron Maiorano Practice Leader, US Corporate Tax, Toronto KPMG T: E: Steven Hurowitz Partner, M&A Tax Services, Toronto KPMG T: E: The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation KPMG LLP, a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.