FEDERATED PRESS CONFERENCE TAXATION OF CORPORATE REORGANIZATION February 27, 28 and March 1, DEBT RESTRUCTURING Kathleen S.M.

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1 FEDERATED PRESS CONFERENCE TAXATION OF CORPORATE REORGANIZATION February 27, 28 and March 1, 2002 DEBT RESTRUCTURING Kathleen S.M. Hanly

2 Debt Restructuring Distress preferred shares Debt forgiveness rules Equity for debt Debt for debt Debt parking Acquisition of control planning this presentation is a simplified overview of some of the income tax aspects of debt restructuring - the summary of the debt forgiveness rules, in particular, addresses only certain provisions all section references are to the Income Tax Act (Canada) 2

3 Distress Preferred Shares Canadian resident corporate borrower (not taxable) replaces e.g. 5% interest with 3.5% dividends for up to five years - e.g. $7.5 million annual saving for $500 million of debt Lender receives comparable after-tax return because dividends deductible Need sufficient debt to justify DPS Debt must have financed Canadian business borrower must be in a loss position such that cannot use interest deductions - the borrower will prefer to make lower non-deductible dividend payments rather than higher deductible interest payments; the borrower therefore sacrifices the loss carryovers that would have been generated by interest deductions (and possibly could have been used in the future) for the present cash flow improvement; where the borrower becomes taxable within the five-year DPS term, it will unwind the DPS because on an after-tax basis interest will be less expensive than dividends there needs to be a certain level of debt in order for the savings from the distress preferred shares ( DPS ) to justify the implementation costs and ongoing administration costs - in this current era of reducing tax rates and low interest rates, the benefit from DPS has been reduced: lower tax rates mean that the creditor needs a higher dividend return to equate to its after-tax interest; lower interest rates mean that the savings from moving from interest to dividends are lower in absolute dollar terms the rule of thumb for the minimum amount of debt necessary to make DPS worthwhile was previously generally about $20 to $30 million - now that number would be substantially higher in the early 1990 s many Canadian corporations with direct or indirect investments in real estate encountered financial difficulty - loans obtained for domestic real estate projects were potentially eligible for DPS refinancing, whereas loans for foreign real estate projects were not; in recent years Canadian companies have increasingly expanded their operations outside Canada; again, debt financing for such foreign operations does not qualify for DPS 3

4 Distress Preferred Shares (cont d) Three financial distress categories BIA proposal or arrangement bankruptcy or receivership default or expected default - usual category For default category lender must deal at arm s length with borrower - this category permits use of Subco structure in simplified terms, paragraph (e) of the term preferred share definition in subsection 248(1) provides that shares will qualify as DPS for up to five years if they are issued: (i) as part of a court-approved proposal to or arrangement with the issuer s creditors under the Bankruptcy and Insolvency Act (Canada); (ii) at a time when all or substantially all of the issuer s assets are under the control of a receiver, receiver-manager, sequestrator or trustee in bankruptcy; or (iii) at a time when, by reason of financial difficulty, the issuer, or another Canadian resident corporation with which the issuer does not deal at arm s length, is in default or could reasonably be expected to default on a debt obligation held by an arm s length person, and the shares are issued directly or indirectly in exchange or substitution for the obligation or part thereof, and the proceeds from the issue of the shares may reasonably be regarded as having been used by the issuer or a non-arm s length corporation in the financing of its business carried on in Canada immediately before the issuance of the shares categories (i) and (ii) generally require that the distressed corporation issue the DPS, thereby resulting in the elimination of the distressed debt on the refinancing - in contrast, category (iii), with its reference to a non-arm s length corporation, permits the DPS refinancing to be effected by means of a transfer of the distressed debt to a subsidiary of the debtor ( Subco ) - the Subco structure enables the debt (and related security) to continue in existence and to be reacquired by the creditor when the DPS are redeemed arm s length lenders generally want to be in a position to reacquire their debt at the end of the DPS term in order to revert to creditor status with their prior debt and seasoned security - accordingly, DPS refinancings are virtually always effected in reliance on category (iii) creditors may nonetheless wish to proceed under one of categories (i) or (ii) (if available) if e.g. they do not deal at arm s length with the debtor and hence cannot qualify under category (iii) 4

5 Distress Preferred Shares (cont d) Obtain advance income tax ruling CCRA generally requires payment default, no deep-pocket shareholders, last resort financing Five-year special tax status - dividends deductible and no Part IV.1 or VI.1 taxes the Subco structure necessitates the obtaining of an advance income tax ruling because (among other things): the consequences of implementing a DPS financing and having the Canada Customs and Revenue Agency ( CCRA ) successfully challenge the DPS status are very costly: e.g. non-deductible dividends, Part VI.1 tax on dividends the default or expected default concept has an element of ambiguity (compared to the objective tests in categories (i) and (ii) referred to on the previous slide) the CCRA requires that a borrower exhaust all other viable sources of financing before it will sanction government assistance in the form of DPS for a period of five years from their issue date, the DPS are: not term preferred shares referred to in subsection 112(2.1), by virtue of paragraph (e) of the definition of term preferred share in subsection 248(1) not guaranteed shares referred to in subsection 112(2.2) by virtue of paragraph 112(2.21)(a) not subject to the dividend rental arrangement provision in subsection 112(2.3) by virtue of paragraph (a) of the definition of dividend rental arrangement in subsection 248(1) not collateralized shares referred to in subsection 112(2.4) by virtue of paragraph (c) of the definition of exempt share in subsection 112(2.6) not short-term preferred shares, by virtue of paragraph (i) of the definition of short-term preferred share in subsection 248(1) not taxable preferred shares, by virtue of the paragraph immediately preceding paragraph (c) of the definition of taxable preferred share in subsection 248(1) the non-application of the term preferred share, guaranteed share, collateralized share and dividend rental arrangement rules ensures that a financial institution can deduct dividends on DPS even though the DPS are acquired in the ordinary course of business 5

6 DPS Structure PUT AGREEMENT Borrower Lender SUPPORT AGREEMENT LOAN COMMON SHARES Subco DPS DEBT PUT/CALL AGREEMENT the borrower incorporates a new subsidiary ( Subco ) and subscribes for Subco s common shares; Subco borrows funds on a daylight loan basis to purchase the distressed loan from the lender for an amount equal to the loan principal amount; the lender subscribes for DPS for a subscription price equal to the loan principal amount; Subco uses the subscription proceeds to repay its daylight loan; Subco, the lender and the borrower enter into various agreements governing their arrangements, including: (i) a support agreement that sets out the borrower s obligations to make payments to Subco in connection with the DPS; (ii) a debt put/call agreement that gives Subco the right to put the distressed loan to the lender at any time, and gives the lender the right to call the loan on specified default events and at maturity; and (iii) a put agreement which gives the lender the right to put the DPS to the borrower on specified default events and at maturity - this put is a secondary unwind mechanism that returns the lender to creditor status, and is generally intended to be used only if the primary unwind mechanism in the debt put/call agreement is unavailable the Subco structure ensures that the existing loan and security are preserved; the debt put/call agreement ensures that the corporate solvency test is met for dividends and redemptions under the Subco structure, Subco generally pays no income or capital tax; note that if the borrower is bankrupt (and therefore exempt from large corporations tax), Subco will not be entitled to an investment allowance for large corporations tax purposes in respect of its investment in the distressed loan - this means that Subco will be subject to large corporations tax, which the borrower will have to fund; the DPS are redeemed within five years of issuance; the CCRA has in at least one instance provided an advance income tax ruling for a second five-year period on the basis that the debtor continued to qualify under the financial difficulty category 6

7 DPS Cash Flow Lender Borrower LOAN (NO INTEREST) DPS DIVIDENDS ON DPS/ REDEMPTIONS OF DPS CAPITAL CONTRIBUTIONS/ PRINCIPAL REPAYMENTS ON LOAN Subco the borrower makes capital contributions to Subco to fund the dividends on the DPS the borrower makes principal repayments on the loan to fund the DPS redemptions the CCRA stipulates in its rulings that the borrower must apply all of its excess cash flow (as defined by the CCRA) to fund principal repayments the CCRA wants to ensure, through the excess cash flow requirement, that the borrower eliminates the DPS as soon as possible and, in particular, is not able to use cash flow savings resulting from the DPS to expand its business and thereby achieve an advantage over its competitors accordingly, the excess cash flow definition effectively limits the borrower to making only those expenditures that are necessary to carry on the existing business the CCRA stated in a technical interpretation dated November 25, 1996 (document no ) that expenditures incurred to acquire a significant interest in another entity carrying on a similar business or otherwise to expand the existing business, e.g. by entering into a joint venture with such an entity, would not be permitted deductions in calculating excess cash flow 7

8 DPS Warehousing Transaction Non-resident or non-taxable domestic lender in worse position with e.g. 3.5% dividends than 5% interest because of reduced revenue - non-resident further prejudiced by increased withholding tax Warehousing permits lender to revert to interest return Warehouser protected from loss on DPS with right to put DPS to lender - compensates lender for put right non-resident lender may be receiving withholding tax-exempt interest (under subparagraph 212(1)(b)(vii)) at a rate of e.g. 5%; it will not want to receive dividends at 3.5% that are subject to 15% (treaty) or 25% (no treaty) withholding tax initially there may be a completely domestic creditor group, but once a loan goes into default lenders are often entitled to transfer their interests to third parties without restriction (resident or non-resident) - this can result in parties such as foreign vulture funds becoming part of the creditor group 8

9 DPS Warehousing Structure SALE PROCEEDS INVESTED IN U.S. BRANCH CANADIAN DOLLAR DEPOSIT SALE PROCEEDS INVESTED IN CANADIAN DOLLAR DEPOSIT U.S. Lender WITHHOLDING TAX- EXEMPT INTEREST PUT FEE Canadian Warehousing Bank INTEREST PUT FEE Canadian Non-Taxable Lender DPS PURCHASED FROM LENDERS Canadian Borrower COMMON SHARES DPS Subco the lenders sell their DPS to the Canadian warehousing bank (the Warehouser ) for an amount equal to the DPS subscription price the lenders place the DPS sale proceeds received from the Warehouser on deposit with the Canadian bank (with e.g. a U.S. branch of the Warehouser in the case of a non-resident lender to avoid Canadian withholding tax on interest on the Canadian dollar deposit (under subparagraph 212(1)(b)(ix)) the Warehouser is entitled to put the DPS back to the lenders on specified default events and at maturity and therefore does not bear the risk of loss on the DPS - if a lender fails to pay the DPS purchase price on the put, the Warehouser is entitled to set off the lender s deposit against the lender s obligation to pay the purchase price the Warehouser pays a put fee (or, alternatively, a higher deposit interest rate) for the right to put the DPS to the lenders - otherwise the Warehouser would be receiving a before-tax equivalent rate return of e.g. 5% (i.e. 3.5% dividends) which is too high given the risk taken by the Warehouser the CCRA takes the position that put fees are not deductible and has stipulated in at least one ruling that the Warehouser could not deduct the put fee (the put fee was added to the cost of the DPS) 9

10 Debt Forgiveness Rules Commercial debt obligation - incurred to earn income Debt settled for less than principal amount Forgiveness not otherwise included in income Section 80 forgiven amount reduces tax attributes in specified order: losses tax bases of assets Once tax attributes exhausted income inclusion, subject to insolvency deduction the debt forgiveness rules in section 80 apply only in respect of a commercial debt obligation, as defined in subsection 80(1), and only where the forgiveness is not otherwise included in income - this discussion assumes that any forgiven debt is a commercial debt obligation in simplified terms, subsections 80(3) to 80(12) provide that a forgiven amount reduces the debtor s tax attributes in the following order: prior year non-capital losses, prior year net capital losses, the undepreciated capital cost of depreciable property, cumulative eligible capital, resource expenditures, the adjusted cost base of capital property, other than shares and debts of corporations of which the debtor is a specified shareholder, the adjusted cost base of shares and debts of non-related corporations of which the debtor is a specified shareholder, the adjusted cost base of shares and debts of related corporations, current year capital losses less current year capital gains in simplified terms, 50% of any remaining forgiven amount that is not transferred to an eligible transferee under section is included in the debtor s income under subsection 80(13), subject to a deduction available to insolvent corporations under section the insolvency deduction effectively limits a corporation s subsection 80(13) income inclusion to two times its net asset value - see also section 61.4, which permits a taxpayer to recognize a subsection 80(13) income inclusion over five years post-acquisition of control loss carryforward restrictions are generally ignored for the purposes of absorbing a forgiven amount in respect of a debt obligation that was issued before the acquisition of control (see the definition of relevant loss balance in subsection 80(1)) 10

11 Transfer of Forgiven Amount Debtor can transfer forgiven amount to related Canadian corporation under section Note interaction among allocation to related corporation shares and debt, income inclusion and section transfer - residual balance concept Debtor jointly and severally liable for transferee tax up to 30% of transferred forgiven amount for 4 years the rules governing the transfer of forgiven amounts are set out in section the transfer is effected by filing an election a debtor can transfer a forgiven amount to an eligible transferee - the term eligible transferee is defined in subsection 80.04(2) and includes a related taxable Canadian corporation in order to transfer a forgiven amount under section 80.04, the debtor must first exhaust its subsection 80(5) to (10) tax attributes the debtor is liable under subsection 80.04(10), to the extent of 30% of the transferred forgiven amount, to pay the eligible transferee s taxes (and interest and penalties in respect thereof) for taxation years ending in the four calendar years after the settlement of the debt that is the subject of the section election 11

12 Equity for Debt 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 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 paragraph 80(2)(g) provides that a debtor that issues shares (other than excluded securities) to a creditor in satisfaction of a debt held by the creditor is deemed to have paid an amount in satisfaction of the debt equal to the fair market value of the issued shares paragraph 80(2)(g.1) provides that where a debt is settled, the debtor is deemed to have paid an amount equal to any increase, as a result of the settlement, in the fair market value of shares held by the creditor (other than shares issued in settlement of the debt) 12

13 Debt for Debt Often preferable to issue debt rather than equity since value of debt 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 where have non-resident holder Often have forgiveness of some debt, replacement debt (interest-bearing), equity kicker where there is insufficient value to support a debt to equity conversion, it may be preferable to convert debt to new debt, e.g. with a lower (or nil) interest rate - note, however, that an interest-free or low-interest loan may not be attractive where the creditor is a non-resident (e.g. a non-resident parent corporation) that is required to accrue interest at a market rate in its home jurisdiction even though it receives no interest stop-loss rules may apply to creditors that replace their existing debt with new debt 13

14 Non-Resident Creditors - 212(1)(b)(vii) Debt Replacement obligation - 212(3) issued in exchange or substitution for 212(1)(b)(vii) obligation BIA proposal or arrangement, receivership or bankruptcy, default or expected default Canadian business - Finance comfort letter subsection 212(3) provides that in specific circumstances a replacement debt for a subparagraph 212(1)(b)(vii) obligation will continue to qualify for the withholding tax exemption and will not be treated as a new obligation absent subsection 212(3), if new debt were issued in satisfaction of a subparagraph 212(1)(b)(vii) obligation, time would start to run again for the purposes of the five-year/25% test; depending on the new maturity date and other terms and conditions of the new debt, this could result in the new obligation failing to satisfy the subparagraph 212(1)(b)(vii) requirements the financial distress categories in subsection 212(3) are the same as those for distress preferred shares - in simplified terms, a replacement obligation issued in satisfaction of a subparagraph 212(1)(b)(vii) obligation is deemed to have been issued at the time the original obligation was issued, where the replacement obligation is issued: (i) as part of a court-approved proposal to or arrangement with the borrower s creditors under the Bankruptcy and Insolvency Act (Canada); (ii) at a time when all or substantially all of the borrower s assets are under the control of a receiver, receiver-manager, sequestrator or trustee in bankruptcy; or (iii) at a time when, because of financial difficulty, the issuer of the replacement obligation, or a non-arm s length Canadian resident corporation, is in default or could reasonably be expected to default on the original obligation, and the proceeds from the replacement obligation can reasonably be regarded as having been used by the issuer or a non-arm s length corporation in financing its active business carried on in Canada immediately before the replacement obligation was issued the Department of Finance issued a comfort letter in 2001 saying that it would recommend in the next set of technical amendments that the Canadian business requirement in paragraph 212(3)(b) be eliminated for replacement obligations issued after June 10,

15 Non-Resident Creditors - 212(3) N/A 212(3) may not apply because e.g. proceeds used outside Canada If amending terms, must ensure not creating new obligation which would result in fiveyear period starting again BEWARE General Electric case Next Canada-U.S. Protocol in General Electric Capital Equipment Finance Inc. v. The Queen, 2002 DTC 6734 (FCA), the Federal Court of Appeal held that new debt obligations had been created when the principal amounts of four promissory notes were reduced (by set-off, against the respective principal amounts, of withholding tax that the debtor had paid), the interest rates were increased to cover the withholding tax and the maturity dates were changed the debtor paid withholding tax on interest on the notes because it did not deal at arm s length with the holders of the notes; the notes apparently otherwise qualified under subparagraph 212(1)(b)(vii); the debtor was later transferred to an arm s length purchaser - the issue of whether new obligations had been created determined whether withholding tax was exigible on interest payments following the transfer the Court stated (at 6738): These represent substantial changes to fundamental terms of the obligations and have the effect of materially altering the terms of the original promissory note. I am of the view that when it can be said that substantial changes have been made to the fundamental terms of an obligation which materially alter the terms of that obligation, then a new obligation is created within the meaning of subpara. 212(1)(b)(vii) of the Act. it is by no means clear that the decision in this case is correct - e.g. the reduction in the principal amount in these circumstances was simply a partial repayment through set-off (and is expressly permitted under subsection 215(6)) - the taxpayer has sought an extension of the period for filing a leave to appeal to the Supreme Court of Canada note that under the next Protocol to the Canada-United States Income Tax Convention (1980), as amended, it is expected that arm s length U.S. residents will be able to receive Canadian-source interest free of Canadian withholding tax; if this occurs, one would expect (subject to the coming into force provisions) that U.S. treaty beneficiaries who deal at arm s length with Canadian debtors will not have to be concerned about whether a new debt has been created on a restructuring of a subparagraph 212(1)(b)(vii) debt 15

16 Debt Parking Parked obligation = specified obligation held by non-arm s length or significant interest holder Significant interest = shares with 25% votes or value the term parked obligation is defined in subsection 80.01(7) in simplified terms, subsection 80.01(2) provides that a person has a significant interest in a corporation if the person owns: shares with at least 25% of the votes attaching to the corporation s shares, or shares with at least 25% of the fair market value of all the corporation s shares for the purposes of determining whether the 25% threshold has been reached, shares owned by non-arm s length persons are aggregated a deduction is available under subsection 80.01(10) where a parked debt that has triggered the forgiveness rules is subsequently repaid note that in the case of Jabin Investments Ltd. v. The Queen, 2001 DTC 1002 (TCC), the Tax Court of Canada held that a debt parking transaction under the old debt forgiveness rules was not subject to the general antiavoidance rule; the Court concluded that since the debt parking avoided the application of section 80, section 80 was not being used and therefore was not being misused; also, since the debt had not been legally extinguished, the policy behind the Act with respect to the settlement of debts had not been abused 16

17 Debt Parking (cont d) Specified obligation at previous time a 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) the term specified obligation is defined in subsection 80.01(6) 17

18 Debt Parking (cont d) Order irrelevant: debt holder becomes significant interest shareholder, OR significant interest shareholder becomes debt holder Debt becomes parked AND tax cost to holder < 80% principal amount debt deemed settled at tax cost forgiven amount = principal amount - tax cost the deemed settlement provision for parked debt is subsection 80.01(8) debt owing to a non-related person is deemed under subsection 80.01(9) to have been settled when it becomes statute-barred 18

19 Sale of Shares and Debt - Debt Parking Canadian Vendor Purchaser DEBT SHARES DEBT SHARES Target Target DEBT FMV = $1 DEBT PRINCIPAL AMOUNT = $100 DEBT = PARKED DEBT $99 FORGIVENESS assume that: the Canadian vendor wholly-owns the target, the debt held by the vendor represents advances made by the vendor and the vendor has not claimed a bad debt loss under subsection 50(1) the Canadian vendor wants to sell the shares and debt of the target to an arm s length purchaser but the purchaser does not want the target s non-capital losses to be eroded by debt forgiveness if the Canadian vendor sells the debt to the purchaser for $1, the debt becomes parked debt on the purchase and triggers a forgiven amount of $99 19

20 Sale of Shares and Debt (cont d) 40(2)(e.1) DENIES LOSS ON TRANSFER OF DEBT 53(1)(f.1) ADDS DENIED LOSS TO ACB OF DEBT TO NEWCO DEBT Canadian Vendor Target Newco SHARES SHARES Canadian Vendor Target SHARES DEEMED SETTLEMENT OF DEBT AT ACB ON WINDING-UP OF NEWCO (80.01(4)) consider the following pre-disposition steps: the Canadian vendor sells the debt in the target to a newly-formed wholly-owned subsidiary of the target ( Newco ) at its fair market value of $1 - paragraph 40(2)(e.1) denies the Canadian vendor the loss on the transfer and paragraph 53(1)(f.1) adds the loss to the adjusted cost base to Newco of the debt Newco is wound up into the target and the debt is deemed to have been settled at its adjusted cost base to Newco under a subsection 80.01(4) election the debt does not become parked debt on the transfer to Newco because the debt is not a specified obligation of the target because the debt was previously owned by a person (i.e. the Canadian vendor) who did not deal at arm s length with the target and because Newco purchased the debt from a related person note that subsection 40(3.3) provides that the inter-affiliate stop-loss rule in subsection 40(3.4) does not apply to dispositions listed in paragraphs (c) to (g) of the definition of superficial loss in section 54 - paragraph (e) of this definition refers to dispositions to which paragraph 40(2)(e.1) applies - paragraph 40(2)(e.1) denies a loss to a taxpayer that transfers a debt obligation to a transferee, where the transferor, transferee and debtor are all related to each other the CCRA issued a ruling on this type of transaction in ATR-66 under the old forgiveness rules and stated that GAAR would not apply because the Canadian vendor is eliminating its ability to claim a loss on the debt as a trade-off for eliminating the debt forgiveness - in the ruling Newco issued a promissory note with a principal amount equal to the fair market value of the debt and that note was assumed by the target on the winding-up of Newco - the Canadian vendor then transferred the note to the purchaser - under the new rules, a transfer of such a note to the purchaser would not result in debt parking because the cost to the purchaser of the note would be the same as its principal amount - see also CCRA document no dated November 14, 1997 a similar result could also be achieved by transferring both the shares and debt of the target to a newly-formed wholly-owned subsidiary of the vendor in return for shares and then amalgamating the target and the subsidiary and selling the shares of the amalgamated entity 20

21 Acquisition of Significant Interest Existing Shareholder Creditor 100% 75% COMMON SHARES 0 25% COMMON SHARES DEBT ACB = $1 DEBT PRINCIPAL AMOUNT = $100 Debtor assume that an investor acquires debt at a discount of more than 20% if a creditor acquires shares of the debtor in the course of a restructuring of the debtor, the debt will become parked and will trigger forgiveness if those shares represent a significant interest in the debtor, i.e at least 25% of votes or value note that the debtor does not necessarily know what the forgiven amount is since it does not necessarily know the creditor s tax cost on a debt restructuring that involves the issuance of equity, it may therefore be desirable to prohibit a creditor from acquiring shares at or above the 25% threshold again, in determining whether the 25% equity threshold has been reached, non-arm s length shareholdings are aggregated - in this connection, a group of unrelated creditors with an aggregate equity interest of 25% or more generally should be considered to be dealing at arm s length with each other (i.e. not acting in concert); accordingly the creditors generally should not be considered to have a significant interest in the debtor in these circumstances 21

22 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 22

23 Triangular Restructuring Old Debtor REDUCTION OF DEBT Creditors ASSETS New Debtor SHARES AND NEW DEBT the consideration for the transfer is the issuance by the new debtor of shares and new debt to the old debtor s creditors the creditors agree to eliminate a corresponding amount owed to them by the old debtor 23

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