In the post-enron world, many financing transactions

Tax Consequences of Debt Restructuring And Workouts in Canada by Jack Bernstein, Kay Leung, and Henry Chong Jack Bernstein, Kay Leung, and Henry Chong are with Aird & Berlis LLP in Toronto. In the post-enron world, many financing transactions have come under scrutiny from both regulators and shareholders. Both are concerned with achieving greater transparency and reliability of financial statements. Parties involved in debt restructuring and workouts have been more sensitive to tax consequences. This article reviews debt forgiveness rules in Canada s Income Tax Act (the act) and addresses the tax consequences of altering existing debt obligations. I. Debt Forgiveness It is difficult to restructure corporate debt without considering debt forgiveness rules. Section 80 of the act contains most of those rules, which have remained mostly unchanged since 1994. A. Position of the Debtor In general terms, debt forgiveness rules apply when a commercial obligation of a debtor is settled and there is a forgiven amount. Subsection 80(1) defines a commercial obligation to include a commercial debt obligation. That is defined in the same subsection as a debt obligation on which interest paid or payable by the debtor under a legal obligation (or if interest had been so paid or payable) was (or would have been) deductible to the debtor (or would have been deductible but for rules in the act that otherwise preclude deduction of interest). Any debt incurred for the purpose of earning income from a business or property is included in the definition. A personal debt on which interest is not deductible does not fall within the definition. The use of the borrowed money determines whether it is a commercial debt obligation. If the debtor has deducted interest on the loan, it is likely that the debt is a commercial debt obligation subject to debt forgiveness rules. Paragraph 80(2)(a) says an obligation is settled by the debtor when the obligation is settled or extinguished (other than by a bequest or inheritance or in consideration for the issuance of particular shares). Forgiven amount is also defined in subsection 80(1). In general, it is the amount of the debt that remains unpaid upon the settlement, minus the amount paid by the debtor in satisfaction of the principal amount of the obligation and other amounts. For example, any amount of the obligation included in the debtor s income under paragraph 6(1)(a) and subsection 15(1) (the employee and shareholder benefit provisions, respectively) reduces the forgiven amount. As a result, forgiven employee and shareholder loans are included in income under paragraph 6(1)(b) and subsection 15(1), respectively, and are not subject to the debt forgiveness rules. The forgiven amount is reduced by the principal amount of the obligation if the debtor is bankrupt. Under paragraph 80(2)(b), interest payable is deemed to be an obligation that has a principal amount and was issued by the debtor for an amount equal to the amount deductible or that may be capitalized under subsection 18(2) or (3.1) or section 21. When a debtor s commercial obligation is settled, the forgiven amount is applied to reduce tax attributes of the debtor in the order described below: Noncapital Loss Carryforwards. The debtor s forgiven amount is applied to reduce, in order, noncapital losses, farm losses, and restricted farm losses from prior years to the extent they would be deductible in the current year. The reduction of loss carryforwards is mandatory. Losses are reduced in the order they arose. Losses that have expired are not reduced (subsection 80(3)). Capital Loss Carryforwards. Any remaining forgiven amount is used to reduce, in order, allowable business investment losses and net capital losses from prior years to the extent they would be deductible in the current year. Those reductions are also mandatory. Again, the loss carryforwards are reduced in the order they arose (subsection 80(4)). Depreciable Properties. Any remaining forgiven amount may be used, to the extent designated by the debtor in a form filed with the year s tax return, to reduce the capital cost of Tax Notes International October 17, 2005 287

depreciable properties and the undepreciated capital cost of depreciable properties of a prescribed class (subsection 80(5)). Eligible Capital Properties. Three-quarters of any remaining forgiven amount may be used, to the extent designated by the debtor, to reduce the debtor s cumulative eligible capital in the debtor s businesses (subsection 80(7)). Resource Pools. Any remaining forgiven amount may be used to reduce, to the extent designated by the debtor, particular resource pools (subsection 80(8)). Nondepreciable Capital Properties. The debtor may apply any remaining forgiven amount (assuming the maximum designations permitted under subsections 80(5), (7), and (8) have been made) to reduce the adjusted cost base of capital properties as designated in a form filed with the debtor s tax return. First, the adjusted cost bases of capital properties may be reduced, except for: (1) shares of corporations in which the debtor is a specified shareholder; (2) debts issued by those corporations; (3) interest in partnerships related to the debtor; (4) depreciable property not in a prescribed class; (5) personal use properties; and (6) excluded properties (subsection 80(9)). Next, and only if the maximum amount was designated under subsection 80(9), the adjusted cost base of any shares of, or debt issued by, a corporation of which the debtor is a specified shareholder can be reduced (subsection 80(10)). In general, a debtor is a specified shareholder if he and any non-arm s-length parties own 10 percent or more of any class of shares of a corporation. If the maximum amount has been applied under subsections 80(9) and (10), subsection 80(11) allows the debtor to apply any remaining amount to reduce the adjusted cost bases of shares, debt held in related corporations, and interests held in related partnerships. Reduction of Current Year Capital Losses. If the debtor has designated the maximum amounts possible under subsections 80(5), (7), (8), and (9) to (11), any remaining forgiven amount is deemed to be a capital gain of the debtor in the year to the extent of the debtor s capital losses in the current year from dispositions of capital properties (subsection 80(12)). Income Inclusion. For individuals, corporations, and trusts, one-half of any remaining forgiven amount is included in the debtor s income under subsection 80(13). When the debtor is a partnership, the entire forgiven amount is included in the partnership s income. For corporations, if there is an eligible transferee of the debtor at the time the obligation is settled, the debtor can transfer any portion of the remaining forgiven amount to the eligible transferee under section 80.04. An eligible transferee is a related taxable Canadian corporation, a related eligible Canadian partnership, or a directed person of the debtor. Directed person is defined in subsection 80(1). It generally means a taxable Canadian corporation or eligible Canadian partnership that either controls the debtor or is controlled by the debtor, the debtor and related parties, or a person or persons who also control the debtor. Thus, the remaining forgiven amount can be applied to reduce the transferee s various tax attributes, rather than forcing an immediate income inclusion to the debtor under subsection 80(13). If the debtor chooses a subsection 80(11) reduction instead of making a transfer under section 80.04, the lesser of the 80(11) reduction and the amount that could have been transferred to the transferees is added into the debtor s income under subsection 80(13). When a debtor has an income inclusion under subsection 80(13), a reserve may be available for the amount. Section 61.2 provides a reserve for Canadian resident individuals other than trusts. In effect, it allows a deductible reserve to the extent the forgiven amount included under subsection 80(13) exceeds 20 percent of the debtor s income (determined without reference to the debt forgiveness) in excess of C $40,000. For example, assume that the individual has income for the year of C $100,000 and that there is a net income inclusion of C $50,000 based on the foregoing rules. The individual would have to include only C $12,000 per year (20 percent times C $60,000). It does not apply if the forgiven amount is on a debt payable by the individual or by a partnership in which the individual is a member. If the individual has not taken advantage of the maximum designations set out above, the minister of national revenue has the authority under subsection 80(16) to reduce the tax attributes. A reserve may be claimed in the year of death with no requirement for an addback in the subsequent year. However, a settlement that occurs within six months after death is deemed to occur at the beginning of the day of the individual s death. A corporation resident in Canada, a trust resident in Canada, or a nonresident carrying on business in Canada can claim a reserve under section 61.4 to spread the income inclusion required by subsection 80(13) over five years. In the first year, the debtor may deduct up to four-fifths of the income inclusion under section 61.4. That amount is added back in the subsequent year under section 56.3, and the debtor may deduct up to three-fifths of the original 288 October 17, 2005 Tax Notes International

income inclusion. The reserve amount becomes twofifths and then one-fifth for the subsequent two years. Section 61.3 addresses insolvent corporations. A deduction is available that essentially limits the income inclusion required by the debt forgiveness rules to twice the corporation s net assets. On the basis of an assumed corporate rate of 50 percent, the income inclusion will not result in the corporation s liabilities exceeding the fair market value of its assets. The minister of national revenue may reduce the tax attributes of the debtor corporation that have not already been reduced if the corporation claims a deduction under section 61.3. The amount claimed as a deduction will also reduce the corporation s scientific research and experimental development balance. The debt forgiveness rules also operate at the partnership level to determine whether there is an unforgiven amount in excess of the tax attributes of the partnership. The full amount of the income inclusion is then allocated to persons who are partners at the end of the year. 1 There is no reserve available to a partnership to mitigate the income inclusion. Instead, it is claimed by the partner. 2 If an active partner has advanced funds to a partnership and that amount is forgiven or settled, no forgiven amount arises. A partnership cannot designate amounts under subsections 80(9), (10), or (11) so that the adjusted cost base of property is reduced to less than its fair market value at that time. 3 That should prevent a partnership from acquiring capital properties to minimize the effect of section 80. The reduction of the cost base of capital properties will be restricted to the adjusted cost base of the properties. If not for that provision, a capital loss could arise on the disposition of the partnership interest. Relief is provided for a partner that has undeducted loss carryforwards and resource expenditure pools attributable to the partnership. 4 Subsection 80(15) provides that a member may not claim a deduction in excess of the amount that would be the partner s income if the partnership had made the maximum designations under subsections 80(5) to (10) on the forgiven amount. The partner would then have to reduce his or her tax attributes by that amount, including the adjusted cost base of the partnership interest. However, if the person is related to the partnership, the individual must have 1 Subsection 80(13). 2 Section 61.2. 3 Subsection 80(18). 4 Subsection 80(15). made the maximum designations under subsections 80(5) to (10) to reduce its tax attributes for that to be effective. 5 To the extent that a balance remains, an individual will be taxable on one-half of the amount under subsection 80(13), but will be entitled to benefit from the reserve mechanism outlined above. Debt parking occurs when a debt (that is, a specified obligation as defined) is transferred at a discount to a person who is not at arm s length with the debtor or who has a significant interest in the debtor, when the objective is to keep the loan outstanding and to avoid the application of the debt forgiveness rules. That was a common practice in the sale of loss companies when losses were financed with shareholder advances. The use of the borrowed money determines whether it is a commercial debt obligation. The debt parking rules essentially deem the amount paid by the non-arm s-length person to be the amount paid to settle the debt. The difference between the face value of the debt and the amount thus paid is treated as forgiven, and the ordinary tax consequences of the debt forgiveness rules will apply. A threshold allows debt to be acquired at a 20 percent discount (or less) without the application of the debt parking rules. Subsections 80.01(6) through (8) contain provisions regarding debt parking. Those rules apply when an obligation issued by a debtor to one creditor is transferred to another creditor related to the debtor or who has a significant interest in the debtor. The debt must be a parked obligation, or an obligation that is a specified obligation 6 and the holder of the obligation does not deal at arm s length with the debtor or, when the debtor is a corporation, has a significant interest 7 in the debtor. 5 Subsections 80(11) and (13) and section 80.04. 6 A specified obligation is issued by a debtor when a person who owned the obligation dealt at arm s length with the debtor and when the debtor is a corporation that did not have a significant interest in a debtor or the obligation was acquired by the holder of the obligation from another person who was, at the time of the acquisition, not related to the holder or the obligation is deemed by subsection 50(1) to be reacquired. 7 Significant interest is also defined as a person who owns shares in the capital stock of the corporation that would give the person 25 percent or more of the votes that could be cast under all circumstances at an annual meeting of shareholders or shares of the capital stock of the corporation having a fair market value of all the issued shares of the capital stock of the corporation. Tax Notes International October 17, 2005 289

II. Position of the Creditor As mentioned above, section 80 applies only to determine the tax position to the debtor, but has no application to the creditor. If a creditor holds a debt obligation as capital property, the general rule in paragraph 40(1)(b) of the act provides that, when capital property is disposed of in the year, the taxpayer has a capital loss equal to the difference between the adjusted cost base of the debt obligation plus any costs of disposition minus the proceeds of disposition. Under subparagraph 40(2)(g)(ii), a taxpayer s capital loss on the disposition of a debt or other right to receive an amount is nil unless the debt was acquired to gain or produce income from a business or property (other than exempt income), or the debt was acquired by the taxpayer as consideration for the disposition of capital property to a person with whom the taxpayer was dealing at arm s length. If an active partner has advanced funds to a partnership and that amount is forgiven or settled, no forgiven amount arises. A taxpayer need not dispose of the debt obligation to claim a loss. Paragraph 50(1)(a) deems a creditor to have disposed of a debt at the end of the year and to have reacquired it immediately thereafter at a cost equal to nil when the taxpayer establishes that the debt (other than a debt owing to him on the disposition of personal use property) became a bad debt in that year. Bad debt is not defined in the act. Whether a debt has become a bad debt during the year is a question of fact. In Interpretation Bulletin IT-159R3, paragraph 10, the Canada Revenue Agency (CRA) holds that a debt is not a bad debt at the end of a tax year unless the debtor is insolvent and has no means of repaying it or the creditor has exhausted all legal means of collecting it. A debt is considered to be bad for the purposes of section 50 only when the whole amount is uncollectible or when a portion of it has been settled and the remainder is uncollectible. Section 50 may not provide full relief to the creditor even though, for accounting purposes, a loan must be written down. When a taxpayer establishes that an amount receivable is a bad debt in the year, but subparagraph 40(2)(g)(ii) denies the resulting capital loss, the CRA takes the position that paragraph 50(1)(a) does not apply. There will be no deemed disposition or reacquisition of the debt. Any realization of the debt in future years will reduce the adjusted cost base thereof rather than produce a capital gain. When subsection 50(1) applies, the debt is deemed to be disposed of for tax purposes. If the debt is owed by a small-business corporation (except when it is owed to a corporation by a non-arm slength corporation), the resulting capital loss qualifies as a business investment loss. One-half of that loss is deductible against any other income. When a debt obligation is not held as capital property, a taxpayer whose ordinary business includes lending money may deduct from income the amortized cost of a loan when he can establish that it has become uncollectible in the year under subparagraph 20(1)(p)(ii). That condition would easily be satisfied when section 80 applies, particularly when there is a written agreement to that effect. Alternatively, a creditor whose ordinary business includes lending money may be entitled to a reserve under paragraph 20(1)(l) on a doubtful debt. It is a temporary reserve, and the amount deducted in one year is added back to the income of the taxpayer for the next year. When the obligation has not been settled or extinguished, a creditor who has deducted an amount under paragraph 20(1)(p) on a bad debt must include in income any amount later recovered on that debt. III. Alterations of Debt Obligations A. Changes to Terms of Debt Instrument When refinancing indebtedness, it is important to ensure that the debt obligation has not been disposed of and replaced with another debt obligation, or section 80 may apply. For a debt obligation to be extinguished at common law, there must be accord and satisfaction (that is, payment) or a novation. Novation is the annulment of one debt and the creation of a substituted debt in its place. At common law, altering the terms of a debt obligation generally does not result in a novation. Contrary to the common law, the CRA takes the position that section 80 may apply when the terms of a debt obligation are changed. Specifically, the CRA holds that some changes in a debt security are so fundamental that they almost invariably precipitate a disposition 8 of the original security. Those changes include: a change from interest-bearing to interest-free, or vice versa; a change in repayment schedule or maturity date; an increase or decrease in the principal amount of the debt; the addition, alteration, or elimination of a premium payable upon retirement; a change in the debtor; and 8 Interpretation Bulletin IT-448. 290 October 17, 2005 Tax Notes International

the conversion of a fixed interest bond to a bond for which interest is payable only to the extent that the debtor has made a profit, or vice versa. Despite the CRA s position in IT-448, it relaxed its position in Technical News No. 14 and stated that if a debt obligation is renegotiated otherwise than as provided for in its original terms, the determination of whether a change in its terms is a substitution of a debt obligation for another should be made in accordance with the law of the relevant jurisdiction. In other words, the CRA has accepted that whether or not a disposition occurs depends on the applicable law. The CRA stated that rescission of a debt obligation will be implied when the parties have effected such an alteration of its terms as to substitute a new obligation in its place, which is entirely inconsistent with the old, or, if not entirely inconsistent with it, inconsistent with it to an extent that goes to the very root of it. In such a case, it is appropriate to view the original obligation as having been disposed of for income tax purposes. In Ontario, rescission occurs only when the changes go to the very root of the original agreement such that there is patent the intention to completely extinguish the first contract, not merely alter it, however extensively, in terms which leave the original subsisting. 9 In Amirault v. The Queen, 90 DTC 1330, the Tax Court considered whether the employee entered into a new stock option agreement. The taxpayer was granted an option in accordance with a stock option plan of his employer. The plan originally offered an opportunity to purchase the shares of the employer at 10 percent below market value. However, when a potential tax problem was identified, the taxpayer agreed to amend the option by substituting a purchase price at the market value on the day the original option was granted. The taxpayer exercised his option rights and claimed a deduction on the basis that he purchased the stock option at fair market value. The minister of national revenue reassessed him, claiming that a new agreement had been entered into and that the new price did not equate with market value on the day the new agreement was made. The court held that no new agreement had been made. It stated: The determination of whether a subsequent agreement has effected a rescission, as opposed to a simple variation, of an earlier agreement depends on the intention of the parties to be gathered from an examination of the subsequent agreement and from all the surrounding 9 See Niagara Air Bus Inc. v. Camerman (1990) 69 O.R. (2d) 717 (Ont. H.C.); rev d by Ont. C.A. on different grounds, (1991) 3 O.R. (3d) 108. circumstances: United Dominion Trust (Jamaica) Ltd. and Michael Mitri Shoucair, [1969] 1 A.C. 340, at page 348. Citing the House of Lords decision in Morris v. Baron [1918] AC 1, the court stated that a written contract may be rescinded by parol either expressly or by the parties entering into a parol contract entirely inconsistent with the written one, or, if not entirely inconsistent with it, inconsistent with it to an extent that goes to the very root of it. The court held that what constitutes a change that goes to the very root of a contract so as to create a rescission depends on the facts of each case. For a debt obligation to be extinguished at common law, there must be accord and satisfaction or a novation. Similarly, in Carma Developers Ltd. v. The Queen, 96 DTC 1798, the taxpayer, CDL, was a wholly owned subsidiary of CL. CDL was heavily indebted to several classes of creditors, particularly operating lenders, project lenders, and debenture holders. The lenders had charges on specific properties of CDL. CDL experienced financial difficulties and sought protection under the Companies Creditors Arrangement Act. A plan was worked out and was filed with and approved by the courts. The CDL plan provided that the creditors assigned to CL the unsecured portion of the indebtedness owed to them by CDL and obtained shares in CL. After the implementation of the CDL plan, the creditors owned about 75 percent of the shares of CL, which in turn owned the debts of CDL assigned to it by the creditors. The minister of national revenue assessed CDL on the basis that the debts of CDL had been settled or extinguished under section 80. The minister of national revenue reduced CDL s capital and noncapital loss carryforwards, the capital cost of its depreciable property, and the adjusted cost base of its nondepreciable capital property. The court held that CDL s debts were not extinguished by novation. There was no new contract. The only difference was the creditor. The court made the following statement on the concept of novation: A novation involves the creation of a new contractual relationship, generally where a debtor is released from its obligation to an obligee with the consent of the obligee and the assumption of the obligation by a third party so that a new obligation arises between the obligee and the third party. Here there is no new contract. The same debt of CDL continues to exist. Only the creditor has changed as the result of the assignment. Tax Notes International October 17, 2005 291

More recently, in Gibralt Capital Corporation v. The Queen, 2002 DTC 1601 (aff d by FCA, 2003 DTC 5270), novation was argued in the context of section 80. A businessman was the sole shareholder of a large group of corporations. The businessman, through personal guarantees, owed the bank C $32 million. A friend of the businessman paid C $10 million to the bank in final payment of the C $32 million debt. His friend, through his corporation, Cal-Con, took assignment of the C $32 million. As a result of a master settlement agreement, the businessman and Cal-Con entered into a new debt restructure agreement in 1993 wherein the businessman turned over many of his assets to Cal-Con. Cal-Con forgave approximately C $16 million. Provincial, a corporation owned by the businessman, was allocated the C $16 million debt. In filing its return for its 1995 tax year ending January 31, 1995, the corporate taxpayer, Gibralt, as the successor to Provincial by amalgamation, reported a reduction in Provincial s noncapital loss carryforward of C $16 million and carried forward from Provincial s 1993 tax year noncapital losses of C $428,890 to reduce its 1995 income to nil. Gibralt s original filing of its 1995 return was done on the assumptions that section 80 of the act applied and that it had sufficient noncapital losses to offset the additional forgiveness of the C $16 million debt. However, Provincial s noncapital losses were disallowed by the minister of national revenue, and Gibralt refiled, arguing that section 80 did not apply. The minister, however, applied section 80. The court found that a new debt obligation was created although no novation occurred. At the Tax Court, Gibralt argued that the C $16 million debt was not a commercial debt obligation under subsection 80(1). Gibralt submitted that when the C $16 million debt was severed and allocated to the different parties under the master settlement agreement, and the other parties were later released, it resulted in a novation. Through the novation, Provincial assumed a new debt legally distinct from the original debt. The new debt, it was argued, was not connected to any source of income, so interest was not and could not have been deductible. The Tax Court found Gibralt s argument untenable. In its view, no novation occurred. In support of its conclusion, it cited the Supreme Court of Canada s decision in National Trust Co. v. Mead, [1990] 5 W.W.R. 459: A novation is a trilateral agreement by which an existing contract is extinguished and a new contract brought into being in its place. Indeed, for an agreement to effect a valid novation the appropriate consideration is the discharge of the original debt in return for a promise to perform some obligation....thecreditor may no longer look to the original party if the obligations under the substituted contract are not subsequently met as promised....assent is the crux of novation. The court found that there was no evidence of the parties assenting to novation. It remarked: In National Trust, supra, the Supreme Court added that The essence of novation is the substitution of debtors. The Appellant argues that with regard to the $9 million, Provincial was substituted for the other joint and several creditors and that a new obligation arose between Provincial and the Appellant. I find that substitution of debtors contemplates a complete substitution. Presently, we have the individual assumption of a joint and several debt by each of the original joint and several debtors and not the substitution of debtors as contemplated by novation. The cases seem to suggest that when novation or rescission does not occur, there is no new debt obligation, which, in our opinion, is consistent with the common law. In contrast, in General Electric Capital Equipment Finance Inc. v. The Queen, 2002 DTC 6734, 10 the court found that a new debt obligation was created although no novation occurred. In Canada, interest paid by a Canadian resident to a nonresident is generally subject to withholding tax at the rate of 25 percent. However, if the requirements of the domestic withholding tax exemption in subparagraph 212(1)(b)(vii) are met, a Canadian corporation may borrow money from a nonresident lender and be exempt from paying a 25 percent withholding tax on interest payments made to the nonresident lender. A nonresident lender is exempt from withholding tax if the borrower is not required to pay more than 25 percent of the principal amount of the loan within five years from the date of issue. The five-year period may be shortened and still qualify for the exemption in the event of failure or default under the said terms or agreement. 11 10 Leave to appeal to the Supreme Court of Canada was denied on October 3, 2002. 11 The CRA considers an event of failure or default under the terms of a loan agreement to be an event that has commercial reality, is beyond the control of the lender and is therefore not contrived....anevent that occurs as a consequence of an act by a person or persons who are not a party to the loan agreement is usually not considered a failure or default under the terms of the loan agreement. A default in payment under the loan, a breach of the credit covenants in the loan agreement, a failure to achieve or maintain financial ratios required by the loan agreement, or a change of control (Footnote continued on next page.) 292 October 17, 2005 Tax Notes International

In the General Electric decision, the issue was whether amendments to the terms of a financing agreement so materially altered the agreement as to result in the creation of a new obligation and the rescission of the original obligation. One of GE s predecessors, International Harvester Credit Corp. of Canada Limited (IHCC) (indirectly owned by International Harvester Co. (IHCo)), financed retail and wholesale sales in Canada of International Harvester products. While raising capital for its financing business from March 15, 1977, to August 8, 1980, IHCC issued four subordinated promissory notes with maturity dates that differed by at least five years from the original issue date to two Bermudan corporations and one U.S. corporation, all part of the IHCo group. The notes did not meet the requirements of the exemption in subparagraph 212(1)(b)(vii) because the beneficial owners of the notes did not deal at arm s length with IHCC. For some unknown reason, IHCC did not pay withholding tax on the interest paid to the non-arm s-length parties, and it was reassessed in 1984 by the minister of national revenue. IHCC paid the applicable withholding taxes. Several changes were then made to the promissory notes. In separate agreements dated February 18, 1985, the beneficial owner of each of the promissory notes sold them to a Netherlands corporation, Harneth, also indirectly owned by IHCo. (The minister did not, however, dispute that IHCC and Harneth dealt at arm s length at the time the interest was paid.) In each case, interest on the applicable note was payable at such a rate as to result in the holder receiving, after the application of any applicable withholding tax, a net return equal to the rate of interest stated on the face of that note. The principal amount of each note was also reduced by the amount of the withholding tax payment IHCC had made on behalf of the holder as a result of the 1984 assessment. On December 18, 1986, the shares of IHCC were sold to Genelcan Limited, an arm s-length party and subsidiary of GE. At the time of the transfer, none of the notes had been repaid. Hence, Genelcan caused IHCC to pay in full all amounts owing on account of the outstanding principal and accrued and unpaid interest on the notes held by Harneth. IHCC paid Harneth all amounts owing under the notes without remitting withholding tax on the interest payments. The minister assessed IHCC (now known as GE) for withholding tax on the interest it had paid on the notes. GE argued that, under subparagraph 212(1)(b) (vii), withholding tax was not exigible because the of the borrower are some examples that may constitute a failure or default, if specified in the loan agreement. interest was paid to an arm s-length party and the original terms of the notes met the requirements of subparagraph 212(1)(b)(vii). It also argued that the only way an existing legal obligation can be superseded to acquire a new issue date is by a novation. The minister of national revenue s position was that the amendments to the original promissory notes resulted in a rescission of the original notes, thus creating new obligations. The new obligations did not meet the requirements of subparagraph 212(1)(b)(vii) because the terms were for a period of less than five years (the amendments provided an extension of one year). The court found that the original promissory notes were so materially altered as to result in new obligations. GE lost its appeal at the federal court-trial division level. The court found that the original promissory notes were so materially altered by the agreements of February 18, 1995, as to result in new obligations. GE appealed to the Federal Court of Appeal. The Federal Court of Appeal dismissed GE s appeal and held that the effect of the February 18, 1985, agreements was to change the interest rate, the manner of calculating the interest rate, the parties, and the maturity date of each note, and to reduce the principal amount. That created a new obligation under paragraph 212(1)(b). Also, IHCC was obliged to pay to Harneth more than 25 percent of the principal amount of the obligation within five years of the issue date on February 18, 1985. According to the court, the fundamental terms of the promissory notes were: the identity of the debtor; the principal amount of the note; the amount of interest under the note; and the maturity date of the note. Because all but one of those fundamental terms were changed, the court concluded 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 subparagraph 212(1)(b)(vii) of the Act. The court noted that although novation is not necessarily the same thing as a change of obligation as that term is used in subsection 212(1)...because novation is an issue of fact, whether or not a new obligation has been created is also, by analogy, a question of fact. It held that the changes did not amount to a novation, but were sufficient to create a new obligation. Tax Notes International October 17, 2005 293

Both courts found it was important that the principal amount was reduced to offset withholding taxes paid, but neither court discussed the application of subsection 215(6). 12 General Electric seems to confirm the CRA s position in IT-448. This case cautions the unwary: Changes to the terms of a loan may create a new debt obligation even if the obligor remains unchanged. Unfortunately, the Federal Court of Appeal did not set out clear guidelines on how significant the changes should be to constitute a new debt obligation under subparagraph 212(1)(b)(vii). This case cautions the unwary: Changes to the terms of a loan may create a new debt obligation even if the obligor remains unchanged. Of course, the CRA accepts the General Electric decision. In a technical interpretation, 13 the CRA adopts the Federal Court of Appeal s decision that the term novation is not included in subparagraph 212(1)(b)(vii) of the Act and that a novation is not required for there to be a new obligation for the purpose of subsection 212(1) of the Act. According to the CRA, when there has been a novation, rescission or accord and satisfaction at common law, it would usually mean that one contract/obligation has been replaced by a new contract/obligation. However, in many cases it is not easy for both income tax practitioners and the CRA to determine whether changes made to a debt obligation result in the creation of a new obligation at law. Often when a debtor has defaulted on a debt obligation, the parties will consider rescheduling the obligation. Given the CRA s position and the recent General Electric decision on a possible deemed disposition on a change in the repayment schedule or maturity date, it may be best not to reschedule. Instead, a waiver or capitalization of interest should be considered. B. Conversion Into Equity When the debt-to-equity ratio of the debtor corporation is out of line, the debtor may be anxious to 12 Subsection 215(6) provides that the person who is obliged under section 215 to withhold the amount of the tax and fails to do so is personally liable for the amount of the tax. Subsection 215(6) provides that the person can recover that amount from the nonresident by deducting that amount from any amount paid or credited to the nonresident or otherwise. 13 Technical Interpretation 2002-0178455, dated June 17, 2003. reduce the amount of indebtedness on the balance sheet and convert some or all of that debt into equity. The conversion may then enable the debtor to seek outside sources of financing to provide it with additional working capital so that it can continue to carry on its business. When a debt obligation held by the creditor as capital property is converted into shares of the debtor corporation under the terms of a debt obligation, section 51 permits a tax-free rollover. The conversion is deemed not to be a disposition of property, and the adjusted cost base of the debt obligation converted becomes the adjusted cost base of the shares issued in consideration. 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. Generally, if the shares fair market value is equal to the debt, the debt forgiveness rules will not apply. As a result, it may be a simple task to clean up the balance sheet and improve the debt-to-equity ratio when the debt is convertible into equity. However, most debt obligations are not convertible into equity under their terms. Can a conversion feature be added to the debt obligation and the conversion be made under the rollover provisions of section 51? In Interpretation Bulletin IT-448, the CRA said that the addition of an optional conversion feature to a particular class of security does not generally involve a disposition. As a result, it may be possible to amend the terms of the outstanding debt obligation to add a conversion feature and later convert the debt to equity. However, in reality, many debtors are hesitant to lose the security that may be attached to the debt obligation. And if the shares carry a fixed dividend rate or a fixed retraction amount, they are taxable preferred shares under the act. As a result, the issuing corporation will be subject to a tax of either 50 percent 14 or 40 percent/25 percent (Part VI.1 tax). However, the corporation is entitled to a deduction in calculating its Part I tax liability equal to three times the amount of Part VI.1 tax paid. Therefore, Part VI.1 tax is recoverable under Part I of the act. However, a debtor corporation with financial difficulties is unlikely to have sufficient Part I income to fully recover that tax. The Part VI.1 tax contains a few exceptions that may still make the issuance of taxable preferred shares a viable option. For example, if, on the conversion of the debt to equity, the shareholder will 14 The rate is now 66.67 percent. It is proposed that it be reduced to 50 percent. 294 October 17, 2005 Tax Notes International

have a substantial interest 15 in the corporation, the preferred share rules will not apply. Also, no tax is payable under Part VI.1 when the amount of dividends paid in any year on all classes of taxable preferred shares issued by the corporation (and associated corporations) does not exceed C $500,000. When a related party holds the debt obligation, or the size of the debt obligation is not too large, a conversion of debt to preferred shares may provide a viable alternative. The act also includes rules designed to discourage the issuance of term preferred shares. 16 Before the introduction of those rules, preferred shares were commonly used to finance corporations. Preferred shares were issued by operating corporations to financial institutions. Dividends paid on those shares (which would otherwise be interest income if the financial institutions loaned funds to the operating corporations) would be tax-free to the holders under subsection 112(1), which allows a deduction on a dividend received by another corporation. Subsection 112(2.1) was enacted to deny the intercorporate dividend deduction in similar situations. Distressed preferred shares are similar to term preferred shares. Generally, they are issued in circumstances of financial difficulty. A distressed preferred share would otherwise be a term preferred share issued: as part of a proposal or an arrangement approved by a court under the Bankruptcy and Insolvency Act; 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 when, because of financial difficulty, the issuer or a related corporation resident in Canada was in default or could reasonably be expected to default on a debt owed to an arm s-length person, and that share was issued, in whole or in substantial part, directly or indirectly, in exchange or substitution of that debt. 15 Generally, substantial interest means a shareholder that has 25 percent or more of the votes and value of the corporation and also owns either 25 percent or more of the nontaxable preferred shares of the corporation or 25 percent or more of each class of shares of the corporation. 16 Term preferred share is defined in the act. Generally, it gives the holder the right to cause (or the issuing corporation may be required to implement) the redemption, acquisition, or cancellation of the share or a reduction of the paid-up capital in the share. The definition of term preferred shares also includes a reference to any share in which the issuing corporation or any other person provides any form of guarantee, security, or similar indemnity or covenant with respect to the share. Distressed preferred shares are not subject to term preferred share rules for up to five years after the shares are issued. If the distressed preferred shares remain outstanding for longer than five years, they become term preferred shares. Distressed preferred shares are subject to debt forgiveness rules and are treated as debt if redeemed, acquired, or cancelled for less than their face value. Before debt is converted into preferred shares, a detailed review of the rules is necessary to ensure that they don t become applicable. The rules are complex 17 and are beyond the scope of this article. 18 Before debt is converted into preferred shares, a detailed review of the rules is necessary to ensure that they don t become applicable. C. Replacing Debt With Debt Replacing existing debt with another debt is generally preferable to issuing equity for debt, because the value of the new debt is irrelevant to the debt forgiveness rules. There is no forgiveness of debt if the principal amount remains unchanged. 19 The exchange of a debt for another debt may be completed on a rollover basis under section 51.1, which is applicable only when: the convertible obligation exchanged contains in its terms a provision conferring upon the holder the right to make the exchange; and the amount payable on the new obligation at maturity is the same as the amount that would have been payable at maturity on the convertible obligation exchanged. That provision applies only when the convertible obligation is capital property of the taxpayer. When 17 See, e.g., Citibank Canada v. The Queen, [2001] 2 CTC 2260 (TCC) (aff d. [2002] 2 CTC 171 (FCA)), in which the court referred to the statutory definition of term preferred share as follows: The definition of term preferred share is prolix in the extreme. The persons who drafted that definition did not practise any economy of words or language. One may well ask how many members of parliament understood the definition when it was made law by amendment to the Act.... Itissodetailed; so particularized; so long and tedious and excessive in its use of language. 18 For a detailed analysis of those rules, see David Downie and Tony Martin, The Preferred Share Rules: An Introduction, Report of Proceedings of Fifty-Fifth Tax Conference, 2003 Tax Conference (Toronto: Canadian Tax Foundation, 2004), 52:1-28. 19 See paragraph 80(2)(h) of the act. Tax Notes International October 17, 2005 295

it applies, the cost of the new obligation and the proceeds of disposition of the convertible obligation are deemed to equal the adjusted cost base of the convertible obligation, therefore deferring any tax consequences on the disposition. When bonds, debentures, or notes are held by a financial institution, the financial institution is subject to the specified debt obligations and mark-tomarket rules in sections 142.2 to 142.6. Under section 142.2 (for specified debt obligations) and section 142.5 (for mark-to-market properties), any gain or loss on the disposition of those properties by a financial institution is on income account. Consequently, section 51.1 does not apply to the conversion of debt obligations by financial institutions. As discussed above, when both the debtor and creditor are Canadian residents, the tax consequences on an exchange of debt for another debt are generally neutral. However, the exchange of an existing debt for a new debt may cause adverse Canadian tax consequences with a nonresident creditor. As discussed above, interest paid by a Canadian resident to a nonresident is generally subject to withholding tax at 25 percent. However, a nonresident lender is exempt from withholding tax under subparagraph 212(1)(b)(vii) if the borrower is not required to pay more than 25 percent of the principal amount of the loan within five years of the date of issue. Subsection 212(3) may allow a corporation in financial difficulty to treat a debt obligation that replaces another as having been issued when that other obligation was issued. The circumstances of financial difficulty include: as part of a court-approved proposal to, or arrangement with, the borrower s creditors under the Bankruptcy and Insolvency Act (Canada); 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 when, because of financial difficulty, the issuer of the replacement obligation, or a non-arm slength Canadian resident corporation, is in default or could reasonably be expected to default on the original obligation. The borrower must have used the original debt to finance an active business in Canada. The Department of Finance has proposed to eliminate that requirement for replacement obligations issued after 2000. The department said that there was no clear basis in tax policy for this requirement. Of course, nonresident creditors should be cautious of the General Electric decision when restructuring debt. There is speculation that under the next protocol to the Canada-U.S. Income Tax Convention (1980), some Canadian-source interest would be paid free of Canadian withholding tax to arm s-length U.S. residents. If that is allowed, U.S. treaty beneficiaries who deal at arm s length with Canadian debtors need not be concerned about whether a new debt has been created on a restructuring of a subparagraph 212(1)(b)(vii) debt. IV. Conclusion There are some tools in the act that may be used to restructure the debts of a corporation without significant adverse tax consequences when the corporation has financial difficulties. Unfortunately, when a corporation has financial difficulties, the tax advisers who have devised the most tax-effective plan will be unable to guarantee that a debtor corporation will not fall from grace, as happened to Enron. 296 October 17, 2005 Tax Notes International