Convertible Debt
Subsection 214(7) applies to deem interest to be paid by a person resident in Canada to a non-resident person where a non-resident person assigns or otherwise transfers to a person resident in Canada a debt obligation issued by a person resident in Canada. The amount deemed to be interest is equal to the amount (the premium) by which the price for which the obligation is assigned or transferred (the assignment price) exceeds the price for which the obligation was issued. A redemption or cancellation of a debt obligation is deemed to be an assignment (pursuant to subsection 214(14)).
Subsection 214(7) does not apply to a debt obligation that is an “excluded obligation”, as defined in subsection 214(8). An excluded obligation includes a debt obligation that was exempt from tax because of subparagraph 212(1)(b)(vii) as it applied to the 2007 taxation year.
Question 1
If a convertible debt obligation does not satisfy the requirements of subparagraph 212(1)(b)(vii) as it applied to the 2007 taxation year, can it qualify as an excluded obligation, pursuant to paragraph 214(8)(c), if the fair market value of the shares issued on conversion exceeds the issue price of the convertible debt obligation?
Response 1
In order to be an “excluded obligation” under paragraph 214(8)(c), a debt must
- not be an indexed debt obligation;
- have been issued for an amount that is not less than 97% of its principal amount; and
- have a yield, expressed in terms of an annual rate on its issue price, that does not exceed 4/3 of the interest stipulated to be payable on its principal amount, or the amount outstanding as or on account of its principal amount.
Whether a particular debt meets these conditions is a question of fact, which must be determined according to the terms of a particular debt obligation. The sole fact that the fair market value of the shares issued on conversion exceeds the issue price of the convertible debt obligation is not, per se, determinative, where the issuer must repay the obligation for an amount equal to the issue price.
Question 2
If a convertible debt obligation does not qualify as an excluded obligation, what is the CRA’s position as to the assignment price when the obligation is converted (into a fixed number of shares determined at the time the obligation arises)? Is it the fair market value of the shares issued or the amount added to stated capital on the conversion?
Response 2
We have accepted that the issuance of shares of a corporation can represent a payment of an obligation. In such a case, it is our view that the amount paid in satisfaction of the principal amount of the obligation depends on the agreement of the parties, which would generally be reflected by the stated capital of the shares issued.
Question 3
If subsection 214(7) applies to a convertible debt obligation, would the premium constitute “participating debt interest,” as defined in subsection 212(3)?
Response 3
Participating debt interest is generally defined as interest, all or any portion of which is contingent or dependent on the use of or production from property in Canada or is computed by reference to revenue, profit, cash flow, commodity price or any similar criterion. The CRA invites submissions from the practitioner community to develop guidance on this issue.
Question 4
Assuming that subsection 214(7) applies to a convertible debt obligation and the resulting premium constitutes participating debt interest, would the CRA also consider non‑participating interest paid pursuant to the terms of the obligation to also be participating debt interest solely because of the premium?
Response 4
Our initial analysis suggests that if the particular premium constitutes participating debt interest, the entire interest amount will be participating debt interest. However, to fully develop its position on this issue, the CRA invites submissions from the practitioner community.