Question 1
Despite its being the subject of questions and responses at the Canadian Tax Foundation’s 2008 annual conference[Footnote 38] and the May 2009 International Fiscal Association (IFA) conference,[Footnote 39] the Canadian withholding tax treatment of convertible debt remains subject to considerable uncertainty. Even in the context of “traditional convertible debentures” having the terms and conditions identified in the CRA’s response at the 2009 IFA conference,[Footnote 40] the CRA declined to comment on status as an “excluded obligation” for the purposes of subsection 214(8) or on the application of the definition of “participating debt interest” in subsection 212(3).
While the CRA’s response at the IFA conference—that conversion of a traditional convertible debenture would, in the CRA’s view, not give rise to any “excess” under subsection 214(7)—is helpful, there is uncertainty about matters that the CRA declined to comment on. The practical consequence of this uncertainty is that if a traditional convertible debenture is to be issued to a non-resident on the basis that the debenture is not subject to Canadian withholding tax, in the absence of an advance income tax ruling, the traditional convertible debenture must still comply with subparagraph 212(1)(b)(vii) more than one and a half years after the general repeal of those requirements.
To illustrate the source of the continuing uncertainty, traditional convertible debentures, like any debentures, are typically assignable. In some cases, traditional convertible debentures may be traded in public markets. Where a non-resident subscribes for a traditional convertible debenture, the price for which the debenture is subsequently assigned or sold may exceed the price at issue. The excess may reflect appreciation in the value of the underlying shares, interest rate changes, improved credit, etc. If the assignee is a resident of Canada and the traditional convertible debenture is not an excluded obligation, the excess would generally be deemed to be interest pursuant to subsection 214(7). If the deemed interest is “participating debt interest” as defined in subsection 212(3), it would be subject to Canadian withholding tax pursuant to paragraph 212(1)(b). If the potential deemed interest on the traditional convertible debenture would be, or may be, participating debt interest, it is unclear whether the fixed coupon on the traditional convertible debenture is thereby also participating debt interest, having regard to the reference in the definition to any portion of interest on an obligation.
Can the CRA comment on whether a traditional convertible debenture is an excluded obligation for the purposes of paragraph 214(8)(c)?
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 percent of its principal amount; and
- have a yield, expressed in terms of an annual rate on its issue price, that does not exceed four-thirds 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 that must be determined according to the terms of a particular debt obligation. However, considering the Tembec [Footnote 41] case and the similarity of the wording in paragraph 214(8)(c) and subparagraph 20(1)(f)(i), we are of the view that for the purposes of paragraph 214(8)(c), the principal amount must be ascertained at the time the debt is issued. In other words, in order to determine whether a particular debt has been issued for an amount that is not less than 97 percent of its principal amount for the purposes of paragraph 214(8)(c), we are of the view that the appreciation or depreciation of the principal amount over time must not be taken into account.
Because there are many varieties of convertible securities in the market, and as stated in CRA document no. 2009‑0320231C6,[Footnote 42] we still encourage the practitioner community to request advance income tax rulings if they have concerns about the application of Part XIII of the Act with respect to convertible debentures in the context of proposed transactions.
Question 2
If a traditional convertible debenture is not an excluded obligation, is any excess of the price for which the obligation is assigned or otherwise transferred over the price for which the obligation was issued “participating debt interest” for the purposes of subsection 212(3)?
Response 2
As stated at the Canadian Tax Foundation’s 2008 annual conference, the CRA invites submissions from the practitioner community to develop guidance on this issue. (Subsequent to the date of the 2009 conference, the CRA received submissions from the Joint Committee on Taxation of the Canadian Bar Association and the Canadian Institute of Chartered Accountants, which are being considered by the CRA.)
Question 3
If the excess would be, or may be, participating debt interest, is the fixed coupon on the traditional convertible debenture also treated as participating debt interest?
Response 3
As stated at the Canadian Tax Foundation’s 2008 annual conference,[Footnote 43] our initial analysis suggests that if the excess 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. (Subsequent to the date of the 2009 conference, the CRA received submissions from the Joint Committee on Taxation of the Canadian Bar Association and the Canadian Institute of Chartered Accountants, which are being considered by the CRA.)