Question 1
Over the past few years, the tax literature has indicated some confusion between the tax treatment applicable on a conversion of a convertible debenture and the tax treatment applicable on an exchange of an exchangeable debenture.
Now that the CRA has completed its analysis with respect to the impact of the Tembec case[Footnote 34] on the application of paragraph 20(1)(f) to exchangeable debentures, can the CRA comment on the tax consequences applicable to the debenture issuer upon the conversion of a convertible debenture?
Response 1
There are many varieties of convertible securities in the market. Moreover, the fundamental characteristics of convertible debentures can differ significantly from one situation to another. Accordingly, it is not possible for the CRA to provide general comments or general positions concerning the tax consequences applicable upon the conversion of convertible debentures that will apply to all possible situations.
However, we are prepared to provide the following comments concerning convertible debentures that have, among other features, the following terms and conditions:
- The debentures are issued for a fixed amount of money in Canadian dollars (for instance, $1,000) that represents the face value of the debentures. The debentures are issued with no original discount.
- The debentures bear interest at a commercial fixed rate per year calculated on their face value. The interest on the debentures is paid by the issuer at least annually.
- The debentures are convertible at any time at the holders’ option into the common shares of the issuer prior to maturity. They may also have an initial non‑conversion period.
- The terms of the debentures specifically provide a fixed conversion ratio (specifying the number of common shares that can be obtained for each debenture). In some cases, the security contract may provide for certain changes in the conversion ratio over time.
We are generally of the view that in the case of a convertible debenture having the features described above, the principal amount of the debenture is equal to its face value. As a result, where there is a conversion of a convertible debenture by its original holder for common shares of the issuer, it is our view that in general there would be no outlay or expense for the purposes of paragraph 18(1)(a).
We generally consider that when shares are issued in repayment of a debt, the amount paid in satisfaction of the principal amount of the obligation depends on the agreement of the parties, which is generally reflected by the stated capital of the shares issued (pursuant to the applicable corporate law). This position is supported by a number of court cases, including Teleglobe Inc. v. The Queen.[Footnote 35]
Since the amount payable and actually paid by the issuer upon conversion is equal to the issue price of the debenture, the issuer does not incur any expense upon conversion. This is consistent with our longstanding position and was confirmed by the comments of the Federal Court of Appeal in Tembec, to the effect that “the issuance of shares by the appellants from their share capital at a lower price than their actual value dilutes the shareholders’ equity without anyone incurring any expenses.”[Footnote 36] Furthermore, the Tembec case stated that paragraph 20(1)(f) was not applicable because no original discount was granted when the convertible debentures examined were issued.
Question 2
Can the CRA comment on the tax consequences applicable to the debenture holder upon the conversion of a convertible debenture?
Response 2
As a general rule, and subject to section 51, the proceeds of a creditor who accepts shares in satisfaction of an outstanding debt is the FMV of the shares.[Footnote 37] Section 51 provides a deferral of the gain that would otherwise be realized by a holder of a convertible debenture upon the exercise of the conversion rights contained in the convertible debenture, provided that the debenture was a capital property of the holder. As a result of the application of section 51, upon the exercise of the conversion rights there would be deemed to be no disposition of the debenture, and the cost of the shares so acquired by the debenture holder would be deemed to be his or her ACB of the debenture immediately before the conversion.
Convertible Debentures and Part XIII
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.)
Central Paymaster Rules
Question
The “central paymaster” rules in new regulation 402.1 will apply if, among other things, a service performed for a corporation “is of a type that could reasonably be expected to be performed by employees of the corporation in the ordinary course [of the business of the corporation].”[Footnote 44] The wording of this test differs from the wording of the test in regulation 402(7) (which applies where the services performed “would normally be performed by employees of the corporation” and which is discussed in Interpretation Bulletin IT‑145R).[Footnote 45]
Can the CRA comment on its interpretation of the “reasonably be expected” test in new regulation 402.1 in the following circumstances?
- The corporation that is the recipient of the services has never performed the particular services and functions itself (for example, where it has never had its own legal staff, and it receives legal services from its parent corporation).
- The services in question are shared administrative (that is, non-operational) services where the corporation does not require the full-time services of any particular employees of the related service provider.
Can the CRA also comment on the consequences if both regulation 402(7) and new regulation 402.1 technically apply to a particular arrangement?
Response
There is no requirement for a corporation to have ever performed “particular services and functions” for regulation 402.1 to apply. The fact that the subsidiary has never had its own legal staff is irrelevant. If employees of the parent corporation (a master-servant relationship) report to a PE of a subsidiary, receive direction from the subsidiary’s corporate structure, and all or substantially all of their economic activity is for the benefit of the subsidiary, then for the purposes of regulation 400 the salaries and wages of the employees would be allocated to the subsidiaries’ gross salaries and wages paid in the year and deducted from the parent’s gross salaries and wages paid in the year.
Generally, in a situation where the services in question are shared administrative (that is, non-operational) services, regulation 402.1 would not apply. If employees of the parent corporation report to a PE of a parent, receive direction from the parent’s corporate structure, and all or substantially all of their economic activity is for the benefit of the parent, which in this case is providing a service to a subsidiary, then for the purposes of regulation 400 the salaries and wages of those employees would be that of the parent’s gross salaries and wages paid in the year.
The interpretation of “normally” for regulation 402(7) has two conditions:
- The service or function performed by the service provider must be one that is already performed by an employee of the corporation. It is the CRA’s position that regulation 402(7) will not apply in situations where the corporation does not have any employees.
- The need for the individual service provider to perform a particular service or function is short-term.
Where the corporation never had its own employees performing the legal services, those services would not be services that were previously performed by the corporation’s employees, and therefore regulation 402(7) would not apply. Where the services provided (shared administrative services) are not short‑term or temporary, they would not meet the definition of “normally.”
Calculating LRIP for Cash-Basis Taxpayers
Question
When a corporation ceases to be a CCPC, subsection 89(8) calculates an addition to the corporation’s low-rate income pool (LRIP). As part of that calculation, the corporation is required to include the total of all amounts each of which is the cost amount to the corporation of a property immediately before the end of its preceding taxation year. “Cost amount” of inventory is defined in subsection 248(1) to be “the value at that time as determined for the purpose of computing the taxpayer’s income” (paragraph (c) of the definition).
The application of this provision to taxpayers carrying on a farming business using the cash method in section 28 is unclear. Under the cash method, income is considered to be earned when cash has been received, and expenses are considered to be incurred when they have been paid. Therefore, if a corporation pays for inventory during the year, it will be entitled to deduct that amount in calculating the corporation’s income for the year. Consequently, the value of the corporation’s inventory at any point during the year does not appear to be relevant for the purposes of calculating the corporation’s income, except for the limited purposes of paragraph 28(1)(b) (which provides for additions to income in order to voluntarily income-average) or paragraph 28(1)(c) (which ensures that the purchase of inventory does not result in losses to the corporation). Subsection 28(1.2) applies only for the purposes of paragraph 28(1)(c) to deem the value of inventory to be the lesser of the cash cost and the FMV of the inventory.
In Interpretation Bulletin IT‑427[Footnote 46] (cancelled and replaced by IT‑427R in 1993),[Footnote 47] the CRA commented that the cost amount of farming inventory for a cash-basis taxpayer was considered to be nil on the rollover of farming inventory under section 85. Section 85 has since been amended to deem the elected amount to be a percentage of the amount included pursuant to paragraph 28(1)(c) (plus any additional amount designated by the parties), and IT‑427R was published to reflect this change. However, it is not clear whether the analysis that led the CRA to conclude that the cost amount of farming inventory was nil would apply for other purposes of the Act, including subsection 89(8).
An analogy might be drawn to Canadian resource property. Canadian resource property acquired by a taxpayer is added to the taxpayer’s resource pools. The CRA has consistently said that the cost amount of Canadian resource property is nil for the purposes of the Act and is not affected by the existence of undeducted resource pools.[Footnote 48]
Can the CRA confirm that it would treat the cost amount of farming inventory of a cash-basis taxpayer as nil for the purposes of subsection 89(8)? Can the CRA also confirm that a cash-basis taxpayer’s accounts receivable, prepaid expenses, accounts payable, and accrued liabilities should generally have a cost amount of nil for this purpose?
Response
For the purposes of applying subsection 89(8), and in accordance with paragraph (c) of the definition of “cost amount” in subsection 248(1), the cost amount of farming inventory to a cash-basis taxpayer immediately before the end of its taxation year preceding its change in status from a CCPC to a non-CCPC generally would be nil, provided that the value of such inventory at that time is not otherwise determined for the purpose of computing the taxpayer’s income.
Furthermore, for the purposes of applying subsection 89(8), the cost amount of rights arising from the prepayment of expenses by a cash-basis taxpayer, immediately before the end of its taxation year preceding its change in status from a CCPC to a non‑CCPC, would be determined pursuant to paragraph (f) of the definition of “cost amount” in subsection 248(1). Accordingly, the cost amount would generally be nil where the amount paid in respect of such prepaid expenses has been deducted in computing the taxpayer’s income for any taxation year preceding the change in status.
The cost amount of accounts receivable to a cash‑basis taxpayer immediately before the end of its taxation year preceding its change in status from a CCPC to a non‑CCPC, for the purpose of applying subsection 89(8), would generally correspond with the face amount that the taxpayer has a right to receive, pursuant to paragraph (e) of the definition of “cost amount” in subsection 248(1).
On the other hand, an amount for the accounts payable of a cash-basis taxpayer should technically be included in variable D of subsection 89(8). Variable D is the total of all amounts each of which is the amount of any debt owing by the corporation, or of any other obligation of the corporation to pay any amount, that was outstanding immediately before the end of its taxation year preceding its change in status from a CCPC to a non‑CCPC.