TN-44-Exchangeable Debentures

Question 1

At the Canadian Tax Foundation’s 2008 annual conference,[Footnote 18] the CRA was asked to provide its views in respect of the application of paragraph 20(1)(f) to exchangeable debentures in light of the Federal Court of Appeal decision in Tembec Inc. et al. v. The Queen.[Footnote 19] The CRA was not prepared to comment at that time because the taxpayer in that case had applied for leave to appeal the decision to the Supreme Court of Canada. On January 22, 2009, the Supreme Court refused leave to appeal.

Can the CRA now provide its views in respect of the application of paragraph 20(1)(f) to exchangeable debentures issued with or without an original discount, considering the decision of the Federal Court of Appeal in the Tembec case?

Response 1

Before the decision in Imperial Oil Ltd. and Inco Ltd. v. Canada,[Footnote 20] the CRA’s position with respect to exchangeable debentures issued with or without an original discount was that a deduction was generally available under paragraph 20(1)(f) with respect to the original discount as well as the appreciation of the principal amount of the debenture over its face value, provided that such appreciation was inherent to the terms and conditions of the debenture.

At the Canadian Tax Foundation’s 2006 annual conference,[Footnote 21] we stated that the CRA would consult with its legal services advisers to determine whether its longstanding position in respect of the application of paragraph 20(1)(f) to exchangeable debentures was supportable at law in light of the comments in the Supreme Court’s decision in Imperial Oil. We also stated that this position would continue to be maintained for exchangeable debentures in place at that time, and mentioned that if these consultations resulted in a change in the CRA’s position, it would be announced to the public when the decision was made.

At the Canadian Tax Foundation’s 2008 annual conference,[Footnote 22] we stated that the CRA was awaiting the final conclusion of the Tembec case in order to complete the analysis announced in 2006, and that if a change of position was necessary, it would be announced and administered on a prospective basis.

In light of the decision of the Federal Court of Appeal in the Tembec case, we are now of the view that our abovementioned position is not supportable at law. Hence, this case limits the deduction of financing costs provided for by paragraph 20(1)(f) to the original discount, granted when an obligation is issued. The appreciation of the principal amount of the debenture over its face value is not deductible under paragraph 20(1)(f). This represents a change of position and will therefore be administered on a prospective basis to debentures issued on or after January 1, 2010. In this respect, a debenture issued prior to January 1, 2010, but modified on or after that date will be considered issued on or after January 1, 2010.

Question 2

If, considering the decision of the Federal Court of Appeal in the Tembec case, the CRA is of the view that paragraph 20(1)(f) does not apply to the appreciation of the principal amount of the debenture over its face value, can the CRA provide its views in respect of the tax consequences applicable to the issuer of exchangeable debentures upon exchange?

Response 2

There are many varieties of exchangeable securities in the market. Moreover, the fundamental characteristics of exchangeable 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 to the issuer of exchangeable debentures, upon exchange, that will apply to all possible situations.

However, we are prepared to provide the following comments concerning exchangeable debentures that have, among other features, the following terms and conditions:

  1. 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.
  2. 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.
  3. The debentures are exchangeable at any time at the holders’ option for shares of another corporation (the target shares) prior to maturity. Some debentures have an initial non-exchange period.
  4. The terms of the debentures specifically provide a fixed exchange ratio (specifying the number of the target shares that can be obtained for each debenture). In some cases, the security contract may provide for certain changes in the exchange ratio over time.

Where there is an exchange of such an exchangeable debenture by the debenture holder for the target shares, the issuer repays its debt by delivering the target shares. Consequently, the debenture issuer may repay more than the face value of the debenture if the FMV of the target shares exceeds the face value of the debenture. However, as the Supreme Court stated in Imperial Oil and other cases, a borrowing obtained to raise financial capital is generally on capital account and any costs related to such a borrowing are therefore payments on account of capital within the meaning of paragraph 18(1)(b) and, as such, are not deductible from income unless the deduction thereof is expressly permitted. It follows that the appreciation of the principal amount of a debenture over its face value is a payment on account of capital, the deduction of which is prohibited by paragraph 18(1)(b). Paragraph 20(1)(e) does not apply to such appreciation, because this would be an amount paid on account of the principal amount of the debenture, and therefore an excluded amount for the purposes of paragraph 20(1)(e). Because the issuer is simply repaying a debt, the issuer does not sustain a capital loss for the purposes of paragraph 39(1)(b) on repayment. We are not aware of any other provision of the Act that allows a deduction to the issuer in these circumstances.

Upon exchange, the issuer also disposes of the target shares for proceeds equal to their FMV, which is the amount of the issuer’s obligation pursuant to the exchangeable debenture that is satisfied by their delivery.

Question 3

Can the CRA provide its views in respect of the tax consequences applicable to the holder of an exchangeable debenture, upon exchange?

Response 3

We are still of the view that when a holder of an exchangeable debenture exercises the right to exchange the debenture for the target shares, the holder would dispose of the debenture for proceeds equal to the FMV of the consideration received—that is, the FMV of the target shares. The adjusted cost base (ACB) of the target shares to the holder would equal the FMV of the debenture given up to acquire them which (ignoring interest rate fluctuations) would ordinarily equal the FMV of the target shares.

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