2006 Ruling 2006-0177541R3 - Amendments to Debt, Conversion

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Whether (a) the addition of a conversion feature to the debt obligation resulted in a disposition; (b) holder of the debt obligation entitled to use subsection 51(1) on the exercise of the conversion feature; (c) there was a 'forgiven amount'?

Position: (a) No; (b) Yes; (c) No

Reasons: (a) Following provincial law, no disposition occurred and no creation of new debt obligation; (b) The shares were acquired in exchange for capital property that was a bond, debenture or note, the terms of which conferred on the holder the right to make the exchange and no consideration other than the share was received by the holder; (c) Based on given facts, "A" and "B" amounts in formula contained in definition of "forgiven amount" equal each other.

XXXXXXXXXX  								2006-017754

XXXXXXXXXX , 2006

Dear XXXXXXXXXX

Re: Advance Income Tax Ruling
XXXXXXXXXX

We are replying to your letters of XXXXXXXXXX , wherein you requested an advance income tax ruling on behalf of the above-named taxpayers. We also acknowledge information provided during various telephone conversations (XXXXXXXXXX ).

To the best of your knowledge and that of the taxpayers involved, none of the issues contained in this ruling request are:

(i) dealt with in an earlier return of the taxpayers or a related person;

(ii) being considered by a tax services office or taxation centre in connection with a previously filed tax return of the taxpayers or a related person;

(iii) under objection by the taxpayers or a related person;

(iv) subject to a ruling previously issued by the Income Tax Rulings Directorate to the taxpayers or a related person; nor

(v) before the courts or, if a judgment has been issued, the time limit for appeal to a higher court has expired.

Unless otherwise stated, all references to a statute are to the Income Tax Act R.S.C. 1985 (5th Supp.), c.1, as amended, and all terms and conditions used herein that are defined in the Act have the meaning given in such definition unless otherwise indicated.

Definitions

a) "Act" means the Income Tax Act, R.S.C. 1985 (5th Suppl.) c. 1, as amended to the date hereof;

b) "adjusted cost base" has the meaning assigned by section 54;

c) "ACo" means XXXXXXXXXX . as described more fully in 2 below;

d) "Asset Transfers" means the transfers of assets as more fully described in 14 below;

e) "BCo" means XXXXXXXXXX . as described more fully in 5 below;

f) "capital property" has the meaning assigned by section 54;

g) "CBCA" means the Canada Business Corporations Act;

h) "CCAA" means the Companies Creditors Arrangement Act (Canada);

i) "CCo" means XXXXXXXXXX as described more fully in 3 below;

j) "CRA" means the Canada Revenue Agency;

k) "disposition" has the meaning assigned by subsection 248(1);

l) "DCo" means XXXXXXXXXX . as described more fully in 5 below;

m) "ECo" means XXXXXXXXXX . as more fully described in 5 below;

n) "FCo" means XXXXXXXXXX . as more fully described in 1 below;

o) "GCo" means XXXXXXXXXX . as more fully described in 4 below;

p) "GCo Amalgamation" means the amalgamation of companies as more fully described in 13 below;

q) "HCo" means XXXXXXXXXX . as more fully described in 11 below;

r) "ICo" means XXXXXXXXXX . as described more fully in 11 below;

s) "JCo" means XXXXXXXXXX . as described more fully in 11 below;

t) "KCo" means XXXXXXXXXX as described more fully in 1 below;

u) "LCo" means XXXXXXXXXX . as described more fully in 4 below;

v) "MCo" means XXXXXXXXXX ., an arm's length purchaser described in 16 below;

w) "non-capital loss" has the meaning assigned by subsection 111(8);

x) "predecessor corporations" means the predecessor corporations to GCo, being BCo, HCo, ICo and LCo;

y) "principal amount" has the meaning assigned by subsection 248(1);

z) "proceeds of disposition" has the meaning assigned by section 54;

aa) "public corporation" has the meaning assigned by subsection 89(1);

bb) "Share Transfers" means the transfers of shares as described more fully 12 below;

cc) "subsidiary wholly-owned corporation" has the meaning assigned by subsection 248(l);

dd) "taxable Canadian corporation" has the meaning assigned by subsection 89(1); and

ee) XXXXXXXXXX

Our understanding of the facts and proposed transactions is as follows:

Facts

Current Corporate Structure

1. FCo is a taxable Canadian corporation and a public corporation and is the successor to KCo, XXXXXXXXXX . The common shares of FCo are listed and trade on the XXXXXXXXXX . There are approximately XXXXXXXXXX common shares issued and outstanding. FCo is a holding company that, through its subsidiaries (principally GCo), XXXXXXXXXX

2. ACo was incorporated under the CBCA and is a taxable Canadian corporation and a subsidiary wholly-owned corporation of FCo. ACo is a holding company and its only assets are the shares of CCo.

3. CCo was incorporated under the CBCA and is a taxable Canadian corporation and a subsidiary wholly-owned corporation of ACo. CCo is a holding company and its only assets are the shares of, and indebtedness owing by, GCo.

4. GCo is a taxable Canadian corporation amalgamated under the CBCA all of the issued and outstanding common shares of which are owned by CCo. As described more fully in 7(f) below, there is indebtedness owing by GCo to CCo in two tiers - a tier 1 debt with a principal amount of approximately $XXXXXXXXXX and tier 2 debt with a principal amount of approximately $XXXXXXXXXX . GCo was formed on the amalgamation, described in 13 below, of HCo, ICo, BCo and LCo (the latter corporation was a shell company with no assets or liabilities). There are also $XXXXXXXXXX class A preference shares of GCo that are held by FCo. These preference shares resulted from the conversion, on XXXXXXXXXX , of indebtedness of $XXXXXXXXXX that was owing by GCo to FCo (prior to the GCo Amalgamation, this indebtedness was owed by HCo and ICo to FCo). GCo is the principal operating subsidiary in the FCo group, and its revenue and earnings represent approximately XXXXXXXXXX per cent of the consolidated revenue and earnings of the FCo group. The stated capital attributable to the issued and outstanding common shares of GCo is $XXXXXXXXXX and the stated capital attributable to the issued and outstanding preference shares of GCo is $XXXXXXXXXX .

5. ACo was incorporated under the CBCA in connection with a plan of arrangement under the CCAA and the CBCA implemented by XXXXXXXXXX . on XXXXXXXXXX (the "XXXXXXXXXX CCAA Plan"). Pursuant to the XXXXXXXXXX CCAA Plan, publicly-traded debt owed by ECo to arm's length creditors was compromised, and ACo became the sole shareholder of ECo and ECo became the sole shareholder of DCo. The shares of ACo were listed and began to trade on the XXXXXXXXXX on XXXXXXXXXX . ECo was later renamed CCo and will be referred to as "CCo" hereafter. DCo was later renamed BCo and will be referred to as "BCo" hereafter.

6. CCo and GCo are served by the XXXXXXXXXX tax services office and tax centre.

The XXXXXXXXXX CCAA Plan

7. The material steps of the XXXXXXXXXX CCAA Plan were as follows:

a. ACo was created and subscribed for common shares of CCo for $XXXXXXXXXX ;

b. the holders of the public debt of CCo transferred such debt to ACo for shares thereof and cash;

c. all of the issued and outstanding shares of CCo, other than the shares held by ACo, were cancelled without any payment;

d. all of the issued and outstanding shares of BCo, other than those held by CCo, were cancelled without any payment;

e. the former public debt of CCo acquired by ACo in (b) above was settled by ACo receiving from CCo an interest-bearing demand note with a principal amount equal to the then fair value of CCo (approximately $XXXXXXXXXX ); and

f. debt of BCo owing to CCo was exchanged for new indebtedness of BCo established in two tiers - the tier 1 debt is a first-ranking demand debt with an original principal amount set at the estimated fair market value of BCo at the time of the XXXXXXXXXX CCAA Plan (approximately $XXXXXXXXXX ), and the tier 2 debt is a subordinated debt having a XXXXXXXXXX year term to maturity and a principal amount equal to approximately $XXXXXXXXXX which was the balance of the amount owing by BCo to CCo remaining after the tier 1 debt.

8. The XXXXXXXXXX CCAA Plan resulted in an acquisition of control of CCo by ACo. On this acquisition of control, the adjusted cost base of the BCo debt held by CCo was written down, pursuant to paragraph 111(4)(c), to its then fair market value of approximately $XXXXXXXXXX . Under 7(f) above, the BCo debt held by CCo was then exchanged for two tiers of debt - the tier 1 debt which had a fair market value and principal amount of approximately $XXXXXXXXXX (the "Tier 1 Debt") and the tier 2 debt which had a principal amount of approximately $XXXXXXXXXX and a XXXXXXXXXX fair market value at that time (the "Tier 2 Debt"). The full adjusted cost base of the BCo debt (approximately $XXXXXXXXXX ) was allocated to the Tier 1 Debt since the fair market value of the Tier 1 Debt was equal to that amount. As a result, the adjusted cost base to CCo of the Tier 1 Debt is equal to the principal amount of the debt of approximately $XXXXXXXXXX and the adjusted cost base to CCo the Tier 2 Debt is XXXXXXXXXX . CCo holds the Tier 2 Debt as capital property.

9. Upon completion of the XXXXXXXXXX CCAA Plan, BCo had a non-capital loss balance in excess of $XXXXXXXXXX , which arose from, among other things, the operation of the business of BCo prior to the XXXXXXXXXX CCAA Plan and the write-down of its depreciable property which occurred in the course of the XXXXXXXXXX CCAA Plan.

Acquisitions and Reorganizations after the XXXXXXXXXX CCAA Plan

10. On XXXXXXXXXX , FCo and ACo entered into an agreement (the "Arrangement Agreement") pursuant to which FCo agreed to acquire all of the issued and outstanding shares of ACo pursuant to a plan of arrangement (the "Arrangement") under the CBCA in consideration for a combination of cash and FCo common shares and FCo class B non-voting shares (all of the class B non-voting shares have since been converted into common shares). The Arrangement was effected on XXXXXXXXXX .

11. At the time that FCo acquired the shares of ACo, FCo owned all of the issued and outstanding shares of HCo, ICo and JCo. Each of HCo, ICo and JCo was a taxable Canadian corporation and incorporated under XXXXXXXXXX . HCo was the principal operating company in the FCo group of companies, and ICo and JCo also carried on operating businesses.

12. Immediately following the acquisition of the shares of ACo by FCo, FCo transferred to ACo all the issued and outstanding shares of HCo and ICo (the "Transferred Shares") in exchange for common shares of ACo. FCo and ACo jointly elected in accordance with subsection 85(1) that the proceeds of disposition to FCo and the cost to ACo of the Transferred Shares be equal to the adjusted cost base to FCo of the Transferred Shares. ACo then transferred the Transferred Shares to CCo in exchange for common shares of CCo. ACo and CCo jointly elected in accordance with subsection 85(1) that the proceeds of disposition to ACo and the cost to CCo of the Transferred Shares be equal to the adjusted cost base to ACo of the Transferred Shares. CCo then transferred the Transferred Shares to BCo in exchange for common shares of BCo. CCo and BCo jointly elected in accordance with subsection 85(1) that the proceeds of disposition to CCo and the cost to BCo of the Transferred Shares be equal to the adjusted cost base to CCo of the Transferred Shares. The three transfers of the Transferred Shares are referred to as the "Share Transfers".

13. Following the Share Transfers, HCo and ICo were continued under the CBCA so that each of BCo, LCo, HCo and ICo were existing under the same governing legislation. BCo, LCo, HCo and ICo were then amalgamated in a vertical short-form amalgamation, to form GCo, in accordance with and in the manner provided by a plan of arrangement under the CBCA (the "GCo Amalgamation"). The GCo Amalgamation complied with the requirements of subsection 87(1).

14. Following the GCo Amalgamation, JCo transferred to ACo its assets (the "JCo Assets") in exchange for the assumption by ACo of certain of its trade payables (the "JCo Payables") and newly authorized preferred shares of ACo which together had an aggregate fair market value equal to the fair market value of the JCo Assets. JCo and ACo jointly elected, in accordance with subsection 85(1), amounts in respect of the JCo Assets that resulted in no income or gain being realized by JCo. ACo then transferred the JCo Assets to CCo in exchange for the assumption by CCo of the JCo Payables and common shares of CCo which together had an aggregate fair market value equal to the fair market value of the JCo Assets. ACo and CCo jointly elected, in accordance with subsection 85(1), amounts in respect of the JCo Assets that resulted in no income or gain being realized by ACo. CCo then transferred the JCo Assets to GCo in exchange for the assumption by GCo of the JCo Payables and common shares of GCo which together had an aggregate fair market value equal to the fair market value of the JCo Assets. CCo and GCo jointly elected, in accordance with subsection 85(1), amounts in respect of the JCo Assets that resulted in no income or gain being realized by CCo. The three transfers of the JCo Assets are referred to as the "Asset Transfers".

15. The Share Transfers, GCo Amalgamation and Asset Transfers were undertaken in order to combine the operating assets and businesses of the FCo group with the operating assets and businesses of the newly-acquired BCo group. GCo continued to carry on the businesses previously carried on by BCo, HCo, ICo and JCo. In addition to achieving operating synergies, the purpose of this combination was to enable the income from the business previously carried on by HCo, ICo and JCo to be offset by the non-capital losses of the former BCo to the extent provided under subsection 111(5).

16. On XXXXXXXXXX GCo agreed to sell the assets of the business formerly carried on by ICo to MCo, an arm's length purchaser, for consideration consisting of cash in the amount of $XXXXXXXXXX and the assumption of related liabilities.

17. GCo incorporated a wholly owned subsidiary under the CBCA ("Newco") and transferred the assets of the business formerly carried on by ICo to Newco in exchange for the assumption by Newco of all related liabilities and common shares of Newco. GCo and Newco intend to jointly elect, in accordance with subsection 85(1), amounts in respect of the transfer such that GCo would recognize an income inclusion under subsection 14(1). The amount of income recognized by GCo under subsection 14(1) is intended to be limited to an amount that would not cause any GCo's business income for the year not to comply with the "substantially all test" provided under subparagraph 111(5)(a)(ii). The amount of the former BCo's non-capital losses that GCo can deduct under paragraph 111(1)(a) for a particular year is limited under subparagraph 111(5)(a)(ii), among others, to the income derived from any other business substantially all the income of which is derived from the sale, leasing, rental or development of similar properties or the rendering of similar services by comparison with the business previously carried on by BCo.

18. On XXXXXXXXXX Newco sold the assets it acquired from GCo as described in 17 to MCo, an arm's length purchaser, for consideration consisting of cash in the amount of $XXXXXXXXXX and the assumption by MCo of related liabilities.

19. FCo confirmed XXXXXXXXXX its intention to establish a dividend policy, XXXXXXXXXX As described above, FCo, ACo and CCo are holding companies, with substantially all of the business operations of the FCo corporate group being carried on by GCo. Accordingly, FCo is entirely dependent upon the cash generated by GCo to be able to comply with its dividend policy. In recognition of this, the boards of directors of GCo, CCo and ACo have each adopted a long-term dividend policy to distribute XXXXXXXXXX per cent of its annual net income as dividends. However, in order to be able to pay a dividend, GCo must comply with the solvency provisions of the CBCA, which prohibits a dividend if there are reasonable grounds for believing that the realizable value of the corporation's assets would thereby be less than the aggregate of its liabilities and stated capital of all classes. The existence of the Tier 2 Debt liability has created some uncertainty and concern as to the possible application of this prohibition. This, in turn, has prevented the directors of GCo from paying any dividends since the GCo Amalgamation. Instead, FCo has funded its dividend payments with funds borrowed from third party lenders, which borrowings have been supported by the cash balances that are being accumulated in GCo. However, funding dividend payments in this manner is not cost-effective and is not sustainable on a long-term basis.

Proposed Transactions

20. The proposed transactions described below ("Proposed Transactions") will follow sequentially.

21. The Tier 2 Debt is governed under the laws of XXXXXXXXXX . In compliance with the laws of XXXXXXXXXX and the CBCA, CCo and GCo will agree to amend the terms of the Tier 2 Debt to provide the holder, namely CCo, with the sole right and discretion to convert the Tier 2 Debt into common shares of GCo with an aggregate fair market value at the time of conversion equal to the principal amount of the Tier 2 Debt. This amendment will not, pursuant to the law of XXXXXXXXXX , result in novation of Tier 2 Debt or cause repayment of the Tier 2 Debt or the creation of a new obligation in its place. Under the laws of XXXXXXXXXX , the amendments as described will only result in a modification of the existing Tier 2 Debt which will continue to exist. It is the joint intention of the parties, namely CCo and GCo, not to create a new contract to substitute for the Tier 2 Debt but that the Tier 2 Debt will continue to exist as amended.

22. CCo will exercise the conversion right in the Tier 2 Debt described above and will receive that number of common shares of GCo with an aggregate fair market value at the time of conversion equal to the principal amount of the Tier 2 Debt and CCo will not receive any other consideration (the "Conversion"). The aggregate stated capital attributable to the total number of common shares issued on the Conversion will be limited to $XXXXXXXXXX under the provisions of the CBCA because the adjusted cost base of the Tier 2 Debt to CCo is nil. CCo has no current intention to undertake any particular transaction with the GCo common shares issued on the Conversion.

Additional Information

23. In addition to the Proposed Transactions, and whether or not the Proposed Transactions proceed, it is intended that the remaining principal amount of the Tier 1 Debt be repaid by GCo with available cash-on-hand approximately by XXXXXXXXXX

24. There is no current intention to undertake any particular transaction with the GCo common shares that will be issued on the Conversion as described in 22 above.

25. XXXXXXXXXX

Purpose of the Proposed Transactions

26. The Proposed Transactions are being proposed in order to eliminate the uncertainty and concern in respect of the corporate solvency prohibition, described in 19 above, so that GCo can commence paying dividends to fund the payment of dividends by FCo.

Rulings Given

Provided that the preceding statements constitute a complete and accurate disclosure of all the relevant facts, Proposed Transactions and purpose of the Proposed Transactions, and provided that the Proposed Transactions are completed in the manner described above, our rulings are as follows:

A. The addition of the right of conversion to the terms of the Tier 2 Debt as described in 21 above will not, in and by itself, result in a disposition, as that term is defined in subsection 248(1) of the Act, of the Tier 2 Debt to CCo.

B. Provided that the Tier 2 Debt is held by CCo as capital property, pursuant to paragraph 51(1)(c) of the Act, the acquisition of the GCo common shares by CCo on the Conversion as described in 22 above, in exchange for the Tier 2 Debt pursuant to the terms therein as described in 21 above, shall, except for the purpose of subsection 20(21) of the Act, be deemed not to be a disposition of the Tier 2 Debt by CCo and the cost to CCo of all the GCo common shares acquired on the Conversion will be equal to the adjusted cost base to CCo of the Tier 2 Debt as determined under paragraph 51(1)(d) of the Act, which is nil, as described in 8 above.

C. Provided that the fair market value of all the GCo common shares issued on the Conversion, as described in 22 above, equals the principal amount of the Tier 2 Debt, the conversion of the Tier 2 Debt to common shares of GCo will not result in a "forgiven amount" as defined in subsection 80(1) of the Act.

D. Subsection 245(2) of the Act will not apply as a result of the Proposed Transactions, in and by themselves, to re-determine the tax consequences confirmed in the rulings given above.

Nothing in this letter should be construed as implying that the Canada Revenue Agency (the "CRA") has reviewed or is making a determination or ruling in respect of:

(a) the laws of the Province of XXXXXXXXXX and the laws of Canada governing the Tier 2 Debt, specifically whether the Proposed Transactions result in the disposition of the Tier 2 Debt and its substitution by a new obligation under such laws;

(b) any tax consequences with respect to the Tier 2 Debt other than those as specifically described in the rulings given above; or

(c) any other tax consequences relating to any facts or Proposed Transactions referred to herein other than those as specifically described in the ruling given above, and in particular, the amount, if any, deductible under subsection 111(5) to the extent permitted under subparagraph 111(5)(a)(ii).

The above rulings are given subject to the general limitations and qualifications set out in Information Circular 70-6R5 (the "Circular") issued by the CRA on May 17, 2002, and are binding provided the Proposed Transactions above are completed on or before XXXXXXXXXX .

The rulings are based on the Act in its present form and do not take into account the effect of any proposed amendments to the Act.

Nothing in this letter should be construed as implying that the CRA has agreed to or accepted:

(i) the GST implications of any of the Proposed Transactions;

(ii) the fair market value of any assets or shares; or

(iii) any other tax consequences of the Proposed Transactions or of related transactions or events that are not described herein.

Yours truly

XXXXXXXXXX
For Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch