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: 1. Whether subsection 51(1) applied to the conversion of a debt into a share. 2. Whether subparagraph 40(2)(g)(ii) applied to deny the loss.
Position: 1. No. 2. question of fact.
Reasons: 1. The debt was not converted pursuant to its terms. 2. The absence of interest on a debt does not necessarily trigger paragraph 40(2)(g)(ii).
May 6, 2014
Audit Division HEADQUARTERS
XXXXXXXXXX TSO Income Tax Rulings
Attention: XXXXXXXXXX Lara Friedlander
Loss on Conversion of Convertible Debt
This is in response to your letter of March 18, 2014 regarding the potential realization of a loss on the conversion of a convertible debenture.
1. XXXXXXXXXX ("Canco") is a taxable Canadian corporation under subsections 89(1) and 248(1) of the Act.
2. XXXXXXXXXX ("ULC") is a taxable Canadian corporation under subsections 89(1) and 248(1) of the Act. ULC is indirectly controlled by Canco.
3. ULC is the sole member of XXXXXXXXXX ("LLC"), a limited liability company formed under the XXXXXXXXXX. As of XXXXXXXXXX ULC held XXXXXXXXXX membership common units in LLC.
4. On XXXXXXXXXX ULC made XXXXXXXXXX loans to LLC, each documented by a promissory note (each, a "Note"). XXXXXXXXXX Notes had a principal amount of U.S.$XXXXXXXXXX; the XXXXXXXXXX had a principal amount of U.S.$XXXXXXXXXX and the XXXXXXXXXX had a principal amount of U.S.$XXXXXXXXXX. The aggregate amount owing under the Notes was U.S.$XXXXXXXXXX. We assume that ULC held the Notes on capital account. The proceeds of the Notes were used to make an interest-bearing loan to a sister corporation.
5. Under paragraph XXXXXXXXXX of each Note, ULC had the right to convert the Note (or a portion thereof) into fully paid and non-assessable shares (the "Shares") of LLC for a price of U.S. $XXXXXXXXXX per Share. A "Share" for this purpose was defined as "an interest in LLC held by a member of LLC for the purposes of the Act". The limited liability agreement governing LLC stated that "[s]ubject to this Limited Liability Company Agreement and the Act, Shares may be issued in separate classes, each such class having its own distinctive rights and privileges." Paragraph XXXXXXXXXX of each Note is an anti-dilution clause which provides that in case of, inter alia, a reclassification of Shares outstanding, a change of the Shares into other shares or other securities or another capital reorganization (a "Capital Reorganization"), where ULC exercises the right to convert the Note into Shares after the effective date of the Capital Reorganization then ULC will be entitled to receive for the same aggregate consideration in lieu of the number of Shares to which the Lender was previously entitled upon such conversion, the aggregate number of shares, other securities or other property which ULC would have been entitled to receive as a result of such Capital Reorganization if, on the effective date thereof, ULC had been the registered holder of the number of Shares into which the note was convertible immediately prior to such Capital Reorganization. Paragraph XXXXXXXXXX of each Note required LLC to send a notice to ULC if paragraph XXXXXXXXXX would require such an adjustment to the conversion price.
6. The Notes did not provide LLC with the right to convert or exchange the Notes on any basis. We assume that there was no other agreement that would require ULC to convert or exchange the Notes for Preferred Shares.
7. On XXXXXXXXXX, all of the Notes were converted into XXXXXXXXXX Preferred Shares of LLC. The taxpayer has represented that the fair market value of those Preferred Shares was U.S.$XXXXXXXXXX, which was also the fair market value of LLC as a whole (i.e., the remaining equity interests in LLC had no value at that time). We assume for purposes of this interpretation that the Preferred Shares were validly issued although the limited liability company agreement governing LLC does not specifically contemplate the issuance of Preferred Shares.
9. XXXXXXXXXX. This consent contained a resolution that the LLC create a class of preferred shares. The resolution provided that these preferred shares would not be entitled to voting rights and dividends, but would have priority over other shareholders on a dissolution and winding-up.
10. XXXXXXXXXX The Subscription Agreement does not otherwise reference ULC's conversion rights under the Notes.
11. The taxpayer did not provide any reason why ULC would wish to convert its Notes into equity which had a fair market value significantly less than the principal amount of the Notes.
1. Does section 51 of the Act apply to the conversion of the Notes?
2. If not, could subparagraph 40(2)(g)(ii) of the Act apply to deny the capital loss on the conversion of the Notes?
The taxpayer takes the position that section 51 does not apply to the conversion of the Notes because the conversion did not occur pursuant to the exercise by the holder of its conversion rights under the Notes. The taxpayer takes this view based on its reading of subsection 51(1) of the Act as well as the published views of the CRA (specifically, XXXXXXXXXX and 58563, referred to below). You have indicated that the taxpayer has argued that the conversion of the Notes did not occur pursuant to the holder's conversion rights for three reasons. First, the Notes were converted into Preferred Shares rather than common membership units of LLC. Second, the Notes were converted at the request of LLC rather than ULC, and therefore ULC was not exercising its conversion rights under the Notes. Third, the Notes were converted at a conversion price that was different than that set out in the Notes.
1. Section 51
Paragraph 51(1)(b) of the Act provides for rollover treatment "[w]here a share of the capital stock of a corporation is acquired by a taxpayer from the corporation in exchange for
a capital property of the taxpayer that is a bond, debenture or note of the corporation the terms of which confer on the holder the right to make the exchange
" and no other consideration was received by the taxpayer for the convertible property. (Paragraph 51(1)(a) of the Act provides for rollover treatment for certain exchanges of shares into other shares of the same issuer, but does not require that the terms of the initial shares provide the holder with a right to make the exchange.)
The CRA considers that a XXXXXXXXXX LLC is a corporation for purposes of the Act (see 9416835) and membership interests in LLC will be considered to be shares for purposes of the Act (see, for example, 2013-048032 (June 11, 2013; 2013 STEP Q. 6)).
Subsection 51(1) of the Act states that the share is acquired "in exchange" for the debt and then refers to the right of the holder to make "the exchange"; this language strongly suggests that the exchange has to occur pursuant to the exchange right. Indeed, this has been the historical view of the CRA.
Most of the CRA statements on point address an earlier version of subsection 51(1) under which the language in current paragraph 51(1)(b) applies to exchanges of both shares and debt. Specifically, for exchanges occurring on or before December 21, 1994, subsection 51(1) stated: "Where shares of the capital stock of a corporation have been acquired by a taxpayer in exchange for a capital property of the taxpayer that was a share, bond, debenture or note of the corporation (in this section referred to as a "convertible property") the terms of which conferred on the holder the right to make the exchange and no consideration was received by the taxpayer for the convertible property other than those shares, the following rules apply:
" Accordingly, notwithstanding the change in law, the older CRA statements address essentially the same language as that currently found in paragraph 51(1)(b) of the Act.
In 58563 (November 2, 1989), the taxpayer described preferred shares that were exchangeable into common shares at the demand of the holder with sufficient notice. The issuer had the option to repurchase the shares within the notice period. The CRA was asked to consider whether the holder's right to exchange had to be absolute in order for subsection 51(1) of the Act to be satisfied. The CRA stated that subsection 51(1) of the Act applied to a conversion made pursuant to the holder's right to convert even if the issuer had the option to repurchase the shares in the meantime.
Similarly at the 1987 Canadian Tax Foundation Conference Round Table, Q. 67 XXXXXXXXXX (November 1, 1987), the CRA stated: "Subsection 51(1) applies where the holder of the share exercises the right to make the exchange pursuant to the terms of the share. It would not apply where conversion occurs automatically upon a specified date or upon the happening of a certain event."
In 9220575 (December 16, 1993), the taxpayer asked whether subsection 51(1) of the Act would apply where the right to convert was in the hands of the issuer's board of directors rather than the holder. The taxpayer also asked whether subsection 51(1) of the Act would apply if both the holder and the issuer had the right to convert. The CRA responded by repeating the answer given at the 1987 Round Table.
Accordingly, we considered whether the conversion of the Notes was a conversion that occurred as a result of the exercise by ULC of its conversion rights under the Notes.
With respect to the taxpayer's first argument, paragraph 5 above indicates that the Notes could be converted into "Shares", which are defined as any interest in LLC, not solely common membership units. Accordingly, the fact that the Notes were converted into Preferred Shares does not necessarily indicate that the conversion was done outside the terms of the Notes.
With respect to the taxpayer's second argument, we note that the documentary evidence you have provided to us shows that ULC "wished" to convert the Notes, and did not mention anything regarding the initiation of the conversion by LLC. We also understand that neither the Notes nor any other agreement between ULC and LLC would have required ULC to convert the Notes at the request of LLC.
With respect to the taxpayer's third argument, if the conversion of the Notes were to have occurred pursuant to the exercise by ULC of its conversion rights under the Notes, one would have expected that approximately XXXXXXXXXX Shares (approximately U.S.$XXXXXXXXXX ÷ U.S.$XXXXXXXXXX) would have been issued. This differential likely indicates that the conversion did not occur pursuant to the terms of the Notes.
Accordingly our recommendation is that section 51 should not apply to the conversion of the Notes into Preferred Shares.
2. Subparagraph 40(2)(g)(ii)
The Notes are not interest-bearing. You have asked whether subparagraph 40(2)(g)(ii) of the Act could deny the capital loss on the disposition of the Notes. Subparagraph 40(2)(g)(ii) of the Act generally applies to deny a loss on the disposition of a debt or other right to receive an amount unless the debt or right, as the case may be, was acquired by the taxpayer for the purpose of gaining or producing income from a business or property (other than exempt income) or as consideration for the disposition of capital property to a person with whom the taxpayer was dealing at arm's length.
Ultimately whether subparagraph 40(2)(g)(ii) of the Act applies to deny a loss is a question of fact. However, the absence of interest on the Notes does not in and of itself lead to the conclusion that the Notes were not acquired by ULC for the purpose of gaining or producing income.
In The Queen v. Byram,  2 C.T.C. 149 (F.C.A.), the Federal Court of Appeal held that the taxpayer's loss on the disposition of a non-interest bearing debt would not be denied by subparagraph 40(2)(g)(ii) of the Act. The Court stated at paragraph 16: "While subparagraph 40(2)(g)(ii) requires a linkage between the taxpayer (i.e. the lender) and the income, there is no need for the income to flow directly to the taxpayer from the loan." The Court stated at paragraph 22: "The shareholders of a company are directly linked to that corporation's future earnings and its payment of dividends. Where a shareholder provides a guarantee or an interest free loan to that company in order to provide capital to that company, a clear nexus exists between the taxpayer and the potential future income." The CRA has long taken the position that where a taxpayer makes a loan to a wholly-owned subsidiary at less than a reasonable rate of interest, there is still a clear nexus, for purposes of subparagraph 40(2)(g)(ii) of the Act, between the loan and the potential for future income in the form of dividends. See, for example, XXXXXXXXXX; 2006-017211 (June 28, 2006). See also paragraph 25 of Interpretation Bulletin IT-533 (October 31, 2003), which contains similar comments in the context of the income earning purpose test in paragraph 20(1)(c) of the Act.
Whether the Notes were acquired for the purpose of earning dividend income is a question of fact. We note our understanding that the proceeds of the Notes were used to make an interest-bearing loan to a foreign affiliate of Canco.
3. Amount Paid in satisfaction of a Debt
Paragraph 80(2)(g) provides that generally, when a corporation issues a share to a person as consideration for a settlement of a debt issued by the corporation, and payable to the person, the amount paid in satisfaction of the debt is deemed to be equal to the fair market value of the share at the time the share was issued. In this case, it appears that paragraph 80(2)(g) of the Act may be applicable as an argument can be made that shares were issued in settlement of debt. The application of subsection 80(13) of the Act to LLC could impact the computation of the foreign accrual property income LLC should LLC have any such income.
We have not considered the application of GAAR to the conversion, but you may wish to consider it further.
For your information a copy of this memorandum may be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. Such a severed copy would also be distributed to the commercial tax publishers for inclusion in their databases. The severing process would remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they could be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Ms. Celine Charbonneau at (613) 952-1361. A copy would be sent to you for delivery to the client.
We trust that these comments will be of assistance.
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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