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 mandatory redeemable preferred shares ("MRPS") are equity or debt.
Reasons: Application of foreign entity classification approach.
January 8, 2016
Patrick Bilodeau HEADQUARTERS
Senior Technical Specialist Income Tax Rulings
GAAR and Technical Support Section Directorate
Aggressive Tax Planning Division Lara Friedlander
Characterization of MRPS
This is in response to your email of August 14, 2015 regarding the treatment of certain mandatorily redeemable preferred shares under the Income Tax Act (Canada) (the “Act”).
Facts and Assumptions
1. XXXXXXXXXX (“Canadian Parent”), a taxable Canadian corporation, holds mandatory redeemable preferred shares (“MRPS”) as well as ordinary common shares in XXXXXXXXXX private limited liability companies, XXXXXXXXXX (“Holdings”) and XXXXXXXXXX (“Finance”). Canadian Parent is the sole shareholder of each of Holdings and Finance.
2. Holdings is part of a “tax unity” for XXXXXXXXXX tax purposes that consists of XXXXXXXXXX (“Capital”) and XXXXXXXXXX (“SA”). Holdings is the sole shareholder of Capital, and Capital is the sole shareholder of SA.
3. The articles of incorporation of Holdings state the following, inter alia, regarding the Holdings MRPS:
a. The MRPS are a component of Holdings’ “subscribed corporate capital”.
b. The MRPS have a “nominal value” of XXXXXXXXXX Euros each.
Holdings must maintain a share premium account and a reserve account for the MRPS.
c. The MRPS must be redeemed in accordance with the provisions of the relevant XXXXXXXXXX corporate legislation on the XXXXXXXXXX anniversary of the date of issuance or at any earlier date at the option of the issuer. The redemption of MRPS can be made only by using sums available for distribution in accordance with XXXXXXXXXX law or the proceeds of a new issue made for the purpose of the redemption.
d. The MRPS may be redeemed for cash or in kind.
e. The redemption price for the MRPS is equal to the subscription price for the MRPS as paid at the time of issue plus any accrued but unpaid preferred dividends through to the date of redemption.
f. Any preferred dividends declared but unpaid in respect of the MRPS shall be paid prior to redemption.
g. Dividends may not be paid on ordinary shares issued by Holdings as long as any redemption price on MRPS remains unpaid.
h. Holdings is required to set aside XXXXXXXXXX% of net profits as a reserve until the reserve equals XXXXXXXXXX% of Holdings’ capital. From XXXXXXXXXX, all remaining net profits will be allocated to the MRPS or the MRPS reserve account in priority as follows:
i. A MRPS shareholder may receive a cumulative preferred dividend (“Dividend 1”) at a rate of XXXXXXXXXX% of the nominal capital of those MRPS. To the extent permitted, Dividend 1 will be declared annually.
ii. A MRPS shareholder may receive a second cumulative preferred dividend (“Dividend 2”) equal to XXXXXXXXXX% of the aggregate of the nominal capital of those MRPS and the amounts credited to the share premium and reserve accounts for those MRPS, as long as that aggregate amount is not capped by an agreement between that shareholder and Holdings. Where Dividend 2 is not declared or paid notwithstanding sufficient distributable reserves or available profits, that amount will be capitalized and transferred to the MRPS reserve account.
Any remaining amounts may be distributed (whether by way of dividends or allocation to different corporate accounts) at the discretion of the shareholders as assembled at a shareholders meeting. Dividends will be paid at the location and date determined by the board of directors.
i. MRPS carry full voting rights, as do the ordinary shares of Holdings.
j. Where there is only XXXXXXXXXX shareholder of Holdings, the MRPS are freely transferable. Where there are multiple shareholders of Holdings, certain transfers must be approved by shareholders who represent at least XXXXXXXXXX of the paid-up capital of Holdings. Where a “Cap Agreement” (footnote 1) or “Keep Well Agreement” (footnote 2) exists between a MRPS shareholder and Holdings, the shareholder cannot transfer those MRPS unless the Keep Well Agreement has been transferred to the transferee of the MRPS and the transferee enters into a Cap Agreement with Holdings that is substantially similar to the existing Cap Agreement.
4. A Keep Well Agreement (the “Keep Well”) dated XXXXXXXXXX, was entered into between Holdings and Canadian Parent as the holder of MRPS in Holdings. Generally, under the Keep Well, Canadian Parent undertakes to subscribe for ordinary shares of Holdings if Holdings has insufficient funds to redeem the MRPS at their maturity.
5. A Cap Agreement (the “Cap”) dated XXXXXXXXXX, was also entered into between Holdings and Canadian Parent as the holder of MRPS in Holdings. Under the Cap, Dividend 2 can be reduced in certain circumstances.
6. The MRPS in Finance are similar to the MRPS in Holdings with a few exceptions, including the following:
a. The MRPS have a nominal value of U.S.$XXXXXXXXXX each.
b. The redemption price for the MRPS will be reduced in the case of an impairment of the underlying assets of Finance. In addition, the MRPS can only be redeemed to the extent that the redemptions would not have the effect of reducing the assets of Finance below the amount of the subscribed share capital of Finance and the reserves which may not be distributed under XXXXXXXXXX law.
c. If the MRPS cannot be redeemed at their full redemption price, the residual portion remains payable by Finance and carries interest of XXXXXXXXXX% per annum.
d. Net profits remaining after reserve requirements have been met are allocated as follows:
i. A MRPS shareholder may receive a cumulative preferred dividend (“Dividend 1”) at a rate of XXXXXXXXXX% of the nominal value of those MRPS. To the extent permitted, Dividend 1 will be declared annually.
ii. A MRPS shareholder may receive a second cumulative preferred dividend (“Dividend 2”) equal to the “Income” of Finance (footnote 3) less a margin as required under applicable transfer pricing rules less Dividend 1. Where Dividend 2 is not declared or paid notwithstanding sufficient distributable reserves or available profits, that amount will be capitalized and transferred to the MRPS reserve account.
e. There is no Cap Agreement or Keep Well Agreement in respect of the Finance MRPS.
f. There are XXXXXXXXXX classes of MRPS of Holdings but only one class of MRPS of Finance.
7. The MRPS are treated as debt for XXXXXXXXXX tax purposes. We understand that the taxpayer’s representatives have stated that the MRPS are treated as equity for XXXXXXXXXX corporate, bankruptcy and private law purposes, and we assume that this is an accurate statement. We assume that the MRPS will have the same rights and privileges as ordinary shares in the issuer, except as otherwise provided in the articles of incorporation. We assume that distributions on the MRPS, if and when declared, will have the same nature under XXXXXXXXXX corporate and private law as dividends paid on the ordinary shares of Holdings and Finance.
8. Distributions on the MRPS have been treated by Canadian Parent as dividends. We assume for purposes of this document that, were the distributions to be dividends, there would be sufficient exempt surplus to allow a full deduction to Canadian Parent under subsection 113(1) of the Act.
Are the MRPS equity for purposes of the Act?
“Share” is defined in subsection 248(1) as, except where the context otherwise requires, “a share or fraction of a share of the capital stock of a corporation and, for greater certainty, a share of the capital stock of a corporation includes a share of the capital of a cooperative corporation (within the meaning assigned by subsection 136(2), a share of the capital of an agricultural cooperative corporation (within the meaning assigned by subsection 135.1(1) and a share of the capital of a credit union”. Interpretation Bulletin IT-392 (now cancelled) does contain some discussion regarding the meaning of the term “share”, but that discussion generally is not relevant to the issues under consideration here.
In Income Tax Technical News No. 38 (September 22, 2008), the CRA states the following:
Our approach remains as stated last year, that is, to determine the status of an entity for Canadian tax purposes, we generally follow the two-step approach described below:
1) Determine the characteristics of the foreign business association under foreign commercial law;
2) Compare these characteristics with those of recognized categories of business associations under Canadian commercial law in order to classify the foreign business association under one of those categories.
Even if we consider all the characteristics of an entity, the most important attributes are the nature of the relationship between the various parties and the rights and obligations of the parties under the applicable laws and agreements.
This remains the CRA’s position. See, for example, the response to question 3 at the May 2015 International Fiscal Association Conference Round Table (2015-058151 (May 28, 2015)).
Although there are somewhat different considerations when characterizing foreign entities as compared to characterizing instruments governed by foreign non-tax law, the approach to characterizing foreign entities is often of considerable assistance in characterizing foreign instruments.
We have examined the characteristic of the MRPS under XXXXXXXXXX law. These characteristics include the following:
- The MRPS are created under and governed by articles of incorporation.
- The articles of incorporation specifically state that the MRPS are part of corporate capital.
- The MRPS carry votes.
- We have assumed that the MRPS are treated in the same way as ordinary common shares, which we have assumed rank after debt in a bankruptcy.
- The MRPS are must be redeemed within XXXXXXXXXX years, but can only be redeemed from funds available for distribution under XXXXXXXXXX law or from the proceeds of a new share issuance.
These characteristics are very similar to traditional shares under Canadian business corporations statutes. Typically, under these statutes, shares are identified as such under the articles of incorporation or other similar constating documents. The rights of shareholders are set out in those documents and in the governing statute. Causes of actions in lawsuits brought by shareholders are typically grounded in the articles of incorporation or similar constating documents (including unanimous shareholders agreements). These corporate documents are not bilateral contracts, but rather legally binding documents to which the corporation and all its shareholders are parties. Shares may or may not carry votes, but in respect of the governance of the corporation, typically only shareholders may vote on matters such as the election of the board of directors. An instrument that is characterized as a share typically ranks last in a bankruptcy.
The fact that the MRPS must be redeemed on or before a stipulated date does not detract from their character as shares. There are numerous examples of preferred shares of Canadian corporations that must be redeemed by the issuer on or before a stipulated date.
We note that since 2010 Rulings has considered a number of situations involving XXXXXXXXXX MRPS. Generally, in files where the status of XXXXXXXXXX MRPS as equity – as opposed to debt or some other type of instrument - was relevant, Rulings accepted that such MRPS would be treated as equity for purposes of the Act.
We also note the following comments of the Tax Court of Canada in Barejo Holdings ULC v. The Queen, 2015 T.C.C. 274 at paragraph 66:
Similarly, when considering a hybrid financial instrument that has a duality of characteristics, some typically features or indicia of debt and others typically features or indicia of capital or equity or investment, Canadian courts have been able to decide whether it in substance reflects a debt relationship or another relationship, such as equity, whose features it also exhibits. In approaching a hybrid instrument in this manner, it is not necessary to deny its hybrid nature and decide it is wholly and solely a particular type of relationship between the parties, say debt or equity. Rather, the Court is to look to and weigh the language chosen by the parties, the parties’ intentions, the surrounding circumstances, and the legislative régime in order to identify the characterization in favour of which the balance clearly tilts as being the substance or main thrust of the transaction to which the contrary indicia remain only incidental or secondary in nature. As discussed in greater detail below, this is the approach to characterizing hybrids expressly set out in the unanimous Supreme Court of Canada in Canada Deposit Insurance Corporation v. Canadian Commercial Bank  3 S.C.R. 558. This was followed and applied by the B.C. Court of Appeal in Coast Capital Savings Credit Union v. British Columbia, 2011 BCCA 20 in deciding when “non-equity shares” were evidences of indebtedness “of the credit union”, not an equity interest therein. A similar approach was essentially adopted by the Quebec Court of Appeal in La Senza Inc. v. Deputy Minister of Revenue of Québec, 2007 QCCA 1335 in deciding that a taxpayer’s obligations under a sale-leaseback financing transaction could be characterized as a form of debt included in taxable capital for provincial capital tax purposes even though not yet due and payable.
The status of the MRPS under the governing corporate and commercial law is of critical importance to the analysis. In this case we have assumed that the MRPS are considered to be equity for XXXXXXXXXX corporate, bankruptcy and private law purposes. We assume that the MRPS will have the same rights and privileges as ordinary shares in the issuer, except as otherwise provided in the articles of incorporation that we have reviewed. We assume that distributions on the MRPS, if and when declared, will have the same nature under XXXXXXXXXX corporate and private law as dividends paid on the ordinary shares of Holdings and Finance. We have assumed that instruments characterized as shares under XXXXXXXXXX law would rank last in a bankruptcy. If these assumptions were not correct, our conclusions could be materially different.
We trust that these comments will be of assistance.
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. A severed copy will also be distributed to the commercial tax publishers, following a 90-day waiting period (unless advised otherwise to extend this waiting period), for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this latter version should be e-mailed to: LPRA-PLAR ITR-DDI Access Team-Équipe d'Accès. In such cases, a copy will be sent to you for delivery to the taxpayer.
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:
1 Defined as any agreement that may be entered into from time to time that caps the amount payable to the MRPS shareholder in respect of Dividend 2.
2 Defined as any agreement that may be entered into from time to time that documents a commitment to subscribe for shares in Holdings in connection with the redemption of the MRPS.
3 Defined as the earnings accrued or received or any gain realized by Finance as determined according to XXXXXXXXXX in relation to the XXXXXXXXXX financial assets acquired or to be acquired by Finance and financed directly with the proceeds resulting from the issuance of the MRPS and/or any other XXXXXXXXXX financial assets replacing from time to time such assets or purchased or financed with the Income and other proceeds arising out of such financial assets or of a disposal of all or part of such financial assets.
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