11 June 1992 Income Tax Severed Letter 2M02190 - Distress Preferred Shares

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

June 11, 1992 1992 CORPORATE MANAGEMENT TAX CONFFRENCE DISTRESS PREFERRED SHARES In 1978, the income tax rules for preferred shares were changed to limit the ability of corporations to use preferred shares as an after-tax financing vehicle. This was accomplished by introducing the "term preferred share" legislation. However, the definition of a term preferred share in subsection 248(1) of the Income Tax Act (the "Act") contains an exception in paragraph (e) for corporations in financial difficulty. The purpose of this exception is to assist a debtor to return to financial health by providing a means for its borrowing costs to be reduced. In the last two years, we in the Rulings Directorate have seen a significant increase in the number of ruling requests concerning proposed transactions utilizing this provision.

In this paper, I will discuss some of the requirements of the law, and at the same time I will make reference to various issues that the Department has considered in providing advance income tax rulings with respect to financial difficulty restructurings. I will also review what information we in the Rulings Directorate usually require in processing the ruling requests.

Shares which meet the requirements of the exception are often referred to as financial difficulty shares or distress preferred shares. Upon substitution of the shares for debt, the corporate creditor is entitled to receive dividends which are deductible in computing taxable income, as opposed to receiving taxable interest income. Document Disclosed Pursuant to The Access To Information Act Document Divulgué en vertu de la loi sur l'accès à l'information

The creditor can then charge a lower dividend rate than the interest rate, and achieve the same after-tax rate of return. Although the dividends are not deductible by the debtor, this is not usually of consequence given its financial difficulty and its resulting loss situation.

A similar result can be achieved by the debtor and creditor converting the debt to an income bond, which term is also defined in subsection 248(1) of the Act. By virtue of subsection 15(3) of the Act, the interest paid and received on an income bond is deemed to be paid and received as a dividend.

The financial difficulty requirements of paragraph (c) of the income bond definition are virtually identical to the paragraph (e) exception in the term preferred share definition. The major difference between the two instruments is that interest on an income bond is only payable to the extent of profits. There is no such limitation on dividends on distress preferred shares. For this reason income bonds are not used as frequently as distress preferred shares.

The small business financing program announced in the February 25, 1992 federal budget extends the preferential tax treatment outlined above to qualifying small business corporations and qualifying individuals and partnerships. The rules for this program will be similar to the rules pertaining to small business development bonds and small business bonds as they applied in 1987 before those provisions were terminated. The rules are contained in sections 15.1 and 15.2 of the Act and the principle is the same, i.e. the interest paid and received is deemed to be a dividend. Small business development bonds and small business bonds may be issued at any time after February 25, 1992 and before January, 1993. Qualifying bonds have a minimum principal value of $10,000 and a maximum of $500,000. There is no such restriction on the dollar amount that may be refinanced using income bonds or distress preferred shares.

Since all of the criteria of the earlier program that ended in 1987 will apply to the new program, Interpretation Bulletin IT-507 Small Business Development Bonds and Small Business Bonds will be used as the basis for administering the new program. It is our intention to issue a Special Release to the bulletin at approximately the same time the legislation is passed.

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Revisions of form T2216 Joint Election in respect of a Small Business Development Bond and form T2218 Joint Election in respect of a Small Business Bond are now available in the District Offices. The appropriate form must be filed by the later of 90 days from the date of issue of the debt or 90 days from the date the legislation receives Royal Assent.

Our experience with the previous program showed that advance income tax rulings were not required prior to the issuance of the bonds. The issuers were able to confirm their eligibility with reference to IT-507, and to the best of my knowledge there were no abuses or difficulties. I expect the same to be true for this program.

Department's Position on the Legislation

The paragraph e) exception in the term preferred share definition for shares issued after November 12, 1981 only applies for five years from the date of issuance of the shares. The practical result is that the shares are five year shares redeemable no later than at the end of that time period. If an income bond, small business development bond or small business bond is utilized, by definition its terms may not exceed five years.

We have received ruling requests that effectively ask for an automatic extension or renewal of the distress preferred shares if the issuer is still in financial difficulty at the end of the five year term. Our position is that the extension or renewal is not automatic; the issuer must demonstrate that it does not have the ability to pay or obtain normal financing to pay the debt that will arise as a result of the required redemption of the distress preferred shares. In other words, all of the requirements (some of which I will discuss later) must again be met. Some favourable rulings have been given in this regard.

The distress preferred shares must be issued:

(i) as part of a proposal to, or arrangement with, its creditors
that had been approved by a court under the Bankruptcy Act,
or
(ii) at a time when all or substantially all of its assets
were under the control of a receiver, receiver-manager,
sequestrator or trustee in bankruptcy, or ...

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• (iii) at a time when, by reason of financial difficulty, the issuing corporation or another corporation resident in Canada with which it does not deal at arm's length was in default, or could reasonably be expected to default, on a debt obligation held by a person with whom the issuing corporation or the other corporation was dealing at arm's length ...

These first two subparagraph are questions of fact that have not been difficult to resolve. The corporation either meets or does not meet these requirements.

We have determined that a plan of arrangement pursuant to the Companies Creditors' Arrangement Act would not meet the requirements of (i) or (ii) above. That act provides insolvent corporations with protection from secured creditors by ensuring that they will not be forced into bankruptcy before a reorganization plan is drawn up. While creditors vote on the reorganization plan and court approval is required, it is not an arrangement approved by a court under the Bankruptcy Act. Additionally, as the assets remain under the control of the corporation, the criteria of subparagraph (e)(ii) are not satisfied. However, in these situations default has usually occurred with the result the conditions of subparagraph e(iii) are met.

It is thus the third subparagraph that is the question of fact which gives rise to the ruling requests on this subject.

From the wording of the provision it is apparent the default, or expected default, must be by reason of financial difficulty. Based on the linkage of these words, we have stated, in paragraph 9 of Interpretation Bulletin IT-507, that a corporation may be considered to be in financial difficulty if the following conditions are present:

• a) Default must be due to a general inability to pay and not as the result of a technical default.
• b) The beneficial shareholders and any associated corporations are not in a position to provide further financing to the corporation.
• c) The corporation is unable to obtain any further financing from unrelated parties, such as a bank.

Additional commentary related to the beneficial shareholders and associated corporations is contained in paragraph 15 of Interpretation Bulletin IT-52R4 concerning income bonds.

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In this bulletin we state that the financial position of all members of a related corporate group must be taken into account in determining whether any member could reasonably be expected to default on a debt obligation by reason of financial difficulty.

For a corporation to be in financial difficulty we also consider the following factors:

• a) The corporation must not have current resources such as cash and unused loan capacity (lines of credit or demand loan facilities) available.
• b) The corporation must not have other sources of funds available. Examples would include funds that could be obtained from the sale of superfluous assets or the issuance of new equity.

We are often asked what time frame is involved in the reasonable expectation of default. Can it be one year or even two years away?

Finance officials advised us that the first draft of the legislation only referred to default. The concern was then raised that in order to refinance using distress preferred shares, the corporation would have to actually default with all the adverse consequences of that action. If default was imminent, would this really be necessary? The answer being negative, the words "or could reasonably be expected to default" were inserted.

In our view, in most cases, a reasonable expectation of default means that default is probably not more than three or four months away. While a gloomy future may be predictable for longer periods, there are normally too many variables for a reasonable expectation of default beyond this period.

We have encountered situations involving the use of daylight loans in situations that go beyond the mere restructuring of the transaction. In our view, there is no expectation of default in a situation where a loan is to be issued with the full knowledge of and on the condition that the loan would be exchanged for distress preferred shares. The obvious tax policy concern is that the loan could be used in abusive situations. For example, a debtor who wanted to acquire an asset using "after-tax financing", and who was not in financial difficulty could borrow an amount in excess of its ability to pay. The debtor would then allege that it is in financial difficulty and entitled to replace the debt with distress preferred shares. We have refused to rule favourably in these cases.

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Given the wording in subparagraph (e)(iii), the issuing corporation may be other than the corporation which is in default as long as the proceeds from the issue of the distress preferred shares are used to replace the debt, or a part thereof.

As well, distress preferred share refinancing can be used in respect of both the principal of the debt and the related accrued but unpaid interest. The words also leave some room for the refinancing costs to be paid out of the share proceeds.

The applicable legislation also contains the requirement that the proceeds from the share issue must reasonably be regarded as having been used in the financing of the issuer's business carried on in Canada immediately before the share was issued. Thus, where the shares are being issued in exchange for a debt, the debt being refinanced must represent borrowed money used in a Canadian business.

Where a company carries on business both in and outside Canada, only the portion of the debt relating to the business carried on in Canada qualifies. In this regard the corporation must be able to support that the proceeds of the debt were used in a Canadian operation. In those unusual circumstances where it is not possible to trace the use( of the proceeds) of the debt to be refinanced, we would be prepared to consider any reasonable method of allocation. Depending on the particular circumstances an allocation based on a comparison of net profit and asset costs may be appropriate.

In one case, an issue arose where the debt was the result of a Canadian corporation having to honour a guarantee given to a creditor of its foreign subsidiary. The funds were borrowed and passed on to the foreign subsidiary by way of a share investment. Shortly thereafter the subsidiary ceased to carry on a business. Three years later, the Canadian corporation was in default on the debt, and wished to refinance using distress preferred shares. We determined they met both the legal conditions and the intent of the legislation since:

a) the debt could no longer be related to a foreign asset
or investment,
b) the debt had been borne by the Canadian business for
some time, and
c) the refinancing would enable the Canadian business (now
the only business) to be carried on.
In another situation we were asked if it would be acceptable for
a corporate general partner of a limited partnership with a 1%
interest in the partnership to issue distress preferred shares on
the basis that the debt of the limited partnership is ultimately
the debt of the general partner.
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In our opinion, the general partner did not satisfy the conditions as the proceeds from the issuance of the financial difficulty shares would have been used in financing of the business of the partners, and not in the financing of the general partner's business.

To satisfy the above noted condition, one proposal brought to our attention, but upon which we have not had a formal ruling request, involved all the limited partners transferring their limited partnership interests to the corporate general partner in return for shares. By eliminating the partnership, the debt which the corporate general partner sought to convert to distress preferred shares would arguably be considered to have been used in the financing of its business carried on in Canada immediately before the shares were issued.

If the situation is one described in subparagraph 248(1)(e)(i) or (ii), the share proceeds need not be used to repay a debt obligation; in these cases the actual use of the proceeds would be the determining factor. The words "in the financing of its business" do not permit the proceeds to be invested in income producing assets that are either unrelated to or inconsistent with the debtor's ordinary business. Thus, it is not possible to issue distress preferred shares, and invest the proceeds in such investments as marketable securities to earn a spread.

REQUIREMENTS FOR A RULING

Excess Cash Flow

When we first became involved in distress preferred share rulings, it became apparent that we were ruling on a question of fact, as opposed to a question of law. In addition, it appeared to us that the Department should probably carry out an audit before ruling on the issue of whether or not the default was due to the financial difficulty of the issuer of the shares. For practical reasons, this was obviously not an acceptable course of action. One argument that was presented to us was that the agreement between the debtors and creditors usually contained an excess cash flow provision. This represented a commitment by the issuer to use cash flow in excess of operating requirements to redeem or retire the distress preferred shares or the income bonds as the case may be. The point was made that if the default was contrived or just temporary, the shares would be redeemed. In order to process these ruling requests as quickly as possible, we decided to place considerable weight on the existence of the excess cash flow provision. We do request a few minor modifications to the normal one a creditor might insist on, since the creditor has other controls it can rely on.

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The excess cash flow definition is essentially the aggregate of the changes in cash flows, as determined in accordance with generally accepted accounting principles, of each of the corporations in the group subject to certain limitations in respect of capital expenditures. These limitations are intended to:

• 1. deny payments to shareholders, other than the holders of the financial difficulty shares, whether by way of dividend or repayment of shareholder loans, and
• 2. restrict expenditures to those necessary to carry on the existing business as opposed to expanding the business.

The definition of excess cash flow utilized in advance income tax rulings has been more or less standardized, but we are prepared to make modifications to accommodate items that may be peculiar to a particular situation. Further it is intended to be in addition to but not a substitute for excess cash flow or surplus cash definitions agreed upon between the creditor and the debtor. In our experience, the creditor often imposes a more explicit and a tighter definition of excess cash flow than we provide for, but it also has the discretion to waive this requirement.

Some examples of modifications to this provision that we have accepted are:

• 1. In a ruling concerning a private corporation, dividends payable to the major shareholder were allowed, since this was partially his form of remuneration. There was a cap on the amount of the dividends which was consistent with amounts paid in previous year.
• 2. In a situation involving a public corporation, regular dividends on the listed shares were permitted, since to do otherwise would have had a detrimental effect on the value of the shares.
• 3. In another case new borrowed funds were not included in excess cash flow on the basis that they were to be used in a self-funding project. This was acceptable since there was no diversion of excess cash flow from existing operations. I should point out that during the evolution of the excess cash flow requirement we at one time specifically provided for the dollar amount of capital expenditures that could be made by the corporation based on forecasted cash flows.

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This proved inappropriate for a number of reasons, including the fact that we in effect admitted ourselves to the day to day operations of the corporation's business in that it would have to seek our approval for increased expenditures. We now provide for reasonable capital expenditures incurred in the ordinary course of the existing business, which is a more appropriate approach given the purpose of the excess cash flow provision.

Attached as Appendix "A" is a typical excess cash flow provision that has been used in many advance income tax rulings.

Information Requirements

Given that we are being requested to rule on a question of fact it is essential that we be provided with sufficient information to allow us to make this determination.

In circumstances where the default has not yet occurred we need the following types of information:

• 1. The ruling application should include the organizational structure and financial statements of all corporations in the organization including major shareholders in closely held situations. If the shares of the troubled corporation are held by an individual or related individuals we request information as to their financial position.

Essentially we are ensuring there are no financial resources within the corporate group which could be utilized to alleviate the financial difficulty.

In other than wholly-owned situations it unlikely that we can expect a controlling shareholder to shoulder the entire financial difficulty of the subsidiary if the minority shareholders are not prepared to contribute.

In wholly-owned and major control situations we normally find that the shareholders have made or are willing to make some contribution to or concession in favour of the troubled corporation.

• 2. There should also be included documentation or evidence that the troubled corporation has attempted alternative means and solutions to avoid the impending default. If alternatives are available, which if adopted would avoid a default, can it be said that if such alternatives are not adopted that the default would be the result of financial difficulty?

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In this respect we are generally provided with, for example:

• a) correspondence concerning failed attempts to refinance the debt with the lending and other financial institutions,
• b) evidence that operations have been rationalized (e.g. salaries, asset sales), and
c) an indication that other financial sources have seriously been considered (e.g. equity).
• 3. In circumstances where the debt is a demand instrument, there should be evidence from the creditor to the effect that demand will be made within three to four months.
• 4. As well, annual cash flow statements should be submitted for the next five years which should substantiate financial difficulty and more particularly the expected default or cash flow deficiency. Again the cash flow deficiency must be expected to continue and not be temporary which would suggest bridge financing might be an appropriate solution.

We also ask for five year cash flows prepared on the assumption that the refinancing is obtained. If such forecasts do not signal improved health and positive cash flows, then we must question why an arm's length creditor would ever agree to the refinancing. If nothing else this suggests we use a greater degree of caution and that perhaps we do not fully understand the particular situation.

Most of the above information will also be requested even where default has occurred given that we need to establish that it was by reason of financial difficulty.

It is important to note that before granting a favourable ruling we must be satisfied that the debtor is unable to obtain adequate relief in any other manner. This position was stated at the 1981 Tax Conference (question 8 at page 732), in commenting on a small business development bond. We stated: "...the availability of an SBDB as a means of affording relief to companies experiencing financial difficulty should be restricted to instances where the issuer is truly in financial difficulty and unable to obtain further financing."

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Issuer of the Financial Difficulty Shares

The refinancing vehicle is almost always a shell corporation (Newco). This is apparently the case as, taking into consideration the various business corporations acts, this structure affords creditors with the most security with respect to the distress preferred shares received in substitution for their debt.

In our view as Newco is utilized only to facilitate the refinancing, its use should not result in any additional tax benefit to the corporation. Accordingly we require that the facts and proposed transactions provide for the following:

• 1. Newco will be a single purpose corporation that will not engage in any business or transactions other than those provided for in the advance income tax ruling, and
2. except for the operation of any applicable law to which Newco is subject, Newco will be wound up without any undue delay after the time that is the earlier of;
• (a) the time at which all of the distress preferred shares are redeemed or cancelled; and
• (b) five years from the date of issuance of the distress preferred shares.

Should the operation of the law prevent the redemption of the distress preferred shares for a particular period of time that commences after the earlier of the dates referred to in (a) and (b) above, then Newco shall not engage in any business transaction other than in respect of the redemption of the distress preferred shares or the winding-up of Newco.

In addition, we require that the corporation in financial difficulty and Newco enter into an agreement that will provide that any amounts contributed to Newco for operating expenses or the payment of dividends, will be regarded as funds to be held by Newco for the benefit of the contributing corporation until the funds are used to make such payment. As a consequence it is our view that such contributions to the capital of Newco will not result in an increase in the fair market value of the shares of Newco, and therefore will not give rise to an increase in the adjusted cost base of such shares pursuant to paragraph 53(1)(c) of the Act.

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RULINGS PROCEDURES

We in the Rulings Directorate recognize that distress preferred share rulings deserve top priority. We realize that the client is trying to save his business, and time is of the essence. Some representatives submit ruling requests with much of the information missing, stating they just want to be in line to have the ruling dealt with. This is neither necessary nor productive. From our point of view, and our experience has shown this, we can process the application much faster if we have a complete package to start with. I assure you there is no need to submit a partial ruling request with these files, since they do receive our immediate attention.

When I first became involved with financial difficulty rulings, there were usually three or four rulings requested. There has been a trend recently to increase the number of requests, with the result that it is not uncommon for us to have to consider thirty or so rulings. This obviously has a very significant impact on the time involved, and many of the rulings requested are unnecessary.

In one particular case, we asked a representative why certain rulings were requested, since we wanted to know what the concern was. The response was that there was not a concern, but he had seen these rulings given in other rulings, so he included them in his request.

Attached as Appendix "B" is a list of the normal rulings given in these advance income tax rulings.

In Information Circular 70-6R2, we say that advance ruling requests should contain the interpretation of the application of the provisions of the Act that are relevant, and a description of the income tax concern that is the cause of the request for the ruling.

In the last two weeks, I was personally involved in two difficult files that we were having some difficulty in processing. We requested a meeting to discuss what the concerns were that were giving rise to the problems. Once the issues were identified, we were able to work together with the representative to resolve these very quickly and process the files.

Our goal is to be able to turn around the files in a timely manner. In this regard, if we have all the information up front, the concerns identified, and your views of the relevant provision of the law, we will be able to provide a much improved service. Although this is particularly important for financial difficulty rulings, this is true for all ruling requests. Document Disclosed Pursuant to The Access To Information Act Document Divulgué en vertu de la loi sur l'accès à l'information

In closing, I would like to publicly thank Theresa Murphy, Lee Workman and Claire Lebel for their input to and assistance in the preparation of this paper. Appendix A TYPICAL EXCESS CASH FLOW PROVISION

Notwithstanding the terms and conditions of the Preferred Shares or any mandatory redemptions of the Preferred Shares that may be required by the Bank, within (120) days after the end of each fiscal period, all Excess Cash Flow arising in that fiscal period shall be applied to redeem the Preferred Shares.

Excess Cash Flow in respect of a particular fiscal period shall be the changes in cash flow for such period of Distressco from all sources, as would be reported on a Consolidated Statement of Changes in Financial Position prepared in accordance with generally accepted accounting principles, if only directly and indirectly wholly-owned subsidiaries of Distressco were so included, but before outlays for:

• (i) the payment of dividends other than dividends paid on the Preferred Shares;
(ii) capital expenditures or any payment on capital account other than in respect of:
• (a) the purchase or redemption of the Preferred Shares, other than redemptions made in the period in respect of the prior period's Excess Cash Flow,
• (b) repayments of indebtedness incurred in the normal and ordinary course of business and in existence at the date the Preferred Shares are issued,
• (c) repayments of additional debt incurred for the specific purpose of funding current operating requirements,
• (d) expenditures or payments between any of Distressco and its directly and indirectly wholly-owned subsidiaries,
• (e) reasonable capital expenditures or payments on capital account incurred in the normal and ordinary course of the existing business and repayments of additional debt for the specific purpose of making such capital expenditures or payments on capital account, and

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(f) repayments of additional debt incurred for the specific purpose of enabling Newco to redeem the Preferred Shares or to pay dividends on the Preferred Shares;
• (iii) repayments of loans to shareholders of Distressco or redemptions of any of the shares of Distressco; and
• (iv) loans to directors, officers and shareholders of Distressco or to other persons, firms or corporations.

For the purposes of this definition of Excess Cash Flow, additional debt shall not include a debt which arose as the result of the use of cash or funds for a purpose that is not envisaged herein. Appendix B

TYPICAL RULINGS

Provided that the foregoing statements constitute complete and accurate disclosure of all of the relevant facts and proposed transactions, we confirm the following:

A. the Preferred Shares of Newco to be issued to the Bank,
as described in paragraph ( ) of the Proposed
Transactions (the "Shares"), will be shares described in
subparagraph (e)(iii) of the definition of "term
preferred share" in subsection 248(1) of the Act for a
period not exceeding five years from the date of their
issuance and, accordingly, the Bank will not be denied a
deduction under subsection 112(1) of the Act for
dividends received or deemed to have been received on
the Shares during such period;

B. subsection 112(2.4) of the Act will not, by virtue of
subsection 112(2.5) of the Act, apply to deny the Bank a
deduction under subsection 112(1) of the Act for
dividends received or deemed to have been received on
the Shares;

C. no amount will be included in computing the income of
Newco under paragraph 12(1)(c) or 12(1)(x), or
subsection 12(3), 12(9), 16(1) or 246(1) or section 9 of
the Act in respect of capital contributions made or
required to be made by Distressco to Newco, as described
in paragraph ( ) of the Proposed Transactions, nor will
such amounts constitute proceeds of disposition, as
defined in paragraph 54(h) of the Act, to Newco from the
disposition by it of any property;
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D. subsection 80(1) of the Act will not apply in respect of
Distressco by virtue of the fact that interest will not
be paid or payable by Distressco to Newco on the
Purchased Loans, as described in paragraph ( ) of the
Proposed Transactions;

E. subject to paragraph 20(1)(e.1) of the Act, expenses
incurred by Newco in the course of borrowing money and
issuing the Shares, will be deductible pursuant to
paragraph 20(1)(e) of the Act to the extent such
expenses are reasonable in the circumstances;

F. the cost amount, within the meaning of subsection 248(1)
of the Act, to the Bank of the Shares will, immediately
after the time that the Shares are issued, be equal to
the amount paid by the Bank for those Shares as
described in paragraph ( ) of the Proposed Transactions;

G. the cost amount, within the meaning of subsection 248(1)
of the Act, to Newco of the Purchased Loans will,
immediately after they are acquired from the Bank, equal
the purchase price paid therefor as described in
paragraph ( ) of the Proposed Transactions;

H. no amount will be included in computing the income of
the Bank under subsection 56(2) of the Act in respect of
any capital contributions made by Distressco to Newco as
described in paragraph ( ) of the Proposed Transactions;

I. if the Purchased Loans are reacquired by the Bank, as
described in paragraph ( ) of the Proposed Transactions,
the cost amount, within the meaning of subsection 248(1)
of the Act, to the Bank of the Purchased Loans will be
the purchase price paid therefor; and

J. as a result of the Proposed Transactions, in and of
themselves, subsection 245(2) of the Act will not apply
to redetermine the tax consequences confirmed in the
rulings given above.

These rulings are given subject to the general limitations and qualifications set out in Information Circular 70-6R2 and are binding on Revenue Canada, Taxation provided that the Preferred Shares are issued by ________________________. These rulings are based on the Act in its present form and do not take into account any proposed amendments. Except as expressly stated, our rulings do not imply acceptance, approval or confirmation of any income tax implications of the facts or proposed transactions. Document Disclosed Pursuant to The Access To Information Act Document Divulgué en vertu de la loi sur l'accès à l'information