30 November 1996 Ruling 9709173 - 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.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Distress Preferrred Share Ruling

Distressco (a CCPC) will be taxable because of the DPS issue and, because the rental income is investment income, will not get a dividend refund because Newco will be paying the DPS dividends. Consequently, any taxable income (and the resulting tax liability) of Distressco will be shifted to Newco by continuing to accrue interest on the distress debt, however Newco will be able to waive this interest, in advance, on a monthly or quarterly basis.

Position:

OK

Reasons:

Not totally dissimilar to standard requirement that Newco waive interest on the debt for the entire term of the DPS. In this case, the interest is being waived periodically rather than in its entirety at the outset.

XXXXXXXXXX							970917
XXXXXXXXXX

Attention: XXXXXXXXXX

XXXXXXXXXX, 1997

Dear Sirs:

Re: Advance Income Tax Ruling
XXXXXXXXXX

We are writing in response to your initial correspondence of XXXXXXXXXX in which you had requested an advance income tax ruling on behalf of the above-noted taxpayers. We also acknowledge our various telephone conversations with respect to this matter and your further correspondence and submissions in support of this request.

You have advised that, to the best of your knowledge and that of responsible management of the taxpayers, none of the issues involved in this ruling application is being considered by a Taxation Services Office or a Taxation Centre of Revenue Canada in connection with any tax return already filed and that none of such issues is under objection or appeal.

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

FACTS

1. XXXXXXXXXX is a "private corporation" and a "taxable Canadian corporation" as those terms are defined in subsection 89(1) of the Income Tax Act (the "Act") and a "Canadian-controlled private corporation" as that term is defined in subsection 125(7) of the Act. The tax affairs of XXXXXXXXXX are administered by the XXXXXXXXXX Taxation Services Office of Revenue Canada and it files its return of income with the XXXXXXXXXX Taxation Centre.

2. XXXXXXXXXX was incorporated on XXXXXXXXXX. The authorized share capital of XXXXXXXXXX consists of XXXXXXXXXX. The issued and outstanding shares consist of XXXXXXXXXX common shares all of which are owned by XXXXXXXXXX.

3. XXXXXXXXXX.

4. Until XXXXXXXXXX, the Property was owned by a co-ownership consisting of a joint venture of

XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX.

In XXXXXXXXXX, XXXXXXXXXX acquired the XXXXXXXXXX% of the Property and operating assets held by limited partnerships and, in consideration, assumed the partnerships' share of the mortgage payable, as described in paragraph 7, below, and other operating liabilities. More specifically,

XXXXXXXXXX

XXXXXXXXXX.

5. XXXXXXXXXX activities are restricted to its investment in the Property and the receipt of modest management fees therefrom. XXXXXXXXXX daily work activities are devoted almost entirely to his investment in XXXXXXXXXX and its investment in the property. In the past he had received a salary from XXXXXXXXXX to the extent that there were profits therein. For the past several years however, XXXXXXXXXX has received neither salary nor dividends from XXXXXXXXXX. XXXXXXXXXX, currently assists in the management of the Property and receives $XXXXXXXXXX as remuneration. XXXXXXXXXX relies on the Property as his sole source of revenue.

6. XXXXXXXXXX, as that term is defined in subsection 248(1) of the Act, and a "taxable Canadian corporation", as that term is defined in subsection 89(1) of the Act. XXXXXXXXXX is, accordingly, a "restricted financial institution" and a "specified financial institution" as those terms are defined in subsection 248(1) of the Act. XXXXXXXXXX deals at arm's length, within the meaning of that term in subsection 251(1) of the Act, with XXXXXXXXXX.

7. The Property is subject to a mortgage securing a loan (the "Mortgage Loan") that is owed to XXXXXXXXXX and that was incurred to consolidate previous financing. Prior to the issue of the Preferred Shares, as described in paragraph 15, below, accrued interest, unpaid property taxes in respect of the Property and the costs associated with the issue of the Preferred Shares will be added to the principal amount outstanding on the Mortgage Loan.

The Mortgage Loan bears interest at the rate of XXXXXXXXXX% per annum and the balance outstanding as at XXXXXXXXXX. As a consequence of an earlier default on the mortgage, XXXXXXXXXX agreed in early XXXXXXXXXX to defer payment of approximately $XXXXXXXXXX of arrears as well as a $XXXXXXXXXX interest rate buy down. At the same time XXXXXXXXXX agreed to lower the interest rate on the mortgage XXXXXXXXXX. The interest rate buy down deferral was to be repaid in XXXXXXXXXX. The deferral of interest was to be repaid by XXXXXXXXXX or the loan would be in default. This latter deferral was not paid and as a result the loan is in default. Additionally, a major tenant has given notice that it will not renew its lease that expires in XXXXXXXXXX. The tenant in question occupies approximately XXXXXXXXXX% of the Property and pays rent of approximately $XXXXXXXXXX per month. Without this tenant, a severe cash deficiency will occur.

8. The decline in the real estate rental market in the XXXXXXXXXX area has resulted in extreme cash flow pressures for the Property. The large amount of vacant office and industrial space on the market has brought rents to extremely low levels and increased the requirement for larger incentives such as tenant inducements and rent-free periods. The resulting decline in revenues and increase in rental costs has placed the Property in a current position of financial difficulty and, once the major tenant's lease expires, the Property will be in severe financial difficulty. Additionally, due to this market deterioration, the possibility of replacing the revenue is doubtful in the short term.

9. On its XXXXXXXXXX balance sheet, XXXXXXXXXX is showing total assets of $XXXXXXXXXX and a deficit of $XXXXXXXXXX. Consequently, it has no other significant assets which could be used to alleviate the financial decline of the Property.

XXXXXXXXXX and the principal shareholder of XXXXXXXXXX have provided personal guarantees to XXXXXXXXXX in the respective amounts of XXXXXXXXXX with respect to the outstanding mortgage on the Property.

The principals of XXXXXXXXXX do not have any unencumbered assets that could significantly alleviate the financial difficulties that are being faced by the property.

XXXXXXXXXX have not been able to convince any alternative financing source to seriously consider providing financing to them given the current state of the real estate market and the reluctance in general of financial institutions to extend credit in this industry at this time. XXXXXXXXXX is not willing to continue to support the Property without the issuance of distress preferred shares to improve cash flow.

Without the conversion of the Mortgage Loan to preferred share capital, as outlined in the proposed transactions described below, XXXXXXXXXX will exercise its various rights under the default provisions of its loan agreements and assume title and possession of the Property or cause the forced sale thereof.

The cash flow projections for the Property for the calendar years XXXXXXXXXX indicate continuing deficiencies if the Mortgage loan is not converted into share capital as outlined in the proposed transactions described below. The following summarizes the projected cash flows comparing the results of the debt remaining outstanding versus the debt being converted into share capital:

					Current		Refinanced with
					Situation		Preferred Shares
					($ 000)		    ($ 000)

XXXXXXXXXX

The cash flow projections for XXXXXXXXXX for the same period are equal to its proportionate interest in the Property or, XXXXXXXXXX%, of the above amounts.

All of the above-noted cash flow projections are premised on the basis that the major tenant referred to in paragraph 7, above, does not, in fact, renew its lease after the expiry of its current lease at the end of XXXXXXXXXX.

PROPOSED TRANSACTIONS

10. XXXXXXXXXX will incorporate a new corporation ("Newco") under either the Canada Business Corporations Act or the XXXXXXXXXX. XXXXXXXXXX will subscribe for a nominal amount of common shares of Newco for nominal cash consideration. Newco will be a single-purpose corporation that will not engage in any business or activity except as provided for in the proposed transactions.

11. The authorized share capital of Newco will include:

(i) an unlimited number of voting and participating common shares;

(ii) an unlimited number of Class "XXXXXXXXXX" preferred shares (the "Preferred Shares"), the attributes of which will be as follows:

(a) non-voting;

(b) non-participating, except for a preferential cumulative dividend entitlement, the rate of which is to be determined in accordance with negotiations with XXXXXXXXXX but which is not expected to exceed XXXXXXXXXX% per annum;

(c) redeemable at $XXXXXXXXXX per share plus accrued unpaid dividends less any amounts previously returned to the shareholder as a return of capital;

(d) retractable at $XXXXXXXXXX per share plus accrued unpaid dividends less any amounts previously returned to the shareholder as a return of capital (the "Retraction Amount"), upon the occurrence of a Designated Event, as described in paragraph 18, below, or, in any event, on the fifth anniversary of their issuance; and,

(e) rank in priority on liquidation or dissolution up to their Retraction Amount.

12. The articles of Newco as well as a unanimous shareholders agreement entered into with the shareholders of Newco will provide that without the unanimous approval of such shareholders:

(i) no transfer or encumbrance of the common shares of Newco will be effective;

(ii) no additional shares of Newco will be issued;

(iii) no transfer or encumbrance of the assets of Newco will be effective; and

(iv) other than as contemplated herein, Newco will not carry on any activities, engage in any business transaction, incur any indebtedness, create any security over its assets, make any guarantee, amalgamate, merge or consolidate, declare or pay dividends (other than on the Preferred Shares) or purchase or redeem any of its shares (other than Preferred Shares).

13. Newco will borrow from XXXXXXXXXX, on a daylight loan basis, an amount equal to XXXXXXXXXX% of the principal amount of the Mortgage Loan owing by XXXXXXXXXX in respect of the Property plus, as noted in paragraph 7, above, any accrued interest, unpaid property taxes and costs of issuance of the Preferred Shares. The daylight loan will be non-interest bearing, have a term of one day and be evidenced by a note. XXXXXXXXXX will guarantee the obligations of Newco to XXXXXXXXXX under the terms of the daylight loan.

14. Newco will purchase its proportion (XXXXXXXXXX%) of the Mortgage Loan, as well as the related security, from XXXXXXXXXX. The purchase price will be equal to the principal amount of the proportionate amount of the Mortgage Loan and will be paid in cash using the proceeds of the daylight loan. It will be agreed between Newco and XXXXXXXXXX that interest will continue to accrue on the Mortgage Loan, however, interest accruing for the initial two months following the date of the purchase of the Mortgage Loan from XXXXXXXXXX will not be payable by XXXXXXXXXX on the Mortgage Loan for as long as Newco holds the Mortgage Loan. Thereafter, Newco may waive, in advance, all or part of its right to receive interest from XXXXXXXXXX with respect to the Mortgage Loan until the occurrence of a Designated Event, as described in paragraph 18 below, or, in any event, until the fifth anniversary of the purchase of the Mortgage Loan. If, on the fifth anniversary of the purchase of the Mortgage Loan and all dividends have been paid on the Preferred Shares, the initial two months of accrued interest will be cancelled immediately prior to the transfer of the Mortgage Loan from Newco to XXXXXXXXXX.

The purpose for the accrual of the initial two months of interest of interest is to provide XXXXXXXXXX with access to the old security at an amount in excess of the amount of any indebtedness under the Mortgage Loan in the event that XXXXXXXXXX requires the Preferred Shares to be acquired for an amount in excess of the amount of the indebtedness under the Mortgage Loan and to compensate XXXXXXXXXX for expected time delays associated with the retraction of the Preferred Shares pursuant to a Designated Event.

15. XXXXXXXXXX will use all of the proceeds received from Newco for the purchase of the Mortgage Loan, as described in paragraph 14 above, to subscribe for Preferred Shares of Newco. If required by XXXXXXXXXX, the stated capital account for the Preferred Shares will be reduced to a nominal amount without any distribution of any amount to the shareholders of Newco.

16. Newco will use all of the proceeds from the issue of the Preferred Shares to repay the daylight loan to XXXXXXXXXX in its entirety.

17. XXXXXXXXXX, Newco and XXXXXXXXXX will enter into an agreement which will provide that after the occurrence of any Designated Event, as described in paragraph 18, below, XXXXXXXXXX will have the following options:

(i) XXXXXXXXXX will be required, at the request of XXXXXXXXXX, to purchase all or some of the Newco Preferred Shares from XXXXXXXXXX for a purchase price equal to the Retraction Price of the Preferred Share. The purchase price will be paid in cash.

To secure the obligation of XXXXXXXXXX to purchase the Preferred Shares from XXXXXXXXXX and to pay the purchase price, Newco will hypothecate and cross collateralize the Mortgage Loan to XXXXXXXXXX as additional security.

(ii) Newco will be required to sell for cash, all or some of the Mortgage Loan to XXXXXXXXXX for an amount equal to the principal amount of the portion of the Mortgage Loan to be sold, adjusted to compensate XXXXXXXXXX for any tax liabilities with respect to the Preferred Shares. Concurrently, Newco will be required to purchase for cancellation all or some of the Shares held by XXXXXXXXXX utilizing the cash proceeds which it receives from XXXXXXXXXX from the sale of the Mortgage Loan.

To secure its obligation to purchase the Preferred Shares held by XXXXXXXXXX and to pay the purchase price, Newco will hypothecate to XXXXXXXXXX its right to receive the sale proceeds from XXXXXXXXXX. XXXXXXXXXX will guarantee all of Newco's obligations to XXXXXXXXXX.

18. "Designated Event" includes, inter alia, events which coincide with the events of default under the various agreements between XXXXXXXXXX which govern the Mortgage Loan.

19. Redemptions by Newco of the Preferred Shares, dividends payable by Newco on the Preferred Shares and any fees or expenses of Newco incurred to maintain good standing under all applicable laws and agreements will be funded by either capital contributions or interest payments from time to time by XXXXXXXXXX to Newco.

20. The capital contributions referred to above will be regarded as funds to be held for the benefit of XXXXXXXXXX until such time as Newco requires the funds to make the payments referred to in paragraph 19, above. Newco will not add contributions of capital to the stated capital of its common shares.

21. Notwithstanding the terms and conditions of the Preferred Shares or any mandatory redemptions of the Preferred Shares that may be required by XXXXXXXXXX, all "Excess Cash Flow", as defined below, arising in each fiscal period, shall be applied to purchase or redeem the Preferred Shares issued by Newco within 120 days after the end of that fiscal period.

22. "Excess Cash Flow" in respect of a particular fiscal period shall be the change or increase in cash flow for such fiscal period of XXXXXXXXXX from all sources as would be reported on a Consolidated Statement of Changes in Financial Position prepared in accordance with generally accepted accounting principles, before outlays for:

(i) the payment of dividends other than dividends 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 the purchases or 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 XXXXXXXXXX and Newco;

(e) reasonable capital expenditures or payments on capital account incurred in the normal and ordinary course of the business of the Property, of Newco or XXXXXXXXXX and repayments of additional debt for the specific purpose of making such capital expenditures or payments on capital account; and

(f) repayments of additional debt incurred for the specific purpose of enabling XXXXXXXXXX to purchase the Preferred Shares or Newco to purchase or redeem the Preferred Shares or to pay dividends thereon;

(g) costs incurred in connection with the issuance of the Preferred Shares.

(iii) repayments of loans to shareholders of XXXXXXXXXX or redemptions of any of the shares of XXXXXXXXXX; and

(iv) loans to directors, officers and shareholders of XXXXXXXXXX or to other persons, firms or corporations.

For purposes of this definition of Excess Cash Flow, additional debt shall not include a debt which arose as a result of the use of cash or funds for a purpose that is not envisaged herein and for the purpose of calculating Excess Cash Flow for a particular fiscal year pursuant hereto, each of the foregoing provisions will be construed so as to prevent duplication or repeated accounting of amounts.

23. The redemption by Newco of the Preferred Shares will be funded through the respective repayment by XXXXXXXXXX to Newco of all or part of the corresponding Mortgage Loan.

24. In the event that the interest paid by XXXXXXXXXX to Newco is in excess of both the required dividend payments to XXXXXXXXXX and Newco's tax liability, the excess will be:

(i) Loaned by Newco to XXXXXXXXXX on an interest-free basis,

(ii) Used by XXXXXXXXXX to reduce the Mortgage Loan balance owing to Newco, and

(iii) Used by Newco to redeem a corresponding amount of the Preferred Shares.

The loan of this excess amount will ensure that the amount of the Mortgage Loan is always equal to the redemption value of the Preferred Shares.

25. Subject to the operation of any applicable law to which Newco is subject, Newco will be wound-up without any undue delay at the earlier of:

(i) the date upon which there are no longer any Preferred Shares outstanding; and

(ii) the date that is five years after the date upon which the Preferred Shares are issued.

26. Any loans existing between XXXXXXXXXX and Newco as a consequence of any transactions as described in paragraph 24, above, will be cancelled by offset upon the winding-up of Newco.

27. XXXXXXXXXX will have the right at any time and from time to time, in their sole discretion, subject to the unanimous shareholders agreement entered into by it, and applicable security restrictions, to sell their Preferred Shares, or any portion thereof, to a third party which is a taxable Canadian corporation (a "Subsequent Acquirer") on such terms and conditions as XXXXXXXXXX may in its sole discretion determine.

PURPOSE

The purpose of the proposed transactions is to convert the long-term debt of XXXXXXXXXX related to the Property into distress preferred share capital and thereby increase cash flow so as to allow it to continue its operations and to improve its overall financial situation.

RULINGS PROVIDED

Provided the foregoing statements constitute a complete and accurate disclosure of all the relevant facts and proposed transactions, the following rulings are provided:

A. The Preferred Shares, as described in paragraph 11 of the Proposed Transactions, to be issued by Newco to XXXXXXXXXX, and, if applicable, sold to a Subsequent Acquirer as described in paragraph 27 of the Proposed Transactions will be:

(i) 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

(ii) "exempt shares" pursuant to paragraph (c) of the definition thereof in subsection 112(2.6) of the Act during that same period;

and, accordingly, subsections 112(2.1), (2.2), (2.3) and (2.4) of the Act will not apply to deny XXXXXXXXXX or a Subsequent Acquirer, as the case may be, a deduction under either of subsections 112(1) or 138(6) of the Act for dividends received or deemed to have been received by it on such Preferred Shares during such period.

B. No amount will be included in computing the income of Newco under either of paragraphs 12(1)(c) or (x) of the Act, subsections 12(3) or (9), 16(1) or 246(1) or section 9 of the Act in respect of capital contributions made or required to be made by XXXXXXXXXX to Newco, nor will such amounts constitute "proceeds of disposition", as defined in section 54 of the Act, to Newco from the disposition of any property.

C. The interest paid or payable by XXXXXXXXXX to Newco in respect of the Mortgage Loan pursuant to the terms and conditions described in paragraph 14 of the Proposed Transactions above, or a reasonable amount in respect thereof, will be deductible by XXXXXXXXXX pursuant to paragraph 20(1)(c) of the Act.

D. No amount will be included in computing the income of XXXXXXXXXX or a Subsequent Acquirer pursuant to either of subsections 15(1) or 246(1) of the Act nor will section 80 of the Act apply to XXXXXXXXXX by virtue of the fact that interest on the Mortgage Loan may be waived at the discretion of Newco, as described in paragraph 14 of the Proposed Transactions, or that interest will accrue at a rate that is less than what is currently accruing in respect of the Mortgage Loan or as a result of the failure of Newco to demand repayment of the Mortgage Loan.

E. Subject to paragraph 20(1)(e.1) of the Act, expenses incurred by XXXXXXXXXX or Newco in the course of the restructuring of the XXXXXXXXXX debt as contemplated herein will be deductible by the corporation incurring the expenses pursuant to paragraph 20(1)(e) of the Act to the extent that such expenses are reasonable in the circumstances.

F. The "cost amount", within the meaning of subsection 248(1) of the Act, to Newco of a Mortgage Loan, immediately after the time that it is acquired from XXXXXXXXXX, will be equal to the price paid therefor, as described in paragraph 14 of the Proposed Transactions.

G. The "cost amount", within the meaning of subsection 248(1) of the Act, to XXXXXXXXXX of the Preferred Shares acquired by it will, immediately after the time of such acquisition, will be equal to the amount paid therefor, as described in paragraph 15 of the Proposed Transactions.

H. The "cost amount", within the meaning of subsection 248(1) of the Act, to XXXXXXXXXX of the Mortgage Loan or portion thereof, as the particular case may be, which is acquired in circumstances described in subparagraph 17(ii) of the Proposed Transactions, will, immediately after such acquisition, be equal to the amount paid therefor.

I. No amount will be included in computing the income of XXXXXXXXXX or a Subsequent Acquirer by virtue of subsection 56(2) of the Act in respect of any capital contributions made or required to be made by XXXXXXXXXX to Newco, as described in paragraph 19 of the Proposed Transactions.

J. Provided that the Mortgage Loan arose from one or more loans made or acquired by XXXXXXXXXX in the course of its XXXXXXXXXX business, the Mortgage Loan reacquired by XXXXXXXXXX, as described in paragraph 17 of the Proposed Transactions, will be considered to have been acquired by XXXXXXXXXX in the ordinary course of its business of XXXXXXXXXX for the purposes of paragraphs 20(1)(l) and 20(1)(p) of the Act.

K. Subsection 112(4) of the Act will not be applicable with respect of any dividends received by XXXXXXXXXX on the Preferred Shares, to any loss realized by XXXXXXXXXX on the Mortgage Loan subsequent to it being reacquired in the circumstances described in paragraph 17 of the Proposed Transactions.

L. As a result of the proposed transactions, in and of themselves, subsection 245(2) of the Act will not be applicable to redetermine the tax consequences confirmed in the rulings given.

These rulings are provided subject to the limitations and qualifications set out in Information Circular 70-6R3 issued by Revenue Canada on December 30, 1996 and are binding upon the Department provided that the proposed transactions are completed on or prior to XXXXXXXXXX. The rulings are based on the Act and the Income Tax Regulations in their present form and do not take into account the effects of any proposed amendments thereto.

Yours truly,

for Director
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch