Facts of conversion of DIP financing and USD bonds to equity (pp. 7-8)
Canco has US$1 billion of bonds (the "Bonds") payable to unrelated parties (the "Bondholders")… [who] do not constitute a "group of persons"… . The Bonds were issued when one US dollar was worth CAD$1…. Canco has CAD$1 billion of adjusted cost base…in its FA shares. FA has no material… surplus. Canco owns no other assets. The current fair market value of the FA shares is… US$100 million. The fair market value of the Canco shares is nominal…[and] of the Bonds is…US$100 million. … One US dollar is currently worth CAD$1.30. Canco has CAD$500 million of non-capital losses and no net capital losses. … All of the non-capital losses are attributable to deductible interest expense on the Bonds.
An unrelated Canadian corporation ("Buyer") proposes to provide US$200 million of debtor-in-possession ("DIP") financing. … Buyer anticipates that after Canco emerges from CCAA, Buyer will own approximately 67% of the shares of Canco (with a fair market value of US$200 million) as a result of Buyer receiving shares of Canco in complete settlement of the DIP financing, and the Bondholders will receive shares of Canco representing 33% of the issued and outstanding Canco shares (with a fair market value of US$100 million) in complete settlement of the Bonds.
Application of s. 111(12) if DIP financing settled first (pp. 9-10)
[S]uppose that the DIP financing is settled 1st, immediately followed by the settlement of the Bonds… .
As a result of the LRE, Canco has a CAD$870 million capital loss from the write down of the ACB in its FA shares [and] Canco has a CAD$300 million foreign currency capital loss from the write down of its Bonds.
The CAD$900 million forgiven amount arising from the Bond settlement would be applied first to Canco's CAD$500 million of non-capital losses… The remaining CAD$400 million forgiven amount would be applied to reduce Canco's net capital losses….
Application of s. 39(2) (on non-forgiven amount only) if DIP financing settled 2nd (pp. 9-10)
Now…the Bonds are settled on Day 1 and the DIP financing is settled on Day 2:
Canco recognizes a CAD$30 million foreign currency capital loss from the settlement of the Bonds (US$100 million x 1.30 minus US$100 million x 1.00). It should be noted that this is significantly less than the CAD$300 million foreign currency capital loss from a write down of the Bonds triggered by a LRE. …
The CAD$900 million forgiven amount arising from the Bond settlement would be applied first to reduce Canco's CAD$500 million of non-capital losses. Canco can then designate, under subsection 80(10), CAD$370 million to reduce Canco's ACB in its FA shares to CAD$630 million (i.e., CAD$1 billion minus CAD$370 million). Lastly, Canco can use its current year CAD$30 million foreign currency capital loss to offset the remaining CAD$30 million forgiven amount under subsection 80(12).
There would be an acquisition of control and loss restriction event for Canco when the DIP financing is settled on Day 2 because the Buyer would acquire 67% of Canco's issued and outstanding shares from this settlement. The principal tax consequence of this LRE would be a CAD$500 million capital loss from the write down of the ACB in its FA shares (i.e., CAD$630 million ACB minus CAD$130 million fair market value).
Subject to the limitations set out in subsection 111(4), Canco ends up with CAD$500 million of net capital losses (CAD$30 million minus CAD$30 million plus CAD$500 million).
If the Bonds are settled first, immediately followed by the settlement of the DIP financing on the same day, subsection 256(9) would deem the acquisition of control and loss restriction event arising from the DIP financing settlement to occur at the beginning of the day, and thus before the Bond settlement. The tax consequences of this sequencing of events would be the same as those described above for the DIP financing settlement-Bond settlement sequencing. Making an election for subsection 256(9) not to apply in this "same day" situation would reverse the sequence of events so that the Bond settlement occurs before the DIP financing (and resulting LRE). …
Comparison of two sequences (pp. 10-11)
The CAD$270 million difference is attributable to different foreign currency capital loss amounts – a CAD$300 million foreign currency capital loss under the DIP financing settlement – bond settlement sequencing, versus a CAD$30 million foreign currency capital loss under the Bond settlement – DIP financing settlement sequencing.
In the example described above, there are sufficient tax attributes under either sequencing of events to absorb the entire forgiven amount, making the sequencing irrelevant from solely a debt forgiveness perspective. However, there may be other reasons to maximize the amount of capital losses and other tax attributes in this type of situation -- for example, Canco may be under a CRA audit and the auditor may be questioning significant portions of Canco's non-capital losses, or there may be some doubt as to the accuracy of the ACB of the FA shares.
Background to s. 39(2.01) (pp. 13-14
Many Canadian companies have or had significant accrued foreign currency gains in their US dollar denominated debts, particularly where the debts were originally issued in 2001 or 2002… . Many of those debts had ten year terms and matured in 2011 and 2012, when the Canadian dollar was at or near parity… .
One of main purposes test (p. 17)
In order to defer recognition of such large foreign currency gains, many Canadian companies effectively used debt parking techniques that had become prohibited by the debt parking provisions introduced in 1995. As will be explained below, these techniques, if designed and implemented properly, could defer recognition of the accrued foreign currency gain and avoid the debt parking provisions.
A Canadian public company (Canco) will be recapitalized so that the provider of debtor-in-possession financing will end up holding 2/3 of the common shares having a fair market value equaling that of the DIP financing provided by it, and most of the balance of 1/3 of the common shares will be received by the holders of the U.S.-dollar bonds, who thereby will recognize a 90% loss in U.S.-dollar terms – or less than that in Canadian-dollar terms.
If the transactions are structured so that the acquisition of control by the DIP financier occurs first (or is deemed to occur first under s. 256(9)), Canco will realize the accrued FX loss on the bonds under s. 111(12). If the bonds are instead settled first, s. 80(2)(k) will effectively prevent realizing an FX loss on the 90% of the bonds that is forgiven, thereby resulting in fewer tax attributes recognized by Canco.
Rescission if the parties could sue on the 2nd arrangement alone (p. 3)
[A] contract will generally be rescinded where the parties intend to extinguish their former contractual relationship and substitute a new and self-contained agreement (as opposed to merely varying the terms of the prior agreement), [fn 18: See, for example, Niagara Air Bus Inc. v Camerman (1989), 69 OR (2d) 717 (HCJ); varied on appeal with respect to the application of the Interest Act, (1991), 3 OR (3d) 108 (CA); leave to appeal dismissed, [1991] SCCA No 374 and Amirault. The intention is to be gathered from the words of the amending agreement and the conduct of the parties at the time of the amendment. The subsequent conduct of the parties is not relevant to ascertaining the parties' intention where the language used in the amendment is clear.] and where the proposed amendments are sufficiently fundamental that they go to the root of the contract and amount to a rescission. The seminal rescission case, Morris v Baron & Co., [fn 19: Morris v Baron & Co., [1918] AC 1 (UK HL).] establishes that one method of determining whether there has been a rescission of an original agreement is to ask whether the parties could "sue on the second arrangement alone, and the first contract is got rid of either by express words to that effect, or because, the second dealing with the same subject-matter as the first but in a different way, it is impossible that the two should be both performed". [fn 20: Per Lord Devlin, in Smeaton Hanscomb & Co Ltd v Sassoon I Setty Son & Co, [1953] All ER 1471(QBD). This reasoning was imported into Canada in Western Tractor Ltd. v Dyck (1969), 70 WWR 215 (Sask CA) and subsequently applied in Alberta in Gill v Kittler (1983), 44 AR 321 (QB).]
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