27 June 1992 Income Tax Severed Letter - Auction 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.

Memorandum for File Debbie Lightheart
Financial Industries Division

Auction Preferred Shares 0-0222

The purpose of this memorandum is to summarize the mechanics of an auction preferred share issue based on the Bell Canada Enterprises Inc. and Bell Canada issues and examples from a Shearson Lehman Brothers publication. This memorandum is not intended to nor does it constitute a detailed review of all the provisions of the Income Tax Act that have or may have application to auction preferred shares.

Cumulative preferred shares are issued with a set dividend, generally paid quarterly, for the first five years. The sharesare redeemable at par plus unpaid dividends at any time after five years. Beginning with the first dividend in the sixth year, the dividend is determined using one of three methods undertaken in the following order:

1) Investor negotiation procedure
• • direct negotiation between the company and the shareholders if that doesn't work ...
2) Dealer bid procedure
• • obtain bids from Investment Dealers
• • each bid will specify
(1) a fixed or floating dividend rate (2) the fee to be paid to the Dealer if its bid is selected (3) the length of the period to be in force
• • any such bid is an unconditional offer by the Dealer to purchase all shares tendered by holders
• • company selects a winner, notifies the shareholders of the dividend rate and the dealer name
• • shareholders not satisfied with the terms can request tht the dealer purchase all or a portion of their shares

if a bid isn't selected by the company or none is submitted ...

3) Auction procedure
• • the dividend rate for each quarter is based on orders placed in an auction conducted prior to the commencement of each quarter
• • the rate established by auction (the ``Established Rate") will be applicable for the next quarter
• • the maximum rate allowed may be capped, at say Bankers' Acceptance Rate plus 50 basis points or 110% the `AA" Composite Commercial Paper Rate
• • existing holders submit any of the following orders:
(1) "Hold order" - hold without regard to the Established Rate set by auction (2) "Bid order" - specify number to hold provided that the Established Rate for the next quarter is not less than a specified rate (3) "Sell order" - sell without regard to the Established Rate set by auction
• • if no order is received, a holder is deemed to have submitted a hold order
• • individuals interested in acquiring shares may submit "bid to buy orders" with the condition that the Established Rate is not les than a rate specified by the potential holder.
• • bid to buy orders can come from existing holders as well as new investors
• • sell and bid orders are irrevocable
• • if all existing shareholders give hold orders, the next quarter's dividend rate is set, at say 50% of Prime Rate (this clause exists to help ensure that the auction procedure works)

The auction procedure works as follows:

• 1) - the established rate will be the lowest rate that clears the market by matching sales and purchases
• 2) - a maximum rate is set (``ceiling rate")
• 3) - existing Holders submit hold, bid, bid to buy and sell orders
• 4) - potential Holders submit bid to buy orders
5) - determine number of shares available for sale which equals total outstanding less hold orders
• • if none, established rate set at 50% of Prime Rate
6) - determine whether the number of bid to buy orders with dividend rate less that the ceiling rate which does not include bid orders, is equal to or exceeds the number of shares offered to be sold regardless of dividend rate plus the number of bid orders by existing holders at rates higher than the ceiling rate
• • if yes, sufficient clearing bids exists
• • if no, considered a failed auction

Sufficient Clearing

• 7) - the Established Rate is the lowest rate specified in the submitted bid orders which, taking into account such rate and all lower rates bid by Existing Holders and Potential Holders, would result in such Existing Holders and Potential Holders owning all available shares
• 8) - each Existing Holder with a submitted bid order specifying a rate higher than the Established Rate or that offreed to sell shares without rgard to the rate shall sell their shares
• 9) - each Existing Holder with a submitted bid order specifying a rate lower than the Established Rate shall continue to hold their shares
• 10) - each Potential Holder with a submitted bid to buy order specifying any rate that is lower than the Established Rate will buy the number of shares so submitted
• 11) - each Existing Holder with a submitted bid order specifying a rate equal to the Established Rate shall continue to hold their shares unless the number of shares subject to all such submitted bids is greater than the shares available determined in (5) less the number already already allocated in (9) and (10) (``Remaining shares"), in which case each Existing Holder with such a submitted bid shall sell a number of shares detemined on a pro-rata basis:
• Remaining shares -------------------------- x Bidder's shares involved in tie All shares involved in tie
• no pro-rations were required prior to this point due to the condition imposed in (6) above.
• 12) - each potential holder with a bid to buy order specifying a rate equal to the Established Rate shall purchase any available shares not accounted for in (9), (10), and (11) above on a pro-rata basis:

Available shares less (9),(10),(11) x Individual's request to bid to buy ---------------------------------- Total # of shares still subject to bid to buy

• • the operation of an auction is illustrated in attached example 1.

Failed Auction

• 13) - the Established Rate is set at the ceiling rate
• 14) - each Existing Holder with a submitted bid order specifying a rate equal to or lower than the Established Rate continues to hold their shares
• 15) - each Potential Holder with a submitted bid order specifying a rate equal to or lower than the Established Rate shall purchase the specified number of shares
• 16) - each Existing Holder with a submitted bid order specifying a rate higher than the Established Rate or that offered to sell without rgard to the Established Rate, shall sell a proportion of their shares determined as:
• Bidder's shares offered for sale -------------------------------- x Number of shares requested Total number of shares offered for sale (in 14 above)
• • the operation of a failed auction is illustrated in attached example 2.

Other remarks

• 1) The auction preferred shares are ``taxable preferred shares". Accordingly tax at 40% of the dividend must be remitted pursuant to subparagraph 191.1(1)(ii).
• 2) A failed auction is very unlikely; thus, the probability of redemption of these shares is very low. As a result it is arguable thta the shares do not meet the test in the paragraph 248(1)(i) definition of ``term preferred share".
• 3) The dividends are deductible as permitted in subsection 112(1). As the shares are not term preferred shares, subsection 112(2.1) will not prevent the deductibility of the dividends.
• 4) If the corporation paying the dividend pays the 40% tax payable under subsection 191.1(1), the company will receive a deduction under paragraph 110(1)(k) for 250%of the tax paid. This calculation assumes a combined federal/provincial corporate tax rate of 40%. If, for instance, the corporation is paying tax in Ontario at the highest rate, a $100 deduction saves the corporation $44.30 in tax, reflecting the 44.30% federal/provincial tax rate for a net reduction in the overall tax burden of $4.30. The April 1989 budget has corrected this for dividends paid after 1989. The federal/provincial tax rate will now be assumed to be 44.44% so instead of a deduction of 250% of the tax paid, there will be a 225% deduction.
• 5) We have not ruled (nor have we been requested to rule) wih respect to an issue of auction preferred shares.

APPENDIX

Example 1 - Successful Auction

"AA" Composite Commercial Paper Rate 10%
Ceiling is therefore 110% of 10% or 11%
100 shares outstanding

#1 10 shares
#2 20 shares
#3 30 shares
#4 30 shares
#5 10 shares
---
100

Bids and Sell Orders from Existing Holders

#1 Continue to hold 10 shares if new rate is at least 7.000% #2 Sell 20 shares #3 Continue to hold 30 shares if new rate is at least 7.250% #4 Continue to hold 30 shares if new rate is at least 7.300% #5 Continue to hold 10 shares if new rate is at least 7.250%

Bid to Buy Orders from Potential Holders

#1 Buy an additional 20 shares if new rate is at least 7.000% #6 Buy 20 shares if new rate is at least 7.125% #7 Buy 15 shares if new rate is at least 7.100% #8 Buy 50 shares if new rate is at least 7.350% #9 Buy 60 shares if new rate is at least 7.400% #10 Buy 40 shares if new rate is at least 7.275%

Available shares

100 - # subject to firm hold
= 100 - 0
= 100

Sufficient Clearing Bids - Calculation (6)

20 shares bid for by Bidder #1 20 shares bid for by Bidder #6 15 shares bid for by Bidder #7 50 shares bid for by Bidder #8 60 shares bid for by Bidder #10 --- 205 exceeds 20 shares offered to be sold by Bidder #2 --- 195

Then rank in order beginning with lowest rate until at least 100 shares can be sold:

Bidder Shares Order
1 10 Continue to hold if new rate is at least 7.000%
1 20 Buy if new rate is at least 7.000%
7 15 Buy if new rate is at least 7.100%
6 20 Buy if new rate is at least 7.125%
3 30 Continue to hold if new rate at least 7.250%
5 10 Continue to hold if new rate at least 7.250%
---
105

Winning Bid Rate is 7.250%

Acceptance and Rejection of Bids, Bids to Buy and Sell Orders

• 1) Existing Holders with bid rates higher than 7.250% or that offered to sell without regard to the Established Rate, must sell

Bidder #4 sells 30 shares
Bidder #2 sells 20 shares

• 2) Existing Holders with bid rates lower than 7.250%, hold

Bidder #1 holds 10 shares

• 3) Potential Holders with a bid to buy order with a rate lower than 7.250%, buy

Bidder #1 buys 20 shares
Bidder #2 buys 20 shares
Bidder #3 buys 15 shares

• 4) Existing Holders with bids to buy order with a rate equal to 7.250%, must sell enough to meet any extra demand

Bidder #3 wants to hold 30 shares
Bidder #5 wants to hold 10 shares
--
40
but only

100 - (#1 - 30)
(#6 - 20)
(#7 - 15) 35 remain
--
5

Each must sell a proportionate number

Bidder #3 gives up 30 x 5 = 4
--
40

Bidder #5 gives up 10 x 5 = 1
--
40

After settlement, shareholders are as follows:

Bidder #1 holds 30 shares
Bidder #2 holds 0 shares
Bidder #3 holds 26 shares
Bidder #4 holds 0 shares
Bidder #5 holds 9 shares
Bidder #6 holds 20 shares
Bidder #7 holds 15 shares
---
100

Each will receive a dividend of 7.250% for the next quarter.

Example 2 - Failed auction

"AA" composite Commercial Paper Rate 10%
Ceiling is therefore 110% of 10% or 11%
100 shares outstanding

#1 10 shares
#2 20 shares
#3 30 shares
#4 30 shares
#5 10 shares
---
100

Bid and Sell orders from Existing Holders

#1 Sell 10 shares #2 Sell 20 shares #3 Continue to hold 30 shares if new rate at least 9.250% #4 Continue to hold 30 shares if new rate at least 11.300% #5 Continue t hold 10 shares if new rate at least 9.250%

Bids to Buy Orders from Potential Holders

#6 Buy 20 shares if new rtae is at least 10.125%

Available Shares

100 - # subject to firm hold
= 100 - 0
= 100

As the number of bid orders by Potential Holders specifying rates equal to or lower than the ceiling rate

20 shares bid by bidder #6

is less than the number offered to be sold by Existing Holders regardless of the dividend rate plus the number bid by Existing Holders at rates higher than the ceiling rate:

• 10 shares offered to be sold by Bidder #1 20 shares offered to be sold by Bidder #2 30 shares bi for by Bidder #4 at a rate above the ceiling rate -- 60

sufficient clearing bids to not existing. The dividend rate for the next quarter is set at the ceiling rate of 11%.

Acceptance and Rejection of Bids, Bids to Buy and Sells

• 1) Existing Holders with bid rates equal to or lower than 11%, continue to hold

Bidder #3 holds 30 shares
Bidder #5 holds 10 shares

• 2) Potential Holders with bid rates equal to or lower than 1%, purchase

Bidder #6 purchases 20 shares

• 3) Existing Holders with bid rates higher than 11% or that offered to sell without regard to the Established Rate, sell a pro-rata number to meet demand

Bidder #1 wants to sell 10 shares
Bidder #2 wants to sell 20 shares
Bidder #3 wants to sell 30 shares

but only 20 shares need to be sold

Each sells a proportionate number:

Bidder $1 sells 10 x 20 = 3
--
60

Bidder #2 sells 20 x 20 = 7
--
60

Bidder #3 sells 30 x 20 = 10
--
60

After settlement, shareholdings are as follows:

Bidder #1 holds 7
Bidder #2 holds 13
Bidder #3 holds 30
Bidder #4 holds 20
Bidder #5 holds 10
Bidder #6 holds 20
---
100

Each will receive a dividend of 11.000% for the next quarter.