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.
Decision Summary Number 90063-3
Originating Section
Leasing & Financing
Officer
T. Murphy
Date
July 30, 1990
Issue 1. What are the tax consequences to the Issuer and the Holder on the exercise by a Holder of the exchange right in an exchangeable debenture? In particular, what are the Issuer's proceeds of disposition of the Target Shares?
- 2. Is section 206.1 of the Income Tax Act (the "Act") applicable to an acquisition of an exchangeable debenture by a Part XI taxpayer?
Section of the Act or regulations, etc.
9, 54(h), 206.1
Subject, Problem, Position, Rationale, Comments: Background
An "exchangeable debenture" means a debenture issued by a corporation (the "Issuer") which gives the holder (the "Holder") the right to exchange the debenture for a specific number of shares of another corporation owned by the Issuer (the "Target Shares").
Exchangeable debentures are gaining popularity as a financing tool particularly among corporations seeking to attract investors described in Part XI of the Act ("Part XI taxpayers").
Decision
When a Holder of an exchangeable debenture exercises the right to exchange the debenture for the Target Shares, the Holder would dispose of the debenture for proceeds equal to the fair market value of the consideration received, i.e. the fair market value of the Target Shares. The adjusted cost base of the Target Shares to the Holder would equal the fair market value of the debenture given up to acquire them which, ignoring interest rate fluctuations, would ordinarily equal the fair market value of the Target Shares.
On an exchange, the Issuer would dispose of the Target Shares for proceeds equal to their fair market value, which is the amount of the Issuer's obligation pursuant to the exchangeable debenture which is satisfied by their delivery. the Issuer's proceeds would thus equal the Holder's adjusted cost base of the Target Shares. The Issuer would be entitled to a deduction under paragraph 20(1)(f) of the Act with respect to the difference between the fair market value of the Target Shares (the amount paid in satisfaction of the principal amount) and the face amount of the debenture (the amount for which it was issued). In other words, if the Issuer is required to deliver the Target Shares, the principal amount, within the meaning of subsection 248(1) of the Act, of his obligation would be an amount equal to the fair market value of the Target Shares.
Section 206.1 of the Act is not applicable to a typical exchangeable debenture, as the Holder would not acquire the Target Shares from the Issuer at a price that may differ from their fair market at the time they are acquired.
Rational
Both issues hinge on whether the exchange right in an exchangeable debenture is an option with a pre-set price.
From the point of view of the investor, exchangeable debentures are similar to convertible debentures (i.e., a debenture which is convertible into shares of its issuer). Section 51 of the Act provides a deferral of the gain which would otherwise be realised by a holder of a convertible debenture upon the exercise of the conversion rights contained in the convertible debenture. This tax deferral would not be necessary if a convertible debenture were considered an option with a pre-set price.
Hence, extrapolating from the provision of section 51 of the Act, we concluded that while the exchange right in an exchangeable debenture is an option, it is not an option with a pre-set price. This conclusion would prevail notwithstanding that the Holder would acquire the Target Shares by first requesting the Issuer to redeem the debenture at its face amount and then applying the redemption proceeds to acquire the Target Shares (the "Intermediate Cash Step"). Our reasoning is based on the premise that a payment, such as the one included in the Intermediate Cash Step, that is conditional upon its repayment would not constitute a bona fide payment. This position was stated publicly at the 1985 Round Table (Question 28) in the context of an employee benefit plan issue.
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