Due to the current economic downturn, many corporations (Borrowers) may find themselves in financial difficulty and need to refinance their existing debt obligations with creditors (Lenders). Such Borrowers may be able to reduce their financing costs through the issuance of “distress preferred shares” (DPS). This method of refinancing generally does not adversely affect the Lenders, as they can receive equal or better after-tax returns on their investments without jeopardizing their security and priority. The Canada Revenue Agency (CRA) has previously issued favourable administrative views in respect of DPS structuring. Accordingly, Borrowers in financial difficulty should discuss the issuance of DPS with their Lenders.
HOW TO QUALIFY AS A DISTRESS PREFERRED SHARE
The DPS rules in the Income Tax Act (Canada) (Act) provide a corporation resident in Canada—a Borrower—with the ability to refinance its commercial debt obligations. A DPS is a share issued by a Borrower in one of the following three scenarios:
At a time when all or substantially all of its assets are under the control of a receiver, receiver-manager, sequestrator or trustee-in-bankruptcy
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—is in default or could reasonably be expected to default on a debt obligation held by a person with whom the issuing corporation was dealing at arm’s length
The proceeds from the DPS issuance must be used by the Borrower—or a corporation with which it was not dealing at arm’s length—in the financing of its business carried on in Canada.
A share may qualify as a DPS for a period of five years, after which period it will become an ordinary preferred share.
Whether a Borrower meets the conditions in the first two scenarios is relatively straightforward.
Determining whether each condition in the third scenario has been satisfied requires greater analysis, particularly whether a Borrower is in:
Financial difficulty; and
Default or could reasonably be expected to default on a debt obligation.
MEANING OF “FINANCIAL DIFFICULTY”
Whether a corporation is in “financial difficulty” is a factual determination assessed on a case-by-case basis. While the phrase does not appear to have been considered by the courts in the context of DPS rules, the CRA has published its own administrative positions. In determining that a corporation is in financial difficulty, the CRA has stated that it would consider the following factors:
A default due to a general inability to pay, and not as the result of a technical default such as the borrower failing to meet certain financial ratio requirements
Beneficial shareholders and any associated corporations not being in a position to provide additional financing to a corporation in financial difficulty
The corporation being unable to obtain any further financing from unrelated parties, such as a bank
The corporation not having current resources available, such as cash and unused loan capacity—for example, lines of credit or demand loan facilities
The corporation must not have other sources of funds available—for example, funds that could be obtained from the sale of superfluous assets or the issuance of new equity
MEANING OF “DEFAULT OR COULD REASONABLY BE EXPECTED TO DEFAULT”
The courts have considered the meaning of “default” and determined that it is generally the inability of a corporation to meet its obligations as they become due.
The scope of the phrase “could reasonably be expected to default” is less certain. In determining whether a corporation could reasonably be expected to default, the CRA will generally look to the following factors:
Whether default is likely not more than three or four months away. While an uncertain future may be anticipated for a longer period, the CRA takes the position that there are too many factors to establish a reasonable expectation of default beyond this period
The financial position of all members of a related corporate group must be considered
Notwithstanding the CRA’s views expressed above, whether a corporation could reasonably be expected to default is a factual determination assessed on a case-by-case basis. For example, there could be circumstances where a corporation could reasonably be expected to default within a longer period than the one stated by the CRA.
TAX BENEFITS OF ISSUING A DPS
Under certain circumstances, when a debt is converted to preferred shares, Part VI.1 tax may be payable by a corporation paying dividends on those preferred shares if they are found to be “taxable preferred shares” or “short-term preferred shares.” Furthermore, such preferred shares may also be “term preferred shares,” with dividends received by certain financial institutions on such shares being denied the intercorporate dividend deduction. These factors often cause Lenders to be wary of converting debt into equity.
However, a DPS is deemed not to be a “taxable preferred share” or a “short-term preferred share.” The payment of Part VI.1 tax can therefore be avoided by the Borrower.
Furthermore, a DPS is also deemed not to be a “term preferred share”. Under normal circumstances, when a Lender receives an interest payment from a Borrower, the Lender generally must pay tax on the interest. If a corporate Lender were to instead hold a DPS, any dividends paid to such Lender on the DPS would effectively be received on a tax-free basis.
In issuing a DPS, a Borrower and its Lender will ordinarily negotiate a fixed cumulative dividend entitlement that is lower than the interest that would otherwise be paid, such as to account for the fact that the Lender effectively receives inter-corporate dividends on a DPS tax-free. This difference between the interest amount and the dividend amount provides real cash savings to the Borrower in financial difficulty and allows it to use the extra cash in the financing of its business.
Note that this refinancing method may not be attractive to non-resident Lenders, which may prefer to receive interest income rather than dividend income, particularly in circumstances where there is no withholding tax attached to the receipt of interest income.
Dividends may only be paid when solvency tests outlined in the relevant corporate statute are satisfied. The payment of interest has no such restrictions.
While the Borrower is unable to deduct the dividend in calculating its income, and was likely deducting the interest, the Borrower is typically in a loss position by the time DPS are issued and may not benefit from such interest deduction in any event. Expenses incurred in the course of issuing the DPS are generally deductible to the extent such expenses are reasonable in the circumstances.
SETTLEMENT OF A DPS
A DPS is considered to be settled when it is redeemed, acquired or cancelled by its issuer. The share terms of a DPS will ordinarily include a mandatory redemption requirement at the end of the five-year period.
STRUCTURING TO SATISFY CRA ADMINISTRATIVE POSITIONS
The CRA has provided its approval of structures that may be utilized to issue DPS, while protecting Lenders when it comes to subordination issues. An example of a common structure involves the following steps:
The creation of a new taxable Canadian corporation (NewCo) that is, initially, a wholly-owned subsidiary of the Borrower. NewCo should be a single-purpose corporation that does not carry on any business or transactions other than those related to the DPS issuance. The Borrower holds common shares of NewCo.
NewCo borrows funds (Loan) on a demand-basis from the Lender in an amount equal to the total contemplated issue price of the DPS. NewCo uses the Loan to purchase the Borrower’s original commercial debt obligation (Original Debt) from the Lender.
The Lender subscribes for NewCo DPS at a subscription price equal to the Original Debt. NewCo uses the subscription proceeds to repay the Loan.
The Lender, Borrower and NewCo enter into a purchase and put agreement to enable the Lender, upon the occurrence of default on such agreement, to require the Borrower to purchase the Lender’s DPS for an amount equal to the redemption value and unpaid dividends.
The Borrower pays down the Original Debt to NewCo and makes contributions of capital to NewCo to enable NewCo to pay dividends on the DPS to the Lender, and to ensure it can cover the potential redemption of the DPS.
NewCo is wound-up into the Borrower after the time that is the earlier of (a) the time at which all the DPS are redeemed or cancelled, and (b) five years from the date the DPS are issued.
The issuance of DPS may provide a corporation resident in Canada certain cash savings during times of financial difficulty. An effective DPS refinancing strategy may be the difference between insolvency and survival.
For further information, or to discuss your particular circumstances regarding DPS refinancing, please contact:
Dan Jankovic 403-260-9725
Ahmed Elsaghir 403-260-9655
or any other member of our Tax group.
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