2014-0563351E5 Mandatory conversions and interest deductibility

Principal Issues: Whether a financial instrument could represent borrowed money notwithstanding a mandatory conversion clause?

Position: Depends on the facts.

Reasons: Previous Rulings positions.

Author: Friedlander, Lara G.
Section: 20(1)(c)

XXXXXXXXXX

                                                2014-056335
                                                Lara Friedlander

May 25, 2015

Dear XXXXXXXXXX:

Re:  Impact of Mandatory Conversion on Interest Deductibility

We are writing in response to your letter of December 23, 2014 concerning the impact of a mandatory conversion clause on the deductibility of interest on notes issued by a taxable Canadian corporation. 

In the hypothetical situation you describe, the notes would carry a fixed rate of interest, be denominated in Canadian dollars, have a term of up to 60 years and be unsecured.  Upon the occurrence of an event of default, which would be limited to the insolvency or bankruptcy of a taxable Canadian corporation (“Canco”), the notes would automatically and mandatorily be converted into fully-paid preferred shares.  The conversion would take place at a fixed number of shares per $1000 of principal amount.  Any accrued interest would also be converted into preferred shares.  The preferred shares would pay cumulative preferential cash dividends at a rate based on the 30-year Government of Canada bond yield plus a spread.  If preferred shares were issued, the full amount would be added to stated capital.  The notes would be extinguished on the conversion. The debt obligations issued by Canco would generally have an investment grade rating with a prescribed credit rating agency.

We assume that Canco would use the proceeds of the notes for purposes of earning income from a business or property (other than to acquire property the income from which would be exempt or to acquire a life insurance policy). You have asked whether the mandatory conversion clause would prevent interest on the notes from being deductible under paragraph 20(1)(c) of the Income Tax Act (Canada) (the “Act”) on the basis that the notes would not be considered to represent “borrowed money”.

Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R6, Advance Income Tax Rulings, dated August 29, 2014.  Also, where the particular transactions are completed, the inquiry should be addressed to the relevant Tax Services Office. Nonetheless, we have provided some general comments below.  

Our Comments

Generally, a borrower lender relationship exists if the lender will be able, at a given time, to enforce repayment of the amount advanced, either by receiving the cash itself or property having an equal value.  Where a mandatory conversion feature such as the one described above is triggered, the lender may be obligated to accept property on a settlement of the debt obligation that has a value that is less than the funds initially advanced.

In the past, rulings relating to paragraph 20(1)(c) of the Act have been issued in respect of interest on debt, the terms of which included a mandatory conversion feature that would be triggered by certain events.  In the circumstances underlying these rulings, the triggering events that could cause a mandatory conversion were considered to be remote and would occur only in extraordinary circumstances, given the particular factual context.   Such triggering events were limited to events such as bankruptcy or insolvency.  Other factors taken into account in those rulings included whether the triggering events were outside the control of the debtor, the purpose of the mandatory conversion clause, the terms and type of shares to be issued on the conversions, the nature of the debtor’s business and industry, and whether the debtor and the creditors would be dealing at arm’s length.

In this situation, we do not have sufficient facts to determine whether the mandatory conversion clause would prevent interest on the notes from being deductible under paragraph 20(1)(c) of the Act. Such a determination can only be made in the context of an advance income tax ruling request. We note that all of the requirements of paragraph 20(1)(c) must still be met, including the requirement that the rate of interest must be reasonable under the circumstances. 

We trust that these comments will be of assistance.

Yours truly,

G. Moore
For Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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