ARCHIVED - Distress Preferred Shares

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Distress Preferred Shares

Contents

• Application
• Summary
• Discussion and Interpretation
  • GENERAL
    • Introduction (¶s 1-2)
    • Income Bonds and Income Debentures (¶ 3)
    • Cost Considerations (¶ 4)
    • Advance Income Tax Ruling (¶ 5)
  • LEGISLATION
    • Definition (¶ 6)
    • Term (¶s 7-8)
    • Companies Creditors' Arrangement Act (¶ 9)
    • Determining Financial Difficulty (¶s 10-11)
    • Use of Daylight Loans (¶ 12)
    • Replacement of Debt (¶ 13)
    • Use of Proceeds (¶s 14-17)
  • STRUCTURE
    • Description (¶s 18-19)
    • Restrictions that apply to Newco (¶s 20-21)
  • REQUESTING AN ADVANCE INCOME TAX RULING
    • General (¶s 22-23)
    • Excess Cash Flow (¶s 24-25)
    • Rulings Procedures (¶s 26-27)
• Appendix
  • I.  Typical Excess Cash Flow Provision
  • II. Typical Issues Addressed in a Ruling on Distress Preferred Shares
  • III. Example of a Structure for Issuing Distress Preferred Shares

Application

This bulletin sets out the current legal requirements that a corporation must satisfy so that its preferred shares, issued under circumstances of financial difficulty, will qualify as distress preferred shares.

Summary

This bulletin discusses certain shares that corporations resident in Canada may issue when they are unable to pay their debts because of financial difficulty. These financial difficulty preferred shares (referred to as "distress preferred shares" in this bulletin) are issued to refinance existing debt. Issuing distress preferred shares is a method of after-tax financing that is specifically permitted under the Income Tax Act. To be certain that proposed distress preferred shares meet the requirements of the law, the corporation in financial difficulty and the proposed subscribers for these shares normally request an advance income tax ruling (in this bulletin also referred to as "a ruling") from Revenue Canada. This bulletin describes the distress preferred shares legislation, how these shares are generally issued, and the information requirements and procedures for obtaining a ruling prior to issuing distress preferred shares.

Discussion and Interpretation

GENERAL

Introduction

¶ 1. In 1978, the income tax rules for preferred shares were changed to limit the ability of corporations to use preferred shares as a method of after-tax financing. This was accomplished by introducing the "term preferred share" legislation. However, paragraph (e) of the definition of "term preferred share," in subsection 248(1), contains an exception for certain shares issued by corporations resident in Canada that are in financial difficulty. The purpose of this exception is to provide a means by which a financially troubled debtor corporation may reduce its borrowing costs while leaving the creditor in at least the same after-tax position.

¶ 2. Shares that meet the requirements of paragraph (e) of the term preferred share definition are often referred to as "distress preferred shares." After exchanging debt for distress preferred shares, the corporate creditor is entitled to receive cumulative fixed dividends which are deductible when computing taxable income as opposed to receiving fully taxable interest income. The debtor and creditor negotiate a lower dividend rate on the distress preferred shares than the interest rate on the debt. The effect is that the debtor's financing costs and cash flow requirements are reduced and the creditor maintains at least the same after-tax rate of return on the funds provided to the debtor. The debtor's cash flow position is improved as its payment requirements are now at a lower rate. Although the lower dividends are not deductible by the debtor, as the interest was, this is not usually of consequence since the debtor is typically not in a taxable position.

Income Bonds and Income Debentures

¶ 3. Rather than issuing distress preferred shares, a debtor in financial difficulty can also reduce financing costs and improve cash flow by converting debt to income bonds or income debentures, which are also defined in subsection 248(1). The interest paid and received on an income bond and income debenture is deemed by subsection 15(3) to be paid and received as a dividend. Since the amount paid is deemed to be a dividend, it is not deductible by the debtor but is generally deductible when computing the taxable income of the creditor. The financial difficulty requirements contained in paragraph (c) of the income bond or income debenture definition are virtually identical to the requirements contained in paragraph (e) of the term preferred share definition. However, one difference is that interest on the income bonds and income debentures is only payable to the extent of profits. There is no such limitation on dividends on distress preferred shares. The rules relating to income bonds and income debentures are explained in the current version of IT-52, Income Bonds and Income Debentures.

Cost Considerations

¶ 4. The process of converting debt to distress preferred shares usually involves complicated banking, tax and corporate law considerations, resulting in significant legal and other costs. For this reason, it would usually only be cost effective to refinance a large debt.

Advance Income Tax Ruling

¶ 5. Due to the uncertainty of determining whether shares will qualify as distress preferred shares, and in light of the significant tax that would be payable if they did not qualify, a ruling is generally requested by the parties involved in the refinancing. ¶s 22 to 27 below outline the conditions that must be satisfied, and the information requirements that are needed, to obtain such a ruling.

LEGISLATION

Definition

¶ 6. Under paragraph (e) of the definition "term preferred share" in subsection 248(1), a share issued after November 12, 1981 will qualify as a distress preferred share for a period not exceeding five years from the date that it was issued, if the share was issued by a corporation resident in Canada:

(b) the proceeds from the issue may reasonably be regarded as having been used by the issuing corporation or a corporation with which it was not dealing at arm's length in the financing of its business carried on in Canada immediately before the share was issued.

Term

¶ 7. A share issued after November 12, 1981 may qualify as a distress preferred share only for a period of five years from the date that it was issued. Consequently these shares are generally redeemable at the end of this five year period. After five years, they cease to qualify as distress preferred shares.

¶ 8. An issuer may still be in financial difficulty at the end of five years and may wish to retain the distress preferred shares financing. However, there is no provision in the Act that provides for an automatic extension or renewal of the distress preferred shares after the five year exemption period expires. To refinance with distress preferred shares, the issuer must again demonstrate that it meets the financial difficulty requirements outlined in this bulletin.

Companies Creditors' Arrangement Act

¶ 9. The circumstances described in ¶ 6(a)(i) and (ii) above are specific and are generally not difficult to confirm. A plan of arrangement under the Companies Creditors' Arrangement Act ("CCAA") would not fit either of these situations. The CCAA provides insolvent corporations with protection from secured creditors by ensuring that they will not be forced into bankruptcy before a reorganization plan is drawn up. Although creditors vote on the reorganization plan and court approval is required, the arrangement is not one approved by a court under the Bankruptcy and Insolvency Act, and ¶ 6(a)(i) above does not apply. Under the CCAA, none of the circumstances in ¶ 6(a)(ii) above apply.

Determining Financial Difficulty

¶ 10. When a corporation seeks protection under the CCAA, default has usually occurred so that the financial difficulty requirement referred to in ¶ 6(a)(iii) above may already be established. However, the existence of financial difficulty can only be established from a review of the facts in each case, and it is this uncertainty that primarily gives rise to a ruling request. To meet the requirement described in ¶ 6(a)(iii) above, the reason for the default or expected default on a debt obligation must be because of financial difficulty. Revenue Canada may consider a corporation to be in financial difficulty if the following conditions are present:

(a) The corporation is in default or can reasonably be expected to default on a debt held by a person with whom it deals at arm's length. Default must be 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. In most cases, a reasonable expectation of default means default is imminent and is probably not more than three or four months away. There is no expectation of default when a loan is to be issued with the full knowledge of the borrower and the lender and on the condition that the loan will be exchanged for distress preferred shares. An example of this would be a financially strong debtor who wanted to acquire an asset using after-tax financing by borrowing in excess of its borrowing capacity, and afterward the debtor claims that it is in financial difficulty and is entitled to replace the debt with distress preferred shares.

(b) The corporation does not have sufficient cash, lines of credit or demand loan facilities available to fulfil its debt obligations.

(c) The corporation does not have other sources of funds available. Examples include funds that could be obtained from the sale of superfluous assets or by issuing new equity.

(d) The corporation cannot obtain refinancing from financial institutions or other unrelated parties except by issuing distress preferred shares.

(e) The beneficial shareholders and associated corporations are not in a position to provide financing. These shareholders or associated corporations are not expected to dispose of long-term business assets to provide further financing to the corporation in financial difficulty. However, where reasonable, they would be expected to borrow against any reasonably liquid assets to provide assistance.

¶ 11. The corporation issuing shares in the situation described in ¶ 6(a)(iii) above does not have to be the corporation that is in default (or expected default) as long as the issuing corporation and the corporation in distress do not deal at arm's length and the proceeds from the issue of the distress preferred shares are used to replace the debt (or part of the debt) that is in default (see ¶ 13 below). In the circumstances outlined in ¶ 6(a)(i) and (ii) above, only the corporation in financial difficulty may issue the preferred shares.

Use of Daylight Loans

¶ 12. The use of daylight loans is acceptable when they are used to facilitate restructuring with distress preferred shares. An example of this would be when a parent corporation consolidates the indebtedness (which is in default) of its subsidiaries by borrowing funds from a bank to make capital contributions to the subsidiaries, who use the funds to repay their indebtedness to the bank. The consolidated debt is then refinanced with distress preferred shares.

Replacement of Debt

¶ 13. Shares that are issued because of financial difficulty must also be issued either wholly or in substantial part, and either directly or indirectly in exchange or substitution for a debt obligation held by a person with whom the issuing corporation was dealing at arm's length (see ¶ 6(a)(iii) above). The intent of this requirement is to ensure that all or substantially all of the share issue proceeds are used either to purchase the debt from the lender or to repay all or a part of the debt that was in default (or expected default). As well, the share issue proceeds can be used to repay both the principal of the debt and the related accrued but unpaid interest. This wording also leaves some room for the refinancing costs to be paid out of the share proceeds.

Use of Proceeds

¶ 14. To meet the requirement described in ¶ 6(b) above, the proceeds from the share issue must reasonably be regarded as having been used in the financing of the issuer's business carried on in Canada immediately before the share was issued. Thus, when the shares are being issued in exchange for a debt, the debt being refinanced must represent borrowed money used in a Canadian business.

¶ 15. If a company carries on business both in and outside Canada, only the portion of the debt relating to the business carried on in Canada qualifies for the distress preferred shares refinancing. In this regard, the corporation must be able to support the assertion that the proceeds of the debt were used in a Canadian operation. In those unusual circumstances when it is not possible to trace the use of the proceeds of the debt to be refinanced, we will consider a reasonable method of allocation. Depending on the particular circumstances, an allocation based on a comparison of net profits and asset costs may be appropriate.

¶ 16. The following examples illustrate the application of the requirements in ¶s 14 and 15 above:

Example 1

A Canadian corporation incurred a debt in order to honour a guarantee given to a creditor of its foreign subsidiary. The funds were passed on to the foreign subsidiary by way of a share investment. Soon after, the subsidiary ceased to carry on business. Three years later, the Canadian corporation defaulted on the debt and wished to refinance using distress preferred shares. In these circumstances, the use of proceeds requirement would be considered to be met on the basis that:

• the debt could no longer be related to a foreign asset or investment;
• the Canadian business had been liable for the debt for some time; and
• the refinancing would enable the Canadian business (now the only business) to continue to be carried on.

Example 2

A corporate general partner of a limited partnership, with a 1% interest in the partnership, wants to issue distress preferred shares on the basis that the debt of the limited partnership is ultimately the debt of the general partner. In this case, the general partner does not satisfy the use of proceeds requirement because the proceeds from issuing the distress preferred shares would not have been used to finance the general partner's business.

¶ 17. If the situation is one described in ¶ 6(a)(i) or (ii) above, the distress share proceeds do not have to be used to refinance a debt obligation. In such a case, the actual use of the proceeds would be the determining factor. However, the share proceeds must be used in the financing of the issuer's business. For example, the proceeds may not be invested in income-producing assets that are either unrelated to or inconsistent with the issuer's ordinary business, and may not be used to acquire investments such as marketable securities in order to earn investment income that exceeds the borrowing cost of the debt.

STRUCTURE

Description

¶ 18. It is usually not the financially troubled corporation ("Distressco") that issues the distress preferred shares in the situation described in ¶ 6(a)(iii) above. A structure has been developed that is generally used in this type of refinancing and involves a new shell corporation ("Newco"), actually issuing the shares. The main reason for this is that, taking into consideration the various business corporations acts, this structure affords creditors the most security with respect to the distress preferred shares received in substitution for their debt. Distressco and Newco must not deal at arm's length and Newco is usually wholly-owned by Distressco.

¶ 19. An example of a structure for refinancing with distress preferred shares is set out in Appendix III to this bulletin.

Restrictions that apply to Newco

¶ 20. As Newco is intended to be used only to facilitate the distress preferred shares refinancing, its use should not result in any additional tax benefit to Distressco. Accordingly, Newco must be a single-purpose corporation that will not engage in any business or transactions other than those related to the distress preferred shares refinancing. Except for the operation of any applicable law to which Newco is subject, Newco must be wound up without any undue delay after the time that is the earlier of:

(a) the time at which all of the distress preferred shares are redeemed or cancelled; and

(b) five years from the date the distress preferred shares are issued.

¶ 21. Distressco and Newco normally enter into an agreement that provides that any amounts contributed to Newco for operating expenses or the payment of dividends will be regarded as funds to be held by Newco for the benefit of Distressco until the funds are used to pay dividends or operating expenses. With these conditions, the contributions to the capital of Newco by Distressco will not result in an increase in the fair market value of the shares of Newco, and will not give rise to an increase in the adjusted cost base of such shares under paragraph 53(1)(c).

REQUESTING AN ADVANCE INCOME TAX RULING

General

¶ 22. As noted in ¶ 5 above, most taxpayers will request a ruling before refinancing with distress preferred shares. If a ruling is requested, the onus is on the debtor to prove that it is in default or can reasonably be expected to default, and that the default or anticipated default is due to financial difficulty. The remaining portion of the bulletin explains the excess cash flow provision and describes other information that we need to process a ruling.

¶ 23. Since the determinations of "financial difficulty", "default" or "reasonably be expected to default", as used in ¶ 6(a)(iii) above, are questions of fact, it is essential that sufficient information accompany each financial difficulty ruling request so that these factual determinations can be made. We need at least the following information:

(a) The organizational structure and financial statements of all corporations in the organization as well as the major shareholders in closely held situations must be provided. If the shares of the troubled corporation are held by an individual or related individuals, we need information about the financial position of the shareholder or shareholders. The purpose of this is to ascertain that there are no financial resources that could be utilized to alleviate the financial difficulty. However, except in the case of wholly-owned corporations, it would not be reasonable to expect a controlling shareholder to shoulder the entire financial burden of the corporation if the minority shareholders were not prepared to contribute.

(b) Documentation or evidence showing that the financially troubled corporation has sought ways to avoid the impending default, including:

• business plans and correspondence concerning failed attempts to refinance the debt with the lending and other financial institutions;
• evidence that operations have been rationalized (for example, through reduction of costs or by the sale of assets); and
• an indication that other financial sources have seriously been considered (such as raising equity capital).

If alternatives are available which, if adopted, would prevent default, and these alternatives are not adopted, it would be doubtful that the anticipated default would be the result of financial difficulty.

(c) In circumstances where the debt is a demand instrument, there should be evidence from the creditor that, absent the distress preferred share financing, demand will be made within three to four months.

(d) Statements showing annual cash flow projections for five years, before and after refinancing with distress preferred shares, should be submitted. These statements should substantiate financial difficulty and, more particularly, the expected cash flow deficiencies and related defaults. The cash flow deficiency must be expected to continue; a temporary deficiency would suggest that bridge financing might be an appropriate solution.

Excess Cash Flow

¶ 24. The purpose of an excess cash flow provision is to provide additional assurance that refinancing using distress preferred shares is a consequence of financial difficulty rather than for some other purpose such as expanding a business, and that the proceeds of the issue are utilized in the business carried on in Canada.

The excess cash flow provision in a ruling represents a commitment by the issuer to use cash flow in excess of operating requirements to redeem or retire the distress preferred shares. Excess cash flow is essentially the total of the cash flows, as determined in accordance with generally accepted accounting principles, of each corporation in the group, subject to certain limitations in regard to capital expenditures. These limitations are intended to:

(a) deny payments to shareholders, other than the holders of the distress preferred shares, whether by way of dividend or repayment of shareholder loans; and

(b) restrict expenditures to those necessary to carry on the existing business as opposed to expanding the business.

¶ 25. The definition of excess cash flow used in a ruling has become more or less standardized (see Appendix I) but modifications are acceptable to accommodate items that may be peculiar to a particular situation.

Rulings Procedures

¶ 26. The Income Tax Rulings and Interpretations Directorate at Revenue Canada recognizes that a ruling request on distress preferred shares deserves top priority and that time is of the essence. Submitting a ruling request with much of the information missing in order to "get in line" is neither necessary nor productive. The Department can process a ruling request much faster if a complete package of information is sent with the ruling request letter.

¶ 27. In Information Circular IC 70-6R2, Advance Income Tax Rulings, it is stated that a ruling request should contain the interpretation of the application of the provisions of the Act that are relevant, and a description of the income tax concern that is the cause of the request for the ruling. A ruling should only be requested on issues relevant to the proposed refinancing. Reference can be made to Appendix II of this bulletin for an example of the issues typically addressed in a ruling on distress preferred shares.

Appendix I

Typical Excess Cash Flow Provision

Notwithstanding the terms and conditions of the preferred shares or any mandatory redemptions of the preferred shares that may be required by the bank, all excess cash flow arising in each fiscal period shall be applied to redeem the preferred shares within 120 days after the end of that fiscal period.

Excess cash flow in respect of a particular fiscal period shall be the change or increase in cash flow for such period of Distressco from all sources, as would be reported on a Consolidated Statement of Changes in Financial Position prepared in accordance with generally accepted accounting principles, if only directly and indirectly wholly-owned subsidiaries of Distressco were so included, but before outlays for:

(i) the payment of dividends other than dividends paid on the preferred shares;

(ii) capital expenditures or any payment on capital account other than in respect of:

(a) the purchase or redemption of the preferred shares, other than redemptions made in the period in respect of the prior period's excess cash flow;

(b) repayments of indebtedness incurred in the normal and ordinary course of business and in existence at the date the preferred shares are issued;

(c) repayments of additional debt incurred for the specific purpose of funding current operating requirements;

(d) expenditures or payments between any of Distressco and its directly and indirectly wholly-owned subsidiaries;

(e) reasonable capital expenditures or payments on capital account incurred in the normal and ordinary course of the existing business and repayments of additional debt for the specific purpose of making such capital expenditures or payments on capital account; and

(f) repayments of additional debt incurred for the specific purpose of enabling Newco to redeem the preferred shares or to pay dividends on the preferred shares;

(iii) repayments of loans to shareholders of Distressco or redemptions of any of the shares of Distressco; and

(iv) loans to directors, officers and shareholders of Distressco or to other persons, firms or corporations.

For purposes of this definition of excess cash flow, additional debt shall not include a debt which arose as a result of the use of cash or funds for a purpose that is not envisaged herein.

Appendix II

Typical Issues Addressed in a Ruling on Distress Preferred Shares

Note: The revised Draft Amendments to the Income Tax Act dealing with Debt Forgiveness, contained in Bill C-70, are not reflected in the following typical rulings as the amending legislation has not been enacted.

Provided that the foregoing statements constitute complete and accurate disclosure of all relevant facts and proposed transactions, we confirm the following:

A. the Preferred Shares of Newco (the "Shares") to be issued to the Bank, and where applicable, sold to a Third Party Purchaser will be

(a) Shares described in subparagraph (e)(iii) of the definition of "term preferred share" in subsection 248(1) of the Act for a period not exceeding five years from the date of their issuance and,

(b) "exempt shares" pursuant to paragraph (c) of the definition thereof in subsection 112(2.6) for that same period

and, accordingly, subsections 112(2.1), (2.2), (2.3) and (2.4) will not apply to deny the Bank, or a Canadian resident corporate Third Party Purchaser, as the case may be, a deduction under subsection 112(1) for dividends received or deemed to have been received by it on such Shares during such period.

B. no amount will be included in computing the income of Newco under paragraph 12(1)(c) or (x), or subsection 12(3), 12(9), 16(1) or 246(1) or section 9 of the Act in respect of capital contributions made or required to be made by Distressco to Newco, nor will such amounts constitute proceeds of disposition, as defined in section 54 of the Act, to Newco from the disposition by it of any property;

C. subsection 80(1) of the Act will not apply in respect of Distressco by virtue of the fact that interest will not be paid or payable by Distressco to Newco on the Purchased Loan;

D. subject to paragraph 20(1)(e.1) of the Act, expenses incurred by Newco in the course of borrowing money and issuing the Shares will be deductible pursuant to paragraph 20(1)(e) of the Act to the extent such expenses are reasonable in the circumstances;

E. the cost amount, within the meaning of subsection 248(1) of the Act, to the Bank of the Shares will, immediately after the time that the shares are issued, be equal to the amount paid by the Bank for those Shares;

F. the cost amount, within the meaning of subsection 248(1) of the Act, to Newco of the Purchased Loan will, immediately after it is acquired from the Bank, equal the purchase price paid therefor;

G. no amount will be included in computing the income of the Bank under subsection 56(2) of the Act in respect of any capital contributions made by Distressco to Newco;

H. if the Purchased Loan is reacquired by the Bank, the cost amount, within the meaning of subsection 248(1) of the Act, to the Bank of the Purchased Loan will be the purchase price paid therefor;

I. no amount will be included in the income of Distressco pursuant to subsections 15(1) and 246(1) of the Act solely by virtue of the fact that interest will not be paid or payable by Distressco to Newco on the Purchased Loan;

J. provided the Purchased Loan arose from one or more loans made by the Bank in the course of its money lending business, the Purchased Loan reacquired by the Bank will be considered to have been acquired by the Bank in the ordinary course of its business of lending money for the purposes of paragraphs 20(1)(l) and 20(1)(p) of the Act;

K. subsection 112(4) of the Act will not apply, in respect of any dividends received by the Bank on the Shares, to any loss realized by the Bank on the Purchased Loan subsequent to it being reacquired by the Bank; and ¹

L. as a result of the Proposed Transactions, in and of themselves, subsection 245(2) of the Act will not apply to redetermine the tax consequences confirmed in the rulings given.

Appendix III

Example of a Structure for Issuing Distress Preferred Shares

A) Distressco is in default on a bank loan.

B) Distressco incorporates Newco, a taxable Canadian corporation. All the common shares of Newco will be owned by Distressco. A class of preferred shares will be authorized in contemplation of issuance as "distress preferred shares".

The preferred shares may have the following characteristics:

(a) a term of five years from the date of issue;

(b) redeemable annually before the end of the term to the extent of any "excess cash flow" (see ¶s 24 and 25 above);

(c) retractable by the holder at any time if default occurs;

(d) the holder will be entitled to annual cumulative preferential cash dividends to be paid at the rate negotiated.

C) Newco will borrow from the bank on a demand loan basis an amount equal to the total planned issue price of the (distress) preferred shares. The loan will be guaranteed by Distressco.

Newco will immediately use all the demand loan funds to purchase the Distressco original loan from the Bank.

D) The bank will subscribe for and acquire Newco preferred shares (the distress preferred shares) at an aggregate subscription price equal to the amount of its demand loan. Newco will use the distress preferred shares proceeds to repay its demand loan from the bank.

Distressco, Newco and the bank will enter into a purchase agreement (put agreement) under which the bank may, upon the occurrence of an event of default, require Distressco to purchase the Newco distress preferred shares for an amount equal to their redemption amount and any accrued but unpaid dividends.

E) Distressco will make periodic contributions of capital to Newco to enable it to make dividend payments on the distress preferred shares. Distressco will also fund ongoing costs and expenses for the operation and administration of Newco.

F) Distressco will pay down the original loan indebtedness to Newco in order to provide Newco with sufficient funds to meet its obligations relating to the redemption of the distress preferred shares. Notwithstanding any redemption of the shares otherwise required, Newco will, for each fiscal period, be required to apply any excess cash flow to redeem the distress preferred shares.

¹ Ruling K in Appendix II was corrected by Erratum dated February 28, 1997.

Previously ruling K read as follows:

K. subsection 112(4) of the Act will not apply, in respect of any dividends received by the Bank on the Shares, or to any loss realized by the Bank on the Purchased Loan subsequent to it being reacquired by the Bank; and

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Director, Business and Publications Division
Income Tax Rulings Directorate
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