Latest Developments in Debt Financing

Transcription

1 Latest Developments in Debt Financing Stephanie Wong June 16, 2003 INTRODUCTION The area of debt financing continues to evolve to satisfy and reflect debtors business objectives, investors preferences and risk tolerances, as well as trends in, and the state of, the markets. The primary objectives of any debt financing structure are to achieve the lowest possible cost of financing for the particular debtor while at the same time generating a return on capital invested attractive enough for investors. A key consideration in achieving those objectives is the tax treatment of the issuer of, and investors in, the financial instrument. The tax treatment of a financial instrument will depend on a number of factors, one of which is whether the financial instrument is characterized as debt or equity for income tax purposes. Other important factors from a tax perspective include the tax status and identity of the issuer and investors and whether the instrument is held by the investors on capital or income account. The characterization of an instrument as debt or equity for tax purposes is also important for determining whether the instrument will be a qualified investment for tax-deferred retirements plans such as RRSPs and RRIFs and whether the instrument constitutes foreign property for such plans. Significant innovation in the area of financial instruments has occurred since the current Canadian federal income tax legislation was enacted in However, the classification of financial instruments for income tax purposes is still based on classical notions of debt and equity and, generally, revisions to the Income Tax Act (Canada) (the Tax Act ) 1 to deal with changes in the area of financial instruments has occurred, if at all, on a piecemeal basis with no comprehensive approach to the treatment of financial C ALGARY M ONTRÉAL O TTAWA T ORONTO V ANCOUVER 1 R.S.C. 1985, c.1 (5 th Supplement), as amended. is an Ontario Limited Liability Partnership.

2 instruments. A detailed discussion of the tax treatment of debt financing arrangements is beyond the scope of this paper and readers are encouraged to consult several excellent sources discussing the tax treatment of financial instruments. 2 Instead, this paper will raise and discuss specific tax issues in the context of a number of recent transactions involving debt instruments. Specifically, this paper will first review the characterization of a financial instrument as debt (vs. equity or derivatives instruments) for income tax purposes, then outline briefly the impact of that characterization on the tax treatment of the financial instrument to the issuer and the investor and, finally, analyze several recent financing transactions of interest. CHARACTERISTICS OF DEBT FOR INCOME TAX PURPOSES The Approach to Characterization Recent debt financing structures, some of which will be discussed below, continue to test the boundaries of what constitutes debt and equity, both for business law and income tax purposes. The characterization of a financial instrument as debt or equity for income tax purposes has a significant effect on the tax treatment of payments and receipts on the instrument as the tax regimes for debt and equity are significantly different. Neither the term debt nor debt obligation is defined in the Tax Act, although both terms are used throughout the legislation. Most definitions of debt found in the common law and in the income tax jurisprudence describe debt as a legally enforceable promise to pay a liquidated amount, or a fixed and certain obligation to pay money or some other valuable property, determinable either now or in the future, with the right of the creditor to receive and enforce payment. 3 In general, a financial instrument will be characterized as debt (or equity) for income tax purposes if it has the legal nature of debt (or equity), and generally its tax treatment will 2 3 See, for example, Elinore J. Richardson, David Glicksman, and Lara Friedlander, Fundamentals of Canadian Taxation of Financial Instruments, in Report of Proceedings of the Fifty-First Tax Conference, 1999 Conference Report (Toronto: Canadian Tax Foundation, 2000); Tim Edgar, the Income Tax Treatment of Financial Instruments: Theory and Practice, infra note 10. See, for example, Black s Law Dictionary, Fingold (D.B.) v. M.N.R., 92 D.T.C (T.C.C.). 2

3 be governed by that characterization, absent any specific legislative response altering such tax treatment. An obvious example of such a legislative response is the introduction of the taxable preferred share, term preferred share and short term preferred rules in the Tax Act to alter the tax treatment of arrangements that were viewed as disguised debt financing arrangements. Before the rules were introduced, preferred shares became popular in after-tax financing arrangements to replace interest income with tax-free intercorporate dividends, minimizing financing costs for issuers and maximize investors after-tax return on investment. The term preferred share and taxable preferred share rules were introduced as specific legislative responses to eliminate the tax benefits of certain preferred share financing arrangements. Another example of a legislative response is the enactment of the thin capitalization rules to limit the deductibility of interest expense in the context of certain foreign related party financings of Canadian corporations, which were viewed as disguised equity financing arrangements. It is important to note that these rules alter the income tax results of specific transactions rather than recharacterizing the nature of the financial arrangement itself for income tax purposes. A number of cases have considered whether an instrument constitutes debt or equity at law. A leading case is Canada Deposit Insurance Corp. v. Canadian Commercial Bank, in which the Supreme Court of Canada considered, in the context of the insolvency of Canadian Commercial Bank (the Bank ), whether a participation agreement (the Participation Agreement entered into by the Bank with the Canada Deposit Insurance Corp. ( CDIC ) prior to its insolvency constituted a debtor-creditor arrangement such that CDIC was an unsecured creditor of the Bank and therefore entitled to rank equally with other unsecured creditors of the Bank. Under the Participation Agreement, the Bank sold to the participants (including CDIC) jointly, a portfolio of assets comprising loans made by the Bank that were unlikely to be recovered. The participation interest of each participant was proportional to its financial contribution and was evidenced by participation certificates issued by the Bank. The Bank agreed to pay each participant its proportionate share of the money received by it on account of each portfolio asset as well as 50% of its pre-tax income, or alternatively 100% of its pre-tax income plus interest if it was unable to obtain shareholder and regulatory approval necessary for it to 3

4 increase its authorized capital to perform the equity agreement entered into among the Bank and the participants (the Equity Agreement ). Under the Equity Agreement, the Bank granted the participants the right to subscribe for shares of the Bank at a named price, subject to shareholder approval and an amendment of law. The Bank also agreed to provide an indemnity equal to the price paid by the participants for the portfolio of assets and, in the case of insolvency, any amount remaining unpaid to a participant was explicitly stated to constitute indebtedness of the Bank. The Participation Agreement also stipulated that the right of each participant (other than CDIC) to money owing to it under the agreement ranked equally with the right of the Bank s depositors to payment in full of the deposit liabilities of the Bank, while the right of CDIC to money owing to it by the Bank was subordinate to the rights of the other participants but ranked in priority to any outstanding bank debentures of the Bank. The Supreme Court of Canada held that the transaction evidenced by the Participation Agreement was, in substance, a loan and not a capital investment, the equity component of the arrangement being incidental to the main features of the transaction. In reaching its conclusion, the Court enumerated the traditional criteria of debt and equity and compared the elements of the Participation Agreement and the Equity Agreement against those criteria. The Court concluded that where a financial arrangement contains elements of both debt and equity, an examination must be made of the parties intentions as reflected by the contractual arrangements and the words used in the documents, and supported by surrounding circumstances including a consideration of the dominant characteristics of the arrangement, in order to determine the true legal nature of the arrangement. Despite the Court s comments that it saw nothing wrong with recognizing a transaction as hybrid in nature, combining elements of both debt and equity, the Court concluded that the arrangement reflected in substance a debtor-creditor arrangement and that certain equity-like features of the arrangement should be given lesser weighting than the debt-like features in determining the legal nature of the arrangement as debt or equity. Under this characterization approach, developed in the context of determining priorities in an insolvency situation, an instrument will be either a debt instrument with incidental 4

5 features of equity or an equity instrument with incidental features of debt, but cannot be both debt and equity, i.e., a hybrid at law. Recent income tax cases such as Citibank Canada v. The Queen 4 adopt this approach to the characterization of debt and equity for income tax purposes and indicate that the Courts will evaluate all of the relevant terms of a financial instrument and characterize the instrument according to its predominant terms. In Citibank, the Federal Court of Appeal considered whether certain preferred shares issued to Citibank Canada were term preferred shares within the meaning of the Tax Act on the basis that the issuing corporations could be required to provide any form of guarantee, security or similar indemnity or covenant with respect to the shares. During the initial five year term of the preferred shares, dividends were payable to Citibank Canada at a fixed rate per annum. At the end of the initial term of the shares, Citibank Canada could convert the shares into common shares in accordance with a formula that entitled it to such number of common shares at the time of conversion having the same market value as the face value of the preferred shares. The Canada Customs and Revenue Agency (the CCRA ) argued that the conversion formula was a form of guarantee, security or similar indemnity or covenant with respect to the preferred shares, rendering such shares term preferred shares within the meaning of the Tax Act and therefore preventing Citibank Canada from availing itself of the intercorporate dividend deduction in subsection 112(1) of the Act. In concluding that the preferred shares of two corporations acquired by Citibank Canada were not term preferred shares within the meaning of the Act, one of the issues the Federal Court of Appeal addressed was whether the arrangement was essentially a debt financing arrangement (and therefore intended to be caught by the term preferred share rules) or a capital investment by Citibank Canada in the issuers of the preferred shares. Upon reviewing the documents evidencing the preferred share arrangements, the Court concluded that the arrangement more closely resembled a capital investment rather than a debt financing arrangement, as there were no provisions in the documents for structured repayment of the investment, for suing the issuing corporations under a note D.T.C (F.C.A.). 5

6 or debenture for recovery of the investment in the event of default, or for binding or seizing property of the issuing corporations. As Citibank Canada did not have any of the recourse traditionally associated with debt instruments, the Court concluded that the arrangement was a capital investment and that Citibank Canada simply had the right to convert its preferred shares into common shares having the same value on the conversion date. In addition, cases such as Shell 5 and Canadian Pacific Ltd. 6 have confirmed that it is the legal nature of a transaction or arrangement rather than its economic substance that is relevant for income tax purposes and, absent a specific provision of the Tax Act to the contrary or a finding of sham, the legal nature of a transaction or arrangement must be respected for income tax purposes. In the view of the Courts, recharacterization is only permissible where the formal label affixed to a particular transaction does not properly reflect its actual legal effect. The CCRA has published some of its views regarding the distinction between debt and equity in several technical interpretations. Generally, the CCRA s position is consistent with the case law in that, in the CCRA s view, it is the legal form of the particular financial instrument, and not its economic substance or treatment for accounting purposes, that will usually determine its income tax treatment. 7 The CCRA also notes that there is no clear dividing line in the law to distinguish debt payments from equity payments and that, as a general rule, the CCRA s view is that a lender s return on debt does not depend on the profitability of the borrower, whereas an investor s return on equity does depend on profitability. 8 Furthermore, the CCRA has indicated that generally equity securities represent ownership claims on a corporation, while debt securities such as bonds and Shell Canada Limited v. The Queen, 99 D.T.C (S.C.C.). Canadian Pacific Ltd. v. The Queen, 2002 DTC 6742 (F.C.A.). See, for example, Technical interpretation , Reporting of Financial Instruments, dated November 27, 1995; Technical interpretation 6M12570, 1996 Corporate Management Tax Conference Round Table, November 15, See Technical interpretation August , Deductibility of Interest in a Particular Situation, dated August

7 debentures represent creditor claims in that the borrower has a fixed obligation and usually an interest obligation to the holders of the debt securities. 9 General Characteristics of Debt and Equity The classical forms of debt and equity are generally described as follows: Investors who hold classical debt as evidence of their capital contributions are seen as having given up all claims to an unlimited share in corporate profits and corporate control. As compensation, they receive both a fixed return that is payable irrespective of the existence of corporate profits and a right to receive a return of their capital in whole or in part at specified times. In addition, these rights may be supported by other rights or arrangements, such as guarantees or indemnities, which reduce the risk that the promised return will not be paid. In contract, investors who hold classical equity (usually referred to as common shares ) as evidence of their capital contributions are seen as enjoying an unlimited right to participate in corporate profits and the right to vote with respect to certain corporate matters. To receive those enhanced rights, they must bear the risk of a variable or contingent return dependent on the existence and extent of corporate profits. As well, they have no right to receive a return of their capital except on liquidation of the corporation; nor do investors receive the benefit of any rights or arrangements that might reduce the investment risk. 10 As we have seen, the Courts and the CCRA continue to rely on classical notions of debt and equity, as outlined above, in characterizing a financial instrument for income tax purposes. Generally, the Courts and the CCRA have focused on certain predominant elements in determining whether a particular financial instrument constitutes debt or equity at law: General Characteristics of Debt: Repayment of capital invested (principal amount) Return on capital invested (interest or other income) Enforceability of payment of income and repayment of capital invested No sharing generally in the future growth or profit of debtor Stipulated date for repayment of capital Ranking before shareholders on bankruptcy or insolvency 9 10 Technical interpretation , Interest Income, dated April 19, Tim Edgar, the Income Tax Treatment of Financial Instruments: Theory and Practice, Canadian Tax Paper no. 105 (Toronto: Canadian Tax Foundation, 2000) at pages

8 General Characteristics of Equity: Sharing in the future growth and/or profits of the issuer Risk of loss of capital invested No stipulated date for return of capital invested Ranking after creditors on bankruptcy or insolvency It is important to emphasize, as did the Court in the Canada Deposit Insurance Corp. case, that any one element of a financial instrument may receive lesser or greater weighting than another element, depending on the particular financial instrument and the intention of the parties as evidenced by the written documents evidencing the arrangement. It is also not necessary that all of the elements outlined above be present before a financial instrument will be determined to be debt or equity at law and for income tax purposes. It should also be recognized that, although traditionally the salient distinction for income tax purposes is whether a financial instrument is debt or equity, a significant number of financial instruments on the market today may either not easily fit or not fit at all within the classical notions of debt and equity as outlined above. As described by Tim Edgar in his book The Income Tax Treatment of Financial Instruments: Theory and Practice 11 in the context of discussing the cubbyhole taxation of financial instruments under the Tax Act, there exists a third category of basic derivative financial instruments for which the tax treatment under the Tax Act is uncertain: Canadian tax-policy makers have largely neglected the tax treatment of the basic price-fixing instruments (forwards, futures and swaps) and price-insurance instruments (options). Like the tax treatment of debtfinancing charges, the taxation of these basic financial instruments (collectively referred to as building-block derivatives ) is governed by general statutory provisions. Unlike the treatment of debt-financing charges, however, these general provisions have no obvious relation to any of the unique issues presented by derivatives. In the absence of statutory provisions and case law that addresses the taxation of derivatives, taxpayers have been left with the application of 11 Supra note 10. 8

9 analogous case law and the administrative pronouncements of Revenue Canada Since the applicability of the reasoning in the analogous case law is often uncertain, the onus has been on the two tax administrations, which have responded in a less than comprehensive manner. The result is that uncertainty surrounds the tax treatment of the basic derivative financial instruments. 12 While the focus of this paper is on debt financing rather than derivative financial instruments, it is important to keep in mind this significant third category of financial instruments to the extent that a financial instrument reviewed in this paper does not appear to fit within the traditional category of debt (or equity), since uncertainty regarding characterization will impact on the ability to determine the appropriate tax treatment of the issuer and investors with respect to the instrument under the Tax Act. IMPACT OF DEBT/EQUITY CHARACTERIZATION ON INCOME TAX TREATMENT The Canadian income tax treatment of a financial instrument continues to depend on its characterization as debt or equity for tax purposes. The tax treatment of debt and equity arrangements are significantly different. As mentioned above, a comprehensive discussion of the tax treatment of debt instruments is beyond the scope of this paper. Instead, this section of the paper will simply highlight some of the key elements of the differing tax treatment accorded to debt and equity and some of the issues that must be considered in determining the precise tax treatment in a given situation. Some of these issues will be dealt with in more detail below in the context of discussing specific financing arrangements. Tax Treatment of the Issuer Where a financial instrument is considered to constitute debt or equity for income tax purposes, generally the issuer s proceeds from issuing the instrument will be viewed as capital (leaving aside certain specified receipts such as premiums). However, where a financial instrument does not appear to fit within the category of either debt or equity, a significant question for the issuer to determine in structuring and determining the tax efficiency of the arrangement is the character of its receipts on the financial instrument 12 Supra note 10 at pages

10 will receipts constitute income, capital, service fees or otherwise? This question may be challenging to answer, especially in cases involving innovative financial instruments. The characterization of the instrument as debt or equity will also have an impact on the deductibility of payments made to investors in respect of the instrument as well as on the tax treatment of financing and other charges incurred by the issuer to issue the financial instrument and to maintain the financial structure. Generally, the after-tax cost of debt to an issuer is much lower than the after-tax cost of equity, as long as the issuer is able to deduct the payments representing a return on capital that it makes to investors either as interest or other deductible financing charges in accordance with the provisions of the Act. The cost is further reduced if the issuer is able to deduct certain charges incurred in issuing the financial instrument and maintaining the financing structure. The deductibility of debt financing costs as well as the timing of deductibility will therefore be key factors to consider in determining the after-tax cost of debt financing to the issuer. Paragraph 20(1)(c) entitles a debt issuer to deduct interest payments made to investors provided four conditions are met. First, the amount must be paid pursuant to a legal obligation to pay interest. Interest is not defined in the Act. At common law, an amount constitutes interest if it represents compensation for the use of money, is calculated with reference to a principal sum and accrues daily. 13 Second, the amount must be paid in the year or payable in respect of the year. Third, the borrowed money on which the interest is payable must be used for an eligible use specified in paragraph 20(1)(c), including for the purpose of earning income from a business or property. Finally, the amount of the interest payment will be deductible only to the extent that it is reasonable. In contrast to simple interest, compound interest is deductible under paragraph 20(1)(d) only when paid. Other specific provisions in the Tax Act may also apply in certain circumstances to deem payments made by the issuer on the debt instrument such as premiums, bonuses and penalties to be interest. 13 Reference as to the Validity of Section 6 of the Farm Security Act, 1944, of the Province of Saskatchewan, [1947] SCR 394, aff d. [1949] AC 110 (PC); Re Balaji Apartments and Manufacturers Life Ins. Co. (1979), 100 DLR (3d) 695 (Ont. HCJ); Sherway Centre Ltd. v. The Queen, [1998] 2 CTC 343 (FCA); Attorney-General for Ontario v. Barfried Enterprises Ltd., [1963] SCR

11 Financing costs other than interest may be deductible under paragraphs 20(1)(e) or (e.1) of the Act. Generally, paragraph 20(1)(e) enables an issuer in specified circumstances to deduct, over a five year period, expenses (other than certain amounts including interest and amounts payable on account of the principal amount of the debt) incurred in the course of borrowing money used by the issuer for the purpose of earning income from a business or property or in the course of an issuance or sale of units or shares. Specifically included in paragraph 20(1)(e) are commissions for securities dealers. Excluded from the deduction are amounts that are contingent or dependent on the use of, or production from, property and amounts computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion. Paragraph 20(e.1) allows an issuer to deduct on a current basis an amount that is a standby charge, guarantee fee, registrar fee, transfer agent fee, filing fee, service fee or a similar fee that can reasonably be considered to relate solely to the year and that is incurred by the issuer for the purpose of borrowing money to be used by the issuer for the purpose of earning income from a business or property. As is the case with paragraph 20(1)(e), paragraph 20(1)(e.1) excludes from deduction payments that are contingent or dependent on the use of, or production from, property or are computed by reference to revenue, profit, cash flow, commodity price or any similar criterion. Some of the other issues that might have to be considered from the issuer s perspective are the deductibility of discounts and premiums and, where the debt instrument is not a plain vanilla debt obligation, the deductibility of contingent payments, participating payments or other equity-linked payments, either as interest or otherwise, under the Act. In certain circumstances equity financing may be attractive to the issuer, especially if the issuer is able to issue shares to investors the terms of which allow the issuer to choose not to pay or to defer paying dividends in the event the issuer experiences financial difficulty. Equity financing may also be attractive where the issuer is seeking to maintain a low debt-to-equity ratio. Where an issuer chooses equity financing over debt financing, dividends paid by the issuer on an equity instrument are paid out of its aftertax earnings, but certain financing costs associated with issuing equity are potentially deductible by the issuer in specified circumstances under paragraphs 20(1)(e) or (e.1). It is important that the equity instrument be structured so that it is not a taxable 11

12 preferred share under the Tax Act or the issuer, if it is not otherwise likely to be taxable, may be subject to tax under Part VI.I of the Tax Act when it pays dividends on the shares. Additional issues such as withholding tax and foreign currency translation arise when the issuer and the investor are not both resident in Canada for income tax purposes. Tax Treatment of the Investor For an investor considering whether to invest in a financial instrument, the characterization of the instrument as debt or equity as well as the precise terms of the instrument will affect the character of payments received on the instrument as well as the timing of the recognition of those payments for income tax purposes. Dividends payable to an investor on an equity instrument may be eligible for the intercorporate dividend deduction if the investor is a Canadian resident corporation (subject to the preferred share rules in the Act) or for the dividend gross-up and credit mechanism if the investor is a Canadian-resident individual. In contrast, an investor may be required to include interest on a debt instrument in income for tax purposes on an accrual basis, regardless of when interest on the debt instrument is actually received or receivable by the investor, and special receipts under the debt instrument such as bonuses and penalties may be deemed to be interest receipts to the investor under the Tax Act. Furthermore, the prescribed debt obligation rules in subsection 12(9) and Regulation 7000 may deem certain amounts to accrue as interest on a debt instrument that may otherwise be treated as a capital gain. For example, an investor holding a non-interest bearing debt instrument as capital property may be required to include in income for tax purposes on an accrual basis a portion of the amount payable on the disposition or maturity of the instrument as deemed interest, rather than recognizing it as a capital gain on disposition or maturity of the instrument. Foreign Investment Entity Rules The basic purpose of the foreign investment entity ( FIE ) rules is to tax Canadian investors on an annual basis in respect of their participating interests in FIEs. Generally, an FIE is a non-resident entity the total carrying value of the investment property of which is greater than 50% of the total carrying value of all of its property at the end of the 12

13 year. Essentially, the rules are intended to catch foreign investment vehicles accumulating foreign income and capital gains that is either not taxed or taxed at low rates in the foreign jurisdiction. The tax treatment of a financial instrument to an investor may also depend on whether the investment constitutes a participating interest in a foreign investment entity. A participating interest in a foreign investment entity means a share of a corporation or an interest in a trust or other non-resident entity, and a property that is convertible into, exchangeable for, or confers a right to acquire, directly or indirectly, an interest in the non-resident entity or a property the fair market value of which is determined primarily by reference to the fair market value of an interest in the non-resident entity. It is important to note that while plain vanilla debt of a non-resident entity will not be considered a participating interest of a Canadian-resident investor in the non-resident entity for the purposes of the FIE rules, a debt that is convertible or exchangeable into, or confers a right to acquire, directly or indirectly, shares of (or an interest in) the nonresident issuer or other property the fair market value of which is determined primarily by reference to the fair market value of shares of (or an interest in) the non-resident issuer may trigger the application of the FIE rules. Where a Canadian resident investor is considered to have a participating interest in an FIE, one of a number of exceptions to the application of the FIE rules may apply depending on the circumstances. There are also rules dealing with tracking interests in tracking entities. These rules are essentially an anti-avoidance measure designed to prevent taxpayers from achieving the economics of a participating interest in an FIE indirectly through an interest that tracks the value of the FIE. The rules may apply where a Canadian taxpayer has a tracking interest in a tracking entity. A tracking entity is a non-resident entity if it meets a twopart test: (i) the total carrying value of its property that is tracked property is less than 90% of the total carrying value of all the property that it owns; and (ii) the total carrying value of its tracked property that is investment property exceeds 50% of the total carrying value of all tracked property. There are also supplemental tests where the nonresident entity is subject to the look through rules because the taxpayer has at least a 25% interest in the non-resident entity. 13

14 Generally, a non-exempt taxpayer may be considered to have a tracking interest in a tracking entity where it has a participating interest in a non-resident entity which is not an exempt interest, that non-resident entity is a tracking entity in respect of the participating interest, the taxpayer has an entitlement to receive payments in respect of the participating interest that are, directly or indirectly, determined primarily by reference to the production from, use of, or profits generated by, one or more properties (referred to as tracked property ) and all or substantially all of the fair market value of the nonresident entity cannot be attributed, either directly or indirectly, to shares of a foreign affiliate. Where the FIE rules apply, an investor with a participating interest in an FIE is required to include in computing the investor s income, for each taxation year in which the investment is held and no exception to the application of the rules applies, a prescribed rate of return on the investment, regardless of whether any amounts in respect of the investment are payable to the investor. The prescribed rate of return method imputes an amount of income to the investor on a monthly basis equal to the applicable prescribed rate of interest (adjusted for the month) multiplied by the designated cost of the taxpayer s participating interest in the FIE at the end of that month. Alternatively, the investor may elect to be taxed on a mark-to-market basis where the investment meets certain requirements and the investor has sufficient information about the investments made by the FIE to compute taxable income. Where the tracking interest rules apply, the investor must use the mark-to-market method. The mark-to-market method requires investors to take into account the annual increase or decrease in the fair market value of their interests in FIEs in computing their income for Canadian tax purposes. Qualified Investment and Foreign Property Issues The characterization of a financial instrument as debt or equity for income tax purposes may also have an impact on whether it will be a qualified investment for tax-deferred investors such as trusts governed by RRSPs, RRIFs, DPSPs and RESPs ( registered plans ) and whether it constitutes foreign property for such investors. These issues will, of course, affect the marketing of the financial instrument to such tax-exempt investors. A registered plan that invests in property that is not a qualified investment will be subject to a penalty tax equal to 1% of the fair market value of all property held by the plan that 14

15 is not a qualified investment, unless the fair market value of all such property has been included in the income of the annuitant on the acquisition of the investment. Similarly, a registered plan is required to pay a penalty tax where the cost amount of foreign property held by it exceeds 30% of the cost amount of all of its property, equal to 1% of the lesser of the cost amount of the plan s property and the amount by which the plan exceeds the 30% limit. Generally, shares of a corporation that are listed on a prescribed stock exchange in or outside Canada, as well as units of mutual fund trusts will be qualified investments for registered plans. A debt instrument will generally be a qualified investment for registered plans if it meets one of a number of specified requirements, including being issued by a corporation whose shares are listed on a prescribed stock exchange in or outside Canada, and it is considered to be a bond, debenture, notes or similar obligation. A bond, debenture, note or similar obligation is generally viewed as a classic debt instrument. Such an instrument generally evidences the initial advance of funds (the principal ) by a lender to a borrower for a defined period of time in consideration of a promise to repay the principal plus a return to compensate the lender for the borrower s use of the principal. The instrument may also evidence the relationship between a creditor and a debtor in a case where the instrument has been the subject of a secondary market transaction. The expectation in either case is that the lender/creditor will be repaid the principal on the maturity date of the instrument (barring the borrower s non-performance or insolvency). The published position of the CCRA regarding the meaning of the phrase bond, debenture, note or similar obligation and other similar phrases for the purposes of the Tax Act is consistent with this view. According to the CCRA, such an obligation represents a written obligation, evidencing the indebtedness of the issuer to the creditor, which contains an explicit promise by the issuer to pay to the creditor a specified amount 15

16 at a specified time. 14 The use of words such as bond, debenture and note may also indicate some degree of negotiability as compared with transactions evidenced by loan agreements which are not specifically included in the list, although to what extent the requirement of negotiability may be relevant is uncertain as neither the Tax Act nor the case law addresses this point. Thus, in cases where a debt instrument is structured with features that depart from the classical notion of debt, an issue may arise as to whether such instrument constitutes a bond, debenture, note or similar obligation for the purposes of the qualified investment rules in the Tax Act. It should be noted that if there is a concern that a debt instrument may not qualify as a bond, debenture, note or similar obligation for the purposes of the Act, it may nevertheless be considered to be a qualified investment if it provides the holder with an unconditional right to another property, such as money, which is itself a qualified investment. Regulation 4900(1)(e) provides that a right giving the owner thereof the right to acquire property all of which is a qualified investment is itself a qualified investment. Therefore, if a debt instrument were to be structured so that a holder of the instrument would have the right to receive a minimum amount of money on the maturity date or on redemption of the instrument, such an instrument would be a qualified investment under the Tax Act for registered plans. This test for a qualified investment does not require that the debt instrument be repaid; however, it does require that the holder be granted an unconditional right to receive a minimum amount of money under the instrument (other than in the event of the issuer s insolvency). Foreign property is defined in subsection 206(1) of the Tax Act to include debt and equity of non-resident corporations and interests in a partnership or trust (subject to certain exceptions). A share or debt obligation of a Canadian resident corporation may also constitute foreign property where the shares of the corporation can reasonably be considered to derive their value, directly or indirectly, primarily from foreign property. In such case, an exception to foreign property status is provided where the corporation meets certain substantial Canadian presence tests set out in the Act. 14 See, for example, Technical Interpretation April , Interpretation of the Words Bond, Debentures, Notes or Similar Obligations in Section 204(e)(iii), dated April 1991; Technical Interpretation , Similar Obligations and 212(1)(b)(ii)(C)(II), dated August

17 RECENT TRANSACTIONS OF INTEREST C&T Strips Program The name stands for the Corporate and Trust Separately Traded Residual, Interest and Package Securities Program and is offered by CIBC World Markets Inc. Another similar program is the CARS and PARS (Coupons and Residuals and Par Adjusted Rate Securities ) Programme offered by RBC Dominion Securities Inc. The most recent short form base shelf prospectus for the C&T Strips Program was filed on February 11, What is the program? CIBC World Markets purchases on the secondary market a pool of previously issued and freely tradeable debt securities (referred to as Underlying Obligations ) of various Canadian corporations and trusts (referred to as the Underlying Issuers ) carrying an approved rating, strips the debt securities into their separate interest and principal components and then sells those components, either separately as components of interest ( Strip Coupons ) or components of principal ( Strip Residuals ), or as packages of strip securities (called a Strip Package ). The Underlying Obligations purchased are registered and held in the name of The Canadian Depository for Securities Limited ( CDS ). The prospectus states that the Underlying Issuers will not receive any proceeds, and CIBC World Markets will not be entitled to be paid any fee or commission by the Underlying Issuers, in respect of the sale by CIBC World Markets of the Strip Securities. CIBC World Market s overall profit or loss will depend upon the consideration paid for such Strip Securities. The Strip Securities Strip Residuals, Strip Coupons and Strip Packages (collectively known as Strip Securities ) are sold on a series by series basis, with each series relating to a separate class or series of Underlying Obligations of an Underlying Issuer. For example, under a recent prospectus, Strip Securities derived from certain Bell Canada debentures due 17

18 June 15, 2014 were issued. 15 The Prospectus states that Underlying Issuers will be various Canadian corporations and trusts which at the time of closing of the related offering of Strip Securities would, to CIBC World Market s knowledge, be eligible to file a short form prospectus under National Instrument The Underlying Obligations must also carry an approved rating, but, otherwise, the prospectus states that the Strip Securities will be derived without regard for the value, price, performance, volatility, investment merit or creditworthiness of the Underlying Issuers. The Strip Packages consist of the entitlement to receive (a) both payments of all or a portion of the principal amounts payable and periodic payments of all or a portion of the interest payable under, the corresponding Underlying Obligations (these Strip Securities are referred to as STARS ) and/or (b) in the case of packages consisting of Strip Coupons, periodic payments of all or a portion of the interest payable under the corresponding Underlying Obligations, in each case, if, as and when paid by the Underlying Issuer on the Underlying Obligations in accordance with their terms. The maturity dates of any particular series of Strip Coupons and the interest component of Strip Packages will be coincident with the interest payment dates for the Underlying Obligations, with terms of up to 30 years or more. The maturity date of a particular series of Strip Residuals and the principal component of Strip Packages parallel the maturity date of the Underlying Obligations for the series. The Strip Securities entitle their holders to payments of all or a portion of the interest and/or all or a portion of the principal of the corresponding Underlying Obligations upon maturity thereof and do not bear interest in the same manner as the Underlying Obligations. The Strip Securities are issuable in Canadian and US dollars. Risk Factors The prospectus notes that there is generally no market through which the Strip Securities may be sold and an investor may not be able to resell the Strip Securities purchased under the prospectus. As such, an investor may have to hold the Strip 15 See the Shelf Prospectus Supplement (filed on February 24, 2003) to the Short Form Base Shelf Prospectus dated February 11,

19 Securities until their maturity to realize on the investment. The prospectus also notes that investors will be entirely dependent on the Underlying Issuers ability to perform their respective obligations under the Underlying Obligations, although investors will not have direct contractual rights against the Underlying Issuers under the Underlying Obligations nor will they have any entitlement to the Underlying Obligations themselves. The prospectus also notes certain tax risk factors that are discussed below. Characterization of Strip Securities for Income Tax Purposes The Underlying Obligations from which the Strip Securities are derived have been issued by various Canadian corporations and trusts and purchased by CIBC World Markets on the secondary market. The Strip Securities relate either to particular Underlying Obligation principal or interest components or to a package combining Underlying Obligation principal and interest components. The Strip Securities themselves are not debt obligations of CIBC World Markets (and the prospectus makes it clear that investors will not have any claim against CIBC for any deficiency arising on the realization of principal or interest), but they evidence the right of holders to receive components of interest and/or principal paid on the Underlying Obligations to which the particular Strip Securities purchased relate, i.e., they evidence an interest in specified debt security components. As such, the Strip Securities may be viewed generally as debt for income tax purposes, although questions arise as to whether separate components of debt instruments are in and of themselves sufficient to constitute debt obligations for the purposes of the Tax Act and whether these instruments are more appropriately viewed for income tax purposes simply as contractual rights included in the third category of derivative financial instruments. Income Tax Treatment of Strip Securities The tax opinion in the prospectus summarizes the principal Canadian federal income tax considerations generally applicable to a prospective purchaser of Strip Securities, other than a financial institution as defined in the Tax Act for the purposes of the mark-tomarket rules, that is resident in Canada and holds Strip Securities as capital property. 19

20 (i) Interest Accrual - Strip Coupons and Strip Residuals The prospectus states that each of the Strip Securities is considered to be a prescribed debt obligation within the meaning of subsection 12(9) of the Act and Regulation 7000(1) and an investment contract within the meaning of subsection 12(11) of the Tax Act. As such, a holder will generally be required to include annually in income notional interest deemed to have accrued on the holder s Strip Coupon or Strip Residual from the date of purchase, irrespective of any entitlement (or no entitlement) to receive a portion of the interest payable under the Underlying Obligation. The amount of notional interest is calculated in accordance with the rules in Regulation Generally, the amount of notional interest that will be deemed to accrue each year on a Strip Coupon or Strip Residual is determined by using the interest rate which, when applied to the payment that the holder is entitled to receive, will produce the present value for the payment under the Strip Coupon or Strip Residual equal to its original purchase price. The specified interest rate determined for the Strip Coupon or Strip Residual is then applied to the purchase price of the Strip Coupon or Strip Residual and the resulting amount is the amount deemed to accrue as interest on the Strip Coupon or Strip Residual. In calculating the income required to be accrued under Strip Packages, a holder will be required to make calculations in respect of each of the components of the Strip Package and then aggregate all the amounts to determine the notional interest deemed to accrue on the Strip Package for the purposes of the Tax Act. The prospectus notes that the interest rate to be applied to calculate notional interest will be the rate which, when applied to all of the payments that a holder is entitled to receive under the Strip Package, will produce present values for such payments that in the aggregate equal the original purchase price of the Strip Package. (ii) Taxation of STARS Acquired at a Discount or Premium The prospectus states that the amount of interest that a purchaser of STARS would be required to include in income for the purposes of the Tax Act should generally be the same as the amount that would be included in the purchaser s income had he or she acquired for par a conventional interest-bearing security at the same time and having the same coupon, payment dates and maturity. However, the prospectus notes that the tax 20

21 consequences would not necessarily be the same if the conventional debt security were acquired at a discount or premium to its principal amount. A purchaser who acquires a conventional debt security at a discount would generally be required to include in income for purposes of the Tax Act the annual interest payment received in each taxation year, and the amount of the discount could, depending on the facts and circumstances of the transaction, including the size of the discount, and the nature of the purchaser, give rise to a capital gain for the holder in the taxation year that included the maturity date, assuming the security was held to maturity. In contrast, if the purchaser were to acquire, on the same date and for the same amount, STARS having the same payment attributes as the conventional debt security and assuming the purchaser held such STARS to maturity, the difference between the acquisition price and the amount of the final payment at maturity representing the principal amount would generally be included in calculating the total notional interest accruing on the components of the STARS for income tax purposes by virtue of Regulation 7000 and subsection 12(9) of the Tax Act. In such circumstance, the Prospectus notes that a purchaser who holds the STARS as capital property might be comparatively disadvantaged in that the amount of the difference between the purchase price of STARS and the principal amount component would be deemed to accrue as interest over the term of the STARS and be taxed at the taxpayer s ordinary marginal rate. (iii) Dispositions of Strip Securities A holder who disposes of, or is deemed to dispose of, a Strip Security will be required to including in computing the holder s income in the year of disposition, an amount equal to notional interest deemed to have accrued to the date of disposition not previously included in the holder s income as interest in accordance with Regulation 7000 and subsection 12(9) of the Tax Act. Assuming the holder holds the Strip Security as capital property, the holder will also realize a capital gain (or a capital loss) to the extent that the proceeds of disposition of the Strip Security, less any costs of disposition, exceed (or are exceeded by) the holder s adjusted cost base thereof at the time of disposition. The holder s adjusted cost base of the Strip Security will be the aggregate of the holder s 21