The Federal Court of Appeal recently dismissed the taxpayers’ appeals in Tembec Inc. et al v. The Queen (Tembec), and denied the deductions claimed by the taxpayers under paragraph 20(1)(f) of the Income Tax Act (the Act) for the difference between the fair market value of common shares issued on the conversion of convertible debt obligations and the issue price of the obligations. The Federal Court of Appeal held that, under paragraph 20(1)(f), the “principal amount” of an obligation is required to be determined at the time of its issuance, not at the time of its conversion into shares.
In Tembec, the Federal Court of Appeal interpreted and applied the approach adopted by the majority of the Supreme Court of Canada in Imperial Oil v. The Queen (Imperial Oil) with respect to paragraph 20(1)(f) of the Act. (For a discussion of the Imperial Oil decision, please see the Osler Update of November 1, 2006.) In that case, the Supreme Court confirmed by a 4-3 majority that foreign exchange losses should not be taken into account in determining whether foreign currency denominated debt is issued at a discount so as to permit the deductibility of all (or a percentage) of a foreign exchange loss pursuant to paragraph 20(1)(f). Applying Imperial Oil, the Federal Court of Appeal in Tembec interpreted paragraph 20(1)(f) as being applicable only in respect of an original issue discount determinable at the time of issue of a debt obligation.
Principal Issue and the Parties’ Positions
In general terms, where the amount paid by a taxpayer in satisfaction of the principal amount of the debt exceeds the amount for which the debt was issued – typically debt issued at an original issue discount – paragraph 20(1)(f) provides for a deduction in computing the taxpayer’s income for the year of repayment of all (or a percentage) of such excess. Both in Imperial Oil and Tembec, the taxpayers argued that paragraph 20(1)(f) should be applied beyond the typical context of debt issued at an original issue discount.
At issue in Tembec was the deductibility under paragraph 20(1)(f) of 75% (as the provision then read) of the excess of the fair market value of the common shares issued on the conversion of certain convertible debt obligations over their stated principal amount. This case was heard on common evidence with Cascades Inc. v. The Queen and Provigo Inc. v. The Queen. The taxpayers claimed that a percentage of the excess was deductible under paragraph 20(1)(f) and that the decision in Imperial Oil should be limited to denying a foreign exchange loss under paragraph 20(1)(f).
Two arguments were advanced in support of the taxpayers’ claims for the paragraph 20(1)(f) deduction. First, it was argued that the “principal amount”, as defined in subsection 248(1) of the Act, is not limited to the stated principal amount of a convertible debt fixed at the time of issuance but that the “principal amount” (as defined) of a convertible debt can exceed the stated principal amount by reference to (and can fluctuate according to) the market value of the shares into which the debt is convertible until the time of conversion. Second, the taxpayers submitted that the amount paid in satisfaction of the principal amount of the obligation pursuant to paragraph 20(1)(f) was the fair market value of the issued shares at the time of the conversion. According to the taxpayers, the conversion price stipulated in the trust indenture was merely a tool to be used by the parties to calculate the number of shares to be issued in satisfaction of the principal amount of the debentures. Since the intention of the parties was to determine a total number of shares to be issued on conversion, it was only at the time of conversion that the maximum amount payable in satisfaction of the principal amount of the debentures could be determined.
The Crown asserted that the Imperial Oil decision conclusively established that paragraph 20(1)(f) should be limited to recognizing original issue discounts and that, in any event, the amount paid on conversion of the debentures was the agreed price and not the fair market value of the shares issued on conversion. With regard to the second argument, the Crown maintained that the amount paid in satisfaction of the principal amount of the obligation is the conversion price stipulated in the trust indenture and not the fair market value of the shares at the time of the conversion. Having regard to the decisions in Teleglobe Canada Inc. v. The Queen and King Rentals Ltd. v. The Queen, the Crown argued that where an agreement between the parties provides for the cost to issue the shares, the terms of the agreement must apply.
Tax Court of Canada Decision
In a brief analysis, Justice Lamarre Proulx for the Tax Court of Canada accepted the arguments of the Crown, holding based upon the decision of the Supreme Court in Imperial Oil that the principal amount cannot fluctuate and the determination of whether debt is issued at a discount must be made at the time of issuance. The Court suggested, following Alcatel Canada Inc. v. The Queen, that the taxpayers had nonetheless made a “real expenditure” at the time the shares were issued in an amount equal to the difference between the fair market value of the shares and the price agreed to in satisfaction of its obligations. However, the Court found that outside the application of paragraph 20(1)(f), the tax treatment of any such expenditure was not before the Court.
Federal Court of Appeal Decision
Justice Noël for the Federal Court of Appeal affirmed the judgment of the Tax Court, taking the view that the Supreme Court had unequivocally determined in Imperial Oil that the deduction permitted by paragraph 20(1)(f) is limited to a “point-in-time discount”, the value of which should be established when the security is issued. According to the Federal Court of Appeal, the decision of the Supreme Court in Imperial Oil has set aside the possibility that any deduction under paragraph 20(1)(f) could reflect the appreciation or depreciation of the principal amount over time or that the amount of the deduction could be ascertained only at the time of repayment.
The Federal Court of Appeal also questioned, without having to decide on, the taxpayers’ argument that the difference between the shares’ value at issuance of the security and their value at the conversion properly constituted a cost of financing. The Court observed that on the face of it, the issuance of shares at a lower price than their actual value dilutes the shareholders’ equity without any expense being incurred.
As the decision of the Federal Court of Appeal was released on June 11, 2008, the taxpayers will have until September 10, 2008 to file an application for leave to appeal the decision to the Supreme Court.
Implications of Tembec
Prior to the decision of the Supreme Court in Imperial Oil, the Canada Revenue Agency (the CRA) had issued a number of advance tax rulings and technical interpretations confirming its view that both the proceeds of disposition of shares delivered in settlement of an exchangeable debt and, for purposes of paragraph 20(1)(f), the principal amount of an exchangeable debenture was the fair market value of the shares so delivered. (See, for example, CRA Document No. 2000-0060103, June 20, 2001). Accordingly, in the context of exchangeable debentures, the CRA had administratively accepted that all (or a percentage) of any excess paid over the issue price of the obligation would be deductible to the issuer under paragraph 20(1)(f). In many circumstances, such a deduction would effectively offset that portion of the taxable capital gain realized on delivery of the underlying shares equal to the excess of fair market value over principal amount of the exchangeable debt. Similarly, the CRA had stated that a paragraph 20(1)(f) deduction would be available in respect of commodity-based loans where the amount payable on maturity exceeded the original face amount due to fluctuations in commodity prices.
In Imperial Oil, the Supreme Court had alluded to the administrative practice of the CRA in affording paragraph 20(1)(f) treatment in respect of variations in the principal amount of commodity-based loans and exchangeable debentures. Justice LeBel, speaking for the majority, had suggested that the CRA’s practice in this regard was “troubling”. Thus, the Supreme Court’s decision in Imperial Oil created uncertainty as to whether all (or a percentage) of the excess over the principal amount of the fair market value of shares delivered upon exercise of the exchange right under an exchangeable debenture was deductible under paragraph 20(1)(f).
The decision of the Federal Court of Appeal in Tembec denies a deduction under paragraph 20(1)(f) in respect of convertible debt not issued at an original discount to stated principal. Despite comments to the contrary in the dissenting judgment in Imperial Oil, the CRA’s administrative position in respect of exchangeables appears generally not to have been applied to convertible debt. Arguably, it was open to the Federal Court of Appeal to dispose of the appeals on the basis, suggested by the Court in obiter, that no amount was paid nor expense incurred by the taxpayers in respect of the excess of the fair market value of the taxpayers’ common shares delivered over the principal amount of the convertible debt so settled. That the Federal Court of Appeal chose to limit its observations to obiter and dispose of the appeals by reference to an interpretation of paragraph 20(1)(f) which limits its application to original issue discount determinable at the issue date of the debt, may give the decision an impact well beyond its holding in respect of convertible debt.
At the 2006 Canadian Tax Foundation Annual Conference, the CRA stated that commodity-based loans and exchangeable debenture financings then in place would still be eligible for paragraph 20(1)(f) treatment. Should application for leave to appeal Tembec not be filed, or if filed, be dismissed by the Supreme Court, the CRA is expected to complete its review and announce its updated administrative position with respect to commodity-based loans and exchangeable debentures. It remains to be seen whether, in light of the Tembec decision, this position will be maintained for issuances of exchangeable debentures and commodity-based loans subsequent to the Supreme Court’s decision in Imperial Oil or whether the CRA will grandfather pre-existing arrangements only.
If the administrative view of CRA regarding the application of paragraph 20(1)(f) to exchangeable debentures is discontinued in light of the decisions in Imperial Oil and Tembec, it will be interesting to observe how the CRA (or potentially, the Department of Finance) react to arguments that by virtue of the terms of an exchangeable debt, the proceeds of disposition to an issuer of exchangeable debt should similarly be limited to the stated principal amount of the debt rather than, as under the CRA’s historical position, the fair market value of the shares delivered upon exchange. Such arguments, perhaps along with clarification of the tax treatment of cash paid in excess of principal upon the cash settlement of exchangeable debentures, may be expected if exchangeable debt is to be issued by Canadian issuers free of potential taxation of “phantom” capital gains arising from the appreciation of the underlying shares. Under the CRA’s historical administrative position, such gains were effectively offset by the deduction permitted under paragraph 20(1)(f).
The Federal Court of Appeal decision in Tembec is available here. The Osler Tax Department has prepared an unofficial translation of this decision that is available here. This translation was prepared in-house and is for information purposes only.