In the current economic climate, the ability to reduce financing costs can make the difference between business recovery and failure. The “distress preferred share” (“DPS”) provisions in the Income Tax Act (Canada) (the “Tax Act”) present an opportunity to reduce such costs, by some 30%. At the same time, a DPS restructuring can give the lender equal or better after-tax income on its investment, without sacrificing its security and priority. In essence, the DPS rules give an interest subsidy to the borrower in difficulty through a tax break to the lender.

What is the Tax Break?

Normally, it does not pay for a lender to convert a loan into preferred shares. The shares will typically carry a fixed dividend and a fixed retraction price, and thus will be “taxable preferred shares” and “term preferred shares” under the Tax Act. Dividends received by a financial institution on a term preferred share are denied the intercorporate dividend deduction, and so, like interest, are taxed at the lender’s full corporate tax rate. Moreover, if the shares are also “taxable preferred shares”, the borrower must pay a Part VI.1 tax on any dividends above its $500,000 annual “dividend allowance”, at a rate that can be as high as 50%.

A DPS, however, is deemed for five years from its issue date, to be neither a term preferred share nor a taxable preferred share. This means that a dividend paid to a lender on the DPS will be a tax-free intercorporate dividend. For example, a lender who receives interest at an 8% rate, and pays income tax at a 30% rate, will have a 5.6% after-tax return. It would obtain the same after-tax return if it received a 5.6% dividend on a DPS instead of interest. For the same five years, the borrower, as issuer of the DPS, is not liable for Part VI.1 tax on the dividend. In effect, any dividend rate higher than the lender’s after-tax return on interest at a given rate, but lower than that interest rate (e.g., between 5.6% and 8%) will leave both the lender and the borrower better off. Although the lower dividends are not tax-deductible to the borrower, typically it will be in a tax loss position and have no current use for a deduction.

What is a DPS?

To qualify, a share must be issued by a corporation that is resident in Canada and must meet two tests: the circumstances of issue and the use of proceeds.

The Tax Act requires that the share be issued in one of the following three circumstances:

(a) in exchange or substitution (directly or indirectly, and in whole or “substantial part”) for a debt obligation:

(i) owing to an arm’s length creditor; and

(ii) on which the issuer, or a Canadian resident corporation with which it does not deal at arm’s length, is, by reason of financial difficulty, in default or could reasonably be expected to default;

(b) as part of a proposal to, or an arrangement with, the issuer’s creditors approved by a court under the Bankruptcy and Insolvency Act (Canada); or

(c) when all or substantially all of the assets of the issuer are under the control of a receiver, receivermanager, trustee in bankruptcy, or sequestrator.

In all cases, the proceeds from the issue of the share must be used by the issuer or a non-arm’s length corporation to finance a business that was carried on in Canada immediately before the share was issued. Accordingly, a DPS structure is not available to refinance foreign operations.

The DPS rules have been a long standing feature of the Tax Act, and the Canada Revenue Agency (“CRA”) has developed extensive administrative practices as to their application. These are of particular relevance where DPSs are to be issued in the “default or pending default” circumstances described in (a) above. These practices, in certain respects, are broader than the wording of the Tax Act itself, and accordingly, as discussed below, an advance tax ruling (“ATR”) is often recommended to confirm that the DPS rules will apply to a proposed debt restructuring.

When Should a DPS Transaction Be Considered?

A financial analysis is needed to evaluate whether a DPS restructuring is appropriate. A lender will not benefit from substituting a tax-free but lower dividend return for interest if it has tax losses or other shelter to offset the interest income. A lender that is a non-resident of Canada will not want to lose the benefit of the withholding tax exemption for interest. For a lender that is taxable in Canada, both its tax rate and the rate of interest otherwise payable on the loan will determine the extent to which a DPS structure can lower borrowing costs. The borrower’s financial condition must be assessed to decide whether such lower costs, over the fiveyear term of a DPS, will facilitate financial recovery.

How Should the Transaction be Structured?

There are many ways in which to structure a DPS issuance. The simplest would be to convert the lender’s debt into DPSs. This would, however, leave the lender as a mere shareholder, losing its security position, and becoming subject to corporate law solvency tests that could prevent the borrower from paying dividends or redeeming the DPSs.

One structure which avoids these issues, and which the CRA has approved in the past, is shown here.

This structure is implemented as described below.

1. The borrower incorporates a new wholly-owned subsidiary (“Newco”). Newco is a special purpose corporation that is restricted from carrying on any business, incurring any liabilities or acquiring any assets, except as contemplated to effect the DPS transaction. Newco’s share capital consists of common shares owned by the borrower and non-voting preferred shares that will be the DPSs. The preferred shares carry the agreed preferential cumulative dividend and have retraction rights on events of default, together with provisions for mandatory redemption out of excess cash flow and, in any event, on their fifth anniversary.

2. Newco borrows funds from the lender on a demand basis in an amount equal to the face value of the loan, and uses these funds to buy the loan and the benefit of the accompanying security from the lender at the face value of the loan. The borrower and Newco agree that no interest will be payable on the loan so long as it is held by Newco, but that the obligation to pay interest will be reinstated should the loan subsequently be assigned or be reacquired by the lender.

3. The lender uses the sale proceeds to subscribe for the DPSs in Newco and Newco applies the subscription proceeds to repay the demand loan.

4. The lender, the borrower and Newco enter into put and support arrangements whereby:

(a) the borrower agrees to make capital contributions to Newco to enable Newco to pay dividends on the DPSs and all fees and expenses required to stay in good standing;

(b) the borrower agrees to make principal payments to Newco, including payments out of excess cash flow, so that Newco will have the funds with which to redeem the DPSs;

(c) the lender has a “call” option to buy back the loan and accompanying security (in effect allowing the lender to revert to its original position as a secured lender);

(d) Newco has a “put” option to require the lender to take back the loan after the lender has exercised its rights to retract the DPS for the then outstanding principal amount which Newco will use to redeem the DPS (so that Newco can meet the corporate law solvency test of having realizable asset value at least equal to the stated capital of the DPSs); and

(e) the borrower and Newco guarantee each other’s obligations to the lender.

Is an ATR Needed?

As a DPS structure depends on tax savings to reduce financing costs, it is common to request an ATR to confirm the tax results, particularly since the CRA has developed administrative practices as to the application of the DPS rules. For example, in determining whether a borrower could “reasonably be expected to default” the CRA requires the default to be quite imminent and that there be no reasonable prospect that a related corporation or major shareholder will fund the borrower. In addition to confirming that a share will qualify as a DPS, an ATR will typically confirm, among other things, the tax-free status of capital contributions made by the borrower to Newco, the non-application of debt forgiveness rules, and the tax consequences to the lender should it reacquire the debt, including a financial institution lender’s ability to claim impaired debt reserves and an uncollectible debt deduction in respect of the reacquired debt.

What Happens After Year 5?

The Tax Act allows a share to qualify as a DPS only for five years from the date of its issuance. If the DPS remains outstanding on the fifth anniversary date, neither the Tax Act nor the CRA’s administrative practice permits an extension of its term. In these circumstances, the lender would commonly exercise its call right and purchase the loan from Newco and Newco would apply the proceeds to redeem the preferred shares. The CRA has indicated that a further DPS refinancing of the reacquired debt may be possible if the borrower continues to meet the financial difficulty requirements contained in the Tax Act.