In the context of the restructuring of the debt of a corporation
in financial difficulty, one of the possibilities that presents
itself is to convert its debt into shares of the corporation.
Various rules provided for in section 80 of the Income Tax
Act (Canada) must then be analyzed. Generally, section 80
provides that, at the time of the settlement of a debt for an
amount that is less than its principal, the difference between the
principal amount of the debt and the amount actually paid or deemed
to be paid must be applied to reduce certain tax attributes of the
debtor corporation, such as business and capital losses.
Ultimately, and to the extent that the value of these tax
attributes is insufficient, an inclusion in the income of the
debtor corporation may occur.
Where a debt is converted into shares, section 80 provides that
the amount deemed to be paid by the corporation is equal to the
fair market value (hereinafter the "FMV") of the shares
issued. The FMV of the shares issued may lead to problems in the
context of the conversion of a debt of a corporation in financial
difficulty. Indeed, it is probable that the shares of such a
corporation in fact have no value or have a greatly reduced value.
Therefore, section 80 will apply if the FMV of the shares issued at
the time of the conversion of the debt is less than its principal
To the extent that the FMV of the shares is insufficient to
cover the principal amount of the debt due to a decline in the
value of the debtor corporation, it will be possible to resort to
another rule provided for under section 80. This rule provides that
when the debtor corporation is a wholly-owned subsidiary of the
creditor, the increase in the FMV of the shares held by the latter
in the debtor corporation further to the extinguishment of the debt
shall be deemed to be an amount paid at that time in settlement of
the debt. For instance, if Aco holds all of the shares of Bco as
well as a debt in the amount of $1M in Bco, and the value of Bco is
also equal to that amount, the pure and simple extinguishment of
the debt, even without consideration, will result in the value of
the shares of Bco held by Aco increasing by an amount corresponding
to the debt. The value of Bco will thus be increased to $2M. In
this case, extinguishment of the debt without payment will not
cause section 80 to apply as regards Bco, because Bco will be
deemed to have repaid the debt in full. However, in order for this
exception to apply, the assets of the debtor corporation must have
a value equal to or greater than all of its liabilities, so that
extinguishment of the debt can be considered as having led to an
increase in the FMV of the corporation's shares.
Other techniques may also be used in order to restructure the
debt of a corporation in financial difficulty while minimizing the
impact of section 80.
It is essential to pay particular attention to this provision so
as to avoid tax consequences likely to make the financial situation
of a corporation even worse. Appropriate tax planning makes it
possible to avoid the pitfalls of section 80 and thus preserve the
tax attributes of a corporation in financial difficulty.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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