Article by Sheldon Vanderkooy, ©2005 Blake, Cassels & Graydon LLP
This article was originally published in Blakes Bulletin on Taxation - April 2005.
Under the withholding tax exemption provision in subparagraph 212(1)(b)(vii) of the Act, the lender may require early repayment of the debt in the event of a failure or default under the terms of the debt. However, there are numerous occasions in which the parties will agree to require early repayment of all or a portion of the debt, but do not wish there to be a default, as a default will typically accelerate all of the debt and have other consequences, including causing cross defaults on other indebtedness of the borrower. This article addresses the Canada Revenue Agency (the CRA) practices allowing the use of "triggering events" to provide for potential prepayment of the debt within 5 years, without the borrower necessarily defaulting under the terms of the debt.
Structuring Triggering Events
In order to satisfy both the requirements of the 5/25 exemption and the commercial objectives of the parties, loans have provided for triggering events. The basic mechanism for a triggering event is that the occurrence of some event (such as material asset sales or a change in control of the borrower) will be considered as an event of "failure" under the terms of the debt. It is significant that an event of "failure" will not have the consequences of an event of default under the terms of the debt. Rather, upon an event of failure, the terms of the debt will require the borrower to make an offer to prepay all or a portion of the remaining principal balance. If the borrower does not make an offer to prepay as required, this would constitute an event of default under the terms of the debt and, therefore, typically accelerate all of the debt. This mechanism depends on maintaining a distinction between the borrower being required to prepay a certain amount of the debt (which is not acceptable to the CRA) and a borrower being required to offer to prepay.
There are two bases for concluding that triggering events do not result in a failure to meet the requirements of the 5/25 exemption. First, the borrower is only required to make an offer to prepay a portion of the debt, and the borrower is not technically required to repay any amount. Second, such an obligation only arises upon an event of failure and, therefore, is an exception contemplated by clause 212(1)(b)(vii)(C). As both these bases are technical and subject to uncertainty, and as there has not been any case law addressing what is an acceptable event of failure or default for the purposes of the 5/25 exemption, in our view the CRA’s acceptance of triggering events should be viewed as an exercise of its administrative discretion. Therefore, other than in circumstances specifically addressed by the CRA in its published administrative policy and rulings, it is advisable that an advance tax ruling be obtained prior to utilizing a triggering event.
Types of Triggering Events
The CRA’s published administrative policy in Income Tax Technical News No. 9 is that they will accept circumstances such as (i) change of control of the borrower, (ii) ratings decline, or (iii) material asset sales, as being acceptable events of failure or default (triggering events) under a particular loan agreement although they might not be listed defaults under the terms of the agreement. Numerous rulings issued by the CRA have also allowed receipt of material insurance or expropriation proceeds as triggering events.
A recently released private income tax advance ruling is of interest in that it provided for a triggering event based on the borrower’s failure to maintain minimum earnings before interest, taxes, depreciation and amortization (EBITDA). Such a failure could be cured via a subscription for shares or other securities, with the cash proceeds of such subscription used to pay debt until a specified leverage ratio is obtained. If the failure is not so cured, the borrower could be required to make an offer to prepay a portion of the debt. The described purpose of this triggering event is to provide the lenders with flexibility as to whether to terminate the financing if the minimum EBITDA "represented to be achievable is not in fact achieved (or cured, if not achieved)". Significantly, the advance tax ruling specifically noted that the lender and the borrower spent significant time analyzing the historical results of the borrower, and reasonably expected the borrower to maintain the minimum EBITDA. Therefore, the minimum EBITDA requirement cannot be said to be a contrived means of requiring the borrower to prepay a portion of the debt prior to five years.
The use of triggering events is reflective of borrowers and lenders wishing to provide for potential mandatory prepayment if certain events occur, without necessarily providing for a full default of the debt. So long as the triggering event is based on unanticipated changes to the risk profile of the borrower and is outside the control of the lender, the use of triggering events will not contravene the policy objectives of the five year debt exemption in 212(1)(b)(vii). The CRA’s acceptance of a triggering event based upon EBITDA is a welcome development, as it suggests that the CRA is open to bona fide triggering events based on changes to the commercial risk associated with a loan that were not within the expectations of the parties at the time of entering into the loan. In other words, an event that would have been acceptable to the CRA as an "event of default" appears likely to be acceptable to the CRA as a "triggering event". However, given the uncertainty of the legal effectiveness of triggering events, it is advisable that an advance tax ruling be obtained prior to utilizing any triggering event other than those circumstances clearly accepted by the CRA in its published administrative policy and advance tax rulings, being (i) change of control of the borrower, (ii) ratings decline, (iii) material asset sales, (iv) receipt of material insurance or expropriation proceeds, or (v) failure to maintain minimum EBITDA (new ruling).
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.