To the great satisfaction of lenders and Canadian borrowers, Part XIII of the Income Tax Act (Canada) was amended in 2008 to generally exempt interest payments from Canadian withholding tax. Exceptions to this rule are "participating debt interest" and, generally, interest paid to a non-arm's length person. A controversy then arose as to whether regular periodic interest payments on convertible debentures held by arm's length non-residents and premiums realized on conversion of such debentures were subject to withholding tax.
This controversy resulted from the interaction of the definition of "participating debt interest" in subsection 212(3) and the deeming rule of subsection 214(7), under which the excess of the fair market value of the shares issued on conversion over the issue price (that is, the conversion premium) could, upon conversion, be deemed to be a payment of interest on the debenture. Because the conversion premium is dependent upon the issuer's stock price, it could fall within the ambit of the definition of "participating debt interest" and, thus, be subject to withholding tax (even if paid to an arm's length non-resident). Furthermore, because the definition of participating debt interest includes interest payable on an obligation "all or any portion of" which is so determined, there was concern that the regular periodic interest payments were also subject to withholding tax.
Tax practitioners therefore often relied on paragraph 214(8)(a) of the definition of "excluded obligation" and ensured that the debentures complied with the so-called 5/25 rule of pre-2008 subparagraph 212(1)(b)(vii). There was uncertainty as to whether the debentures satisfied another exception in paragraph 214(8)(c) on the basis of the issue price being not less than "97% of the principal amount" and a yield-based test, as it was (and is still) unclear whether the conversion premium was to be taken into account in applying those tests.
In 2009, CRA indicated that it would not consider there to be any excess for purposes of subsection 214(7) on conversion of what it designated as "traditional convertible debentures" – i.e. debentures having the following terms and conditions:
- The debentures must be unsecured subordinated debts issued by a public corporation with no original issue discount and for a fixed amount of money in Canadian dollars representing the face value of the debenture;
- The debentures must bear interest at a commercial fixed rate calculated on their face value that is to be paid by the issuer at least annually;
- The debentures must be convertible into common shares of the issuer at the holder's option prior to maturity for either a fixed conversion price or a fixed conversion ratio (which must exceed the issuer's stock price at the time of issuance, but which may change over time if provided for in the governing document); and
- The debentures must have a specified maturity date and, on that date, the issuer must be able to redeem the debentures at a redemption price of 100% of the face value, plus accrued and unpaid interest.
In 2012, CRA issued a ruling to the effect that regular periodic interest payments made on convertible notes issued by a Canadian public corporation would not be caught by the definition of "participating debt interest" and, consequently, would not themselves be subject to withholding tax.
Finally, on July 2, 2014, CRA released a technical interpretation extending its relief position to "standard convertible debentures" issued by Canadian public corporations. CRA considers debentures with the following terms and conditions to be standard convertible debentures:
- The debentures may be (or not) secured, subordinated, denominated in a foreign currency, issued with an initial discount and convertible at the holder's option at any time or at certain specific times;
- The debentures may provide for a fixed conversion price or a fixed conversion ratio (which may be adjusted as a result of standard anti-dilution provisions);
- The interest rate may be fixed or floating, but must not be participating; and
- The debentures are repayable at maturity at their face value, plus accrued and unpaid interest, and may be redeemable by the issuer prior to maturity at a redemption price representing a fixed percentage of the face value, plus accrued and unpaid interest.
Considering the underlying purpose of subsections 212(3) and 214(7), CRA confirmed that conversion premiums on standard convertible debentures would not be subject to withholding tax as there was no indication that the legislator intended to consider a conversion premium to be "participating debt interest".
Although CRA's comments provide comfort, they are limited to standard convertible debentures issued by Canadian public corporations. Furthermore, CRA expressly stated that it doubts that it was the legislator's intention that the "excluded obligation" exception of paragraph 214(8)(c) should apply to convertible debentures. Therefore, uncertainty still exists regarding convertible debentures that are not standard (or traditional) convertible debentures and, consequently, indentures and other governing documents must be reviewed carefully to ensure that the terms and conditions of such debentures either fall within CRA's position or comply with the 5/25 rule of pre-2008 subparagraph 212(1)(b)(vii).
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