The Federal Court of Appeal recently issued its decision in the tax appeal by the Crown from the Tax Court of Canada's decision in favour of Agnico Eagle Mines Limited (Agnico) and determined that the foreign exchange gains arising on a conversion of US dollar-denominated convertible debentures issued by Agnico should be computed by comparing the Canadian dollar equivalent of the debentures as of the date of issuance of the debentures with the Canadian dollar fair market value of the shares into which the debentures were converted as of the date of conversion. This decision is at odds with the Tax Court decision, which concluded that no foreign exchange gain arose because the true consideration received on the issuance of the common shares was the subscription price paid for the debentures. The method of computing the foreign exchange gain mandated by the Court of Appeal resulted in a reduction/elimination of the foreign exchange gain assessed by CRA.
Issuers of foreign-denominated convertible debt should consider the tax and corporate consequences of issuing these securities in light of this case.
In 2002, Agnico issued approximately US$144M of $1,000 principal amount convertible debentures. At the time the debentures were issued, the Canadian dollar-US dollar exchange rate was C$1.588 to US$1.00, resulting in the Canadian dollar principal amount of the debentures being approximately $230M.
The debentures were redeemable by Agnico on or after February 15, 2006, for a redemption price equal to the principal amount plus accrued and unpaid interest and could be satisfied in Agnico common shares. Holders also had a conversion right, which entitled them to receive 71.429 common shares per convertible debenture at any time prior to redemption or maturity. In late December 2005, Agnico gave notice of its intention to redeem the debentures and satisfy the redemption price by issuing 63.4767 common shares per debenture. As a result, most holders exercised their conversion rights, since they were entitled to a greater number of common shares on conversion compared to on redemption.
Conversions occurred in 2005 and 2006 after the Canadian dollar had strengthened and when one US dollar was exchangeable for Canadian dollars which varied from 1.1443 to 1.1726. In the CRA's view, Agnico made aggregate foreign exchange gains on the conversions of approximately C$62M in 2005 and 2006. Such gains represented the Canadian dollar difference between the principal amount of the converted debentures between their date of issuance and dates of conversion, calculated using the Canadian-US dollar spot rates on those dates. Agnico, on the other hand, took the position that no foreign exchange gains were realized on the conversions because it did not dispose of any property to satisfy the debentures on the conversions and that the common shares which it issued in satisfaction of the debentures were issued for the consideration initially paid by the subscribers for the debentures.
The Tax Court judge sided with Agnico and held that Agnico did not realize any foreign exchange gains on the conversions on the basis that the Canadian dollar value of the debentures on the date of conversion was not relevant and the relevant date for determining value was the date the debentures were initially issued. The Federal Court of Appeal arrived at a different conclusion and held that Agnico realized a foreign exchange gain on the conversions to the extent that the fair market value of the common shares issued on conversion, computed in Canadian dollars on the date of conversion, exceeded the principal amount of the debentures at the time of issuance computed in Canadian dollars determined at that time. While the CRA's computation of the foreign exchange gain did not take into account the cost to Agnico of issuing its common shares, the Court of Appeal took this cost into account, which would appear to produce a net effect of reducing substantially the foreign exchange gain realized by Agnico as computed by the CRA.
The methodology used by the Court of Appeal to calculate the foreign exchange gain or loss has two elements embedded in it; (i) a foreign exchange gain realized by Agncio as a result of the Canadian dollar increasing in value relative to the US dollar between the dates of issuance and of conversion of the debentures; and (ii) an economic loss or cost realized by Agnico on the conversion as a result of the fair market value of the common shares issued at the time of conversion being in excess of the principal amount of the debentures converted. The gain referred to in (i) would be a foreign exchange gain under subsection 39(2) of the Income Tax Act Canada). The loss or cost referred to (ii) is not the result of foreign exchange changes, but rather arises as a result of the increase in the fair market value of the shares to be issued on conversion of the debentures. If the obiter comments of the Federal Court of Appeal in Tembec Inc. v. R., 2009 D.T.C. 5877 (F.C.) are representative of the law, no deduction for such cost is permitted. As noted by the Noel, J.A., "On its face, the issuance of shares by the appellants from their share capital at a lower price than their actual value dilutes the shareholders' equity without an expense having been incurred by anyone."
Administratively, in earlier tax rulings the CRA had allowed a deduction for the loss in (ii) under paragraph 20(1)(f) of the ITA, but this position was reversed by the CRA in 2009, effective for debentures issued after January 1, 2010. The basis of a deduction under paragraph 20(1)(f) had been rejected by the Supreme Court of Canada in Imperial Oil Ltd v. R. 2006 SCC 46.
The Court of Appeal's decision in Agnico also focuses on the corporate law in the Business Corporations Act (Ontario) and appears to hold that the excess of the fair market value of the shares issued on conversion of a convertible debenture over the issue price of the convertible debenture is the amount paid by the issuer, and presumably should be the amount added by the directors of the issuer to the stated capital of the shares at the time the shares are issued. It will be interesting to see whether the CRA accepts this position and whether a similar treatment should apply in the case of other securities such as warrants or options where the consideration given to the issuer includes the relinquishment of the holder's right (i.e., the in-the-money amount) to acquire the shares. The Court of Appeal's decision seems to support the view that the stated capital account of the issuer should reflect the full fair market value of the shares at the date of issuance upon a debt conversion (rather than only the principal amount of the debentures repaid as a result of the conversion). On this basis, the paid-up capital of the issuer would be similarly increased. Arguably, this increase in stated capital and corresponding increase in tax paid-up capital should not give rise to a deemed dividend under subsection 84(1) of the ITA on the basis that the liabilities of the issuer (the debentures and obligation to settle them on conversion) have decreased by the same amount as the paid-up capital increase.
Another matter which will need to be confirmed by the CRA is its position regarding "standard" convertible debentures that the excess of the fair market value of the shares issued on conversion over the principal amount of the convertible debt is not deemed interest which would be considered "participating debt interest" for Canadian withholding tax purposes under subsection 214(7) of the ITA. It is expected that CRA's position should remain unchanged by this decision.