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 amount.
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.
