Why seller pre-closing debt cleaning transactions are costly to buyer
International Tax Review is part of the Delinian Group, Delinian Limited, 4 Bouverie Street, London, EC4Y 8AX, Registered in England & Wales, Company number 00954730
Copyright © Delinian Limited and its affiliated companies 2024

Accessibility | Terms of Use | Privacy Policy | Modern Slavery Statement

Why seller pre-closing debt cleaning transactions are costly to buyer

fotoflexer-photocanadaflag.jpg

John Leopardi and Emmanuel Sala, Blake, Cassels & Graydon explain why seller pre-closing debt cleaning transactions are costly to the buyer.

The effect on the application of the debt forgiveness rules of a practice on satisfying outstanding debt before the sale of a business was considered has recently been considered in Canada.

The reactions of the Canada Revenue Agency (CRA) and the Tax Court of Canada (TCC) to what was construed, essentially, to be a circular flow of funds culminated in the application of those rules. It may be prudent to consider the TCC’s reasons when any seemingly orchestrated flow of funds is involved in a planning context.

Ford US (US Seller) wanted to sell its Canadian recycling operations carried on by US Seller’s wholly owned subsidiary Greenleaf Canada Acquisitions (Canco). An arm’s-length buyer, Pièces Automobiles Lecavalier (Can Buyer) and US Seller agreed on a price for the shares of Canco that were considerably lower than US Seller’s cost of the shares and loans made by US Seller to Canco.

Prior to the arm’s-length sale of Canco, US Seller converted part of its outstanding debt to Canco for shares of Canco: US Seller made a cash contribution of $14,843,596 to Canco for Canco common shares and Canco then repaid $14,944,302 of a $24,369,439 outstanding debt owing to US Seller (Debt Conversion Transactions). Can Buyer subsequently purchased Canco’s shares for $1 and the remaining debt of Canco, of $9,750,000, owing to US Seller for a cash payment of $9,742,008. The result of the debt conversion transactions was that tax attributes of Canco’s assets were not eroded pursuant to specific debt-parking rules under the Canadian Income Tax Act (ITA).

Had the debt conversion transactions not been completed by US Seller, the debt would have been considered a “parked obligation” under the debt forgiveness rules and would have resulted in a deemed debt settlement of the outstanding debt upon the subsequent sale of Canco’s debt and the shares. Moreover, a specific debt forgiveness rule under the ITA is intended to prevent a taxpayer from working around such rules by converting a debt to equity having a lower fair market value than the principal amount of the converted debt.

The CRA assessed Canco, invoking the general anti-avoidance rule (GAAR) under the ITA, on the basis that the debt conversion transactions and the sale of Canco was a series of transactions which avoided the application of the debt-parking rules and abused the debt-forgiveness rules. Canco argued that US Seller had imposed the debt conversion transactions on Canco and such transactions were separate from the sale transaction. Canco further submitted that US Seller needed to convert the debt to equity to realise US Seller’s economic loss for US income tax purposes. Canco however failed to produce evidence, including a US tax expert, to support this submission and the TCC made a negative inference from this failure.

The TCC held that in proceeding by way of the debt conversion transactions rather than effecting a direct conversion of the debt to shares, Canco circumvented the application of the debt-parking rules -thereby giving rise to a tax benefit to Canco, being the preservation of its tax pools and applied the GAAR accordingly.

The TCC stated that the application of the GAAR would in any event also be justifiable under the circumstances on the basis that the conversion of the debt to shares, through a circling of cash rather than a direct conversion, represented an abuse of the specific debt forgiveness rule regarding the conversion of debt to equity.

more across site & bottom lb ros

More from across our site

EMEA research now open
Luis Coronado suggests companies should embrace technology to assist with TP data reporting, as the ‘big four’ firm unveils a TP survey of over 1,000 professionals
The proposed matrix will help revenue officers track intra-company transactions from multinationals
The full list of finalists has been revealed and the winners will be presented on June 20 at the Metropolitan Club in New York
The ‘big four’ firm has threatened to legally pursue those behind the letter, which has been circulating on social media
The guidelines have been established in the wake of multiple tax scandals and controversies that have rocked the accounting profession
KPMG Netherlands’ former head of assurance also received a permanent bar and $150,000 fine; in other news, asset management firm BlackRock lost a $13.5bn UK tax appeal
The new, fully integrated office will also offer M&A, dispute resolution, IP and corporate tax services
The new guidance concerns a recent 1% excise tax on the repurchases of corporate stock for both US and certain foreign companies
Interpath has hired a managing partner from rival accounting firm BDO to lead the new operation
Gift this article