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

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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.

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