Distress Preferred Shares Remain a Viable Tool to Reduce Financing Costs

In challenging financial times, corporations need to evaluate all tools available to restructure their debt obligations to reduce financing costs. One tool that may be useful is distress-preferred share financing. If structured properly, the use of distress preferred shares would lower a debtor’s borrowing costs while maintaining the after-tax amount received by lenders. This result can be achieved without sacrificing the lenders’ priority on the existing debt obligation.

Once the restructuring is completed, the lender receives dividends on the distress-preferred shares on a tax-free basis, rather than interest on the existing debt obligation that must be included in income. As a result, a lender can accept a dividend rate on the distress-preferred shares that is lower than the interest payable on outstanding debt thereby reducing the debtor’s cash flow requirements.  The debtor forgoes the ability to deduct the interest it would have paid on the debt because dividends are not deductible. However, the forgone deduction does not result in immediate cash taxes as the debtor has ample other available tax deductions.

Tax Advantages of Distress Preferred Shares

Generally, it is not tax efficient for a financial institution to convert debt into preferred shares having debt-like attributes because such shares will be caught by specific rules in the Income Tax Act (Canada) (“Act”) targeting “term preferred shares” and “taxable preferred shares”.  The following adverse consequences would arise on such a conversion:

  1. dividends received on the preferred shares are included in the holder’s income and the offsetting intercorporate dividend deduction is denied;
  2. the debtor is subject to tax under Part VI.1 of the Act on dividends it pays on the preferred shares (above its annual dividend allowance); and
  3. the debt forgiveness rules may apply to the exchange of debt for preferred shares.

Moreover, on an exchange of debt for preferred shares, the financial institution would lose its status as a secured creditor.

However, in a properly structured transaction, the financial institution can effectively retain the benefit of its position as a secured creditor, the preferred shares can fit within a specific exception to the definition of “term preferred share” (referred to as “distressed-preferred shares”) and the consequences of the debt forgiveness rules can be avoided. The structure will have an initial term of five years before it must be unwound.

To fit within the distress-preferred share exception, the preferred shares must be issued in one of the following circumstances:

  1. as part of a proposal to, or an arrangement with, the corporation's creditors that had been approved by a court order under the Bankruptcy and Insolvency Act;
  2. at a time when all or substantially all of the corporation's assets were under the control of a receiver, receiver-manager, sequestrator, or trustee in bankruptcy; or
  3. at a time when, by reason of financial difficulty, the issuing corporation or another corporation resident in Canada with which it does not deal at arm's length was in default, or could reasonably be expected to default, on a debt obligation held by a person with whom the issuing corporation or the other corporation was dealing at arm's length, and the share was issued either wholly or in substantial part, and either directly or indirectly in exchange or substitution for that obligation or a part thereof.

Market practice has been that financial institutions are not prepared to proceed with a distress-preferred share financing unless favourable advance tax rulings are issued by the Canada Revenue Agency.  Much energy is devoted to satisfying the CRA that the debtor is in financial difficulty. 

In our view, the COVID-19 crisis makes such a lengthy process impractical. We have asked the Department of Finance whether the Act can be amended to dispense with the financial difficulty requirement in the present economic circumstances.

Members of our Tax Group would be pleased to discuss the tax advantages of distress preferred share financings.

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