Summary of Technical interpretation 2014-0524651I7 E (May 6, 2014).
Canco (a taxable Canadian corporation or “tcc”) indirectly controls ULC (another tcc), which is the sole member of US LLC.
ULC loans amounts to LLC under notes that provided for the conversion of the principal amount of the notes to shares in the capital of the LLC.
The notes were later converted to preferred shares of the LLC at a fmv equal to the LLC’s fmv (which appears to have been substantially less than the principal amount of the notes).
It appears ULC consented to the conversion, which consent provided for the LLC creating a class of preferred shares.
The consent and related subscription agreement did not refer to the conversion rights under the notes.
The issues:
1. Does section 51 of the Act apply to the conversion of the notes? CRA says no.
2. If not, could subparagraph 40(2)(g)(ii) of the Act apply to deny the capital loss on the conversion of the notes? CRA says question of fact.
The CRA response:
Subsection 51(1) of the Act states that the share is acquired “in exchange” for the debt and then refers to the right of the holder to make “the exchange”; this language strongly suggests that the exchange has to occur pursuant to the exchange right.
Subsection 51(1) applies where the holder of the share exercises the right to make the exchange pursuant to the terms of the share. It would not apply where conversion occurs automatically upon a specified date or upon the happening of a certain event.
In this case:
With respect to the taxpayer’s first argument, paragraph 5 above indicates that the Notes could be converted into “Shares”, which are defined as any interest in LLC, not solely common membership units. Accordingly, the fact that the Notes were converted into Preferred Shares does not necessarily indicate that the conversion was done outside the terms of the Notes.
With respect to the taxpayer’s second argument, we note that the documentary evidence you have provided to us shows that ULC “wished” to convert the Notes, and did not mention anything regarding the initiation of the conversion by LLC. We also understand that neither the Notes nor any other agreement between ULC and LLC would have required ULC to convert the Notes at the request of LLC.
With respect to the taxpayer’s third argument, if the conversion of the Notes were to have occurred pursuant to the exercise by ULC of its conversion rights under the Notes, one would have expected that approximately XXXXXXXXXX Shares (approximately U.S.$XXXXXXXXXX ÷ U.S.$XXXXXXXXXX) would have been issued. This differential likely indicates that the conversion did not occur pursuant to the terms of the Notes.
Loss? 40(2)(g)(ii) applies because no interest on notes? Maybe. Byram. But note proceeds were used by the LLC to make an interest-bearing loan to a Canco FA.
Amount paid in satisfaction of debt? 80(2)(g)? It may apply.
