Principal Issues: Opco is a Canadian-controlled private corporation as defined in subsection 125(7). Opco will issue a convertible debenture to a non-resident investor. The debenture will be convertible in common shares of the capital-stock of Opco only when a second round of financing occurs and the conversion ratio will be based on Opco’s fair market value at that time. How paragraph 251(5)(b) should apply under these circumstances?
Position: Paragraph 251(5)(b) should apply at any particular time before the conversion and the conversion ratio should be based on Opco’s fair market value at that particular time.
Reasons: Application of paragraph 251(5)(b) and previous positions.
FEDERAL TAX ROUNDTABLE OCTOBER 7, 2019
2019 APFF CONFERENCE
Question 11 Convertible debenture and application of paragraph 251(5)(b)
A Canadian corporation ("Opco") is controlled by a shareholder resident in Canada. The only shares issued by Opco and held by the Canadian shareholder are one million common shares of the capital stock of Opco with an estimated fair market value of two million dollars. Opco issued a debenture, bearing interest, to a non-resident investor in the amount of five million dollars. The debenture provided for a right of conversion into common shares of the capital stock of Opco only in the event that Opco proceeds with a second round of financing. The number of common shares that would be issued pursuant to the exercise of the conversion right would be determined based on the fair market value of Opco determined in the second round of financing.
For example, if the value established in the second round of financing is four million dollars, being four dollars per common share then outstanding, the non-resident investor could convert the five million dollar debenture into 1,250,000 common shares of the capital stock of Opco.
The corporation must apply paragraph 251(5)(b) in order to determine whether it is a Canadian-controlled private corporation as defined in subsection 125(7). A non-resident investor holding the debenture would be entitled to receive common shares of the capital stock of Opco and would thus be deemed to be in the same position with respect to control of Opco as if it held such common shares. The number of common shares that would be issued in the event of the exercise of the conversion right by the non-resident Investor is not determinable as it will be determined based on the fair market value of Opco at the time of the second round of financing which will occur in a few years.
Question to the CRA
How should Opco apply paragraph 251(5)(b) with respect to the debenture conversion right held by the non-resident investor?
CRA Response
For the purposes of subsection 251(2) and the definition of "Canadian-controlled private corporation" in subsection 125(7), subparagraph 251(5)(b)(i) provides inter alia that where at any time a person has a right under a contract, in equity or otherwise, either immediately or in the future and either absolutely or contingently, to acquire, shares of the capital stock of a corporation or to control the voting rights of such shares, the person shall, except where the right is not exercisable at that time because the exercise thereof is contingent on the death, bankruptcy or permanent disability of an individual, be deemed to have the same position in relation to the control of the corporation as if the person owned the shares at that time.
The application of paragraph 251(5)(b) should be analyzed on a case-by-case basis in the light of all the facts, circumstances and relevant documents relevant to a particular situation.
Based on the facts submitted, the debenture constitutes a contract that accords the non-resident investor the right to acquire common shares of the capital stock of Opco. That right is conditional upon OPCO proceeding with a second round of financing. The number of common shares of the capital stock of Opco issued upon the conversion of the debenture will be determined based on the fair value of the common shares of the then outstanding shares of capital stock of Opco (the “conversion ratio”). According to the facts submitted in the question, the exercise of the right of conversion is not limited to conditions such as death, bankruptcy or permanent disability of an individual.
By virtue of subparagraph 251(5)(b)(i) and because of the conversion right for the debenture as described in this question, the non-resident investor would be deemed, at a particular time, to be in the same position in relation to the control of Opco control as if it were the owner of the shares of the capital stock of Opco to which the conversion right applied at that time. To calculate the conversion ratio upon exercise of the conversion right of the debenture at that time, and consequently the number of shares to be issued to the non-resident investor, the fair market value of the common shares of the capital stock of Opco then outstanding should be used.
The determination of fair market value can only be made after considering all of the relevant circumstances and facts relevant to a particular situation.
Yvon Beaudoin
(514) 496-6688
October 11, 2019
2019-081270