Canada: No forex gain on conversion of USD-denominated debentures
10 February 2015
Posted by: Author: Ilia V. Korkh
Author: Ilia V. Korkh (Couzin Taylor LLP, Vancouver)
Agnico-Eagle Mines Limited (2014 TCC 324) was the first case in which a Canadian court considered whether the conversion of foreign-currency-denominated debentures into shares can result in forex gains or losses. Generally, such instruments are common for Canadian companies that are seeking debt financing in foreign markets. Convertible debentures are also popular with investors who may want to have the security of interest income with an option to convert into equity at a later date if the share price increases.
The general rule in subsection 261(2) is that Canadian taxpayers must determine their tax results using Canadian dollars. If any relevant amounts are in a foreign currency, paragraph 261(2)(b) requires that the amounts be converted into Canadian dollars at the relevant spot rate "for the day on which the particular amount arose.” Subsection 39(2) provides that where a taxpayer has "made a gain” or "sustained a loss” due to currency fluctuation, the gain or loss is deemed to be a capital gain or loss from the disposition of foreign currency.
In 2002, Agnico issued US-dollar-denominated convertible debentures in the aggregate amount of US$144 million (Cdn$228 million based on the exchange rate at the time of issuance). Each of these interest-bearing debentures had a principal amount of US$1,000 and could be either converted or redeemed. On conversion, each holder was entitled to a fixed amount of shares of Agnico. On redemption by the issuer, each holder would receive the value of principal plus accrued and unpaid interest, both of which could be paid in cash or in shares of Agnico.
In 2005 and 2006, most debenture holders exercised their right to convert the debentures into shares. Agnico redeemed the few remaining debentures by issuing shares in lieu of cash. Accordingly, all of the debentures were extinguished. But due to a weakened US dollar, the Canadian-dollar value of the extinguished principal had decreased since issue. Because of this decrease, the CRA assessed Agnico on the basis that it realized capital gains under subsection 39(2).
The assessment was based on the application of spot exchange rates to the principal amounts of the debentures at the time of issuance (Cdn$228 million) and the time of extinguishment (Cdn$166 million). Agnico argued that subsection 39(2) should not apply on the conversion, since the amount paid for the debentures was effectively the amount paid for the shares that were later issued on conversions: accordingly, there was no forex gain on the repayment of debt. Agnico also noted that the increased market value of shares meant that the value of the shares issued on the extinguishment (Cdn$280 million) was greater than the amount for which the debentures were issued (Cdn$228 million).
Woods J agreed that from the economic point of view it was clear that Agnico did not realize a gain, having issued shares worth a higher amount than the amount that it received on the issuance of the debentures. From the tax point of view, however, the amount "paid out” by a taxpayer upon the issuance of shares is not the market value of the shares but rather the amount for which the shares were issued, which is determined by the agreement of the parties.
There are several ways to determine the amount at which the parties intended the shares to be issued. An amount added to stated capital may be relevant, but Agnico did not expressly authorize a specific amount to be added to its stated capital upon conversion. The transaction documents may also express the intention of the parties. Having reviewed the indenture, Woods J noted that the conversion right entitled the holder to a fixed amount of shares per debenture, resulting in the issue price of US$14 per share. Woods J then had to determine the appropriate spot rate date on which to convert this amount into Canadian dollars—the date on which the debentures were issued or the date on which they were extinguished. She concluded that the appropriate conversion date was the date on which the debentures were issued, because this was the date when the consideration for the (future) issuance of the shares was fixed and received by Agnico. Accordingly, Agnico did not realize a forex gain on the conversion. However, Agnico did realize a gain on the few debentures that were redeemed. In particular, the indenture stated that the shares issued on redemption were "in satisfaction of the Redemption Price,” which became payable on the date of the redemption. Therefore, the spot rate at the time of redemption applied, giving rise to a gain under subsection 39(2).
Overall, the decision reduces the taxation risk of convertible debentures, making them more predictable. The decision may also have wider implications: in particular, convertible debentures of income funds may be considered to be repaid at principal (rather than appreciated value), alleviating deemed interest issues under subsections 214(7) and (14).
This article first appeared on ctf.ca.