Distress Preferred Shares: Tips and Traps

As a result of the current economic downturn, many corporations may find themselves in financial difficulty and need to refinance their existing debt obligations with creditors (lenders). Distress preferred shares (DPS), as defined in subsection 80(1), are an option in that regard for a corporation resident in Canada. This method of refinancing can be attractive to lenders because they can receive equal or better after-tax returns on their investments—essentially by converting taxable interest to non-taxable intercorporate dividends—without jeopardizing their security and priority. Part of this increase in after-tax returns to the lender normally coincides with a dividend rate that is lower than the prior interest rate, providing the borrower with extra cash to assist in the financing of its business. Tips and traps associated with this financial instrument are provided below. For an introductory overview, see our earlier article.

Three Tips

  1. In issuing DPS, the borrower and the lender will ordinarily negotiate a fixed cumulative dividend entitlement that is lower than the interest that would otherwise be paid. Although the borrower is unable to deduct the dividend in calculating its income, and was likely deducting the interest, the borrower is typically in a loss position by the time DPS are issued and may not benefit from such interest deduction in any event. Also, expenses incurred in the course of issuing the DPS are generally deductible to the extent that they are reasonable in the circumstances.

  2. The CRA's administrative position in respect of the time period when a corporation "could reasonably be expected to default" is not more than three or four months away (IT-527, "Distress Preferred Shares," June 12, 1995). This specific period has no basis in law. Whether a corporation could reasonably be expected to default should be determined on a case-by-case basis and any analysis should be largely fact-driven. As a result, there are circumstances where a corporation could reasonably be expected to default within a time frame that is longer than the one stated by the CRA.

  3. Structuring a DPS issuance to include a new taxable Canadian corporation that is a subsidiary of the borrower can help to quell any lender concerns regarding subordination of their debt interest to equity at the borrower level.

Three Traps

  1. Dividends may be paid only when the solvency tests outlined in the relevant corporate statute are satisfied. For example, section 42 of the Canada Business Corporations Act states that a "corporation shall not declare or pay a dividend if there are reasonable grounds for believing that (a) the corporation is, or would after the payment be, unable to pay its liabilities as they become due; or (b) the realizable value of the corporation's assets would thereby be less than the aggregate of its liabilities and stated capital of all classes." If the distressed borrower does not meet these legal tests, the lender will not receive payment. In contrast, the payment of interest has no such corporate restrictions.

  2. DPS refinancing may not be attractive to non-resident lenders. Certain non-resident lenders may prefer to receive interest income rather than dividend income, particularly in circumstances where there is no withholding tax attached to the receipt of interest income. For example, article XI of the Canada-US tax convention effectively eliminates the withholding tax imposed in the country where the interest arises.

  3. A share may qualify as a DPS for a period of five years, after which period it will become an ordinary preferred share. To avoid falling into the disadvantageous categories of "taxable preferred share," "short-term preferred share," or "term preferred share," the terms of a DPS should include a mandatory redemption requirement at the end of the five-year period.

Ahmed Elsaghir and Dan Jankovic
Blake Cassels & Graydon LLP, Calgary

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