Shares for Debt: A Tax-Efficient Solution for Struggling Companies

In today's challenging economic climate, many companies find themselves grappling with substantial debt obligations. While traditional debt settlement methods, such as refinancing or write-offs, may not always be feasible or tax-efficient, an alternative approach has gained traction: shares for debt transactions. This article explores the tax implications and benefits of settling debt through the issuance of shares, using real-life examples and data from recent Arch Biopartners Inc. transactions.



What is a Shares for Debt Transaction?

A shares for debt transaction involves a company settling its outstanding debt by issuing new shares to the creditor(s) instead of making cash payments. This approach can be particularly appealing to companies facing cash flow constraints or seeking to optimize their capital structure.

Tax Implications for the Debtor Company

When a company engages in a shares for debt transaction, the tax implications can be significant. The new legislation in section 19 of the Income Tax Act, effective from 1 January 2018, impacts the tax treatment of such transactions. Here's how it works:

1. Calculation of Debt Benefit: The 'debt benefit' is calculated by comparing the face value of the claim (including outstanding interest) before the conversion with the market value of shares acquired. If existing shares are held in the company before the conversion, the 'debt benefit' is calculated by comparing the face value of the claim before the conversion with the market value of shares acquired solely as a result of the conversion.
2. Exclusion of Capital Portion: The 'debt benefit' is only recouped with reference to outstanding interest and not to the capital portion. This means that only the interest component of the loan is subject to tax, not the principal amount.
3. Non-application to Non-interest-bearing Loans: Section 19 is not applicable to non-interest-bearing loan conversions.

For example, in a recent Arch Biopartners Inc. transaction, the company settled an aggregate of $57,246.57 in interest accrued up to February 1, 2025 on a deferred convertible note. The 'debt benefit' was calculated as the outstanding interest of $57,246.57, as the capital portion was excluded. The company issued 31,112 common shares at a deemed price of $1.84 to the holder of the note, who was an arms-length party to the company.

Tax Implications for the Creditor Company

In the context of a group of companies, where one company owns at least 70% of another, section 19 does not apply to a debt benefit in respect of any debt owed by a company that owes the debt to another company in the same group where the debtor reduces or settles the debt by means of a share issue. This means that there would be no tax implication for the creditor company if Arch Biopartners were to subscribe for shares using the loan as the means of settlement.

Benefits of Shares for Debt Transactions

Shares for debt transactions can offer several benefits to struggling companies, including:

1. Improved Cash Flow: By converting debt into equity, companies can preserve their cash for other critical operations and investments.
2. Enhanced Capital Structure: Issuing shares can help companies optimize their capital structure, potentially improving their financial health and access to future financing.
3. Tax Efficiency: As demonstrated, shares for debt transactions can be tax-efficient, with only the interest component of the loan subject to tax.
4. Potential for Value Creation: If the issuing company's share price appreciates, the creditor may benefit from the increased value of the shares received.

In conclusion, shares for debt transactions can be a tax-efficient and valuable solution for companies seeking to settle their debt obligations. By understanding the tax implications and benefits, companies can make informed decisions about their capital structure and financial future. As the example of Arch Biopartners Inc. demonstrates, this approach can be particularly appealing in today's challenging economic climate.