Convertible Preferred Shares Not Term Preferred Shares

The Federal Court of Appeal recently rendered its judgment in Citibank15 and affirmed the Tax Court of Canada’s earlier decision.16 The issue in Citibank was whether certain shares constituted “term preferred shares,” as defined in subsection 248(1) of the Act. Where a specified financial institution (SFI) acquires term preferred shares in the ordinary course of business, subsection 112(2.1) of the Act denies the SFI a deduction for dividends received on the shares. Dividend income on such shares is therefore taxable to an SFI. Citibank Canada (“Citibank”) acquired, in its 1990 taxation year, 25 cumulative redeemable perpetual first preference shares of B.C. Gas Inc. (“B.C. Gas”) for $500,000 per share and 10 cumulative redeemable convertible auction perpetual preferred shares of Le Groupe Videotron Ltée (“Videotron”) for $1 million per share. The B.C. Gas preference shares paid dividends at 8.5 percent per annum during the first five years. At the end of five years, the preference shares were either renewable at a dividend rate determined on the basis of market rates prevailing at that time, or convertible into common shares, at the election of the holder. Under the conversion option, the shares were convertible into that number of B.C. Gas common shares that had a market price, determined as of the conversion date, equal to the subscription price for the preference shares.17 In the event that the common shares were worth less than $1 per share at the time of conversion, the number of common shares was calculated on the assumption that their market price was $1, and the holder received shares worth less than the preference share subscription price. The Videotron preferred shares had similar attributes to the B.C. Gas preference shares. In the discussion that follows, the B.C. Gas and Videotron shares are collectively referred to as “the shares.” Citibank deducted dividends received on the shares under subsection 112(1) of the Act. The minister denied Citibank the deduction on the grounds that the shares were “term preferred shares.” In the minister’s view, the conversion right “guaranteed” that Citibank could acquire common shares with a fixed dollar value without regard to market f luctuations and therefore gave Citibank a “level of protection against loss.”18 The conversion right was therefore a “form of guarantee, security or similar indemnity or covenant” within the meaning of subparagraph (a)(iii) of the term preferred share definition. In the taxation year at issue, subparagraph (a)(iii) provided that a share of an issuing corporation was a term preferred share if