Tax Consequences for Limited Recourse Capital Notes

Marco Iampieri B.A., JD, M.B.A.

Limited recourse capital notes (“LCRN”) are yielding some impressive coupon payments.  LCRNs are a new and complicated hybrid security.  This article will provide preliminary Canadian federal income taxation information as it discusses the tax treatment for third-party investors by investing in LCRNs. 

Principal Canadian Federal Income Tax Treatment

At the outset, LCRNs have unique factual properties and risks, some of which are beyond the scope of this tax-focused article. The tax considerations described are general in nature,  may not be applicable to every investor’s idiosyncratic factual scenario, and are also not exhaustive of all tax consequences.

This article has canvassed and referenced the Canadian federal income tax treatment mentioned within the Prospectus Supplement to the Short Form Base Shelf Prospectus dated June 22, 2020 for the Bank of Montreal.

LCRN Holders Resident in Canada

• On account of capital or business income

LCRN holders may, in certain circumstances, be entitled to have these and all other “Canadian securities” of the Resident Holder, as defined in the Income Tax Act, (“ITA”) treated as capital property by making the irrevocable election permitted by subsection 39(4) of the ITA.

• Interest income

A LCRN holder will be required to include in computing its income for a tax year any interest or deemed interest on the LCRN investment that accrues to the holder by the end of the taxation year. There would be an exception if the LCRN holder accounted for the same interest income in a preceding tax year.

• Dispositions of Notes

Generally, a LCRN holder will realize a capital gain or capital loss equal to the amount by which the proceeds of disposition are greater than the LCRN holder’s adjusted cost base and costs of disposition. The LCRN holder is required to include in their income for the tax year the amount of capital gain for the disposition of the note at the prescribed capital gains inclusion rate, currently set at 50%.

On a disposition or deemed disposition of LCRNs, other than a disposition as the result recourse event (as defined in the trust indenture agreement for the special purpose vehicle), the LCRN holder will be required to include in their income for the tax year the amount of income that has accrued from the date of the last interest payment to the date of disposition. Again, there is an exception if the LCRN holder accounted for the same interest income in a preceding tax year.

On a disposition as the result of a recourse event (stress scenario) as defined in the trust indenture agreement for the special purpose vehicle, the proceeds of disposition will be the fair market value of the security received as a result of the recourse event, which in the previous article’s example were preferred shares. The capital gain or capital loss will be equal to the amount by which the proceeds of disposition (the value of the preferred shares) are greater or less than the adjusted cost base of the LCRN at the time of the deemed disposition.

LCRN Holders Not Resident in Canada

• Interest Income

Under the ITA, interest, principal, and premium paid or credited to non-resident LCRN holders will be exempt from Canadian non-resident withholding tax.

• Predetermined stress scenario exchange for LCRN

The predetermined stress scenario exchange for an LCRN will result in a disposition of LCRNs for the purposes of the ITA. A non-resident LCRN holder will not generally be subject to tax under the ITA in respect of such disposition.

Conclusion

LCRNs are complicated hybrid securities with unique risk profiles, but they have advantages that advisors may wish to raise in financial planning discussions with certain clients. The yield is attractive for fixed-income investors. The LCRN legal structure is attractive for non-resident investors who yearn for Canadian market exposure without non-resident withholding tax.