Canada: Canadian Counsel @ Gowlings

Edited by Mr Christopher Alam

• Amendments to Canadian Insolvency Legislation to Deal With Aircraft

• Amendments to the Bankruptcy and Insolvency Act ("BIA") and the Companies' Creditors Arrangement Act ("CCAA")
• Receivership/Interim Receivership
• Priority of Interests

• The Canada Revenue Agency View on Consignment May Result in Double Taxation for U.S. Multinational Firms Operating in Canada

Amendments to Canadian Insolvency Legislation to Deal With Aircraft

An Act to implement the Convention on International Interests in Mobile Equipment and the Protocol to the Convention on International Interests in Mobile Equipment on Matters Specific to Aircraft Equipment (the "Act") received Royal Assent on February 24, 2005 (although it has not yet been declared in force) and is intended to implement the Convention on International Interests in Mobile Equipment (the " Convention ") and the Protocol to the Convention on International Interests in Mobile Equipment on Matters Specific to Aircraft Equipment (the " Protocol "). The Act will come into force on a future date to be fixed.

The purpose of the Convention is to facilitate and encourage asset-based lending. The Convention establishes a legal regime for the creation, enforcement, perfection and priority of "international interests" -- security interests or lease interests with defined rights -- in three categories of high-value uniquely-identifiable mobile equipment: (a) aircraft objects; (b) rolling stock; and (c) space property. Priority between international interests will be established when the holder of the interest files notice of its interest in an international registry. The Protocol implements the Convention with respect to aircraft objects -- airframes, aircraft engines and helicopters above a minimum size or power threshold.

The Act will make a number of amendments to the BIA and the CCAA (which are the primary Canadian insolvency statutes) to impose restrictions on the rights of a reorganizing debtor or bankruptcy trustee to use aircraft objects after the commencement of an insolvency proceeding. These amendments are intended to give persons who finance or lease aircraft objects the ability to exercise their remedies in an insolvency proceeding unless the debtor or bankruptcy trustee: (a) maintains the aircraft object in accordance with the applicable agreement; and (b), within 60 days of the commencement of the insolvency proceeding, cures all defaults under the applicable agreement (except insolvency defaults) and ensures that no new defaults occur (except insolvency defaults). This has the effect of significantly enhancing the treatment of persons who finance or lease aircraft objects in insolvency proceedings under the BIA and the CCAA when compared to persons who finance or lease other types of equipment.

The Act attempts to deal with both security interests and lease agreements in respect of aircraft assets in a single exception to the stay of proceedings that arises under the BIA or is imposed by a court under the CCAA.

When a reorganization is commenced under the CCAA, a court relies on a single section of the CCAA – section 11 -- to both: (a) stay secured creditors from enforcing their security; and (b) prevent equipment lessors from terminating their leases. As a result, dealing with security interests and lease agreements in respect of aircraft objects as a single exception to the stay of proceedings under the CCAA accomplishes the objective of the Act.

However, unlike under the CCAA, the automatic statutory stay that arises when a debtor commences a reorganization under the BIA deals only with the rights of creditors to enforce claims against the debtor. Restrictions on the ability of parties to contracts with the debtor to terminate those contracts is dealt with in separate provisions of the BIA and these provisions of the BIA were not amended by the Act. As a result, a debtor reorganizing under the BIA may not be restricted in its rights to make use of leased aircraft objects in a reorganization depending on whether the lease is characterized as a "financing" lease or a "true" lease.

The Act fails to address the fact that receiverships and interim receiverships have expanded in scope in recent years to the point that, in practice, a receivership or interim receivership can be very similar to a reorganization in the sense that the debtor's business continues to operate. On an application to appoint a receiver or interim receiver a court has broad discretion. It is not uncommon for a court to make an order in the context of a receivership or interim receivership that restricts the ability of equipment lessors to terminate leases provided that the receiver or an interim receiver, continues to make payments owing after the date of the appointment order. It is also not uncommon for a court to stay secured creditors from enforcing their security.

The Act contains no provisions that restrict the ability of a court to stay the termination of leases of aircraft objects or the enforcement of security over aircraft objects. Unless such restrictions are imposed, it will be possible for a court to impose a stay of proceedings in the context of a receivership or interim receivership that will prevent the termination of leases of aircraft objects and stay the enforcement of security over aircraft objects without requiring that the receiver or interim receiver (a) maintain the aircraft object in accordance with the applicable agreement; and (b), within 60 days of the commencement of the insolvency proceeding, cure all defaults under the applicable agreement (except insolvency defaults) and ensure that no new defaults occur (except insolvency defaults).

Under the Convention, a Contracting State may declare that certain non-consensual rights that would, under the Contracting State's domestic laws, have priority over the rights registered pursuant to the Convention and which, if any, of these will be registerable under the Convention. A non-consensual right or interest has priority over a registered interest only if a declaration is filed. A Contracting State may also declare that the Convention does not affect rights to arrest or detain an object for the payment of amounts owing for the services provided.

There are a number of non-consensual interests that arise under provincial and Canadian federal law that currently have priority over the interests of secured creditors.

In addition, rights of arrest and detention are created by Civil Air Navigation Services Commercialization Act (Canada) in connection with the fees charged by Nav Canada and under the Airport Transfer (Miscellaneous Matters) Act in connection with airport user fees.

Canada has not yet determined what, if any, declarations will be made under the Convention.

International auditors in Canada are increasing their audit and inspection activity of international transactions which may lead to significant tax exposure for multinational companies operating in Canada. This inspection activity is targeting the transfer price charged between related parties within a multinational entity on goods, services and/or intangibles crossing international borders. The increase in audit activity has resulted in more transfer pricing adjustments being raised and assessed, putting organizations at risk of double taxation - a situation where a firm pays tax in two tax jurisdictions with respect to the same income.

Consignment manufacturing is becoming very important as the world economy becomes increasingly globalized and more competitive. Within this new world economy, multinational firms are utilizing consignment arrangements and taking advantage of cheap labour markets around the world as part of a broader tax planning approach to move profits across international borders. The issue of consignment as it relates to Canada, typically involves a consignor, usually the U.S. parent, consigning material to a related Canadian manufacturer (the consignee). The consignee then uses the consigned material within its manufacturing process and ships the finished goods back to the U.S. parent or customers of the U.S. parent, at a pre-determined price. The transfer price , in theory, should compensate the Canadian entity for the functions, assets and risks assumed in the manufacturing process. The question then becomes "does this transfer price reflect arm's length standards?"

In the past, one of the approaches that tax authorities such as the Canada Revenue Agency (CRA) took when dealing with the issue of consignment was to remove the consigned material from the manufacturers' cost base and assign an appropriate mark-up on the remaining costs (which generally included only labour and overhead). To adjust for the fact that the consigned manufacturer held no inventory and hence held no inventory risks (such as shrinkage) relative to the set of comparables, an inventory adjustment was often performed to the set of comparables. Given the fact that this approach results in much lower profits than a comparable manufacturer with inventory, the CRA decided to re-visit their approach on consignment manufacturing.

The CRA has taken a new look at the consignment issue and has come up with some new approaches. Recognizing the fact that many Canadian manufacturing operations involved in consignment arrangements are assuming functions and risks similar to that of comparable, third party manufacturers operating at arm's length (except for the inventory function), the new CRA approach attempts to assign more reliable returns to consignment manufacturers. The CRA believes that the consigned material used in the manufacturing process should be included in the consignment manufacturers' cost base and should be marked up. To compensate for the fact that the consignee performs no inventory function and assumes none of the associated risks, the CRA approach requires an inventory adjustment be made to the comparable set.

The profits of a consignment manufacturer would equal a mark-up (determined from a set of comparables) on its cost base less an inventory adjustment to account for the fact that the manufacturer does not take legal possession of the consigned inventory.

While the CRA believes that this approach to consignment is more reliable than previous approaches, many argue that this view is theoretically incorrect due to the belief that it is difficult to earn profits on resources an entity does not legally own.

From a practical standpoint, finding resolution to this issue with the Internal Revenue Service (IRS) has been difficult as the CRA approach results in more profits remaining in Canada. Making this situation even more complicated is the fact that many U.S. multinational corporations have consignment arrangements with foreign affiliates where substantial profits are repatriated back to the U.S. Any adoption of the Canadian consignment viewpoint by the IRS would jeopardize the repatriation of such profits, a fact that may not be acceptable to policymakers in Washington. The differing views held by both the IRS and the CRA on the issue of consignment will no doubt make it more difficult for the parties to come to resolution on issues involving consignment given they cannot agree on a common approach to the problem.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.