Principal Issues: Is a warrant an inducement payment described in paragraph 12(1)(x)?
Position: Yes
Reasons: The warrant was received by the taxpayer while earning income from a business as an incentive to grant a XXXXXXXXXX operating contract to a third party.
November 14, 2007
XXXXXXXXXX Tax Services Office Headquarters
XXXXXXXXXX Income Tax Rulings Directorate
Attention: XXXXXXXXXX Michel Lambert, CA, M.Fisc.
(613) 957-8962
2007-025460
Application of paragraph 12(1)(x)
This is further to your memorandum of September 27, 2007 in which you asked whether paragraph 12(1)(x) applies to the situation described below.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act (the "Act").
Name of the parties
XXXXXXXXXX The Taxpayer
XXXXXXXXXX Aco
XXXXXXXXXX Bco
XXXXXXXXXX Cco
The Facts
1. XXXXXXXXXX The Board of Directors of Aco considered various scenarios for the transfer of operations and equipment to another corporation and decided on the one offered by Bco.
2. Cco is the parent corporation of Bco. It negotiated all the agreements with Aco. However, the contracts were concluded between Bco and Aco.
3. The Taxpayer is a corporation resulting from the amalgamation of several corporations including Aco. It assumed the tax consequences arising from the contracts between Aco and Bco as a result of the amalgamation.
4. The sale of the XXXXXXXXXX assets and the XXXXXXXXXX operating agreement were concluded with Bco on XXXXXXXXXX. Those agreements provide for a sale price for the assets, a price for services over a period of XXXXXXXXXX years and the issuance by Cco of a share purchase warrant to Aco. It is this warrant that is the subject of this request. The purpose is to establish the tax treatment to the Taxpayer and to Aco.
5. The following are excerpts from two minutes of the Board of Directors of Aco that preceded the signing of the agreements with Bco.
XXXXXXXXXX
6. On XXXXXXXXXX, Aco and Bco signed an asset purchase agreement and an operating agreement. Each of the contracts states that the parties will enter into the other contract on the same day.
The purchase contract specifies in paragraph XXXXXXXXXX that the purchase price is $XXXXXXXXXX. The vendor (Aco) acknowledges that it has today received from the buyer (Bco), in payment of the purchase price, an amount of $XXXXXXXXXX by bank transfer representing the purchase price less an amount of $XXXXXXXXXX as payment by the vendor of the first payment due to the buyer under the operating agreement. The vendor also received the warrant in its favour for the subscription to Class A shares of Cco.
Paragraph XXXXXXXXXX of the same contract adds that the purchase price is allocated to the purchased assets in accordance with Annex XXXXXXXXXX (to the exclusion of the warrant). According to that Annex, the value of the warrant is not considered in the allocation of the cost of the assets to the buyer and their sale price to the vendor.
7. Article XXXXXXXXXX provides that the operating agreement takes precedence between the parties over the asset purchase agreement in the event of conflict between the two agreements.
Section XXXXXXXXXX of the operating agreement states that the operating agreement constitutes the entire agreement between the parties with respect to the matters dealt with therein, except as to the partnership agreement and the supplemental agreements. Section XXXXXXXXXX provides that the legal documents relating to the sale of assets between Aco and Bco and the warrant constitute supplemental agreements.
8. The warrant certifies that Aco has the right to subscribe for the number of XXXXXXXXXX shares specified therein subject to the conditions set out therein. It also states that "XXXXXXXXXX”.
Regarding the assignment of the warrant, the XXXXXXXXXX clause provides as follows:
XXXXXXXXXX
Aco has recorded a value for the warrant in its financial statements using the Black-Scholes model.
Your Question
9. You asked whether paragraph 12(1)(x) applies to add the value of the warrant to the Taxpayer's income in the year it is received.
Your Opinion
10. You are of the view that the warrant is an amount received as an inducement for Aco to sign the operating agreement as it signed it. Consequently, the best tax treatment would be that it is an inducement payment to which paragraph 12(1)(x) applies.
Taxpayer's Opinion
11. According to the legal documents, the warrant was issued to Aco as payment for the assets sold to Bco on XXXXXXXXXX. Accordingly, the warrant was not allocated as an incentive paid to Aco to accept Cco's bid for the services contract.
12. Furthermore, the Taxpayer is of the opinion that "for tax purposes, the warrant has no value". In a letter sent to you on June 29, 2007, the Taxpayer writes as follows:
XXXXXXXXXX
In support of its view, the Taxpayer argues that since the warrant under the terms of the warrant cannot be transferred to a third party, its fair market value is nil.
13. The Taxpayer also refers to Shell Canada v. The Queen, 99 DTC 5682, where the Supreme Court of Canada held that the economic reality underlying a situation could not justify a recharacterization of the bona fide legal relationships established by a taxpayer.
Our Opinion
14. A taxpayer shall include in computing income from a business by virtue of paragraph 12(1)(x), inducement payments received from a person referred to in subparagraph 12(1)(x)(i) to the extent that they are not described in subparagraphs 12(1)(x)(v) to (viii).
15. The persons referred to in subparagraph 12(1)(x)(i) include a person who pays an amount in order to achieve a benefit or advantage for the payer or for persons with whom the payer does not deal at arm’s length. We are of the view that the issuance of the warrant by Cco was for the purpose of providing a benefit to Bco, a related corporation, either to acquire the XXXXXXXXXX assets of Aco or the XXXXXXXXXX year operating agreement for the XXXXXXXXXX systems or both.
16. One of the conditions for the application of paragraph 12(1)(x) is that an amount (other than a prescribed amount) be received by the taxpayer in a year in the course of earning income from a business. Subsection 248(1) defines the term amount as money, rights or things expressed in terms of the amount of money.
We are not in a position to value the warrant, as this is a matter for the valuators. The remainder of our analysis assumes that the warrant has a value that is an amount that Aco received at the time the warrant was granted.
17. Paragraph 12(1)(x) includes an inducement received by a taxpayer. The term "inducement payment" is not defined in the Act. Its interpretation is determined by the ordinary meaning of the words. It is this rule that the courts have applied to give meaning to the term. In this respect, the term "paiement incitatif" is translated into English as "inducement".
In French Shoes Ltd v. Her Majesty The Queen, 86 DTC 6359, the Federal Court stated: "An inducement is not a "windfall", it is an incentive, a reason for doing something."
In A. v. William E. Coutts Co Ltd, (1968) 1 O.R. 549 (C.A.), the Court said:
The ordinary meaning of the word "induce" connotes the act of leading or bringing about another person by persuasion or influence to some particular line of action which he would not have done or followed but for such inducement.
In Supermarché Ste-Croix Inc. v. Her Majesty the Queen, 95 DTC 871, Mr. Justice Lamarre Proulx of the Tax Court of Canada commented [TaxInterpretations translation]: "An incentive payment is always given in consideration for an obligation on the part of the recipient.”
According to the Petit Robert, the word incentive means "qui incite à faire quelque chose." ["that which encourages the doing of something."]
In our view, a payment that is made to induce the recipient to do something will generally be considered an inducement payment.
18. It must therefore be established what Aco was induced to do in order to receive the warrant.
The Asset Purchase Agreement, the Operating Agreement and the Warrant are interrelated, as one cannot exist without the other two. Both contracts were entered into on XXXXXXXXXX and the warrant was also issued on that date. In our view, it is the entirety of the documents, including the minutes, that must be considered to determine what prompted Aco to obtain the warrant.
According to Aco's minutes, it appears that the warrant induced Aco to enter into the operating agreement for a period of XXXXXXXXXX years instead of a shorter period XXXXXXXXXX.
19. The Taxpayer claims that the warrant forms part of the sale price of the assets. Although the warrant is mentioned in the asset purchase agreement, the facts indicate that the parties did not consider the warrant as part of the sale price (or purchase price) of the assets.
In support of this conclusion, it should be noted, inter alia, that the contract for the purchase of the assets provides that the purchase price of the assets is $XXXXXXXXXX and that Aco acknowledges having received on XXXXXXXXXX from Bco, in payment of the purchase price, an amount of $XXXXXXXXXX by bank transfer representing the purchase price less an amount of $XXXXXXXXXX in payment by the seller of the first payment due to the buyer under the operating agreement. Aco allocated the purchase price of $XXXXXXXXXX to the assets sold in accordance with Annex XXXXXXXXXX of the agreement.
In addition, Aco has recorded a value for the warrant in its financial statements without taking it into account in the allocation of the sale price of the assets. In addition, the Taxpayer is amortizing the value placed on the warrant over a period of XXXXXXXXXX years, which is the term of the operating agreement granted to Bco. In our view, these are additional indicators that Aco did not relate the warrant to the sale of its assets but rather to the operating agreement granted to Bco.
Consequently, we do not accept the Taxpayer's argument that the warrant forms part of the consideration received for the sale of the assets. In our view, the warrant is an inducement for the purposes of paragraph 12(1)(x) because it induced Aco to grant a XXXXXXXXXX year operating contract to Bco instead of a shorter XXXXXXXXXX period. This is not a conclusion based on economic reality but on Aco's reasons for doing something (according to the French Shoes decision cited above: the "reason for doing something").
20. An inducement payment referred to in paragraph 12(1)(x) must be in the form of a grant, subsidy, forgivable loan, deduction from tax, allowance or any other form of inducement. The English version translates "sous toute autre forme" as "any other form of inducement". We are of the opinion that the warrant fulfils this condition.
21. Subparagraphs 12(1)(x) (v) to (viii) provide for exceptions to the application of paragraph 12(1)(x). We have reviewed those exceptions and we are of the view that none of them applies to the situation under consideration.
22. In our view, the warrant is an inducement received by Aco to grant the operating agreement to Bco for a period of XXXXXXXXXX years XXXXXXXXXX. We are of the opinion that the warrant is an inducement payment for the purposes of paragraph 12(1)(x) the value of which must be included in income for the taxation year in which it is received.
23. Section 49 will also apply. For the Taxpayer, subsection 49(3) will apply at the time the option under the warrant is exercised. Under subsection 52(1), the cost of the warrant will reflect the amount included in income pursuant to paragraph 12(1)(x).
Access to Information
24. For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, the electronic library version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
We hope that these comments are of assistance.
Manager
Financial Sector and Exempt Entities Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.