2015 Ruling 2015-0589471R3 - Earnout -- summary under Paragraph 12(1)(g)

Background

The corporate Shareholders (with equal shareholdings) of Holdco (a Canadian-controlled private corporation) wish to sell X% of their shares to an arm’s length officer (the “Key Employee”) of (wholly-owned) Opco on an earnout basis. As Holdco is not permitted under the BCA to issue treasury shares until the consideration for the shares is fully paid (so that Holdco may not issue treasury shares to the Key Employee on an earnout basis), the Shareholders will instead sell a portion of their Holdco shares to Opco, who will then sell those shares to the Key Employee on an earnout basis. Under the BCA, Opco may hold Holdco shares for a maximum of 30 days, notwithstanding that Opco is a subsidiary of Holdco.

Proposed transactions

1. The Holdco Shareholders will transfer a portion of their common shares to Opco (jointly electing in due course under s. 85(1)) at an agreed amount equal to their ACB) in exchange for a corresponding number of non-voting preferred shares which will have a right to cumulative dividends (in an aggregate amount equal to the Purchase Price described below - less any applicable taxes payable thereon by Opco) which are payable from time to time as soon as practicable after any portion of the Purchase Price is received by Opco and such taxes are determined, and which will not be redeemable or retractable until such dividends have been paid.
2. The parties have structured an earnout because they will be unable to determine the value of the goodwill of Holdco and the subsidiaries at the date of the sale to the Key Employee. Accordingly, within 30 days, Opco will sell (pursuant to the “Purchase Agreement”) those Holdco Common shares to the Key Employee in exchange for cash consideration (the “Purchase Price”) payable in five tranches as follows:
   
   1. X% of consolidated net after-tax income of Holdco and the Subsidiaries under IFRS, subject to adjustments for dilutive etc. events and for the add-back of taxes arising on the sale under the Purchase Agreement (“Consolidated Income”) for the first taxation year ending after the Holdco Common shares are sold (but excluding the portion thereof earned before the disposition of such shares), plus X% of the shareholder equity as of the time of sale and X% of any dividends receivable at that time, payable as soon as practicable after such amounts are determined; and
   2. specified percentages of the Consolidated Income for the second, third, fourth and fifth taxation year ending after the Holdco Common shares are sold, payable as soon as practicable after it is determined for each such year and, in any event, no later than five years after the end of such taxation year of the sale.
3. The Purchase Agreements provides for adjustments to the Purchase price in the event of an acquisition or IPO.
4. As soon as practicable after any portion of the Purchase Price is determined (e.g., when Consolidated Income for a taxation year is determined), the Key Employee will pay the required portion of the Purchase Price to Opco, whereupon Opco will pay the required Earnout Tracking Dividends.
5. A copy of the Purchase Agreement will be sent to the CRA for the taxation year in which the shares were disposed of, along with an undertaking to follow the cost recovery method as described in IT-426R.

Purposes

Since each of the Shareholders may deal at arm’s length with Holdco, the FMV of the Holdco Common shares is difficult to determine, and the Key Employee is an employee of Opco, a sale of Holdco Common shares by the Shareholders to the Key Employee may not be described in s. 7. It is intended that the provisions of s. 7 apply to the proposed transactions.

The purpose of the Dividend Policy is to ensure that the equity invested in Holdco and the subsidiaries (accumulated earnings on hand) is minimized at all times. The proceeds of the dividends may be loaned back to the payor (to the extent the payor requires funds) and, in that event, are intended to be secured by the creditor.

Rulings

1. S. 12(1)(g) will not apply to the disposition of Holdco Common shares by Opco to the Key Employee in 2.
2. Opco will be required to reduce the adjusted cost base to it of the Holdco Common shares disposed of in 2 as amounts on account of the Purchase Price become determinable. Once the cumulative such an amount exceeds Opco’s ACB of the Holdco Common shares, under s. 40(1) the excess will be considered a capital gain. For these purposes, an amount becomes determinable once it is capable of being calculated with certainty.
3. S. 55(2) will apply to an Earnout Tracking Dividend, with their safe income determination time being the time that is immediately before the time the first of the Interim Income Dividends is paid.