2015 Ruling 2015-0589471R3 - Earnout -- summary under Safe-Income Determination Time

Background

The equal and unrelated (corporate) shareholders of Holdco (a Canadian-controlled private corporation) wish to accommodate the purchase of shares of Holdco by Holdco's subsidiary (Opco), so that Opco may in turn sell those Holdco shares to an Opco key employee on an earnout basis and with the key employee’s purchase being governed by the s. 7 rules. (This arrangement cannot be accommodated by issuing treasury shares of Holdco directly to the key employee on an earnout basis as the governing Business Corporations Act requires that shares are to be fully-paid on issuance.) Under the ruled-upon transactions:

1. The Holdco shareholders transfer a portion of their Holdco common shares on a s. 85(1) rollover basis to Opco in consideration for preferred shares of Opco bearing a cumulative dividend which tracks the payment of the earnout payments described below (presumably giving rise to a significant increase in Opco under s. 55(3)(a)(ii) or (v));
2. The key employee immediately purchases those Holdco common shares from Opco (perhaps also described in s. 55(3)(a)(ii) or (v)) in consideration for five annual instalments, with each annual instalment based on the most recent year’s earnings (plus, in the case of the first instalment, the opening shareholders’ equity), with adjustments to the purchase price on any IPO or business acquisition; and
3. Each instalment payment after its receipt by Opco is dividended (as the "Earnout Tracking Dividends") by Opco to the Holdco shareholders on the tracking preferred shares.

Dividend Policy

In addition, the directors of Holdco and its subsidiaries have adopted a policy of paying dividends approximating but not exceeding their cumulative income up to the dividend payment time (including such dividends from subsidiaries) minus income taxes thereon. The proposed transactions commence with paying the dividends (the “First Annual Dividends”) that were already recorded as dividends payable at the end of an initial taxation year, and both declaring and paying (at the same time) dividends in respect of the interim period to date (the “Interim Income Dividends”). Furthermore, further such dividends (the “Second Annual Dividends) will be declared and paid as soon as practicable after the end of the next such taxation year. All such dividends will be designated as eligible dividends. The Dividend Policy would have been adopted irrespective of the other proposed transactions, and the Key Employee was prepared to acquire the Holdco common shares regardless of whether the Dividend Policy was implemented, on the basis that he would still be able to obtain financing for such purchases, even if he did not receive dividends on his purchased Holdco shares.

Rulings

S. 55(2) will not apply to the receipt of the First Annual Dividends, Interim Income Dividends or Second Annual Dividends, provided that their full amount does not exceed the amount of safe income on hand that could reasonably be considered to contribute to the capital gain that could be realized on a disposition at FMV, immediately before the dividend, of the shares of the corporation on which the dividend was received at the safe income determination time for the transaction, event or series of transactions that includes the receipt of the dividend. The safe-income determination time in respect of each Second Annual Dividend will be the time that is immediately before the time the first of those Second Annual Dividends are paid and the safe income determination time in respect of all of the First Annual Dividends and the Interim Income Dividends will not be later than the time that is immediately before the earlier time that the first of such dividends is paid.

S. 55(2) will apply to an Earnout Tracking Dividend that is received by a corporation resident in Canada. The safe income determination time for the Earnout Tracking Dividends will be immediately before the time the first of the Interim Income Dividends is paid.