Principal Issues: [TaxInterpretations translation]
Tax treatment for the purchaser of certain indemnity payments under a share purchase agreement payable by the vendor.
Position:
Applied against the cost of the shares acquired.
Reasons:
The vendor had undertaken, as part of the sale of its shares, to indemnify the purchaser for any loss suffered after the purchase of the shares in respect of an event the cause of which arose before such sale. The indemnity payment was a capital payment linked to the acquisition of the shares of the corporations concerned and was primarily intended to protect the purchaser against any loss of value. It was essentially a mechanism for adjusting the price paid for such shares and should therefore reduce the cost of those shares to the purchaser.
January 11, 2001
XXXXXXXXXX Tax Services Office Headquarters Patrick Massicotte Audit Division (613) 957-9232
Attention: XXXXXXXXXX File # 2000-003716
Request for Technical Interpretation:
XXXXXXXXXX
This is in response to your request of July 10, 2000 for our opinion as to the tax treatment applicable to the facts set out below. We apologize for the delay in responding to your request.
FACTS
According to the documents you have submitted to us, the essential facts and transactions are as follows:
1. XXXXXXXXXX, as purchaser, entered into a share purchase agreement (Agreement I) with XXXXXXXXXX (Vendor I), as vendor;
2. The purpose of the agreement was to transfer ownership of the shares of the operating corporations: XXXXXXXXXX (Corporations I);
3. The sale price of the shares was set at $XXXXXXXXXX in accordance with paragraph XXXXXXXXXX of Agreement I, subject to an automatic price adjustment of $XXXXXXXXXX if certain shares were not delivered XXXXXXXXXX;
4. Paragraph XXXXXXXXXX of that agreement provided for a compensation mechanism by Vendor I in the event that certain Losses were incurred by XXXXXXXXXX or the acquired Corporations I. The term “Losses” is defined in paragraph XXXXXXXXXX of the agreement. In general, it refers to any type of damage, loss, claim or other suffered by a person in relation to a given matter;
5. By application of those provisions, XXXXXXXXXX has claimed, to date, the sum of $XXXXXXXXXX from Vendor I (i.e. XXXXXXXXXX% of the purchase price);
6. XXXXXXXXXX entered into, as purchaser, a second share purchase agreement (Agreement II) with XXXXXXXXXX (collectively referred to as Vendors II), as vendors;
7. The purpose of the agreement was to transfer ownership of the shares of the operating corporations: XXXXXXXXXX (Corporations II);
8. The sale price of the shares was set at $XXXXXXXXXX in accordance with paragraph XXXXXXXXXX of Agreement II. No automatic price adjustment clause was provided for in that agreement;
9. Paragraphs XXXXXXXXXX of that agreement also provide for a compensation mechanism by the Vendors II in the event that certain Losses are incurred by XXXXXXXXXX or the acquired Corporations II. The term “Losses” is defined in paragraph XXXXXXXXXX of the agreement in the same way as in Agreement I of XXXXXXXXXX;
10. Through the application of those provisions, XXXXXXXXXX has claimed, to date, the sum of $XXXXXXXXXX from the Vendors II (i.e. XXXXXXXXXX% of the purchase price);
11. In addition, paragraph XXXXXXXXXX of Agreement II provides for an additional compensation mechanism by Vendors II in respect of environmental claims. No claims have been made by XXXXXXXXXX or the Corporations II in respect of that provision of the agreement;
12. The business of each of the corporations in question is directly or indirectly related to XXXXXXXXXX.
QUESTION
You wish to know our opinion regarding the tax treatment applicable to damages received or that could eventually be received by XXXXXXXXXX as a result of the application of paragraph XXXXXXXXXX of Agreement I and paragraphs XXXXXXXXXX of Agreement II. In addition, you asked for our comments on the tax treatment applicable to damages that may be received under paragraph XXXXXXXXXX of Convention II.
Position of the Taxpayer
All amounts paid by the vendors as damages under paragraph XXXXXXXXXX of Agreement I and XXXXXXXXXX of Agreement II were essentially credited by XXXXXXXXXX to the cost of its equity investments in the Corporations I and the Corporations II.
YOUR POSITION
In your opinion, all of the damages should be taken into account in computing the income of Corporations I and Corporations II since they essentially constitute compensation for losses incurred by the latter.
OUR OPINION
In order to determine the tax treatment applicable to the compensation received or that could eventually be received by XXXXXXXXXX or Corporations II following the application of such paragraphs of each of the agreements, we must first determine who is legally entitled to that compensation. XXXXXXXXXX.
XXXXXXXXXX
Those provisions clearly indicate that the vendors must pay such compensation to XXXXXXXXXX and not to the operating corporations (Corporations I and Corporations II). In this context, it cannot be concluded that those clauses constitute stipulations for third parties within the meaning of articles 1444 et seq. of the Civil Code of Quebec, XXXXXXXXXX.
Consequently, it is not appropriate to consider such compensation in computing the income of Corporations I and Corporations II. Only XXXXXXXXXX must assume the tax consequences of the payment of the damages. To that end, it must be remembered that the compensation clauses in question are part of share purchase agreements. They are essentially intended to protect the purchaser against the unfavourable economic effect of certain events that may occur following the purchase of the shares, events that were unknown at the date of the transaction but which, had they been known, would undoubtedly have been reflected in the value attributed to the shares at that time. In addition, the applicable paragraphs of Agreement II provide that the compensation is intended to compensate for a loss suffered by the purchaser.
The payments resulting from those compensation mechanisms are closely linked to the purchase of the shares and are of the same nature. Without those compensation clauses, it is reasonable to believe that the purchaser would probably not have agreed to pay the same price under the same terms for the purchase of the said shares.
In this type of situation, the Canada Customs and Revenue Agency's position is set out in paragraph 9 of Interpretation Bulletin IT-365R2, Damages, settlements, and similar receipts, which provides: “Where the amount of compensation relates to a particular asset that was not disposed of, the amount will serve to reduce the cost of that asset to the taxpayer.” Paragraph 14 of IT-285R2, Capital Cost Allowance-General Comments, provides for similar treatment.
In our view, the application of the damages received by XXXXXXXXXX, pursuant to paragraph XXXXXXXXXX of Agreement I and paragraphs XXXXXXXXXX of Agreement II, to reduce the cost of the shares of Corporations I and II is the appropriate tax treatment in the circumstances.
XXXXXXXXXX
Consequently, it would be appropriate to take into account the compensation payable under those provisions in computing the income of Corporations II as and when their entitlement arises, i.e. when they incur expenses to remedy the environmental problems identified by the parties.
For your information, a copy of this memorandum will be severed using the Access to Information Act and will be available in the Legislative Access Database (LAD) located on the mainframe of the Canada Customs and Revenue Agency. 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 Legislative Access Bank 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 (613) 957-0682. A copy that has been severed in accordance with the Privacy Act will be sent to you for delivery to the client.
We hope you find these comments helpful. Should you require any additional information regarding this matter, please do not hesitate to contact us.
Best regards,
Ghislaine Landry, CGA
Manager
Business and Individuals Section
Business and Publications Division
Income Tax Rulings Directorate
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