Principal Issues: Whether the cost recovery method as described in IT-426R (Archived) Shares Sold Subject to an Earnout Agreement would be applicable to a limited partnership in the situation as described below?
Position: No.
Reasons: Conditions in par. 2 of IT-426R(Archived) not satisfied. Conditions not designed for limited partners of a limited partnership in a situation as described below.
FEDERAL TAX ROUNDTABLE, OCTOBER 7, 2021
APFF CONFERENCE 2021
Question 8
Application of the cost recovery method
Interpretation Bulletin IT-426R (footnote 1) lists in paragraph 2 the conditions that must be satisfied in order to use the cost recovery method in a share sale transaction that includes an earn-out clause. It is difficult to meet all of the conditions set out in paragraph 2 of IT-426R in the situation where a limited partnership that has various Canadian resident partners and non-resident partners, and is therefore not a "Canadian partnership" (as defined in subsection 102(1)), makes a sale of shares pursuant to a contract containing an earn-out clause. The conditions referred to in paragraphs 2(e) and 2(f) of IT-426R are difficult to apply in this context.
In practice, the partners of the partnership are not required to file information returns under ITR section 229. The Partnership will compute its income as if it were a separate person resident in Canada. This computation will be provided to the Partners resident in Canada for the purpose of taxing the income and/or taxable capital gains realized by the Partnership, computed in accordance with the Canadian rules. Since there is no requirement to file information returns in Canada under ITR section 229, it is difficult to meet the condition stated in paragraph 2(e) of Interpretation Bulletin IT-426R that the vendor submit a copy of the agreement of sale with its income tax return. In addition, limited partners generally do not have access to the sales contract containing the price adjustment clause, so that it would be difficult for them to meet this condition as well. For the purpose of meeting the condition in paragraph 2(f) of IT 426R that the vendor is a person resident in Canada for the purposes of the Act, the partnership cannot be considered by itself to be a resident of Canada, but a partner who is required to report a taxable capital gain is a resident of Canada, but is not the vendor.
Question to the CRA
Assuming the first four conditions in paragraphs 2(a) to (d) of Interpretation Bulletin IT-426R are satisfied, would the partnership in the above situation be able to use the cost recovery method to calculate the portion of the taxable capital gain (resulting from the sale of the shares) that would be attributable to the partners resident in Canada, which would be provided to the partners to be taxed under that method?
CRA Response
The conditions of application in paragraph 2 of IT-426R were not designed for limited partners of a limited partnership in a situation as described above.
Consequently, the cost recovery method could not be used by a limited partnership in such a situation.
Robert Gagnon
October 7, 2021
2021-090098
FOOTNOTES
Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:
1 CANADA REVENUE AGENCY, Interpretation Bulletin IT-426R (archived), "Shares Sold Subject to an Earnout Agreement", September 28, 2004.
UNCLASSIFIED