Principal Issues: Whether the cost recovery method as described in IT-426R (Archived) would be applicable to a limited partnership or the limited partners in the situation described in the letter.
Position: No.
Reasons: Conditions in par. 2 of IT-426R (Archived) are not satisfied. Conditions were not designed for limited partnerships or limited partners in a situation as described in the letter.
XXXXXXXXXX 2021-088465 R. Gagnon
May 17, 2022
Dear XXXXXXXXXX:
Re: Cost Recovery Method in Interpretation Bulletin IT-426R (Archived)
We are writing in response to your letter dated March 5, 2021 in which you requested our comments concerning your questions in respect of the application of the cost recovery method (as described in Interpretation Bulletin IT-426R (Archived) - Shares Sold Subject to an Earnout Agreement) in the situation described in your letter.
Unless otherwise stated, all statutory references herein to sections or components thereof are references to the relevant provision of the Income Tax Act, R.S.C. 1985, c.1 (Fifth Suppl.), as amended (“Act”).
Our understanding of the situation described in your letter is as follows:
1. The vendor is a limited partnership (“Partnership”) formed pursuant to the Limited Partnerships Act of the Province of Ontario.
2. Partnership has its central management and control in Canada. As such, Partnership is a “Canadian resident partnership” as defined in subsection 248(1). However, Partnership is not a “SIFT partnership” as defined in subsection 197(1).
3. The partners of Partnership include individuals and corporations that are Canadian residents and non-residents of Canada for the purposes of the Act. As such, Partnership is not a “Canadian partnership” pursuant to subsection 102(1).
4. TargetCo is a U.S. company and has no activities in Canada. Partnership holds less than 5% of the shares of the capital stock of TargetCo. As such, Partnership is a minority shareholder of TargetCo.
5. The shares of the capital stock of TargetCo held by Partnership are “capital property” (as defined in section 54) to Partnership.
6. The shares of the capital stock of TargetCo are not “taxable Canadian property” (as defined under subsection 248(1)), and the non-resident partners of Partnership are not subject to Canadian tax on any taxable capital gain realized on the disposition of the shares of TargetCo by Partnership.
7. Partnership sells its shares of the capital stock of TargetCo to BuyerCo, with whom it deals with at arm’s length. The proceeds received by Partnership on closing exceed the Partnership’s adjusted cost base (as defined under section 54) of the shares. As such, Partnership will report a taxable capital gain on the disposition pursuant to paragraph 96(1)(c).
8. Partnership was not directly involved in the negotiations for the sale of TargetCo and was not active in the business operations of TargetCo.
9. In addition to the proceeds received on the closing of the sale, Partnership may receive additional payments in future fiscal periods pursuant to an earnout clause in an agreement.
10. The earnout clause in the agreement is not a reverse earnout arrangement (i.e. where the sale price of the property is originally set at a maximum which is equivalent to the fair market value of the property at the time of the sale and which can be subsequently decreased if certain conditions related to production or use are not met in the future).
Your Questions
In order to determine whether the cost recovery method described in Interpretation Bulletin IT-426R (Archived) could apply to Partnership on the sale of its shares of the capital stock of TargetCo in the situation described above or to the limited partners, you asked us the following questions:
1. Does a “Canadian resident partnership” (as defined under subsection 248(1)) satisfy condition (f) outlined in paragraph 2 of Interpretation Bulletin IT-426R (Archived)?
2. Does the passive nature of the involvement of Partnership (vendor) in the negotiation of the sale of its investments in TargetCo meet condition (c) outlined in paragraph 2 of IT-426R (Archived), that the vendor and the purchaser cannot agree on the value of the underlying goodwill at the date of the sale?
3. Does the information return prepared by Partnership (i.e. T5013) meet condition (e) of paragraph 2 of IT-426R (Archived)?
4. In the alternative, if Partnership is not eligible to follow the process in IT-426R (Archived), will the eligible partners of Partnership be able to follow the procedures outlined in IT-426R (Archived), provided they meet all the conditions of IT-426R (Archived)?
Our Comments
This technical interpretation provides general comments about the provisions of the Act. It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R12, Advance Income Tax Rulings and Technical Interpretations.
The conditions for the application of the cost recovery method described in paragraph 2 of Interpretation Bulletin IT-426R (Archived) were not designed to apply to limited partnerships in situations such as described above.
The definition of “Canadian resident partnership” in subsection 248(1) was introduced in the Act in 2007 consequential to the rules regarding SIFT partnerships (see section 197 in Part IX.1 – Tax on SIFT Partnerships). It is not relevant for the application of condition (f) in paragraph 2 of Interpretation Bulletin IT-426R (Archived), which is dated September 28, 2004. Moreover, a limited partnership is not a person resident in Canada for the purposes of the Act (although it is deemed to be a separate person resident in Canada for limited purposes in subsection 96(1)).
The CRA will in general consider that condition (c) in paragraph 2 of Interpretation Bulletin IT-426R (Archived) is satisfied even if a particular vendor is not directly involved in the negotiations for the sale of shares, when it is reasonable to assume that the earnout feature relates to underlying goodwill the value of which cannot reasonably be expected to be agreed upon by the vendors/shareholders and the purchaser at the date of the sale and as a result of the negotiations by certain vendors/ shareholders, the earnout feature is included in the sale agreement of the particular vendor.
The partnership information return in prescribed form (T5013 forms as described in the T4068(E) Guide for the Partnership Information Return (T5013 Forms)) that must be filed in general by partnerships pursuant to subsection 229(1) of the Income Tax Regulations, does not constitute a return of income for the purpose of condition (e) of paragraph 2 of Interpretation Bulletin IT-426R (Archived).
As previously mentioned, the conditions for the application of the cost recovery method described in paragraph 2 of Interpretation Bulletin IT-426R (Archived) were not designed to apply to limited partnerships. Therefore, neither a partnership nor the partners of a partnership in situations such as described above may use the cost recovery method described in Interpretation Bulletin IT-426R (Archived).
We trust our comments will be of assistance. We apologize for the delay in responding to your request.
Yours truly,
Urszula Chalupa, LL.B, M. Fisc.
for Division Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch