Earnout based on subsidiary goodwill
One of the conditions provided in IT-426R for application of the cost recovery method (in subpara. 2(c)) is that it must be 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 vendor and the purchaser at the time of the sale.
The quantum of the proceeds of disposition of the shares of a corporation (Holdco) under an earnout clause is determined by reference to the future earnings generated by one out of three of its subsidiaries (ACo), so that the earnout feature relates only to the goodwill of ACo. CRA indicated that this earnout feature meets the condition of subpara. 2(c), indicating that the same reasoning applied as in 2019-0824531C6.
Timing of satisfaction of 5-year condition in subpara. 2(d)
Suppose a vendor owns shares of a target corporation whose year-end is September 30, 2022. The shares of the target corporation were sold on October 1, 2022. The purchaser of the shares of the target corporation chooses a December 31 year-end for the target corporation. Under the terms of the purchase and sale agreement for the shares of the target corporation, the earnout amount will be determinable no later than September 30, 2027. For the conditions of subparagraph 2(d) to have been met, when must the earnout amount be paid?
CRA noted that since (per para. 2(a) of the Bulletin) the vendor and purchaser referred to in para. 2(d) were dealing at arm’s length, one would expect s. 249(4) to deem the target to have a year-end immediately before the acquisition of control. In the example, the shares of the target thus would be acquired in the short taxation year of the target ending on December 31, 2022 so that, under the 5-year rule in para. 2(d), the earnout feature would be required to end no later than December 31, 2027.
Regarding the requirement that the last contingent amount “may [only] become payable” pursuant to the sale agreement within the 5-year period, CRA noted that under the cost-recovery method set out in para. 3, the vendor will reduce the ACB of the shares sold as amounts on account of the sale price becoming determinable, and that para. 5 of the Bulletin indicates that an amount becomes determinable when it is capable of being calculated with certainty, and the taxpayer has an absolute (but not necessarily immediate) obligation to pay. CRA considered that para. 2(d) of the Bulletin required that there be a clear legal, but not necessarily immediate, obligation to pay the last contingent amount, no later than December 31, 2027, in order for the cost recovery method to apply.
Finally, CRA indicated that there is no requirement under subpara. 2(d) that the contingent amount in fact be paid within such 5-year period .