Principal Issues: Whether the debt would be an "excluded obligation" after the amalgamation in the situation described (Newco purchased all the shares of the capital stock of Target, there is a reverse earn-out clause in the purchase agreement, subsection 143.4(2) was applicable at the time of the purchase of the shares of Target, amalgamation of Newco and Target)?
Position: Yes.
Reasons: Paragraph (a) of the definition "excluded obligation" in subsection 80(1).
FEDERAL TAXATION ROUNDTABLE 10 OCTOBER 2014
2014 APFF CONFERENCE
Question 15
Section 80 and reverse earn-out clause
In a transaction for the purchase and sale of shares of a taxable Canadian corporation (the "Target"), the terms of the purchase and sale agreement often include a reverse earn-out clause. According to the CRA's position, if the relevant conditions in paragraphs 9 and 10 of Interpretation Bulletin IT-462 (now archived) are met, a reverse earn-out clause permits the vendor of the shares to consider that the portion of the selling price that is subject to the reverse earn-out clause is not covered by paragraph 12(1)(g). It is also common in such share purchase and sale transactions for the share purchaser to be a newly-incorporated corporation ("Newco"), which is then amalgamated with Target. Target shares acquired by Newco are then canceled on the amalgamation.
If the financial performance objectives included in a reverse earn-out clause do not materialize, the obligation created under the purchase and sale agreement is reduced and could give rise to a "forgiven amount" within the meaning of subsection 80(1), assuming that a legal obligation to pay the maximum selling price would have arisen at the time of the execution of the purchase and sale agreement. In addition, subsection 143.4(2) could have the effect of reducing the cost of shares in the capital of Target at the time of their acquisition by Newco to an amount equal to the portion of the purchase and sale price that is not subject to the reverse earn-out clause, since there could be a "right to reduce" within the meaning of the definition in subsection 143.4(1) as a result of this clause.
A "right to reduce" within the meaning of the definition in subsection 143.4(1) is a right to reduce or eliminate an amount in respect of an expenditure (as defined in subsection 143.4(1)), provided that such right includes a right to reduce which is contingent upon the occurrence of an event, or which in any other way is contingent, if it is reasonable to conclude, having regard to all the circumstances, that the right will become exercisable.
If the cost of the shares in the capital stock of Target has been reduced prior to the amalgamation as a result of the application of subsection 143.4(2), the debt payable to the vendor should qualify as "excluded obligation" as defined in subsection 80(1). Consequently, the settlement of the debt after the amalgamation should not result in a "forgiven amount" within the meaning of subsection 80(1), even though the Target shares were canceled on the amalgamation.
Questions to the CRA
a) Can the CRA confirm that a reduction in the cost of the shares of Target (through the application of subsection 143.4(2) of the ITA) prior to the subsequent amalgamation of Target with Newco permits the debt to qualify as an "excluded obligation" (as defined in subsection 80(1) of the ITA), so that the settlement of the debt following the amalgamation should not result in a "forgiven amount" (as defined in subsection 80(1) of the ITA), even though the shares in the capital stock of Target acquired by Newco are canceled on the vertical amalgamation?
(b) When the transaction (and related debt) occurred in a taxation year ending before March 16, 2011 (so that s. 143.4 did not apply due to the transitional rule), or where there was no "right to reduce" as defined in subsection 143.4(1), would the CRA be of the view that the fact that the shares no longer exist after the amalgamation and that their cost is therefore not reduced, could result in a "forgiven amount" because the debt that is settled would not qualify as an "excluded obligation" as defined in subsection 80(1)?
CRA response
Preliminary Comments
In the situation presented, our understanding is that you have assumed that Newco, at the time of the acquisition, has an existing legal obligation to pay the maximum purchase price, so that ITA subsection 143.4(2) would be applicable at the time of the acquisition of the shares respecting the unpaid purchase price, and that the purchase price would be extinguished after the amalgamation.
It is not possible to provide definitive responses without knowing all the facts of a specific case. However we can offer the following general comments which nonetheless, in some circumstances, would not apply in a particular situation. The income tax treatment of particular transactions will only be confirmed by the CRA in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R6, Advance Income Tax Rulings and Technical Interpretations.
CRA Response to Question 15(a)
It appears to us that a reduction in the cost of the shares in the capital stock of Target through the application of subsection 143.4(2) prior to the amalgamation would in general permit the debt to qualify as "excluded obligation" as defined in subsection 80(1), by reason of the application of paragraph (a) of that definition.
Paragraph (d) of the definition of "excluded obligation in general could not apply because the debt was of a capital nature.
CRA Response to Question 15(b)
In such situations, it appears to us that in general the extinguishing of the debt could generally give rise to a "forgiven amount" given that the debt would not qualify as an "excluded obligation" as per the definition provided in paragraph 80(1).
In the situations presented in this question (with ITA subsection 143.4(2) not being applicable), the fact that the shares no longer existed following the amalgamation and that consequently their cost would not be reduced, does not appear relevant to the question of there being a "forgiven amount" as defined in paragraph 80(1).
Robert Gagnon
(613) 957-2108
October 10, 2014
2014-053815