2015-0609671I7 Earnout, Amalgamation, Cost of Shares and ECE

Principal Issues: The income tax treatment to an amalgamated corporation of earnout payments made pursuant to a share purchase agreement entered into by a predecessor corporation.

Position: The earnout payments made by the amalgamated corporation form part of the cost of the shares acquired pursuant to the share purchase agreement and as such are not eligible capital expenditure. In addition, the earnout payments are not eligible capital expenditure to the amalgamated corporation because the conditions in the preamble of subsection 14(5) are not met since such outlays were not incurred by the amalgamated corporation in respect of a business and were not incurred for the purpose of earning income from the business.

Reasons: See below.

Author: Schnitzer, Irina
Section: 14(5) and 87

                                                                                                                                                    March 14, 2016

Minh-Thi Truong                                                                                                                          Income Tax Rulings Directorate
Canada Revenue Agency                                                                                                           Irina Schnitzer
Legislative Application Section                                                                                                   (613) 670-9009
Large Business Audit Division 

                                                                                                                                                    2015-060967

Re:  Deduction of Earnout Payments - Amalgamation

We are writing in response to your email and various telephone conversations wherein you requested our views on the income tax treatment of earnout payments made by XXXXXXXXXX (“Amalco”) pursuant to a share purchase agreement.

Unless otherwise stated, every statutory reference herein is to the Income Tax Act (Canada) (the “Act”) and all references to monetary amounts are in Canadian dollars.

FACTS

The facts as we understand them are as follows:

1. XXXXXXXXXX (“Targetco”) was a corporation incorporated under the Business Corporations Act (XXXXXXXXXX) (“BCA”). The shareholders of Targetco were XXXXXXXXXX individuals XXXXXXXXXX (the “Shareholders”).

2. XXXXXXXXXX (“Acquisitionco”) was a corporation incorporated under the XXXXXXXXXX for purposes of acquiring Targetco. The shareholder of Acquisitionco was a corporation resident in XXXXXXXXXX.

3. Acquisitionco, Targetco and the Shareholders entered into a share purchase agreement dated XXXXXXXXXX (the “Agreement”). Pursuant to the Agreement Acquisitionco was to purchase all of the outstanding shares of Targetco (the “Shares”) for a base purchase price of $XXXXXXXXXX plus earnout payments of up to $XXXXXXXXXX (the “Earnout Payments”).

4. The payment by Acquisitionco of the Earnout Payments was dependent on Targetco XXXXXXXXXX. The relevant part of the earnout clause in the Agreement provides as follows:

XXXXXXXXXX  Payment of the Total Earnout Amount

As additional consideration of the Shares and in addition to the base Purchase Price payable to the Shareholders pursuant to Section XXXXXXXXXX, the Shareholders shall be entitled to receive an aggregate amount of cash equal to the Total Earnout Amount payable as provided in this Section:

       XXXXXXXXX

5. Immediately following the purchase by Acquisitionco of the Shares, Acquisitionco and Targetco amalgamated in a short form amalgamation pursuant to section XXXXXXXXXX of the BCA to form Amalco (the “Amalgamation”).

6. After the Amalgamation, from XXXXXXXXXX to XXXXXXXXXX, as the various milestones and conditions set out in the Agreement were met, Amalco paid the Earnout Payments to the Shareholders.

7. Amalco reported the Earnout Payments as ECE and claimed deductions pursuant to paragraph 20(1)(b) in the amount of $XXXXXXXXXX and $XXXXXXXXXX in its XXXXXXXXXX and XXXXXXXXXX taxation year, respectively. 

8. For accounting purposes Amalco reported the amount of the total purchase price of $XXXXXXXXXX as goodwill discounted on the basis of the probability of paying the Earnout Payments and some holdbacks and a XXXXXXXXXX% discount factor. The probabilities for the Earnout Payments were determined to be XXXXXXXXXX% and XXXXXXXXXX% for each of the XXXXXXXXXX.

ISSUE

What is the income tax treatment of the Earnout Payments to Amalco?

OUR POSITION

It is our view that the Earnout Payments are part of the cost of the Shares and as such are not ECE. Case law mandates, and the Canada Revenue Agency (the “CRA”) consents, that a contingent liability, such as an ordinary earnout payment, is added to the cost of property, to which the contingent liability relates, once the contingent liability is payable. The Earnout Payments were a contingent liability until they became payable and as such are included in the cost of the Shares at that time, regardless of whether or not the Shares exist at the time. In addition, it is our view that the conditions in the preamble of subsection 14(5) have not been met because the Earnout Payments were not incurred by Amalco on account of capital for the purposes of gaining or producing income from the business.

TAXPAYER’S VIEW

The taxpayer’s representative is of the view that since the Shares ceased to exist the Earnout Payments cannot constitute cost of non-existing assets. The taxpayer’s representative submits that the Earnout Payments, at the time the amounts thereof crystallized and the amounts were paid, were properly attributable to the underlying assets of Targetco which had become assets of Amalco as a result of the Amalgamation and specifically to the goodwill value attributable to the business previously carried on by Targetco and as such constitute ECE of Amalco (see attached Appendix 2). In support of this position, the taxpayer’s representative analogizes the present situation to a leveraged buy-out transaction where the CRA’s position is and jurisprudence has determined that the amalgamated corporation is entitled to an interest deduction even though the original income producing source (the shares of target) ceases to exist. In addition, the taxpayer’s representative is of the view that the taxpayer is conservative in reporting the payments as ECE and that an argument could be made that the Earnout Payments are deductible under subsection 9(1) and paragraph 18(1)(a), although the latter position will not be pursued by the taxpayer if the CRA accepts that the Earnout Payments are ECE.

OUR COMMENTS

Definition of ECE in subsection 14(5) and Cost of Shares

It is our view that the earnout payments constitute cost of the Shares for purposes of paragraph (f) of the definition of eligible capital property in subsection 14(5) (“the ECE paragraph (f) exclusion”). Case law provides that the cost of property is the outlay or price that the taxpayer made or gave up in order to acquire the asset and a contingent liability is added to the cost of property at the time the liability becomes absolute. The jurisprudence has not contemplated or commented on the cost of property in situations where the property to which the contingent liability relates ceases to exist prior to the contingency becoming absolute. We understand that some tax practitioners are of the view that a contingent liability, such as an ordinary earnout, cannot be added to the cost of the property acquired if the property is no longer owned by the purchaser and such view has been expressed in publications. (footnote 1) However, we understand those views were held in the context where the determination of cost has to be made at a specific time, such as on the disposition of the property, or on the claim of a capital cost allowance. For example, subsection 40(1) generally provides that a taxpayer’s gain for a taxation year from the disposition of any property is the amount by which the taxpayer’s proceeds of disposition exceed the total of the adjusted cost base to the taxpayer of the property immediately before the disposition. Pursuant to that provision, in the context of determining a taxpayer’s gain upon a disposition of a capital property, the property that the taxpayer disposes of has to exist and the adjusted cost base of that property reflects the cost to the taxpayer of the property at that time. In contrast, the reference to the terms “cost of, or any part of the cost of” as found in the ECE paragraph (f) exclusion has no timing restriction and does not require that the property to which the cost relates still be in existence at the time of inclusion of an outlay or expense as an ECE.  In our view, the ECE paragraph (f) exclusion is an exclusion based on the conceptual and qualifying aspect that an outlay that is properly categorized as cost of acquisition of a property cannot be an ECE.  The ECE paragraph (f) exclusion is not a provision that has any bearing with the computation of or determination of an amount of cost of property listed therein for any purpose where such cost is used to determine income of the taxpayer.  In other words, timing and the existence of property may be relevant for terms such as “adjusted cost base”, “cost amount”, etc., where such terms are used in the determination of income but not for purposes of determining whether an expense or outlay can be viewed as being the cost of or part of the cost of a property listed in the ECE paragraph (f) exclusion.

The word “cost”, although often utilized in the Act, such as “adjusted cost base”, “cost amount” “cost of capital” is not defined in the Act. The Oxford Concise English Dictionary, 9th edition defines the word “cost” as: “what a thing costs; the price paid or to be paid, etc.” Black’s Law Dictionary, 6th edition, ascribes the following meaning to the word “cost”: “The sum or equivalent expended, paid or charged for something.”

Case law has provided that the cost of property is “the price that the taxpayer gave up in order to get the asset”. (footnote 2)  In Sherritt Gordon Mines Ltd v. MNR, 68 DTC 5180, the court stated:

In the absence of any definition in the statute of the expression “capital cost to the taxpayer of property” and in the absence of any authoritative interpretation of those words as used in Section 11(1)(a), insofar as they are being considered with reference to the acquisition of capital assets, I am of opinion that they should be interpreted as including outlays of the taxpayer as a business man that were the direct result of the method he adopted to acquire the assets. In the case of the purchase of an asset, this would certainly include the price paid for the asset. It would probably include the legal costs directly related to its acquisition. It might well include, I do not express any opinion on the matter, the cost of moving the asset to the place where it is to be used in the business. When, instead of buying property to be used in the business, the taxpayer has done what is necessary to create it, the capital cost to him of the property clearly includes all monies paid out for the site and to architects, engineers and contractors. It seems equally clear that it includes the cost to him during the construction period of borrowing the capital required for creating the property, whether the cost is called interest or commitment fee. Such cost is a capital cost that could not be deducted as an operating expense, without special authority. Possibly as good a way as any of testing the matter is to consider the possibility of a third person creating the required assets to the taxpayer’s specifications to sell them to him when completed. All their financing costs would enter into the price that the taxpayer would have to pay for the assets and there would be no doubt that the price would be the capital cost of the property to him if he bought it ready to use. If that be so, why should those costs be classified otherwise when he creates the asset himself? [Emphasis added]

The CRA has accepted the courts’ definition of the word “cost” in various documents; for example, in technical interpretation E 9225745 the following relevant comments were made:

The word “cost” is one of variable meaning “capable of a larger or narrower constitution according to the subject matter and the circumstances of the particular case.  It is sometimes used to express the value of a thing and sometimes the price paid for it”. (Singer Metals, Inc. v. Industrial Management Corp., 253P.2d 515, (D.C. App., 2d, Cal. 1953).  The word “cost” in its various forms (actual cost, capital cost, cost base, conversion cost, deemed cost, etc.) is probably used over a thousand times in the Act and Income Tax Regulations.  It is not, however, defined in the Act or Regulations.[Emphasis added]

[…]

As you indicate, Interpretation Bulletin IT-174R states in paragraph 1 that the term “capital cost of property” generally means the full cost to the taxpayer of acquiring the property.  This includes legal, accounting, engineering or other fees incurred to acquire the property.  Thus, if provincial sales tax and the GST are included in the statement of adjustments or similar document drawn up at the time of sale, such “fees” would become part of the capital cost of the property. (See IT-63R3 paragraph 11 for an example of a departmental publication setting this out with respect to provincial sales tax.).

In technical interpretation E 57996 the following comments were made regarding the term “cost of a share”:

In our opinion the “cost of a share can only include amounts which the purchaser has paid for the share or has the obligation to pay. If the vendor of, the share has no recourse to the purchaser for any additional instalments of the purchase price but can only realize on his security (i.e. the pledged share) only the amounts actually paid would be added to the cost of the share as they are paid or become payable. [Emphasis added]

In the present file, pursuant to the Agreement: “XXXXXXXXXX”.

The Agreement describes the circumstances under which Acquisitionco shall pay the Earnout Payments as follows: 

       XXXXXXXXXX

It is apparent, from the above noted excerpts of the Agreement, that the outlays for the Shares is $XXXXXXXXXX; however, since the Earnout Payments were dependent upon the achievement of certain milestones and on the continuous employment of certain Shareholders, the Earnout Payments appear to have been a contingent liability until such payments became payable. It is trite law that a contingent liability does not form part of the cost of the property until it becomes absolute or a real liability. (footnote 3) 

In Mandel v. The Queen, 78 DTC 6518, (footnote 4) the issue before the Federal Court of Appeal was whether the liability to pay the balance of the purchase price was a real or a contingent liability. The Court concluded that the liability was contingent and that the cost of property would be increased at the time that a payment was made in satisfaction of the contingent liability:

The trial judge, after careful analysis of the expert testimony, decided that the liability to pay the balance was contingent for relevant purposes, and I agree with him. The consequence, of course, was that the balance was not properly includable in the taxpayer’s capital cost for the taxation year. The amounts actually paid in the future from earnings, if any, would be taken into capital cost in the years of payment. [Emphasis added]

This principle was accepted by the Court in Lipper v. The Queen, 79 DTC 5246 (FCTD) (“Lipper”) and Daishowa. In Lipper the Court stated:

Lawrence H Mandel v The Queen, [1977] 1 FC 673, affirmed on appeal in [1978] CTC 780; 78 DTC 6518, firmly establishes the principle that a contingent liability to contribute towards capital costs is not to be taken into account in such circumstances in calculating capital cost to the taxpayer unless and until the contingency arises. […]

[Emphasis added]

In Daishowa, the Supreme Court of Canada stated:

[39]  A contingent liability is “a liability which depends for its existence upon an event which may or may not happen”: Canada v. McLarty, 2008 SCC 26, [2008] 2 S.C.R. 79, at para. 17, quoting Winter v. Inland Revenue Commissioners, [1963] A.C. 235 (H.L.), at p. 262. This Court has recognized that the contingent nature of a liability may have implications on the tax treatment of the liability. In McLarty, for instance, this Court recognized that, although a taxpayer generally incurs an expense when he has a legal obligation to pay a sum of money, no expense is incurred for tax purposes if the liability is contingent: paras. 14-16. In Mandel v. The Queen, [1980] 1 S.C.R. 318, aff’g [1979] 1 FC 560, this Court affirmed the Federal Court of Appeal’s determination that a taxpayer who purchases a capital asset may not include in his capital cost a liability to the vendor if the liability is contingent.

[Emphasis added]

The CRA has confirmed the above-noted principle on numerous occasions. In technical interpretation 2002-0164607 the following relevant comments were made:

When a business is sold and the purchaser assumes contingent liabilities as part of the consideration for the business, it is our view that the vendor’s proceeds of disposition would include the fair market value of the contingent liability assumed by the purchaser.  However, the cost of the asset to the purchaser would not include the contingent liability until the contingency has been met, pursuant to paragraph 18(1)(e) of the Income Tax Act (the “Act”).  Our position on the application of paragraph 18(1)(e) to the cost of assets is consistent with existing jurisprudence as expressed in a line of cases including that of Lawrence H. Mandel v. the Queen (80 DTC 6148) heard by the Supreme Court.  When the purchaser pays the contingent liability, the amount would be added to the cost of the assets acquired.

[Emphasis added]

It is apparent that, if the Earnout Payments would have been payable or paid prior to the Amalgamation by Acquisitionco, then the Earnout Payments would have been added to the cost of the Shares. However, the Amalgamation had the result that the Shares were cancelled prior to the Earnout Payments being payable or paid and the Earnout Payments were paid in regards to property that no longer existed. It is our view that, regardless of whether the Shares existed at the time that the Earnout Payments became payable or paid, the Earnout Payments nevertheless are part of the cost of the Shares. Mandel, affirmed by the Supreme Court of Canada in Daishowa, appears to dictate such a result by stating that a contingent liability is added to the cost of the property in the year of payment.

Based on the jurisprudence and the CRA’s previous positions, a contingent liability forms part of the cost of property in the year it becomes payable or is paid. Accordingly, we are of the view that the Earnout Payments constitute cost of the Shares at that time. The fact that the Shares no longer existed, as a result of the Amalgamation, does not change this position. Any other position would lead to improper income tax results.

From a policy perspective, it is inappropriate and illogical to conclude that an amount that is a legal obligation, although a contingent obligation, created pursuant to a contract for the purchase and sale of shares by a predecessor corporation changes its characteristics of cost of capital property to something else as a result of an amalgamation and the fact that such obligation became payable after the amalgamation at a time where the property to which the obligation relates no longer exits.

The argument by the taxpayer’s representative that “Amalco was required to turn its mind to alternatives for recognition of the amounts paid” or that “it would be inappropriate to simply treat the earn-out payments as “nothings” for tax purposes” is flawed and inaccurate. Regardless of how the acquisition of the Shares would have been structured (via payment of purchase price of $XXXXXXXXXX at the time of closing, a reverse earnout or ordinary earnout), Amalco would be in the same position as a result of the timing of the Amalgamation and the cancellation of the Shares since the cost of the Shares would have disappeared on the Amalgamation. The difference between cost of the Shares of $XXXXXXXXXX and $XXXXXXXXXX immediately before the Amalgamation is only relevant in regards to bump room for the assets of Targetco, if a bump was available under paragraphs 87(11)(b) and 88(1)(c). We were not provided with information regarding whether a bump was implemented upon the Amalgamation, but we note that a bump can only be made on capital property and eligible capital property is not an eligible property for bump purposes.  Accordingly, regardless of how the acquisition of the Shares was structured, via payment of $XXXXXXXXXX at time of closing, reverse earnout or ordinary earnout, Amalco is in the same position, it had to give up $XXXXXXXXXX to acquire the Shares and the Shares were cancelled as a result of the Amalgamation, with no possibility of increasing the cost of eligible capital property under the bump provisions.

In conclusion, it is our view that the Earnout Payments form part of the cost of the Shares and the Amalgamation should not entitle Amalco to re-characterize an amount that is cost of the Shares simply because the Earnout Payments were made at a point in time where the Shares no longer exist. Allowing such a re-characterization of cost of non-depreciable property to ECE would in effect allow a bump on eligible capital property. Such a result is offensive and inappropriate.

Conditions in the Preamble of the definition of ECE – Incurred for the Purpose of Earning Income from Business

Although it is our view that the Earnout Payments constitute cost of the Shares, and such payments are explicitly excluded from ECE pursuant to the ECE paragraph (f) exclusion, we are also of the view that the conditions in the preamble of the definition of ECE are not met. This latter view is based on the position that the Earnout Payments were not incurred for the purpose of earning income from Amalco’s business.

Pursuant to subsection 14(5), the outlay or expense incurred has to be in respect of a business and for the purpose of earning income from the business. In other words, the expense has to be tied to the source of the income in relation to which the expense is incurred.

The phrase “for the purpose” was examined by the Court in Royal Trust Co. v. Minister of National Revenue, 57 DTC 1055 (Ex. Ct.), and although the provision relevant in that case was paragraph 12(1)(a), the comments made by the Court are of relevance:

[33] The essential limitation in the exception expressed in section 12(1)(a) is that the outlay or expense should have been made by the taxpayer “for the purpose” of gaining or producing income “from the business”. It is the purpose of the outlay or expense that is emphasized but the purpose must be that of gaining or producing income “from the business” in which the taxpayer is engaged. […]

The above excerpt emphasises that the purpose of the outlay must be examined. In the present file, a position can be taken that the purpose of the Earnout Payments is the original purpose of the Earnout Payments which is determined at the time the liability is entered into, i.e., at the time the Agreement is entered into. According to the Agreement, the purpose of the Earnout Payments was to provide additional consideration for the acquisition by Acquisitionco of the Shares. This purpose does not change as a result of the Amalgamation; rather, the original purpose of Acquisitionco flows through to Amalco as a result of the Amalgamation. Support for this position can be gleamed from the Federal Court of Appeal’s comments in Dow Chemical Canada Inc. v. The Queen, 2008 DTC 6544 (FCA):

[29] There can be no doubt about the object and purpose of section 87. A common thread throughout this provision is the continuation of the rights and obligations of the predecessor corporations to the “new corporation”. With respect to any debt or other obligation incurred or issued by a predecessor, paragraph 87(7)(d) provides that the Act is to be applied “as if” the obligation had been incurred or issued by the “new corporation”.

[Emphasis added]

According to the above excerpt, Amalco has to be placed in the shoes of Acquisitionco at the time of Acquisitionco entering into the Agreement. At that time, the purpose for the Earnout Payments was not to earn income from a business but to acquire a capital asset, i.e., the Shares. Consequently, the purpose to Amalco of paying the Earnout Payments was to acquire the Shares.

In the alternative, a position can be taken that the Earnout Payments were not incurred for the purpose of earning income from a business because Amalco became liable for and incurred the Earnout Payments as a consequence of the mechanisms of an amalgamation as set out in the BCA and the Act. Pursuant to those statutes, Amalco becomes liable for the obligations of its predecessors. Pursuant to section XXXXXXXXXX of the BCA, at the time of the Amalgamation, the property, rights and interest of each of Acquisitionco and Targetco continue to be the property, rights and interest of Amalco and Amalco continues to be liable for the obligations of each of Acquisitionco and Targetco. As a result of the Amalgamation, Amalco was liable for the Earnout Payments and the satisfaction of such liability, via the payment of the Earnout Payments, does not have a purpose of earning income from a business, it is simply the satisfaction of a liability.

The taxpayer’s representative relies on case law and CRA’s views regarding the tracing/linking concept in the context of a leveraged buy-out followed by an amalgamation to support the position that the Earnout Payments were incurred by Amalco for purposes of earning income from its business. It is our view that the tracing/linking concept is not applicable in the present file.

Paragraph 1.44 of S3-F6-C1: Interest deductibility, provides the following comments regarding the tracing/linking process:

A corporation might acquire shares of another corporation with borrowed money. Subsequently, the other corporation may be wound-up or amalgamated with the borrowing corporation. Under the tracing/linking process described above, a link for the current use of the borrowed money is readily established between the shares that were initially acquired (and have disappeared) and the assets formerly held by the acquired corporation that has been wound-up or amalgamated. There is no arm’s-length requirement in establishing such a link.

As is apparent from the above, the tracing/linking process is in relation to the “use” of the borrowed money; in particular, the tracing/linking process traces the use of the borrowed money by examining not only the direct use of the borrowed money but also the indirect use of such funds. The taxpayer’s representative seeks to expand the tracing/linking process, as applied to paragraph 20(1)(c), to subsection 14(5). We disagree with the taxpayer’s submissions, subsection 14(5) does not utilize a “use” test but looks to the purpose of incurring the outlay and accordingly the tracing/linking process cannot be applied in the present file.

We are also of the view that the Earnout Payments are not comparable to interest on a loan but rather could be compared to loan repayments. Tracing is therefore not relevant because loan repayments are not deductible from income.

In addition, although we indicated at the 2002 Annual Conference of the Canadian Tax Foundation that our position regarding the deductibility of interest in the context of a leveraged buy-out followed by an amalgamation was supported by the flexible approach of linking adopted by the Supreme Court of Canada in Ludco Enterprises Ltd et al. v. The Queen, (footnote 5) there is no “tracing” of the assets of the amalgamated corporation as a replacement or substitution for the shares of the target corporation that no longer exist following the amalgamation. While it might be argued that the amalgamated corporation “acquires” the assets of the predecessor corporations upon the amalgamation, the assets are not legally replacing the shares of the predecessor corporations. Notwithstanding this technical difficulty, from a policy standpoint, it was the CRA’s view that interest should be deductible in the context of a leveraged buy-out followed by an amalgamation. Our position is supported by the general scheme of section 87 which is to treat the amalgamated corporation as a continuation of the predecessor corporations standing in their place with respect to assets, liabilities and tax accounts. Of particular relevance is the rule in subparagraph 87(2)(c)(ii), which provides that the amalgamated corporation may deduct in computing its income for a taxation year any amount paid or payable by it in that year that would, if it had been paid or payable by the predecessor corporation in its last taxation year, have been deductible in computing the income of the predecessor corporation for that year.  In addition, pursuant to subsection 87(7), where a debt of a predecessor corporation that was outstanding immediately before the amalgamation became a debt of the new corporation on the amalgamation, the new corporation is deemed to have incurred the debt at the time it was incurred by the predecessor corporation. Paragraph 87(2)(j.6) also provides that the new corporation is deemed to be the same corporation as, and a continuation of, each predecessor corporation for the purposes of loss of source rules in section 20.1. Although none of these deeming rules are technically applicable in relation to the deductibility of interest in the context of a leveraged buy-out followed by an amalgamation, they certainly provide support for the CRA’s position on that matter.

Our position regarding the deductibility of interest in the context of leveraged buy-out transactions is also supported by a desire to achieve a consistent tax result: the interest was deductible before the amalgamation and it should continue to be deductible after the amalgamation provided that the assets of the amalgamated corporation continue to be used for the purpose of gaining or producing income from a business or property.

In the present case, according to the taxpayer’s view, the tax treatment of the Earnout Payments would change from being part of the cost of non-depreciable property (the Shares) before the Amalgamation to being ECE after the Amalgamation. This would achieve a completely different tax result. In addition, such result would go against the scheme of the Act; mainly, that a taxpayer cannot bump the cost of “ineligible property” (which includes eligible capital property) upon an amalgamation pursuant to paragraphs 87(11)(b) and 88(1)(c).

Even if the tracing/linking process could be applied in the context of subsection 14(5), which in our view it cannot, we believe that it would not support the taxpayer’s position. As indicated above, it is our view that the purpose of the Earnout Payments, which is to provide additional consideration for the acquisition of the Shares, does not change as a result of the Amalgamation even if the Shares disappear. Since the purpose of the tracing/linking process is to provide for continuity, either it would simply not be relevant in the present case or it would achieve the same result: the original purpose of Acquisitionco would flow through to Amalco as a result of the Amalgamation.

Furthermore, it is questionable whether the tracing/linking process would be applicable in the context of contingent obligations. For tax purposes, a contingent obligation is only recognized when the contingency becomes absolute. In the present case, the obligation to make the Earnout Payments became absolute only after the Amalgamation. Therefore, it could be argued that the purpose of the Earnout Payments could only be determined after the Amalgamation at the time the payments were made. In such case, as explained above, it is our view that such payment would have no purpose of earning income since Amalco has incurred the Earnout Payments only as a consequence of the mechanisms of an amalgamation under the BCA and the Act. We cannot see how the tracing/linking process could be applicable in this alternative.

In conclusion, the legal relationship between the parties to the Agreement was a purchase and sale of the Shares, not a purchase of the assets of Targetco. Acquisitionco and the Shareholders were at arm’s length and, as such, freely negotiated the terms of the Agreement. The purchase of shares and the purchase of assets entail different tax consequences to the purchaser and vendor. Goodwill can only be acquired on the purchase of a business. (footnote 6)  Amalco is attempting to reclassify payments that would have been adjustments to the cost of the Shares into ECE by amalgamating prior to the Earnout Payments becoming payable. Had Acquisitionco incurred the Earnout Payments, they would clearly not be ECE; consequently, the Earnout Payments cannot be ECE of Amalco simply as a result of the Amalgamation. To allow a corporation to purchase shares and subsequently claim ECE as if the corporation had purchased assets because of the timing of an amalgamation in relation to additional payments for shares would yield inappropriate tax results.  In the same vein, we cannot see how the taxpayer could successfully argue that the Earnout Payments constitute deductible expenses since paragraph 18(1)(a) is also based on a purpose test and, as previously discussed, the purpose test has not been met.

Yours truly,

Stéphane Prud’homme, LL.B, M. Fisc.
Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1  For example, see Peter H. Baek, “Purchase and Sale of a Business: Selected Purchaser Issues”, 2002 Conference Report.

2  See for example, Singer Metals, Inc. v. Industrial Management Corp., 253P.2d 515, (D.C. App., 2d, Cal. 1953, The Queen v. Stirling , 85 DTC 5199 (FCA) (Stirling) at pages 9-11; Coast Capital Savings Credit Union v. The Queen, 2015, DTC 1180, para. 31.

3  The definition of the term  “contingent liability” has been defined by the Supreme Court of Canada in Daishowa v. R, 2013 DTC 5085, (SCC) (“Daishowa”) as:[39] A contingent liability is “a liability which depends for its existence upon an event which may or may not happen”: Canada v. McLarty, 2008 SCC 26, [2008] 2 S.C.R. 79, at para. 17, quoting Winter v. Inland Revenue Commissioners, [1963] A.C. 235 (H.L.), at p. 262. […]. See also Wawang Forest Products Ltd. v. The Queen, 2001 FCA 80, for a definition of the term “contingent liability”.

4  Aff’d by the Supreme Court of Canada in Mandel v. The Queen, [1980] 1 SCR 318.

5  2001 DTC 5505.

6  See paragraph 6 and 7 of Interpretation Bulletin IT-143R3.

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