2019-0824461C6 2019 CTF Q10 - Earnout payments to non-residents

Principal Issues: 1. Should earnout payments made to non-residents in respect of a previous disposition of shares that were not taxable Canadian property be subject to subparagraph 212(1)(d)(v) withholding? 2. If subparagraph 212(1)(d)(v) applies, does the requirement to withhold not apply where the recipient is resident in a treaty country that has a typical exemption from Canadian tax on gains realized on the sale of shares that do not derive more than 50% of their value from real or immovable property in Canada?

Position: 1. Generally no. 2. Not applicable based on response to 1.

Reasons: 1. Consistent with the administrative position in respect of earnout payments received by non-resident vendors of shares that are taxable Canadian property.

Author: Patel, Komal
Section: 12(1)(g), 212(1)(d)(v), 2(3), 115(1)(a)(iii), 115(1)(b), 248(1) taxable Canadian property

2019 CTF Annual Conference

CRA Roundtable

Question 10: Earnout payments to non-residents

Shareholders of a Canadian resident corporation (“Canco”) that carries on an active business sell their shares to an arm’s-length third party. The shares of Canco are not taxable Canadian property. The purchase price for the shares includes an earnout payment. The earnout relates to the goodwill of the business (EBITDA over a two-year period). The earnout is paid in the third year following the closing of the share purchase. The Canadian resident shareholders rely on the CRA administrative position in IT-426R to obtain capital gains treatment on the sale of the shares and to use the cost recovery method in reporting their gain. There are also some non-resident shareholders.

Please confirm that subparagraph 212(1)(d)(v) does not require that the purchaser withhold tax when the earnout payment is made to the non-resident shareholders.

If there is withholding under subparagraph 212(1)(d)(v), please confirm that the requirement to withhold does not apply where the recipient is resident in a treaty country that has a typical exemption from Canadian tax on gains realized on the sale of shares that do not derive more than 50% of their value from real or immovable property in Canada.

CRA Response

As stated at the 2005 APFF Conference, the CRA generally would not apply subparagraph 212(1)(d)(v) of the Act when shares that are taxable Canadian property are sold by a non‑resident under an agreement that includes an earnout clause in respect of future earnings, provided the first four conditions in paragraph 2 of IT‑426R Shares Sold Subject to an Earnout Agreement (Archived) are met. The first four conditions are as follows:

1.    The vendor and purchaser are dealing with each other at arm's length.
2.    The gain or loss on the sale of shares of the capital stock of a corporation is clearly of a capital nature.
3.    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 vendor and purchaser at the date of the sale.
4.    The earnout feature in the sale agreement must end no later than 5 years after the end of the first taxation year of the corporation (whose shares are sold) in which the shares are sold. For the purposes of this condition, the CRA considers that an earnout feature in a sale agreement ends at the time the last contingent amount may become payable pursuant to the sale agreement.

Where a non-resident disposes of shares that are not taxable Canadian property, the consideration for which includes an earnout payment, it is our view that the fair market value of the right to receive an amount under the earnout clause would generally be included in the proceeds of disposition of the shares, provided the first four conditions in paragraph 2 of IT‑426R, as outlined above, are met. Where this is the case, it is our view that the purchaser generally would not be required to withhold tax under subparagraph 212(1)(d)(v) of the Act in respect of the earnout payment made to a non-resident vendor of the shares.

Ann Kippen
Komal Patel
2019-082446
December 3, 2019

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