2019-0824531C6 2019 CTF - Q12 - Earnout and Cost Recovery Method

Principal Issues: Could the cost recovery method be applied in the scenario where an earnout clause relates only to the underlying goodwill of a subsidiary?

Position: The mere fact that the earnout feature relates only to the underlying goodwill of the subsidiary will not preclude the application of the cost recovery method.

Reasons: Position in the Interpretation Bulletin IT-426 [archived].

Author: Gélinas, Lyne
Section: 12(1)g), 39(1)

2019 CTF Annual Conference

CRA Roundtable

Question 12: Earnout and Cost Recovery Method

A taxpayer sells his/her shares of a corporation (“Company A”).  The only assets owned by Company A are the shares of another corporation (“Company B”).

The proceeds of disposition of the shares of Company A are determined pursuant to an earnout clause in an agreement.  In this situation, the quantum of proceeds is determined by reference to the future earnings generated by Company B.  Under this scenario, the earnout feature relates only to the underlying goodwill of Company B.

Interpretation Bulletin IT-426R [archived] (footnote 1) describes the cost recovery method of reporting capital gains or capital losses on the sale of shares subject to an earnout agreement.  Taxpayers may use the cost recovery method where certain conditions are satisfied.

Does the CRA agree to apply the cost recovery method to the sold shares of Company A?

CRA response

The CRA is of the view that the mere fact that the earnout feature relates only to the underlying goodwill of Company B will not preclude the application of the cost recovery method.

The question of whether the conditions set out in the Interpretation Bulletin IT-426R [archived] are met in a particular situation is a matter of fact that requires an analysis of all relevant facts in this particular situation.

Previous opinions issued by the CRA should be read in conjunction with this response.

Lyne Gélinas
2019-082453
December 3, 2019

FOOTNOTES

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

1  CANADA REVENUE AGENCY, Interpretation Bulletin IT-426R [archived], “Shares Sold Subject to an Earnout Agreement”, September 28, 2004.

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