2022-0949761C6 2022 CTF Question 11 Earnout Agreement

Principal Issues: How to interpret the five-year period within which the earnout agreement may last pursuant to subparagraph 2(d) of IT-426R and whether the goodwill described in subparagraph 2(c) in IT-426R can relate to one out of multiple subsidiaries.

Position: The five-year period is based on the end of the taxation year in which the shares are sold, and the goodwill can relate to one of multiple subsidiaries.

Reasons: The language in IT-426R.

Author: 2022-0949761C6
Section: 12(1)(g), 40(1)(a)(iii)(C), 249(4)

2022 CTF Annual CRA Round Table – November 29, 2022

Question 11 – Shares Sold Subject to an Earnout Agreement

In the Interpretation Bulletin IT-426R “Shares Sold Subject to an Earnout Agreement” (September 28, 2004) [archived] (“IT-426R”) the Canada Revenue Agency (“CRA”) describes the cost recovery method of reporting gains or losses on the sale of shares subject to an earnout agreement. Generally speaking, under the cost recovery method the vendor reduces their adjusted cost base of the shares as amounts on account of the sale price become determinable. Once such an amount on account of the sales price exceeds the adjusted cost base of the shares, as reduced by any such previous amounts, the excess is considered to be a capital gain that is realized at the time that that amount became determinable, and the adjusted cost base becomes nil.

A. Paragraph 2 of IT-426R sets out the conditions for a taxpayer to be able to use the cost recovery method. Subparagraph 2(c) states 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.

At the CRA Round Table at the Canadian Tax Foundation’s (CTF’s) 2019 Annual Conference, the CRA addressed a situation where a vendor sold shares of a corporation, with the only assets owned by the corporation being the shares of a subsidiary. The proceeds of disposition of the shares of the corporation were determined pursuant to an earnout clause, with the quantum of proceeds determined by reference to the future earnings generated by the subsidiary. Under this scenario, the earnout feature related only to the underlying goodwill of the subsidiary. The CRA indicated that the mere fact that the earnout feature related only to the underlying goodwill of the subsidiary would not preclude the application of the cost recovery method.

Suppose a vendor owns shares of a Holdco and the Holdco owns shares of 3 corporations: ACo, BCo and CCo. The proceeds of disposition of the shares of Holdco are determined pursuant to an earnout clause, with the quantum of proceeds determined by reference to the future earnings generated by ACo. Under this scenario the earnout feature relates only to the goodwill of ACo.

Does this earnout feature meet the condition of subparagraph 2(c)?

B. There is a difference between the html and pdf versions of the condition in subparagraph 2(d) of IT-426R on the CRA website. Specifically, the html version on the CRA website provides:

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.

whereas the pdf version provides:

The earnout feature in the sale agreement must end no later than 5 years after the date of the end of the 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.

Can the CRA confirm which version of subparagraph 2(d) reflects its policy?

C. 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, must the earnout amount be paid by December 31, 2027 or September 30, 2028, or is it sufficient that it was determinable on September 30, 2027.

CRA Response (A)

The question of whether the conditions set out in the IT-426R are met in a particular situation requires an analysis of all relevant facts.

However, consistent with the CRA’s response at the CRA Round Table at the CTF’s 2019 Annual Conference, the mere fact that the earnout feature of the sale of the Holdco shares relates only to the underlying goodwill of one of the subsidiaries owned by Holdco will not preclude the application of the cost recovery method.

CRA Response (B)

After having looked into the historical amendments to subparagraph 2(d) of IT-426R in the CRA’s files it has been determined that the pdf version of the document on the CRA’s website, which matches the language used in the French pdf and French html versions of IT-426R, is the correct version of the Interpretation Bulletin. Notwithstanding that IT-426R is archived, the CRA has updated the CRA’s website so that the html version of IT-426R matches the pdf version.

It is not considered that the slight variation in language between the two versions of subparagraph 2(d) in IT-426R would lead to a different interpretive result.

CRA Response (C)

As noted above, the question of whether the conditions set out in IT-426R are met in a particular situation requires an analysis of all relevant facts.

This example raises three general questions. First, which taxation year is relevant for the purposes of calculating the five-year period set out in subparagraph 2(d) of IT-426R. Second, what is meant by the reference to “may become payable” in subparagraph 2(d) of IT-426R and is it equivalent to the term “determinable”. Finally, does the CRA’s administrative policy for the use of the cost recovery method impose a requirement that amounts under the earnout feature be paid within a certain period of time.

Relevant Taxation year for the Purposes of Calculating the five-year Period

As confirmed above, pursuant to subparagraph 2(d) of IT-426R, the earnout feature in the sale agreement must end no later than 5 years after the end of the 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.

In order for the CRA’s administrative position regarding the use of the cost recovery method to apply, subparagraph 2(a) of IT-426R requires that the vendor and the purchaser be dealing at arm’s length. Therefore, it is generally expected that if the cost recovery method applies there will be an acquisition of control of the target corporation. It is also assumed that there would be an acquisition of control of the target corporation for the purposes of the question given the purchaser has selected a new taxation year on the acquisition of the target corporation. If there is an acquisition of control of the target corporation then subsection 249(4) of the Act will apply to deem the target corporation to have a taxation year-end that occurs immediately before the acquisition of control. Therefore, the shares of the target corporation will be acquired in the short taxation year that the purchaser has selected ending on December 31, 2022 and the earnout feature must end no later than December 31, 2027.

Distinction between “determinable” and “payable” in IT-426R

The word “payable” is not specifically defined in the Act. The courts have generally interpreted the word payable according to its ordinary meaning as either synonymous with an amount that is due (where there is a present obligation to pay) or to describe the circumstances where there is a clear legal, though not necessarily immediate, obligation to pay an amount. (footnote 1)

As noted above, under the cost recovery method set out in paragraph 3 of IT-426R the vendor will reduce the adjusted cost base of the shares they have sold as amounts on account of the sale price become determinable. Any amounts for the sale of the shares that are in excess of the adjusted cost base will be considered a capital gain that is realized once the amounts become determinable. Paragraph 5 of IT-426R indicates:

“For the purposes of this bulletin, an amount becomes determinable once it is capable of being calculated with certainty and the taxpayer has an absolute but not necessarily immediate right to be paid. Where the sale agreement stipulates a minimum amount payable by the purchaser in any event, that amount is considered to become determinable by the vendor at the time of the sale.”

IT-426R indicates that the meaning of the term “determinable” in paragraph 5 was modified to specify that an amount be brought into account when the taxpayer has an absolute but not necessarily immediate right to be paid.

Given this context, it is considered that the reference to an amount becoming “payable” in subparagraph 2(d) of IT-426R is meant to refer to circumstances where there is a clear legal, though not necessarily immediate, obligation to pay the amount. Therefore, subparagraph 2(d) of IT-426R requires that there is a clear legal, though not necessarily immediate, obligation to pay the last contingent amount under the earnout feature no later than December 31, 2027 in order for the cost recovery method to apply.

Payment of the Last Contingent Amount

There is no requirement in subparagraph 2(d) of IT-426R setting out as to when the last contingent amount must be paid.

T. Witteveen

2022-094976

November 29, 2022

FOOTNOTES

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

1 Bank of Nova Scotia v. The Queen, [1980] C.T.C. 57 80 D.T.C. 6009, [1980] 2 F.C. 545; Timagami Financial Services Ltd. v. The Queen, [1981] C.T.C. 76 81 D.T.C. 5064, [1981] 2 F.C. 777; affd [1982] C.T.C. 314 (F.C.A.) 82 D.T.C. 6268, [1983] 1 F.C.413.

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