8 January 2003 External T.I. 2002-0161395 - CAPITAL GAINS RESERVE

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: Whether a reserve under 40(1)(a)(iii) of the Act can be claimed where proceeds consist of trust units held in escrow and released over a 5 year period.

Position: Based on the facts provided, no.

Reasons: Generally, where proceeds consist of trust units or shares which are issued to the taxpayer but held in escrow, no portion of the proceeds can be considered payable after the end of the year.

XXXXXXXXXX 2002-016139

P. Massicotte, CA, M.Fisc.

January 8, 2003

Dear XXXXXXXXXX:

Re: Capital Gains Reserve

We are writing in reply to your letter dated September 5, 2002 wherein you enquired whether an amount can be claimed pursuant to subparagraph 40(1)(a)(iii) of the Income Tax Act (the "Act") in computing a capital gain for a taxation year in a situation as described below.

Facts

The relevant facts as we understand them are as follows:

1) A taxpayer resident in Canada (the "Vendor") sells the shares of his corporation (the "Shares") to an arm's length purchaser (the "Purchaser") for an aggregate purchase price of $XM ("Purchase Price").

2) The purchase and sale agreement ("Agreement") provides that the Purchase Price will be paid in part by cash, and the balance by the issuance of units of a mutual fund trust to the Vendor on or by the closing date.

3) The Vendor and Purchaser also agree that a portion of the units to be issued (approximately 80%) will be held by an Escrow Agent (the "Escrowed Units"), which will hold the units as security for any subsequent payment the Vendor may be required to make to the Purchaser as a result of the Vendor's liability and indemnity obligations under the Agreement.

4) The Vendor is the registered holder of all the Escrowed Units and participates in (will receive) every income distribution made by the trust while held in escrow. Moreover, the Vendor is entitled to vote in respect of the Escrowed Units at any meeting of the unitholders.

5) However, the Escrow Agent cannot release or otherwise deal with the Escrowed Units in any way, except as provided in the Agreement and the Escrow Agreement (see 7 below).

6) While in escrow, the Vendor also agrees not to grant a security interest in the Escrowed Units to any person other than the Purchaser.

7) Pursuant to the Agreement and the Escrow Agreement, a portion of the Escrowed Units is to be released annually by the Escrow Agent to the Vendor over a 5-year period. After each such release, the Vendor may deal with the released units without the above restrictions.

Your comments

Given that in the situation above the portion of the proceeds of disposition of the Shares corresponding to the value of the Escrowed Units would only be released over a five-year period, you submit that such a portion of the proceeds of disposition should be considered payable over that period and that a reserve should be allowed under subparagraph 40(1)(a)(iii) of the Act to the Vendor. Moreover, you submit that the release of the Escrowed Units over such a period is comparable to the result achieved had the Purchase Price been payable by the issuance of a promissory note providing for instalments over a five-year period with interest.

Our comments

As discussed in our previous telephone conversation (Massicotte/XXXXXXXXXX), and in our letter of September 19, 2002, pursuant to Information Circular 70-6R5, written confirmation of the tax implications arising from particular transactions is given by this Directorate only in respect of proposed transactions in the context of an advance income tax ruling request. Where the particular transactions are completed, the inquiry should be addressed to the relevant tax services office. However, we are prepared to provide you with the following general comments.

In general, subparagraph 40(1)(a)(iii) of the Act provides that a taxpayer may claim the deduction of a reasonable amount as a reserve in computing the gain for a taxation year from the disposition of any property where a portion of the proceeds of disposition of the property is payable to the taxpayer after the end of the year. The issue of whether a portion of the proceeds of disposition of a property is payable after the end of the year is a question of fact that can only be answered after a detailed examination of all the facts related to a particular situation.

The Act does not define the term "payable". However, it is defined in Black's Law Dictionary (6th Edition) as: "Capable of being paid [...]; admitting or demanding payment; [...] A sum of money is said to be payable when a person is under an obligation to pay it. Payable may therefore signify an obligation to pay at a future time ...". In the context of the disposition of property, the purchaser's obligation to pay is determined in accordance with the terms of the contract between the parties (see for example section 27 of the Sale of Goods Act of Alberta).

In our view, an amount is payable if there is a genuine obligation to pay the amount. In other words, there is an enforceable claim by a creditor representing an absolute, though not necessarily immediate, right to be paid in relation to the proceeds of disposition of the property. Such a claim may exist where the entirety of the purchase price agreed upon has not been paid or when a bill of exchange or other negotiable instrument (such as a cheque or promissory note) has been received as conditional payment and the condition on which it was received has not been fulfilled by reason of the dishonour of the instrument or otherwise (see for example sections 38 and 48 of the Sale of Goods Act of Alberta).

The word "payment" is also defined in Black's Law Dictionary (6th Edition) as: "The fulfilment of a promise, or the performance of an agreement. A discharge of an obligation or debt [...] Payment is a delivery of money or its equivalent ... by one person from whom it is due to another person to whom it is due. A discharge in money or its equivalent of an obligation or debt owing by one person to another, and is made by the debtor's delivery to creditor of money or some other valuable thing, and creditor's receipt thereof, for purpose of extinguishing debt."

It is therefore our understanding from the above that where a purchaser has delivered money or any other valuable thing representing the entire purchase price according to the terms of a contract of sale, the purchaser is discharged of its debt in relation to the purchase price and no portion would remain unpaid. The vendor would have no enforceable claim against the purchaser after that time with respect to the purchase price. For the purposes of subparagraph 40(1)(a)(iii) of the Act, no portion of the proceeds of disposition would remain payable where the vendor no longer has any enforceable claim against the purchaser in relation to the proceeds of disposition of the property.

In the situation described above, it is our opinion that the Vendor would no longer have any enforceable claim against the Purchaser in relation to the proceeds of disposition of the Shares once the Purchase Price is paid as provided in the Agreement, i.e. once the cash is paid and the units are issued to the Vendor. As a result no portion of the proceeds of disposition would be considered payable after that time (in this case, the closing date) and no reserve would be allowed under subparagraph 40(1)(a)(iii) of the Act.

You submit that the fact a portion of the proceeds of disposition provided in the Agreement is held in escrow, and the exercise of some the Vendor's rights in relation to the Escrowed Units is restricted, such as the right to dispose of the units or to grant any security interest in the units to any person other than the Purchaser, would indicate the units do not belong to the Vendor. However, these restrictions are accepted by the Vendor only for the purpose of securing the payment the Vendor may be required to make pursuant to his liability and indemnity obligations under the Agreement. In our view, such arrangements are not relevant in determining whether a portion of the proceeds of disposition remains payable after the end of the year. Moreover, they are usually not regarded as significant factors in determining beneficial ownership either (as indicated in paragraphs 15 to 18 of IT-170R).

Finally, you submit that the situation in this case should be compared to a situation where a taxpayer accepts a promissory note for all or part of the sale price of a property sold. A promissory note is an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay, on demand or at a fixed or determinable future time, a sum certain in money, to, or to the order of, a specified person, or to bearer. We understand it is a well accepted rule in law that payment by means of a negotiable instrument such as a promissory note is prima facie conditional on the instrument being honoured at maturity.

A promissory note is therefore generally accepted by the vendor in the context of the sale of property only as evidence of, or security for, the unpaid portion of the purchase price and the vendor's rights to recover the unpaid purchase price are merely suspended until such time as the maker of the note fails to honour the note. In other words, the original debt in relation to the purchase price of the property is not affected by the delivery of a promissory note, and an amount in relation to the proceeds of disposition would remain payable, unless the governing contract of sale provides specifically that the note has been accepted as absolute payment.

Where a promissory note has been accepted as absolute payment, no amount would remain payable in respect of the disposition, as the proceeds would be considered to have been paid or satisfied by the receipt of the promissory note, and therefore no reserve under subparagraph 40(1)(a)(iii) of the Act would be available. In a situation involving a promissory note, the issue is therefore whether the debt has been paid by the delivery of the note. In our view, the situation described in this letter can, at best, only be compared to a vendor accepting a promissory note as absolute payment. Notwithstanding these comments, it is well accepted that different tax consequences may flow from different transactions or legal relationships. Courts consistently support the view that legal relationships, as established by the taxpayers, must be respected and given full effect, absent a sham (see recent Supreme Court of Canada decisions in Singleton, 2001 DTC 5545; Enterprises Ludco Ltd, 2001 DTC 5518; Shell Canada, 99 DTC 5669, and Continental Bank Leasing Corp., 98 DTC 6505). As a result, recharacterization can only be permitted if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect, which is not the case according to the facts described above.

We trust these comments will be of assistance to you.

Yours truly,

Milled Azzi, CA
For Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch