CRA rules on using a combination of a dirty s. 85 reorg, the s. 7 rules and the IT-426R earnout (cost-recovery) rules for an employee incentive buyout transaction

The (corporate) shareholders of Holdco (a Canadian-controlled private corporation) wish to accommodate the purchase of shares of the Holdco for an operating subsidiary (Opco) by an Opco key employee on an earnout basis and with the key employee’s purchase being governed by the s. 7 rules. (This cannot be accommodated by issuing treasury shares of Holdco or Opco to the key employee on an earnout basis as the governing Business Corporations Act requires that shares be fully-paid on issuance.) Under the ruled-upon transactions:

1. The Holdco shareholders transfer a portion of their Holdco common shares on a s. 85(1) rollover basis to Opco in consideration for tracking preferred shares of Opco;
2. The key employee immediately purchases those Holdco common shares from Opco in consideration for five annual instalments, with each annual instalment based on the most recent year’s earnings (plus, in the case of the first instalment, the opening shareholders’ equity), with adjustments to the purchase price on any IPO or business acquisition; and
3. Each instalment payment is immediately dividended by Opco to the Holdco shareholders on the tracking preferred shares.

Re 2, CRA rules that the cost-recovery method in IT-426R was to be used by Opco.

Re 3, s. 55(2) deemed the tracking dividends to be capital gains to the holders of the tracking preferred shares.

There’s more. Before the implementation of the above transactions, Holdco and Opco adopted a policy of dividending out all of their operating earnings – but deferred paying any of these dividends until the rulings were granted. CRA ruled that the dividend determination time for the “Second Annual Dividends” (i.e., dividends payable based on the annual income for the Opco taxation year ending after the sale of the Holdco common shares by Opco to the key employee) is the time immediately before their payment rather than the time immediately before the payment of the previous dividends, so that the safe-income exception in s. 55(2.1)(c) could access the more recent earnings.

Neal Armstrong. Summaries of 2015 Ruling 2015-0589471R3 under s. 12(1)(g), s. 55(1) – safe income determination time and s. 85(1).