4432002 Canada – Tax Court of Canada finds that a sale agreement did not have a reverse earn-out so that s. 12(1)(g) applied

The taxpayer and another company sold their rights to software for lump-sum payments plus additional payments (labeled in the sale agreement as “Earn-Out Payments”) calculated as a declining percentage of the software sales made by the purchaser (“MITT”) over the following three years, except that the total payments (to both vendors) were capped at US$8 million. The agreement was later re-negotiated, after some of the payments had been made, to cancel the remaining lump-sum payments and provide that MITT was to pay US$1.734 million to the taxpayer as a prepayment of the remaining Earn-Out Payments (but without any obligation of the taxpayer to repay this amount), so that the taxpayer would be entitled to receive further Earn-Out Payments if this level was exceeded (which, in fact, occurred) - and the cap was reduced to US$7.6 million.

St-Hilaire J confirmed the CRA view that all of the sales-based payment were includible in the taxpayer’s income pursuant to s. 12(1)(g) rather than being governed by the eligible capital amount rules. In rejecting the taxpayer’s principal argument that the purchase price cap established that such payments were received pursuant to a “reverse earnout” arrangement, St-Hilaire J stated:

This is not … a situation where the sale agreement provided that MITT will pay the maximum amount, a portion of which may have to be repaid if certain financial targets are not met. … Rather, what one finds … are clauses providing for the payment of lump sums and the payment of additional amounts based on sales of the Software. … [T]he sales agreements … are clearly "earnout" agreements. …

[T]here is nothing in the wording of paragraph 14(1)(b) to suggest that it should be accorded precedence over paragraph 12(1)(g).

The fact of an additional Earn-Out Payment being made over and above the US$1.734 million prepayment helped to confirm that the prepayment also was an amount based on the software sales.

The taxpayer had been reassessed for Part III tax on the basis that there had been no resulting additions to its capital dividend account. Three months after these reassessments, it made elections pursuant to s. 184(3) and requested that the elections be held in suspense until its appeal was settled. St-Hilaire J stated:

I find that the appellant's subsection 184(3) elections are valid. These elections result in the excess dividends being treated as taxable dividends, resulting in the permitted avoidance of Part III tax.

Neal Armstrong. Summaries of 4432002 Canada Inc. v. The Queen, 2022 CCI 101 under s. 12(1)(g) and s. 184(3).