5 March 2003 External T.I. 2002-0142745 - Transaction Costs - Aborted Share Sale

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: Tax treatment of transaction costs incurred by Target and shareholder in respect of aborted share sale

Position: Question of fact whether deductible by Target; not deductible by shareholder

Reasons: The law

XXXXXXXXXX 2002-014274
Gwen Watson
March 5, 2003

Dear XXXXXXXXXX:

Re: Transaction Costs - Aborted Share Sale

This is in reply to your letter of May 27, 2002, wherein you requested our views regarding the tax treatment, under the Income Tax Act (Canada) (the "Act"), of certain fees incurred in connection with an aborted sale of shares.

In your hypothetical scenario, an individual, A, owns 50.01% of the common shares and 100% of the preferred shares of Target, a Canadian-controlled private corporation. Bidder, a competitor of Target, expressed interest in purchasing the business of Target, and it was eventually agreed that A would sell A's shares of Target to Bidder. In connection with the sale of shares, A incurred legal and accounting fees for:

1. due diligence with respect to Bidder;

2. due diligence with respect to Target, for the purposes of providing Bidder with documented evidence regarding Target's business;

3. a valuation;

4. negotiating the purchase price;

5. advice to A regarding the sale of shares; and

6. drafting the purchase and sale agreement.

Ultimately, the sale of shares did not occur.

In your view, Target could reimburse A for at least a portion of the expenses listed in paragraphs 1 to 4 above and then deduct these expenses in computing its business income in accordance with the reasoning in The Queen v. Boulangerie St-Augustin Inc., 97 DTC 5012 (FCA). In particular, you believe that the foregoing fees would be deductible by Target because they would be incurred in complying with the directors' general fiduciary responsibilities to the shareholders and Target (for example, to carry out proper due diligence and protect shareholder value), and further, that these duties are analogous to the ones imposed on the directors of a public corporation to prepare an information circular, as illustrated in Boulangerie.

With respect to the fees incurred by A (i.e. those that do not relate to the directors' fiduciary responsibilities and which are not reimbursed by Target, in particular the fees referred to in paragraphs 5 and 6 above), you note that these fees would not be immediately deductible by A under subparagraph 40(1)(a)(i) because A did not dispose of the Target shares. In the alternative, you have asked whether A could:

1. deduct the fees under subparagraph 40(1)(a)(i) in the taxation year when A eventually disposes of the Target shares to, say, a third party other than Bidder;

2. treat the fees as a capital loss in the taxation year in which these fees are incurred; or

3. add the fees to the adjusted cost base of the Target shares owned by A.

In the event that none of these options are applicable, you have asked whether the Canada Customs and Revenue Agency (the "CCRA") would be willing to recommend to the Department of Finance that the Act be amended to account for such fees.

The particular situation outlined in your letter appears to relate to a factual one, involving a specific taxpayer. As explained in Information Circular 70-6R5, it is not this Directorate's practice to comment on proposed transactions involving specific taxpayers other than in the form of an Advance Income Tax Ruling. Should your situation involve a specific taxpayer and a completed transaction, you should submit all relevant facts and documentation to the appropriate Tax Services Office for their views. We are, however, prepared to offer the following general comments.

Our Comments

Deductibility by Target

As indicated in paragraph 10 of Interpretation Bulletin IT-99R5 Legal and Accounting Fees, consolidated in December 2000, the deductibility of transaction costs, including:

(a) fees for legal, accounting and other consultants relating to the structuring of the transactions;

(b) the cost of negotiating contracts; and

(c) the cost of obtaining letters patent, supplementary letters patent, amendments to them, etc;

is dependent on the nature of the underlying transactions (as income or capital) and the applicability of the provisions of paragraphs 18(1)(a), 18(1)(b), 20(1)(e), or 20(1)(cc), or the definition of "eligible capital expenditure" in subsection 14(5), as the case may be.

In Boulangerie, the Court found that expenses incurred by the target corporation to prepare directors' circulars in compliance with the target corporation's obligations under the Quebec Securities Act were properly deductible under subsection 9(1), and were not precluded by paragraphs 18(1)(a) or (b). The findings in Boulangerie were based in part on the decision in British Columbia Power Corporation v. MNR, 67 DTC 5258 (SCC), where the Court stated (at page 5264):

The ultimate control in law of a limited company rests with its shareholders and it is they who have the legal power to determine its policy. This power cannot be properly exercised unless the shareholders are informed periodically with respect to the company's affairs. A public company incorporated under the Companies Act, R.S.C. 1952, c. 53, is required, by Section 121, to furnish its shareholders with copies of its balance sheet, statement of income and expenditure and statement of surplus prior to its annual meeting.

In my opinion, the reasonable furnishing of information from time to time to shareholders by a company respecting its affairs is properly part of the carrying on of the company's business of earning income and a corporate taxpayer should be entitled to deduct the reasonable expense involved as an expense of doing business.

The CCRA commented on the impact of the Boulangerie case in the context of the deductibility of take-over bid costs in technical interpretation 2001-0105605:

The Agency's current view is that expenses incurred to meet the target's obligations imposed under a Securities Act and/or Business Corporations Act in producing circulars for shareholders concerning take-over bids would generally be deductible under subsection 9(1) of the Act, provided these expenses are reasonable. These expenses would normally include legal and accounting fees, costs of obtaining fairness opinions (valuation reports), and printing and mailing costs.

Therefore, generally speaking, the CCRA is of the view that costs incurred by a target corporation for the purpose of preparing directors' circulars will generally be deductible because these expenses are incurred pursuant to the statutory duties imposed on the target corporation to furnish information to its shareholders, relating to its affairs, so that the shareholders can make an informed decision.

While the expenses outlined in paragraphs 1 to 4 above may have been incurred by Target (via the reimbursement to A) to comply with the directors' fiduciary duties, we do not agree that these duties are analogous to the statutory duty to provide directors' circulars because the expenses in question do not relate to furnishing information to shareholders, as described in the preceding paragraph. Accordingly, we do not agree with you that these expenses would be deductible under the principles expressed in Boulangerie. Rather, the expenses will only be deductible if they satisfy the requirements set out in the Act, including those in subsection 9(1), paragraphs 18(1)(a) and (b) and section 67 (and as further detailed in Interpretation Bulletin IT-99R5) and ultimately, this is a question of fact that can only be determined by a review of all the circumstances.

We also comment on the application of subparagraph 20(1)(e)(i), relating to the deduction of expenses of issuing or selling shares, in light of the recent decision of International Colin Energy Corporation v. The Queen, 2002 DTC 2185 (TCC). The issue in this case was whether the taxpayer was entitled to deduct fees paid to its financial advisor in the course of a take-over of the taxpayer by way a plan of arrangement under the Alberta Business Corporations Act. Regarding the application of paragraph 20(1)(e), in dicta, the Court stated that a "sale" in subparagraph 20(1)(e)(i) could only "...refer to a sale by the shareholders in the course of a corporate transaction of the type involved here where the interests of the corporation are affected." Ultimately, however, the Court declined to conclude on this point.

We do not agree with the Court's interpretation of subparagraph 20(1)(e)(i). In our view, there are other possible interpretations of the word "sale". For instance, a sale in subparagraph 20(1)(e)(i) could mean a sale of the shares by an underwriter to the public, after the particular corporation has issued such shares to the underwriter. Accordingly, the CCRA would not generally regard the expenses incurred by Target in your hypothetical scenario as being deductible under paragraph 20(1)(e).

As a final point, we note that a shareholder benefit may arise under subsection 15(1) if Target reimburses A for expenses that were incurred primarily for the benefit of A.

Tax Treatment to A

Pursuant to subparagraph 40(1)(a)(i), a taxpayer may, in computing the gain from the disposition of property, subtract from the proceeds of disposition the amount of any outlays or expenses, to the extent that these expenses were made or incurred by the taxpayer for the purpose of making the disposition. In paragraph 14 of Interpretation Bulletin IT-99R5, the CCRA acknowledges that legal and accounting fees may constitute expenses of disposition for the purposes of subsection 40(1). In response to your first question, however, it is our view that the expenses incurred by A would not be deductible in computing the gain on the eventual disposition of the Target shares to the third party because the purpose test in subparagraph 40(1)(a)(i) would not be satisfied at that time. For instance, in Avis Immobilien G.M.B.H. v. The Queen, 94 DTC 1039 (TCC) (affirmed in 97 DTC 5002 (FCA)), the Court stated that the purpose test in subparagraph 40(1)(a)(i) was "directed to the action of making a particular disposition" and means "for the immediate or initial purpose of" and not the eventual or final goal that the taxpayer may have in mind.

With respect to your second question, subparagraph 40(1)(b)(i) generally provides that a taxpayer's loss from the disposition of property is the amount, if any, by which the total of the adjusted cost base of the property and any outlays or expenses to the extent they were made or incurred for the purpose of making the disposition, exceed the taxpayer's proceeds of disposition of the property. Because A has not disposed of any property at the time when the expenses are incurred, the expenses themselves cannot result in a loss under subparagraph 40(1)(b)(i).

Lastly, the "adjusted cost base" of non-depreciable property is defined in section 54 and subsection 248(1) to be the cost to the taxpayer, as adjusted in accordance with section 53. The term "cost" is not defined in the Act, but rather is to be determined under common law principles (see for instance The Queen v. Stirling, 85 DTC 5199 (FCA) and Bodrug Estate v. The Queen, 91 DTC 5621 (FCA)). In our opinion, the expenses incurred by A would not form part of the adjusted cost base of the Target shares, either under common law principles or by virtue of the provisions of subsection 53(1).

In summary, the expenses incurred by A in respect of the aborted share sale appear to be "nothings" for the purposes of the Act. Your tax policy concern with this result, and a possible amendment to the Act, are the responsibility of the Department of Finance. Should you wish to pursue your concerns further, we suggest that you contact the Tax Policy Branch of the Department of Finance directly by writing to L'Esplanade Laurier, 140 O'Connor Street, Ottawa, Ontario, K1A 0G5.

We trust our comments will be of assistance to you. These comments are provided in accordance with the practice outlined in paragraph 22 of Information Circular 70-6R5, and are not binding on the CCRA.

Yours truly,

Mark Symes
Section Manager
for Division Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Legislation Branch