24 May 2012 External T.I. 2011-0429991E5 - Price Adjustment Clause

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.

Principal Issues: 1) Does a price adjustment clause provided in the statutes of a corporation or in a purchase and sale agreement expire for the purposes of subsection 152(4)? 2) In the event where the valuation method used is not fair and reasonable, would that make the PAC non-operating for purposes of the Act and therefore prohibit the CRA from adjusting the redemption value of the preferred shares? 3) In the case where a bona fide error was made when evaluating the common shares of the capital stock of a corporation which is discovered many years later, will the value of the preferred shares of the capital stock of the corporation be automatically adjusted up to their FMV?

Position: 1), 2) and 3): General comments provided.

Reasons: Question of fact.

XXXXXXXXXX
							2011-042999
							J. Lafrenière
							(613) 941-2956
May 24, 2012

Dear Sir:

Re: Price Adjustment Clause

This is in reply to your emails dated December 1st and 2nd, 2011 in which you requested our comments on the application of a price adjustment clause (hereinafter “PAC”) in a particular situation (hereinafter the “Particular Situation”).

Unless otherwise stated, every reference herein to a part, section, subsection, paragraph or subparagraph is a reference to the relevant provision of the Income Tax Act (hereinafter the “Act”).

Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of a request for an advance income tax ruling submitted in the manner set out in Information Circular 70-6R5, Advance Income Tax Rulings, dated May 17, 2002. The Particular Situation outlined in your emails appears to be a factual one, involving specific taxpayers and completed transactions. We are, however, prepared to provide the following general comments.

Particular Situation

You describe the following situation. Mr. A (hereinafter the “Taxpayer”) owns all of the issued and outstanding common shares (hereinafter the “Old Common Shares”) of the capital stock of a corporation (hereinafter “OPCO”). In Year-1, the Taxpayer exchanges his Old Common Shares for preferred shares (hereinafter the “Freeze Shares”) of the capital stock of OPCO in the course of a reorganization of the capital of OPCO under section 86 (hereinafter the “Estate Freeze”). The Estate Freeze is made in favour of the Taxpayer’s child (hereinafter the “Related Person”).

Among the rights and privileges attached to the Freeze Shares, there is a PAC. Moreover, a PAC is also provided in the purchase and sale agreement governing the exchange of the Old Common Shares for the Freeze Shares.

After the death of the Taxpayer in Year-16, his estate requests a clearance certificate under subsection 159(2). As part of the process, the Canada Revenue Agency (hereinafter the “CRA”) is of the opinion that, when the Estate Freeze was implemented in Year-1, the Old Common Shares were valued below their fair market value (hereinafter “FMV”) and consequently the redemption value of the Freeze Shares was undervalued.

Your questions

1) Does a PAC included in the statutes of a corporation or in a purchase and sale agreement expire for the purposes of subsection 152(4)? More particularly, can the CRA challenge in Year-16 the redemption value of the Freeze Shares issued in Year-1 and adjust the value upward in Year-16, fifteen years after the Estate Freeze, for the purposes of subsection 70(5)?

2) The CRA will generally recognize an agreement and its PAC if: “The agreement reflects a bona fide intention of the parties to transfer the property at fair market value and arrives at that value for the purposes of the agreement by a fair and reasonable method” (footnote 1) . If the method used in the Particular Situation was not “fair and reasonable” – would that make the PAC non-operating for purposes of the Act, and therefore prohibit the CRA from adjusting the redemption value of the preferred shares?

3) In the case where a bona fide error was made when evaluating the common shares of the capital stock of OPCO (e.g. the evaluator forgot to take into account the FMV of an asset of OPCO), will the value of the preferred shares of the capital stock of OPCO be automatically adjusted upward to their FMV?

Our comments

It is a question of fact whether in a particular situation a PAC, either included in the rights, privileges, conditions and restrictions of a particular class of shares of a particular corporation or in a purchase and sale agreement would meet the conditions set out in IT-169. Also, the determination of whether the method used by the parties to determine FMV is “fair and reasonable” will depend on the circumstances of each case.

Valid PAC

If a PAC is recognized by the CRA as being valid, it is our position that its application would generally have a retroactive effect back to the moment of the transaction to which the PAC is applicable.

In this regard, reference can be made to the Gurberg (footnote 2) case. In this particular case, a taxpayer was involved in an estate freeze in 1988 whereby he acquired preferred shares of the capital stock of a corporation in exchange for all his common shares of the capital stock of that corporation. The common shares of the capital stock of the corporation exchanged, had been subject to an evaluation report as at June 30, 1988 which provided for a FMV of $7.9M. However, the estate freeze was implemented on December 31, 1988 based on the June 30’s evaluation.

The taxpayer died on August 13, 1991 and the taxpayer’s wife died on January 27, 1992. The preferred shares of the capital stock of the corporation were deemed to have been disposed of by the estate of the taxpayer on January 27, 1992 at their FMV. It had been established by Revenue Canada that as at the date at which the taxpayer implemented the estate freeze (i.e. December 31, 1988) the FMV of the common shares of the capital stock of the corporation to be exchanged for preferred shares of the capital stock of the said corporation was $9.7M instead of $7.9M. Consequently the redemption value of the preferred shares was undervalued by $1.8M. On December 1st, 1993, Revenue Canada reassessed the 1992 taxation year of the estate of the taxpayer, based on a deemed proceeds of disposition of $9.7M. Subsequently, on March 17, 1994, the Ministère du Revenu du Québec (hereinafter “MRQ”) reassessed the estate of the taxpayer on the same basis.

The estate of the taxpayer was of the view that the PAC had no retroactive effect and the FMV of the preferred shares could not be modified since the year in which the freeze was undertaken was statute-barred. On the other hand, the MRQ was of the view that the FMV of the preferred shares of the capital stock of the corporation was already adjusted to its true FMV because of the retroactive effect of the PAC.

The PAC, as provided in the rights, privileges, conditions and restrictions of the preferred shares stated that the FMV would be subject to revision in accordance with any binding agreement with, or decision by, the appropriate taxation authorities, or any judgment of a court of competent jurisdiction. Because a binding agreement was reached with Revenue Canada, the Court was of the view that the PAC was also applicable for the MRQ’s reassessment with retroactive effect to the date of issuance of those shares on December 31, 1988 (footnote 3) .

No Valid PAC

Our Directorate is of the view that generally if there is a significant discrepancy between the FMV established by the CRA and the one established by a taxpayer with respect to a particular property, it may indicate that the taxpayer did not make a real effort to determine the FMV of the property, then the PAC would not be valid (see for example, the Guilder News Co. (1963) Limited et al. (footnote 4) and the Daniel Wagner et al. (footnote 5) cases).

Particular Situation

In the Particular Situation, if the PAC is valid the consequences would be the following:

1) By virtue of the PAC, the FMV of the Freeze Shares would be adjusted retroactively to Year-1.

2) Paragraph 152(4)(a) and subsection 86(2) would not be applicable.

3) Under subsection 70(5) the deemed proceeds of disposition received by the Taxpayer for the Freeze Shares immediately before his death in Year-16 (and their cost for the Taxpayer’s estate) would be equal to their FMV as adjusted by the PAC.

However, in the Particular Situation described above, if the PAC is not valid, in our view, the consequences would be the following:

1) There would be no adjustment to the FMV of the Freeze Shares back in Year-1.

2) It could be argued that using an unfair and unreasonable valuation method with respect to the valuation of the Freeze Shares could be considered for the purposes of the application of subparagraph 152(4)(a)(i) as a misrepresentation attributable to neglect, carelessness or wilful default, thus allowing the CRA to make a reassessment in Year-1 in order to apply subsection 86(2) to the Taxpayer.

In that regard, it could be argued that it would be reasonable to regard any portion of the excess between the FMV of the Old Common Shares and the redemption value of the Freeze Shares at the time of the Estate Freeze (hereinafter the “Excess”) as a benefit that the Taxpayer desired to have conferred on the Related Person for the application of subsection 86(2).

3) Furthermore, the Excess surrendered by the Taxpayer would consequently increase the FMV of the “new” common shares of the capital stock of OPCO subscribed by the Related Person in favour of whom the Estate Freeze was implemented by the Taxpayer. Thus when the Related Person would sell the “new” common shares of the capital of OPCO, the Related Person would probably be taxable on the Excess.

4) Finally, when the Related Person would subsequently sell the “new” common shares of the capital stock of OPCO and realize a capital gain on the sale of those shares, paragraph 110.6(7)(b) could apply to deny any capital gains deduction claimed by the Related Person under section 110.6. Indeed the CRA could consider the disposition of the “new” common shares of the capital stock of OPCO held by the Related Person as being part of a series of transactions or events in which the Old Common Shares were acquired by OPCO for consideration that was significantly less than their FMV at the time of acquisition.

We trust the above comments will be of assistance.

Yours truly,

Maurice Bisson, CGA
Section Manager
Corporate Reorganization Section IV
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

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

1 IT-169 – Price Adjustment Clauses, August 6, 1974 (hereinafter “IT-169”), at par. 1.
2 Gurberg v. Québec (S.M.R.Q.), [2006] R.D.F.Q. 36 (Qc.C.A.).
3 Idem, at paragraphs 30 and 31.
4 Guilder News Co (1963) Limited et al. v. The Queen, 73 DTC 5048 (F.C.A.).
5 Daniel Wagner et al. v. The Queen, 2001 DTC 5674 (F.C.A.).