11 January 2013 External T.I. 2012-0436771E5 - Sale of a business

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) Would the repayment of Aco's debt and the associated early repayment penalty be considered a reduction in the proceeds received for the purposes of calculating the Shareholder's capital gain on the transaction?
2) In which period can the remainder of the unamortized financing fees be claimed?
3) Are the penalties related to the early retirement of the debt deductible in Aco and if so, in which tax year (on the closing date or subsequent to closing)?
4) How does the fact that the long term debt of Aco is being settled by Shareholder affect the deductibility of the penalties associated with the early debt retirement with the early debt retirement?
5) Since the Shareholder is paying the debt personally, without a corresponding amount payable by Aco to Shareholder, is this debt repayment considered income in Aco in the period subsequent to closing?

Position: 1) Yes. 2) A prorated portion in the DYE taxation year. Balance amortized over future periods pursuant to subparagraph 20(1)(e)(iii) of the Act. 3) No. 4) Not deductible by Aco. 5) No. The Forgiveness of debt rules in section 80 do not apply.

Reasons: Question of fact. Legislation

XXXXXXXXXX 2012-043677
John Parker CMA
Attention: XXXXXXXXXX

January 11, 2013

Dear XXXXXXXXXX:

Re: Sale of a business

We are writing in response to your enquiry of February 14th 2012, wherein you asked our opinion on the treatment of certain transactions related to the sale of a business. You have provided us with the following facts of a hypothetical situation:

1) The shareholder owns 100% of Aco, a small business corporation.

2) Bco is a taxable Canadian corporation owned by a foreign parent.

3) The shareholder has entered into a Purchase/Sale Agreement (the "PSA") whereby he would sell 100% of the outstanding shares of Aco to Bco.

4) Aco has a $2,000 bank loan payable to a Canadian chartered bank. The financing agreement related to this debt imposes certain penalties and fees related to the early repayment of the debt.

5) Aco incurred $50 of financing fees related to the long-term debt when the loan was initially acquired. These financing fees are being amortized over 5 years pursuant to paragraph 20(1)(e) of the Income Tax Act (the "Act") and a balance of $30 will remain unamortized as of the closing date.

6) The PSA stipulates that the shareholder is to receive $5,000 as proceeds of sale upon closing. However, the PSA also states that the shareholder is responsible to settle certain outstanding debts of Aco which will require the shareholder to repay the $2,000 bank loan. Upon closing, the shareholder's lawyer will receive $5,000 as the proceeds of the sale. The lawyer will immediately repay the Aco bank loan of $2,000 to the Canadian chartered bank and the early repayment penalty of $200. The shareholder will receive the remaining proceeds.

Your Questions

You asked our opinion regarding the following questions which relate to the above hypothetical scenario.

1) Would the repayment of Aco debt and the associated early repayment penalty be considered a reduction in the proceeds received for the purposes of calculating the shareholder's capital gain on the transaction?

2) Since the debt is repaid in full upon closing, and Aco is deemed to have a taxation year end immediately prior to closing (the "DYE"), in which period can the remainder of the unamortized financing fees be claimed?

3) Are the penalties related to the early retirement of the debt deductible in Aco? If so, in which tax year?

4) How does the fact that the long term debt of Aco is being settled by the shareholder affect the deductibility of the penalties associated with the early debt retirement?

5) Since the shareholder is paying the debt personally, without a corresponding amount payable by Aco to the shareholder, is this debt repayment considered income in Aco in the period subsequent to closing?

Our Comments

Written confirmations of the tax implications inherent in particular transactions are provided by this Directorate where the transactions are proposed and are the subject matter of an advance income tax ruling submitted in the manner set out in Information Circular 70-6R5, "Advance Income Tax Ruling", dated May 17, 2002. This Information Circular and other CRA publications can be accessed on the internet at http://www.cra-arc.gc.ca/formspubs/menu-e.html. Where a particular transaction has already been completed, a review of the relevant facts and circumstances surrounding the situation would be required. Such review would normally be conducted by the applicable Tax Services Office during the course of an income tax audit which, if undertaken, would be carried out after the particular taxpayer has prepared and filed its income tax return for the year. Nonetheless, we are prepared to offer the following general comments relating to the hypothetical situation.

Relevant Sections of the Act

Paragraph 249(4)(a) of the Income Tax Act (the "Act") states:

"Where at any time control of a corporation (other than a corporation that is a foreign affiliate of a taxpayer resident in Canada and that did not carry on a business in Canada at any time in its last taxation year beginning before that time) is acquired by a person or group of persons, for the purposes of this Act,

• (a) subject to paragraph (c), the taxation year of the corporation that would, but for this paragraph, have included that time shall be deemed to have ended immediately before that time;"

Therefore, Aco will have a deemed year end immediately before the time at which control of Aco is acquired by Bco. Subsection 256(9) of the Act provides that, unless a corporation otherwise elects (in its income tax return for the year ending immediately before the acquisition of control), control is deemed to have been acquired at the beginning of the particular day in question.

Subparagraph 40(1)(a)(i) of the Act states:

"Except as otherwise expressly provided in this Part

• (a) a taxpayer's gain for a taxation year from the disposition of any property is the amount, if any, by which
• (i) if the property was disposed of in the year, the amount, if any, by which the taxpayer's proceeds of disposition exceed the total of the adjusted cost base to the taxpayer of the property immediately before the disposition and any outlays and expenses to the extent that they were made or incurred by the taxpayer for the purpose of making the disposition, …"

Question 1

In regard to "Question 1", the PSA specifies that the shareholder will receive, on the closing date, proceeds of disposition of $5,000. The PSA also requires that from his proceeds, the shareholder must repay an outstanding bank loan of $2,000. In addition, there is an early repayment penalty of $200 to be paid by the shareholder, on closing, to the bank. The loan repayment of $2,000 as well as the $200 penalty should be deducted from the proceeds of disposition when determining the shareholder's capital gain pursuant to subparagraph 40(1)(a)(i) of the Act. These amounts can be considered to be "outlays and expenses…. made or incurred by the taxpayer for the purpose of making the disposition".

There is support for this position in past opinion letters issued from Income Tax Rulings as well as support in jurisprudence. In the decision, Fradet v. The Queen, 83 DTC 5445 (FCTD) affirmed in HMQ v. Bertrand Fradet and Jean-Paul Demers (FCA), 86 DTC 6411, the issue was whether or not an amount paid to retire certain debts of a corporation, whose shares were being sold, was deductible from the proceeds of disposition of the shares to the vendor shareholders. The parties had agreed that part of the selling price received from the buyer would be used by the vendors to retire the debt obligations. The court allowed the taxpayers' appeal finding that the deduction of the repayment of the loans was an outlay or expense to the extent that it was made or incurred by the taxpayers for the purpose of making the disposition under subparagraph 40(1)(a)(i) of the Act. The Court found that the agreement, properly construed, provided that the taxpayers would use part of the sale price to pay the debt owing to the company.

Interpretation Bulletin IT-104R3 entitled "Deductibility of Fines or Penalties" paragraph 5 states: "If a fine or penalty (e.g., a mortgage prepayment penalty) is incurred in connection with the disposition of a capital property, the cost of the fine or penalty is taken into account under subsection 40(1) for the purposes of calculating any gain or loss on that disposition."

Question 2

Paragraph 20(1)(e) of the Act provides that a taxpayer can deduct an amount for financing expenses that are incurred in the course of borrowing money used by the taxpayer for the purpose of earning income from a business or non-exempt income from property. These expenses are normally only deductible in equal portions (20% per year) over a five year period beginning with the year in which the expenses were incurred. If there is a short taxation year, the otherwise deductible portion is subject to a pro-rata adjustment. In your example, there is $30 of unamortized financing expenses at the closing date.

Therefore, a portion of the unamortized financing fees would be deductible in the DYE prorated pursuant to the formula contained in subparagraph 20(1)(e)(iii) of the Act. That is, $50 multiplied by 20% multiplied by the number of days in the taxation year divided by 365 days. The remaining unamortized balance would be deductible in future periods by Aco also pursuant to the formula in subparagraph 20(1)(e)(iii) of the Act.

Question 3

The early repayment penalty is not deductible by Aco as this amount was paid by the former shareholder on closing as a condition of the sale. As explained above, $200 would be an outlay made by the shareholder for the purpose of making the disposition of the Aco shares and would be deductible from his proceeds of disposition when determining his capital gain under subparagraph 40(1)(a)(i) of the Act.

Question 4

If Aco paid the early repayment penalty directly, instead of by the shareholder, then the amount of the penalty, generally, would be deductible under subsection 18(9.1) of the Act, over what would have been the remaining term of the obligation.

Question 5

Section 80 of the Act applies when a commercial obligation of a debtor, with the exception of an excluded obligation, is settled or extinguished for an amount less than the principal amount of debt. The terms "settled" and "extinguished" are not defined in the Act. However, paragraph 6 of Interpretation Bulletin IT-293R, "Debtor's Gain on Settlement of Debt" states that:

"For a debt or obligation to be "settled or extinguished" all liability for payment must be terminated. Payment, cancellation, set-off, substitution of debtors and release are examples of some possible means of settlement. A debt or obligation is not settled where a creditor abandons his right to enforce payment or becomes statute-barred from enforcing his right to payment."

When a "commercial obligation" as defined in section 80 of the Act is settled or extinguished, subsections 80(3) through 80(12) of the Act apply in sequential order to reduce tax attributes of the debtor, such as non-capital losses and capital loss carry forwards and the cost of certain properties, to the extent of the "forgiven amount" of the obligation. If there is a remaining unapplied forgiven amount after the application of subsections 80(3) through 80(12) of the Act, one-half of the unapplied forgiven amount is included in the debtor's income under subsection 80(13) of the Act.

The definition of "forgiven amount" found in subsection 80(1) of the Act states:

"forgiven amount" at any time in respect of a commercial obligation issued by a debtor is the amount determined by the formula

A - B

where

A is the lesser of the amount for which the obligation was issued and the principal amount of the obligation, and

B is the total of

• (a) the amount, if any, paid at that time in satisfaction of the principal amount of the obligation,"

In your hypothetical situation, "A" in the above formula would be $2,000 which is the outstanding principal of the bank loan and "B" would be the amount paid by the shareholder on closing in satisfaction of the principal which is also $2000. Therefore, since A – B is equal to zero there is no "forgiven amount" and as a result the forgiveness of debt rules in section 80 of the Act would not apply to Aco. Consequently, there would be no income inclusion in Aco in the period subsequent to closing.

We trust our comments will be of assistance.

Doug Watson
for Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch