25 November 2021 CTF Roundtable Q. 1, 2021-0911841C6 - Indemnities and subsection 87(4)

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: Whether indemnities provided for representations, warranties and potential liabilities may be viewed as part of the proceeds of disposition of the shares.

Position: It's a question of fact and law. Where the representations and warranties are bona fide representations and warranties that are usually encountered in M&A transactions, the payment of indemnities to settle such representations and warranties is normally made quite some time after the transaction itself and would normally not be considered to form part of the proceeds of disposition of the property that is the subject of the M&A transaction. As such, and depending on specific facts and circumstances, such payment would normally not be viewed as proceeds of disposition of shares of a predecessor corporation in the context of a triangular amalgamation to which subsection 87(9) applies.

Reasons: see document.

2021 CTF Annual Conference
CRA Roundtable

Question 1: Indemnities and subsection 87(4)

Pursuant to subsection 87(4), shareholders of a predecessor corporation only receive rollover treatment where they receive no consideration for the disposition of those shares on the amalgamation, other than shares of the capital stock of the new corporation. In the context of certain corporate transactions, using a triangular amalgamation pursuant to subsection 87(9) is common (e.g., where a public corporation acquires the shares of a private corporation or where the target corporation has many shareholders). In these transactions, the parties may provide indemnities to one another for representations, warranties and potential liabilities that exist at the time of closing. Where such indemnities are provided, are the requirements of subsection 87(4) still satisfied?

For example, imagine an M&A transaction where a taxable Canadian corporation (“Parent”) enters into an agreement to acquire the shares of another taxable Canadian corporation (“Target”). The parties agree to carry out the transaction by way of triangular amalgamation whereby Parent creates a newly formed wholly-owned subsidiary and it proposes to amalgamate with Target pursuant to subsection 87(9). Pursuant to the agreement, each shareholder of Target would dispose of his/her/its shares of Target in exchange for a certain number of shares of Parent.

1. If the shareholders of Target provide indemnities to Parent for any representations, warranties, etc. which indemnities will be settled with a cash payment to Parent, do subsections 87(2) and 87(4) continue to apply?

2. Assume that as part of the transaction, certain of the Parent shares that were issuable to the Target shareholders as part of the transaction are instead placed in escrow during the indemnity period. If no indemnity claim arises, the shares will be released from escrow to the Target shareholders. If an indemnity claim is made by Parent, the parties agree that Parent can repurchase such shares from escrow for $1 and cancel them (note that the number of shares cancelled would have a value equal to the amount of the indemnity claim). Would the CRA ascribe the value of the indemnity claim that is satisfied as an amount “paid by the corporation” for purposes of paragraph 84(3)(a), such that a deemed dividend may arise if the amount paid is in excess of the paid up capital of such shares?

3. If Parent provides indemnities to the Target shareholders for any representations, warranties, etc. in the form of cash payment to Target shareholders, would this be consideration other than shares of Parent for purposes of subsection 87(4)?

4. If, instead, Parent provides indemnities to the Target shareholders for any representations, warranties, etc. in the form of a subsequent issuance of additional shares of Parent to Target shareholders, would this continue to be in accordance with the provisions of section 87(4)?

CRA Response

How a payment is treated from a tax point of view depends mostly on the legal nature of the payment. The main question to be asked is whether a payment to settle indemnities for representations, warranties, etc., in a M&A type of transaction can be considered as payment for the settlement of such indemnities or proceeds of disposition of shares being disposed of in such transaction. This cannot be answered here as it is a mixed question of fact and law. Where the representations and warranties are bona fide representations and warranties that are usually encountered in M&A transactions, the payment of indemnities to settle such representations and warranties is normally made quite some time after the transaction itself and would normally not be considered to form part of the proceeds of disposition of the property that is the subject of the M&A transaction. As such, and depending on specific facts and circumstances, such payment would normally not be viewed as proceeds of disposition of shares of a predecessor corporation in the context of a triangular amalgamation to which subsection 87(9) applies. The specific answers to the questions are as follows:

1. If the settlement for cash is made by the shareholders of Target to Parent, we do not see why the condition in paragraph 87(1)(a) would not be respected in this situation. Even if the cash payment was made by the corporation that results from the amalgamation (the “new corporation”) to Parent, we would presume that such payment is made quite some time after the amalgamation, once it is established whether all representations and warranties have been respected or satisfied, and, therefore, would not be made on the amalgamation or be part of the amalgamation. In that situation, we do not see how the condition in paragraph 87(1)(a) would not be met since all property of the predecessor corporations have become property of the new corporation by virtue of the amalgamation.

The question of whether Parent could benefit from the application of subsection 87(4) is only relevant where Parent owns shares of a predecessor corporation that have an ACB lower than FMV. However, as discussed above, the payment of an indemnity quite some time after the amalgamation regarding bona fide representations and warranties would normally not be considered to be consideration received for the disposition of shares of a predecessor corporation, depending on specific facts and circumstances.

2. It looks like the share consideration to be received by a shareholder of a predecessor corporation may be reduced by a repurchase by Parent of shares issued as consideration for shares of a predecessor corporation for $1 and the value of the shares repurchase would correspond to the indemnity claim made by the Parent. For example, let’s say that Parent had issued $10M of its shares to the shareholders of the Target. The indemnity claim amounts to $1M. Parent repurchases $1M worth of shares held by the Target shareholders for $1. In this situation, the reduction in value of the shares held by the Target shareholders is made as consideration for the settlement of the indemnity claim. Therefore, the amount considered to be paid for the repurchased shares under subsection 84(3) should be equal to the amount of settlement for the indemnity claim. The Target shareholders are viewed as having received $1M for the repurchase of the shares and having made a payment of $1M to Parent to settle the indemnity claim.

3. As discussed above, cash payments made by Parent to Target shareholders to settle indemnity claims would normally not be viewed as consideration received by the Target shareholders for the disposition of shares of a predecessor corporation, depending on facts and circumstances.

4. As discussed above, if Parent issues additional shares to the Target shareholders to settle indemnity claims, such shares issuance would normally not be viewed as consideration for the disposition of shares of a predecessor corporation, depending on facts and circumstances. In such situation, the value of the shares issued by Parent to the Target shareholders would represent an amount paid to such shareholders to settle the indemnity claim and taxed accordingly.

Marc Ton-That
2021-091184
November 25, 2021