25 November 1998 External T.I. 9802305 - POST CLOSING ADJUSTMENT

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 Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues: whether certain post closing adjustment payments are deductible under section 42

Position: depends on the terms and conditions of the relevant agreement

Reasons: normal rules of interpretations

XXXXXXXXXX 980230
F. Francis
Attention: XXXXXXXXXX

November 25, 1998

Dear Sirs:

This is in reply to your letter of January 28, 1998, wherein you requested our comments with respect to the tax treatment of certain payments made by a vendor to a purchaser pursuant to a share sale agreement.

You advise that, in arm’s-length transactions involving the purchase and sale of all of the shares of a corporation, the value and status of the subject corporation’s assets and liabilities are usually material elements and the subject matter of numerous provisions of the agreement of purchase and sale. In some circumstances, the purchase price of the shares is wholly or partially based on the value of specified assets and/or liabilities of the subject corporation and provision is made for upward and/or downward adjustments to the price where actual values cannot be determined with precision prior to the closing of the transaction. Where the relevant date for determination of the values or amounts of the assets and/or liabilities is on or about the closing date, the agreement of purchase and sale will generally set out a procedure to be implemented following the closing for establishing these amounts or values and for any consequential adjustment payments to be made. Once a final determination has been reached that the assets and/or liabilities exceed or fall short of the parameters set out in the agreement of purchase and sale, the vendor of the shares will be entitled to receive a payment from the purchaser or will be obligated to make a payment to the purchaser. Where this occurs in the same taxation year of the vendor in which the shares are sold, the vendor will likely report its gain or loss in respect of the shares factoring in the results of the adjustment.

You request our opinion with respect to the proper tax treatment where such payments are made by the vendor in a taxation year subsequent to the year in which the shares were sold. You ask us to assume that the vendor is a resident of Canada, that the shares of the subject corporation are held by the vendor as capital property, and that the vendor and the purchaser deal with each other at arm’s length.

It is your view that, although the agreement of purchase and sale may treat the payment as an adjustment to the purchase price of the shares, the appropriate treatment would be to allow the vendor to report a separate capital loss in the year in which the amount is established. In this regard you opine that section 42 of the Income Tax Act (the “Act”) would appear to be applicable to any payment made by the vendor to the purchaser, in that such payment would relate to “conditional or contingent obligations given or incurred by the taxpayer in respect of the disposition of shares.”

Our Comments

Section 42 of the Act is applicable with respect to any outlay or expense made by a taxpayer pursuant to or by reason of a warranty, covenant or other conditional or contingent obligation given or incurred by the taxpayer in respect of a disposition of capital property. The issue as to whether an outlay or expense is made pursuant to or by reason of such an obligation would depend on the legal substance of a particular agreement. The determination of legal substance is a question of fact, where one must consider all the facts and circumstances, including any contracts, to determine the legal rights and obligations arising from a particular transaction. Where section 42 of the Act is applicable, any outlay or expense made or incurred by a taxpayer in satisfaction of such an obligation is deemed to be a capital loss from the disposition of capital property for the taxation year in which such outlay or expense is made or incurred.

In any other situation, the tax consequences of any outlay will depend on the terms and conditions of the particular agreement. The Department’s views on the sale of property are contained in Interpretation Bulletin IT-170R. As stated therein, when the words in the definition of “disposition” are read in conjunction with the definition of “proceeds of disposition” in section 54 of the Act, it is evident that the date of disposition of capital property sold occurs at the time that the vendor is “entitled to --- the sale price.” Further, it is the Department’s view that the sale price of any property sold is brought into account for income tax purposes when the vendor has an absolute but not necessarily immediate right to be paid. Where the selling price of property is based on the production or use of the property, paragraph 12(1)(g) may be applicable.

The Department’s views on the tax consequences of shares sold subject to an earnout agreement are contained in Interpretation Bulletin IT-426. Where the conditions outlined in paragraph 1 are met, the Department permits the use of the cost recovery method of reporting the gain or loss on the sale of shares under an earnout agreement.

In summary, the determination of the tax consequences of amounts paid subsequent to the sale of shares, whether as an adjustment to proceeds of disposition, an outlay subject to section 42 of the Act or a non-deductible capital outlay, cannot be made without an examination of the pertinent agreements and facts.

The above comments are an expression of opinion only. As noted in Information Circular 70-6R3, issued on December 30, 1996, they are not binding on the Department.

Yours truly,

for Director
Reorganizations and International Division
Income Tax Rulings and
Interpretation Directorate
Policy and Legislation Branch