29 October 2013 External T.I. 2013-0507881E5 - 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: Preferred shares are issued to a taxpayer in consideration for property. The redemption value of those shares would be equal to the fair market value of the property acquired by the corporation. Pursuant to a price adjustment clause contained in the articles of incorporation, the redemption value of the preferred shares would be adjusted to reflect the fair market value of the consideration if the amount considered to be the fair market value is changed. If the preferred shares are redeemed before an upward adjustment to the redemption value is made, the corporation would pay an additional amount to the taxpayer. If the price adjustment clause meets the requirements to be considered valid by the CRA,
1. In which year would the additional payment be included in income?
2. Would there be any penalty on income tax resulting from the application of the price adjustment clause?
3. Would there be any interest on income tax resulting from the application of the price adjustment clause?

Position: 1. In the year of the receipt of the additional payment.
2. There would be no penalty for false statement or omission and if the tax return is produced within the deadline provided for in the Act, there would be no late-filing penalty.
3. If the tax return is produced within the deadline provided for in the Act and if the instalments were paid during the year as provided for in the Act, there would be no interest with respect to the tax on the additional payment.

Reasons: 1. Previous position.
2. Wording of the Act. If the CRA recognizes the validity of the price adjustment clause, it means that the taxpayers have made a real effort to determine the fair market value and that such determination was performed in good faith.
3. Wording of the Act.

XXXXXXXXXX
2013-050788
Sylvie Labarre, CPA, CA

October 29, 2013

Dear Sir:

Re:  Price Adjustment Clause

This is in reply to your letter of October 8, 2013 in which you requested our opinion with respect to the tax consequences arising from the application of a valid price adjustment clause in the scenario described below.

Hypothetical scenario

In year 1, there is an issuance in favour of a taxpayer of preferred shares of the capital stock of Opco with a redemption value equal to the fair market value ("FMV") of the property given by the taxpayer in consideration for the issuance of those shares. The FMV and redemption value of the shares are determined by the parties at the time of the issuance of the said shares. The preferred shares are subject to a price adjustment clause contained in the articles of incorporation whereby the redemption value of the shares issued will be changed if the FMV of the property given in consideration for the shares is determined by the Canada Revenue Agency (the "CRA") to be different from the one established at the time of the transaction (or an additional amount will be paid if the change is upward and the preferred shares issued are redeemed before the determination by the CRA).

In year 5, Opco redeems all the preferred shares of its capital stock that were issued in Year 1 to the taxpayer.

In year 7, the CRA determines that the FMV of the property and the redemption value of the preferred shares should have been higher than the FMV determined by the parties.

Pursuant to the price adjustment clause, the taxpayer receives an additional payment from Opco in year 8.

The CRA considers that the parties meet the requirements set out in Income Tax Folio S4-F3-C1, Price Adjustment Clauses, to recognize the price adjustment clause as being valid.

Questions

1. When would the taxpayer have to include the additional payment as income?

2. With the application of a valid price adjustment clause, would there be any penalty on the taxpayer and/or corporation?

3. With the application of a valid price adjustment clause, would there be any interest owed by the taxpayer and/or the corporation (assuming that the additional tax is paid in a timely manner)?

Our comments

This technical interpretation provides general comments about the provisions of the Income Tax Act (the "Act") and related legislation. It does not confirm the income tax treatment of a particular situation but is intended to assist you in making that determination. The income tax treatment of transactions will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R5, Advance Income Tax Rulings.

If the preferred shares are redeemed before an upward adjustment to the redemption value is made by the CRA, if the price adjustment clause contained in the articles is valid and if an additional payment is made to the taxpayer with respect to the adjustment in a subsequent year (after the redemption of the shares), CRA's longstanding position is that the additional payment will be treated as a dividend that will be included in the taxpayer's income in the year of receipt under subsection 84(3) of the Act.

Such a conclusion was reached using the textual, contextual and purposive ("TCP") approach of interpretation. As the additional payment relates to the redemption of the shares, we believe that, under the TCP approach, the additional payment should be governed by subsection 84(3) of the Act and taxed as a dividend. The following reasons were mentioned in support of this conclusion in Question 4.6 of the Federal Taxation Round Table at the 1998 APFF Congress:

a) The payment results from a right relating to a share.

b) The payment is made by reason of a redemption of shares referred to in subsection 84(3) of the Act; it is accessory to such a redemption.

c) Treating the payment as a capital payment would change the nature of the payment otherwise made and of the income otherwise realized.

d) This position promotes uniform treatment of shareholders and corporations in respect of the application of subsection 84(3) of the Act.

However, as the additional payment is not determined at the time of the redemption of the shares, we believe that it should not be included in the income of the taxpayer in the year of the redemption as part of the amount paid under subsection 84(3) of the Act. In such a case, the CRA will not adjust retroactively the redemption value of the shares redeemed. Rather, the CRA has taken the position to tax the additional payment pursuant to the general rules with respect to the dividends, that is, to tax such amount at the time it is received.

With respect to the penalties, paragraph 1.5 of the Income Tax Folio S4-F3-C1, Price Adjustment Clauses provides the requirements governing the recognition of a price adjustment clause. When the CRA recognizes a price adjustment clause, it means that the taxpayer has made a real effort to determine the FMV and that the determination of the FMV was performed in good faith. In such a case, there would not be any penalty with respect to a false statement or omission. Furthermore, if the tax return is produced within the deadline in the year of receipt of the additional payment by the taxpayer, there would be no late-filing penalty.

With respect to the interest, if the shares were redeemed before the application of the price adjustment clause and the dividend is added to the income of the taxpayer in the taxation year in which the taxpayer receives the additional payment, there would be no interest with respect to the income tax computed on that additional amount if the income tax is paid in a timely manner pursuant to the Act and if any instalment computed under the Act with respect to the income tax for the year of the receipt was remitted on time.

We trust that our comments will be of assistance to you.

Yours truly,

Stéphane Prud'Homme, LL.B, M. Fisc.
for Division Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch