2009 Ruling 2009-0337651R3 - Reverse Earnout - Application of 12(1)(g)

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: Will paragraph 12(1)(g) of the Act apply to amounts received by a Canadian resident vendor, resulting from a long-term reverse earnout agreement, where the earnout agreement otherwise reflects contingent consideration in respect of the disposition of shares of a XXXXXXXXXX subsidiary? If 12(1)(g) were to apply, the provision effectively recharacterizes what would be proceeds of disposition to a full income inclusion.

Position: In the particular facts of this case, no.

Reasons: Although it is arguable that 12(1)(g) applies, in this case reliance has been placed upon the Agency's administrative position outlined in paragraph 9 of IT-462 which indicates that paragraph 12(1)(g) does not apply where the sale price of property is originally set at a maximum which is equivalent to the FMV of the property at the time of sale. A reverse earn-out results in the meeting of this condition.

XXXXXXXXXX 2009-033765

XXXXXXXXXX , 2009

Dear Sirs or Madams:

Re: XXXXXXXXXX ("Vendor")
Advance Income Tax Ruling

We are writing in reply to your letter of XXXXXXXXXX in which you requested an advance income tax ruling on behalf of the above-referenced taxpayer.

Vendor's tax affairs are administered by the XXXXXXXXXX Tax Services Office and it files its tax returns at the XXXXXXXXXX Taxation Centre under Business Number XXXXXXXXXX

To the best of your knowledge and that of the taxpayer involved, none of the issues involved with this request:

(i) is involved in an earlier return of the taxpayer or a related person;

(ii) is being considered by a tax services office or a taxation centre in connection with a tax return already filed by the taxpayer or a related person;

(iii) is under objection by the taxpayer or a related person; or

(iv) is before the courts or, if a judgement has been issued, the time limit for appeal has not expired.

The ruling given herein is based solely on the facts, proposed transactions and purposes of the proposed transactions described below. Facts and proposed transactions in the documents submitted with your request not described below do not form part of the facts and proposed transactions on which this ruling is based and any reference to these documents is provided solely for the convenience of the reader.

1 Definitions

In this letter, the following terms and definitions are used:

1.1 "ACo" means XXXXXXXXXX .;

1.2 "Act" means the Income Tax Act (Canada), R.S.C. 1985, c.1 (5th Supp.), as amended to the date hereof, and unless otherwise stated, every reference herein to a Part, section, subsection, paragraph or subparagraph is a reference to the relevant provisions of the Act;

1.3 "active business" has the meaning assigned by subsection 95(1);

1.4 "Additional Product Consideration" refers to those amounts receivable by Target from time to time for the sale of Products to a Third Party under those Product Agreements, including the CCo Agreement and the DCo Agreement, that are based on a percentage of net sales proceeds from arm's-length sales;

1.5 "adjusted cost base" has the meaning assigned by section 54;

1.6 "BCo" means XXXXXXXXXX ., and where appropriate, includes a reference to its successor, Target;

1.7 "BCo Acquisition" refers to the acquisition by Vendor in XXXXXXXXXX of all of the shares of BCo XXXXXXXXXX , with Target being the ultimate surviving corporation XXXXXXXXXX ;

1.8 "Board" refers to the Board of Directors of Vendor;

1.9 XXXXXXXXXX

1.10 "capital gain" for a taxation year from the disposition of any property has the meaning assigned by section 39;

1.11 "capital loss" for a taxation year from the disposition of any property has the meaning assigned by section 39;

1.12 "capital property" has the meaning assigned by section 54;

1.13 "CCo" means XXXXXXXXXX ;

1.14 "CCo Agreement" is a Product Agreement XXXXXXXXXX , between BCo and CCo, XXXXXXXXXX ;

1.15 "Closing" means the closing date, as specified by Vendor and Purchaser, of the purchase and sale of the Target Shares contemplated in section 3 below;

1.16 "Contract Manufacturer" is a XXXXXXXXXX company and the current primary contract manufacturer for the Products;

1.17 "controlled foreign affiliate" has the meaning assigned by subsection 95(1);

1.18 "DCo" means XXXXXXXXXX ;

1.19 "DCo Agreement" is a Product Agreement XXXXXXXXXX , between BCo and DCo;

1.20 "Excluded Assets" means those assets of Target that Vendor and Purchaser agree will not be held by Target at Closing. XXXXXXXXXX

1.21 "Excluded Liabilities" means those liabilities or obligations of Target that Vendor and Purchaser will agree that Target will be released from at Closing (and which are not anticipated to be of significant value at Closing, if any). XXXXXXXXXX

1.22 "Execution Date" means the date on which an agreement for the purchase and sale of the Target Shares is entered into by and between Vendor and Purchaser;

1.23 "foreign affiliate" has the meaning assigned by subsection 95(1);

1.24 "income from property" has the meaning assigned by subsection 95(1);

1.25 "Intercompany Notes" means those promissory notes aggregating XXXXXXXXXX in principal amount, plus accrued and unpaid interest thereon, issued by Vendor and owing to Target;

1.26 "investment business" has the meaning assigned by subsection 95(1);

1.27 "Obligation" means such portion of the Purchase Price as described in paragraph 3.3(d) below;

1.28 "Prepayment" means such amount or amounts that Purchaser or an affiliate thereof may pay Vendor in respect of the Obligation, as provided pursuant to paragraph 3.4 below;

1.29 "proceeds of disposition" has the meaning assigned by section 54;

1.30 "Product Agreement" refers to each agreement, including the CCo Agreement and the DCo Agreement, entered into between BCo or Target and a Third Party with respect to the marketing and distribution of the Products and similar or other products, as amended from time to time. Together these agreements are referred to as Product Agreements;

1.31 "Products" means XXXXXXXXXX ;

1.32 "public corporation" has the meaning assigned by subsection 89(1);

1.33 "Purchase Price" means the aggregate purchase price payable by Purchaser to Vendor in full payment for the Target Shares, as described in paragraph 3.3 below;

1.34 "Purchaser" means Contract Manufacturer or a corporation related to Contract Manufacturer;

1.35 "Quarterly Additional Product Consideration" means all Additional Product Consideration received after Closing, by Target and/or any successor or permitted assignee thereof, calculated in accordance with the terms of each of the CCo Agreement and the DCo Agreement in effect as of Closing, in respect of sales of the Products;

1.36 "Regulations" means the Income Tax Regulations;

1.37 "Reverse Earnout" refers to the mechanism by which the Purchase Price will be reduced if a pre-determined condition related to earnings or performance is not met, as described in paragraph 3.5 below;

1.38 "Surplus Assets" means such assets (including cash, certain specified cash equivalents and the Intercompany Notes) of Target, which assets will be held by Target on Closing;

1.39 "Target" means XXXXXXXXXX ., and where appropriate, includes a reference to its predecessor, BCo;

1.40 "Target IP" means the Target#1 IP and the Target#2 IP;

1.41 "Target Shares" means all of the issued and outstanding shares of common stock of Target, being XXXXXXXXXX such shares, XXXXXXXXXX ;

1.42 "Target#1 TM" is XXXXXXXXXX , the trademark name under which the Products are currently marketed by the Third Parties for the XXXXXXXXXX ;

1.43 "Target#1 IP" refers to all the intangible assets owned by Target, including copyrights/proprietary rights, trademarks, know-how/trade secrets and patents, which provide protection of the Target#1 TM Products XXXXXXXXXX in major markets and other jurisdictions throughout the world;

1.44 "Target#2 TM" means XXXXXXXXXX , a trademark name of Target's XXXXXXXXXX ;

1.45 "Target#2 IP" refers to all the intangible assets owned by Target, including copyrights/proprietary rights, trademarks, know-how/trade secrets and patents, which provide protection of the Target#2 TM XXXXXXXXXX in major markets and other jurisdictions throughout the world;

1.46 XXXXXXXXXX

1.47 "taxable Canadian corporation" has the meaning assigned by subsection 89(1);

1.48 "Third Parties" refer to the different arm's-length third parties that are non-residents of Canada, including CCo and DCo, each of which has entered into a Product Agreement with BCo or Target, as the case may be;

1.49 "Threshold Amount" refers to such amount that is the quotient obtained by XXXXXXXXXX and

1.50 "Threshold Anniversary" refers to the XXXXXXXXXX or earlier anniversary of Closing, as agreed by Purchaser and Vendor, at which time any balance of the Obligation owing by Purchaser to Vendor will no longer be payable, as provided under paragraph 3.5 below.

2 Facts

2.1 The Vendor is a company organized and existing under the laws XXXXXXXXXX Canada. XXXXXXXXXX Its fiscal year end is XXXXXXXXXX .

2.2 XXXXXXXXXX . Vendor is XXXXXXXXXX a taxable Canadian corporation.

2.3 XXXXXXXXXX

2.4 Target, organized under the laws of XXXXXXXXXX is a wholly-owned subsidiary of the Vendor. At all relevant times, it is a foreign affiliate and a controlled foreign affiliate of the Vendor. Target is a resident of the XXXXXXXXXX for purposes of the Act, the Regulations and the XXXXXXXXXX Treaty. Target's current key business assets consist of the Target IP.

2.5 The Target Shares are capital property of the Vendor, and have an adjusted cost base that is significantly greater than the Purchase Price. Target has not paid any dividends to the Vendor since the BCo Acquisition.

2.6 BCo is the predecessor of the Target. On XXXXXXXXXX , the Vendor acquired all of the shares of BCo from arm's length parties in the BCo Acquisition.

2.7 Since the incorporation of its predecessor BCo in XXXXXXXXXX under the laws of XXXXXXXXXX , the Target has been involved in XXXXXXXXXX . The Target IP was carried over from BCo to the Target through the BCo Acquisition.

2.8 Target has entered into various Product Agreements, under which Target provides specified territories to the Third Parties in respect of the distribution of the Products or similar and other products for a predetermined period.

Business Restructuring and Developments

2.9 XXXXXXXXXX

2.10 XXXXXXXXXX

2.11 XXXXXXXXXX , Target and Contract Manufacturer entered into a long-term supply agreement for XXXXXXXXXX the Products. Contract Manufacturer continues to be the contract manufacturer of the Products for Target, XXXXXXXXXX

2.12 XXXXXXXXXX

2.13 XXXXXXXXXX , the income earned under the Product Agreements and the non-product agreements referred to in such letter is not considered income from an investment business nor income from property.

3 Proposed Transaction

3.1 XXXXXXXXXX , the Vendor is in negotiations with the Purchaser for the Vendor to sell, and for the Purchaser to acquire, the Target Shares. The Vendor deals at arm's length with the Purchaser, XXXXXXXXXX . Negotiations are ongoing and while a final draft of the purchase and sale agreement is not currently available, it is anticipated that the final form of the purchase and sale agreement for the Target Shares, which will be governed by the law of XXXXXXXXXX , will include the key terms as described in paragraphs 3.2 to 3.10 below.

3.2 The Vendor and the Purchaser will agree that at Closing, the Target will not hold the Excluded Assets, nor will it be responsible for the Excluded Liabilities.

3.3 The Purchase Price will be equal to approximately XXXXXXXXXX and will consist of the following components:

(a) XXXXXXXXXX payable in cash at Closing;

(b) an amount equal to the amount of the Surplus Assets, payable at or immediately following Closing in cash, cash equivalents or a combination thereof (in Purchaser's sole discretion);

(c) XXXXXXXXXX payable in cash no later than the XXXXXXXXXX anniversary following the Closing, and

(d) XXXXXXXXXX (which is anticipated to constitute a significant percentage of the Purchase Price) payable without interest in cash, in quarterly amounts, commencing for the quarter ended XXXXXXXXXX and for each full quarter thereafter, payable no later than XXXXXXXXXX days following the last date of each quarter, with each such payment to be in an amount that is equal to XXXXXXXXXX % of the Quarterly Additional Product Consideration for such quarter.

3.4 Notwithstanding the payment terms set forth in paragraph 3.3(d) above, upon at least XXXXXXXXXX business days' written notice to the Vendor, at any time or from time to time, as applicable, the Purchaser or an affiliate thereof may pay the Vendor any or all of the balance of the Obligation not previously paid to the Vendor based on the Quarterly Additional Product Consideration pursuant to paragraph 3.3(d). XXXXXXXXXX

3.5 The Obligation will terminate upon the Threshold Anniversary to the extent not fulfilled prior to such date. In other words, the Purchase Price will be reduced by the unpaid amount of the Obligation if the cumulative amount of the Quarterly Additional Product Consideration received by the Target and/or any successor or permitted assignee thereof (XXXXXXXXXX % of which is paid or payable to the Vendor under paragraph 3.3(d) above) during the period ending on the Threshold Anniversary is less than the Threshold Amount. Any balance of the Obligation owing by the Purchaser to the Vendor on the Threshold Anniversary will no longer be payable.

3.6 From and after Closing, until the earlier of such time as payments to the Vendor in respect of the Obligation have been paid in full or on the Threshold Anniversary, the Purchaser will covenant as follows:

(a) to operate the business related to the Products in substantially the same manner as such business was conducted prior to Closing and in compliance with all applicable laws, rules and regulations;

(b) not to terminate or take such action as may cause to be terminated the CCo Agreement or the DCo Agreement;

(c) not to amend the CCo Agreement or the DCo Agreement in a manner that could reasonably be expected to adversely affect the likelihood of the payment to the Vendor of amounts in respect of the Obligation, and

(d) not to engage in any action with the intent to, directly or indirectly, adversely impact or materially delay, or which would have the effect of adversely impacting or materially delaying, the payments to the Vendor of amounts in respect of the Obligation.

3.7 The Vendor and the Purchaser will provide mutual covenants that, except as otherwise explicitly permitted, neither it nor its affiliates will, directly or indirectly through any licensee, engage in, or cause or actively assist any other person to engage in, any competitive activity, from Closing and continuing until the XXXXXXXXXX anniversary thereof.

3.8 From and after Closing, the Purchaser, and not the Vendor, will be solely responsible and liable for XXXXXXXXXX , authorizations, licenses, applications, agreements, permits and other permissions held by the Target in respect of the Products and the Target IP.

3.9 The purchase and sale agreement for the Target Shares will be binding upon and inure to the benefit of the Vendor and the Purchaser and their respective successors and assigns, provided however, that the Purchaser may not sell, transfer, assign, license, sublicense, delegate, pledge or otherwise dispose of, whether voluntarily or involuntarily, by operation of law or otherwise, such agreement or any of its rights or obligations thereunder (other than to an affiliate of the Purchaser) without the prior written consent of the Vendor, which consent may be granted, withheld or conditioned at the Vendor's sole and absolute discretion, provided further that, any permitted assignment shall preserve the Vendor's rights under such agreement.

3.10 The sale of the Target Shares from the Vendor to the Purchaser will be subject to certain closing conditions, including certain requisite filings under XXXXXXXXXX

3.11 The Purchase Price will be less than the Vendor's adjusted cost base of the Target Shares immediately before the sale of such shares to Purchaser.

3.12 For greater certainty, the Vendor warrants that the Vendor and Purchaser of Target are dealing at arm's length, and in respect of the purchase and sale of the Target Shares (the "Transaction"), neither party has "accommodated" the other party to achieve unintended Canadian tax results (and for the avoidance of doubt, "unintended Canadian tax results" is not meant to include the characterization of the total amount of the proceeds from the Transaction as capital proceeds of disposition for the purposes of computing a capital gain or capital loss for Canadian income tax purposes).

3.13 The sale of the Target Shares from the Vendor to the Purchasor will occur at fair market value.

3.14 The Vendor acquired the Target Shares as capital property, and will be disposing of them as capital property.

3.15 The Vendor will report the Purchase Price as proceeds of disposition of the Target Shares in the taxation year in which the Closing occurs. Since the proceeds of disposition are less than the adjusted cost base of the Target Shares, a capital loss will result. For its XXXXXXXXXX taxation year, the Vendor reported a taxable capital gain, XXXXXXXXXX , of approximately $XXXXXXXXXX . Aside from the approximate $XXXXXXXXXX mentioned in the foregoing, the Vendor does not currently intend to carry back the capital loss arising from the sale of the Target Shares to a taxation year preceding the taxation year in which the Closing occurs.

3.16 Except for an existing license granted by Target to Vendor in XXXXXXXXXX with respect to Target#2 IP, as referred to in paragraph 1.20, XXXXXXXXXX (which currently has a negligible value in comparison to the total Purchase Price for the Target Shares), the Vendor is not currently using the Target IP owned by Target, nor will the Vendor do so for the duration of the Reverse Earnout.

3.17 As a result of the Transaction, the Vendor will have no control over Target or the Target IP held by Target, other than ancillary contractual conditions that would be normal in a sale of property involving vendor-take-back debt (including those as described in paragraphs 3.6 and 3.9).

3.18 Purchaser is not currently and will not be using the Target IP before the Closing occurs.

3.19 To the knowledge of the Vendor, the Purchaser, XXXXXXXXXX , has agreed that it will report the Transaction as a purchase of shares for XXXXXXXXXX income tax purposes. To the knowledge of the Vendor, the Purchaser will not be claiming, for XXXXXXXXXX income tax purposes, the payments made under the Reverse Earnout as tax deductible amounts based on production or use of property, XXXXXXXXXX .

4 Purpose of the Proposed Transaction

4.1 In light of recent economic conditions and XXXXXXXXXX , Vendor and its group of affiliates have been in the process of redirecting their resources and efforts XXXXXXXXXX. Accordingly, a sale of the Target Shares by Vendor to Purchaser XXXXXXXXXX to allow Vendor and its group of companies to focus resources XXXXXXXXXX .

5 Rulings Given

Provided that the preceding statements constitute a complete and accurate disclosure of all of the relevant facts, proposed transactions and purpose of the proposed transactions, and provided that the proposed transactions are completed in the manner described above, our rulings are as follows

A. We confirm that the total amount of the Purchase Price referred to in paragraph 3.3 above will constitute proceeds of disposition of the Target Shares to the Vendor for the purposes of computing a capital gain or capital loss pursuant to subsections 39(1) and 40(1) of the Act from the disposition of the Target Shares to Purchaser for the taxation year of the Vendor in which the Closing occurs.

B. We confirm that no portion of the Purchase Price referred to in paragraph 3.3 above will be considered income pursuant to paragraph 12(1)(g) of the Act.

C. We confirm that any balance of the Obligation that will no longer be payable as described in paragraph 3.5 above as a result of the Reverse Earnout will be a capital loss of Vendor under paragraph 39(1)(b) of the Act for the taxation year of the Vendor in which such balance no longer becomes payable.

The above rulings are given subject to the general limitations and qualifications set out in Information Circular 70-6R5 dated May 17, 2002, and are binding on the Canada Revenue Agency ("CRA") provided that the proposed transactions are completed by XXXXXXXXXX .

Other Comments

Nothing in this ruling should be construed as implying that the CRA has agreed to or reviewed any tax consequences relating to the facts and proposed transactions described herein other than those specifically described in the rulings given above. In particular, nothing in this ruling should be construed as implying that the CRA has agreed to

(i) the fair market value in respect of any property mentioned in this ruling

(ii) the classification of any of the entities described in this ruling; and

(iii) the tax consequences of any reorganizations referred to in this ruling.

Yours truly,

XXXXXXXXXX
Section Manager
for Division Director
Business and Partnerships Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch