Tax Issues in Purchase and Sale Agreements Jean-Philippe Couture, Borden Ladner Gervais LLP Charles Taylor, Deloitte & Touche LLP Calgary Young Practitioners Group Tax Issues in Purchase and Sale Agreements (PSA) Agenda 1. Structure 2. Determination of Purchase Price 3. Contingent Liabilities and Contingent Consideration 4. Purchase Price Allocation 5. Beyond the Boilerplate PSA Provisions 6. Management of Risk under the PSA 7. Post-transaction Financial Statements and Filings 2 Calgary Young Practitioners Group
1. Structure Fundamental Questions Determine the structure of the transaction Often developed by the client s internal business group and investment bankers Fundamental questions are: Assets vs. shares what is subject matter of transaction Purchase price Risk to be assumed by each of vendor and purchaser Each issue must be documented Overriding requirement is acceptance by client and that understood by all professional advisors Get tax advice before PSA terms are circulated to the parties, to ensure proper drafting of intended sale structure and proceeds thereto 3 Calgary Young Practitioners Group 1. Structure - Fundamental Questions Historic rule of thumb vendors prefer a share transaction and purchasers prefer an asset transaction Share sale imposes due diligence burden and requires extensive tax representations in PSA Affected by tax jurisprudence recent tax litigation has focused on asset purchase agreements Structure also affected by the characteristics of vendor and purchaser Is an asset acquisition feasible? Difficult to enforce indemnity clauses on vendors who are public company shareholders or on private equity Purchaser characteristics are less constraining as an acquisition vehicle may be established to suit needs 4 Calgary Young Practitioners Group
1. Structure Asset vs. Share Transaction Why Share Transaction: Why Asset Transaction: For vendor, offers better tax integration and a potential deferral of immediate taxation e.g., safe income election or capital gains exemption for QSBC shares Potential tax exemption for non-canadian vendors if shares are not Taxable Canadian Property or are treaty-exempt Minimizes transaction taxes e.g., land transfer tax, possibly provincial PST Key non-tax factor Share transaction may be only viable transaction structure (e.g., public company target, or if problematic to transfer key assets due to 3 rd party consents or customer loyalty to existing legal entity) Reduces uncertain tax treatment of contingent liabilities Full tax basis in acquired assets (including goodwill) results in higher base for future deductions (or for future disposition), but forgoes access to vendor s tax loss carryforwards and other tax pools. However, a tax shield calculation could be the solution to bridge the tax leakage between a share and asset transaction Generally no responsibility for existing liabilities (actual and undisclosed) of target company Purchaser acquires only the assets it wants or needs to carry on the business 5 Calgary Young Practitioners Group 2. Determination of Purchase Price Factors: Cash vs. Share Consideration Present Payments vs. Future Payments Price Adjustments Determinable but not yet known e.g., working capital Risk shifting for contingent amounts Hold backs Cost of property acquired should be amount specified under PSA (Teleglobe) Liabilities assumed become proceeds to vendor and cost base of asset to the purchaser Timing of tax treatment and recognition a critical issue if contingent liabilities 6 Calgary Young Practitioners Group
2. Determination of Purchase Price - Adjustments Standard Post-closing adjustments Focus is to true-up value of estimated items (e.g. working capital, outstanding tax liabilities, tax shield) to actual amounts on Closing Date Identity of vendor will affect feasibility and structure of adjustment provisions e.g., public company shareholders, vendor on brink of insolvency, private equity From a drafting perspective, the adjustment mechanics must: 1. Specify a clear accounting methodology and consistent application, i.e., not just choice of GAAP/IFRS but must also reflect vendor s past accounting practices 2. Determine how adjustment to be settled e.g., use of escrow funds, other? 3. Future income taxes should not usually be a relevant factor for a price adjustment clause 7 Calgary Young Practitioners Group 2. Determination of Purchase Price Adjustments Concern over CRA adjustments if benefit conferred under non-arm s length transactions Consider section 69 of ITA and other anti-avoidance provisions under assetrollover provisions Such adjustments could generate a one-sided re-allocation Risk managed under non-arm s length transactions by inserting a purchase price adjustment clause into PSA Price adjustment clause often ignored if non-arm s length transaction is preliminary to arm s length sale 8 Calgary Young Practitioners Group
2. Determination of Purchase Price Adjustments From a drafting perspective, the purchase price adjustment clause must be: 1. Effective as of the date of the original transaction 2. Identify how consideration to be adjusted (e.g. deemed to be a non-interest bearing loan, etc.) 3. A price adjustment clause should be broad and not limited to being triggered only if the CRA makes a determination of FMV: Clause should also reference a proposed tax assessment Would address comments made in Garron decision The articles of incorporation.. contain a provision that would have adjusted the redemption value of the Freeze Shares upon a determination by a taxing authority or a court that the fair market value of the Freeze Shares was some amount other than $50 million, but that clause was never in play because no such determination was made. 9 Calgary Young Practitioners Group 3. Adjustments - Contingent Liabilities/Consideration Where part of a business combination, IFRS requires all assets and liabilities be recorded at fair value at the acquisition date by the purchaser, contingent liabilities are estimated and recorded regardless of probability of being incurred For example, a $100 million lawsuit with a 5% chance under Canadian GAAP would not have been recorded for accounting purposes, IFRS requires a contingent liability to be recorded at fair value by the purchaser However, the vendor may not have recorded the contingent liabilities Formerly, under Canadian GAAP, assets and liabilities were also recorded at fair value at the acquisition date, however contingent liabilities are generally only recorded when they are probable and measureable This treatment would be consistent for both the purchaser and vendor 10 Calgary Young Practitioners Group
3. Adjustments - Contingent Liabilities/Consideration IFRS requires recognition of contingent consideration at fair market value at the acquisition date If settled with cash, recorded as a liability which is subsequently re-valued each reporting period with mark to market adjustments recognized through the income statement. If settled with shares, equity classification may be appropriate and no mark to market adjustments are required Counter-intuitive post-close results, e.g., income recognition where earnout targets are not met To avoid the mark to market adjustment, consideration given to structuring earnouts (as explained on following slides) as equity or eliminating altogether Contingent consideration was generally not recognized under Canadian GAAP until contingency was resolved and payment became due 11 Calgary Young Practitioners Group 3. Adjustments - Contingent Liabilities/Consideration US comparison On a winding up or reorganization, acquiring corporation steps into the shoes of the distributing corporation with respect to obligations which give rise of liabilities later [IRC Sec. 381(c)(16)] Acquiring substantially all the properties of a corporation solely in exchange for stock is not tainted by the assumption of liabilities [IRC Sec 368(1)(C)] Reduces the likelihood of tax disputes arising from having to value that which cannot readily be measured 12 Calgary Young Practitioners Group
3. Adjustments - Contingent Liabilities/Consideration Application of Daishowa (FCA) CRA: Included estimate of reforestation liabilities in Daishowa s proceeds FCA: The ascribed value of a contingent liability to be included in the vendor's proceeds For one of transactions at issue, parties had ascribed a value to the assumption of reforestation liabilities even if not recorded as part of proceeds Irrelevant whether the amount was an accurate estimate of the ultimate reforestation costs or was a contingent liability - this was the agreed amount No offsetting deduction for vendor Can the assets and obligations be considered as severable? 13 Calgary Young Practitioners Group 3. Adjustments - Contingent Liabilities/Consideration Drafting considerations for Contingent Liabilities in PSA: 1. Consider whether contingent liabilities are to be assumed by purchaser 2. If parties do not ascribe a value to the contingent liabilities, suggestion from Daishowa (FCA) is that the court will not seek to impute a value Is it better to allocate to contingent liability the minimum reasonable value? 3. If vendor wishes to minimize the purchase consideration it is deemed to receives, consider eliminating an expansive listing of business liabilities Implications for Financial Statement and CRA audits? 4. Should specific liabilities be allocated to specific assets? 5. Parameters of Solicitor - Client privilege Would solicitor-client privilege avoid CRA scrutiny of parties negotiating positions? Contrast with accountants planning memos presented in Daishowa? 14 Calgary Young Practitioners Group
3. Adjustments - Contingent Liabilities/Consideration Earnouts vs. reverse earnouts Portion of proceeds determined by reference to future earnings generated from underlying assets Reverse earnout attractive to vendor if it can benefit from a capital gains reserve for unpaid proceeds Proposed subsection 143.4 may apply to a reverse earnout where there is a contingent amount, which may reduce the cost of the property to the purchaser when initially recorded 15 Calgary Young Practitioners Group 3. Adjustments - Contingent Liabilities/Consideration Application of Earnout clauses: If the proceeds consist of shares or trust units issued to vendor but held in escrow account, a reserve under subsection 40(1) is not available (CRA Views 2002-0161395) Consideration paid by way of the earnout will not taint a section 88 bump if the earnout is solely a mechanism to value the business (CRA Views 1999-0010965 and 2007-0243261C6) Vendor cannot claim a reserve on the unpaid purchase price of the reverse earnout attributable to a sale of goodwill, unless election under subsection 14(1.01) has previously been made No debt forgiveness should apply to the purchaser if it does not pay all of the reverse earnout 16 Calgary Young Practitioners Group
4. Purchase Price Allocation Starting point for asset allocation is based on Golden Court determined that taxpayer's allocation between land and building was reasonable: the figure agreed upon by the parties in an arm s length transaction that is not a sham must govern. Limited re-allocation provisions under the ITA Key section is section 68: will permit a reallocation of consideration inappropriately allocated between assets, services and restrictive covenant Section 68 (unlike section 69) applies to both arm s length and non-arm s length transactions 17 Calgary Young Practitioners Group 4. Purchase Price Allocation Real bargaining between arm s length parties is prima facie proof that allocation is reasonable If yes, CRA should accept the allocation However, consider Transalta (under appeal to FCA) CRA: Section 68 of ITA applies to reallocate Transalta s proceeds, nil to goodwill and all to hard assets TCC: No real bargaining between parties and re-allocated goodwill down to upper limits of what was a reasonable range End of range that was closest to bona fide agreement What does hard bargaining actually mean? What evidence is required for arm s length allocation? What if one of the parties is indifferent to the allocation? 18 Calgary Young Practitioners Group
4. Purchase Price Allocation Purchase price allocation on an asset purchase Purchaser may want to allocate consideration to depreciable assets with highest tax depreciation rates, vendor would want to allocate consideration to nondepreciable capital assets PSA should explicitly state the allocation in a schedule Include a covenant that all income tax filings will be prepared by the purchaser and vendor in accordance with the allocation For accounting purposes, the allocation may be different determined by relative fair value estimates, which may not be consistent with the allocation in the agreement 19 Calgary Young Practitioners Group 4. Purchase Price Allocation Allocation of values also relevant for share transaction No hard bargaining between parties in terms of allocation The allocation of value will determine whether any write-downs will be required on an acquisition of control by subsections 111(4), 111(5.1) or 111(5.2) on capital property, depreciable property or cumulative eligible capital Value allocated among the legal entities acquired will be a factor in determining whether a bump is available or how much debt may be pushed down IFRS requires allocation of purchase price on a relative fair value basis with the difference being recorded as either goodwill or negative goodwill. Negative goodwill is recognized through the income statement under IFRS, e.g., a good deal would result in an income pick up, whereas Canadian GAAP would have resulted in a decrease to the value of the acquired assets 20 Calgary Young Practitioners Group
5. Beyond the Boilerplate PSA Provisions Definitions Taxes Need an expansive definition Tax Returns Broader than just corporate tax returns Representation should apply to all returns and schedules that have been filed (e.g. information returns), and not be limited only to returns required to be filed Should represent that all tax returns are correct and complete in all material respects, except as disclosed in schedule to disclose all known errors and exposures Financial Statements Determine whether basis of presentation to be specified as GAAP or IFRS No material change since issue date. What does material mean? Are all cash taxes owing recorded as current tax payable on balance sheet? 21 Calgary Young Practitioners Group 5. Beyond the Boilerplate PSA Provisions Tax Representations Given public availability of information has become part of legal boilerplate Tax representations have become standardized, therefore limited ability to suggest alternative wording Must understand rationale for particular clauses May need to prioritize, especially if the principals to the sale of a private company insist on a bare-bones agreement 22 Calgary Young Practitioners Group
5. Beyond the Boilerplate PSA Provisions Tax Representations - Key provisions Tax pools and attributes consider the need for an explicit rep. of the amount (e.g. quantum of tax losses or UCC balances), rather than the representation that the tax returns are correct and complete Financial statements consistently prepared in accordance with GAAP (IFRS) No unpaid taxes, except taxes not yet due or currently under objection All withholding taxes and source deductions (including stock options) paid on a timely basis How to verify that holder of option was eligible for 110(1)(d) deduction? GRIP/LRIP considerations, balances, pre-closing steps and Part III.1 tax All transactions were conducted on an arm s length basis (transfer pricing) 23 Calgary Young Practitioners Group 5. Beyond the Boilerplate PSA Provisions Signing Date vs. Closing Date vs. Effective Date If gap between signing and closing, paragraph 251(5)(b) could cause the company to lose its CCPC status during the interim period and generate a deemed year-end under subsection 249(3.1) Control deemed to occur at the commencement of the day, not the actual time of acquisition Amendment to deeming rule now provides that it does not apply for purposes of determining whether a corporation is an SBC or CCPC This amendment overrides La Survivance case However, may still elect for acquisition to occur at a particular time subsection 256(9) election 24 Calgary Young Practitioners Group
5. Beyond the Boilerplate PSA Provisions Signing Date vs. Closing Date vs. Effective Date Where shares are issued as purchase consideration, IFRS requires the purchase price to include the FMV of the shares at the closing date, whereas Canadian GAAP valued the shares at the date of transaction announcement As a result, any movement in the share price after the announcement of the transaction impacts the purchase price and if favourable increases goodwill The use of caps and floors may limit volatility in share deals or cash may be used in lieu of shares as purchase consideration Financial statement implications, such as the potential for future goodwill impairment, which could reduce earnings 25 Calgary Young Practitioners Group 5. Beyond the Boilerplate PSA Provisions Signing Date vs. Closing Date vs. Effective Date Drafting Considerations If wish to pursue subsection 256(9) election, may need to define both Closing Date and Closing Time in PSA Since the actual acquisition of control may not happen at the commencement of the day, the definition of pre-closing taxes should explicitly include pre-closing transactions implemented on the Closing Date If an Effective Date sale, the PSA will require extensive drafting to allocate both the earnings generated during the interim period, ability for vendor to claim discretionary deductions (e.g. CCA) during interim period, and responsibility for taxes Usually drafted as a purchase price reduction, unless purchaser can access all cash retained in specific bank accounts maintained by vendor or target 26 Calgary Young Practitioners Group
5. Beyond the Boilerplate PSA Provisions Covenants - Preparation of tax returns Typical requirement is that all reasonable tax deductions be claimed for AoC return and that no filing positions be adopted that are inconsistent with prior tax filings Overriding requirement is that all returns be prepared in accordance with applicable law, even if conflicts with prior filing positions Issue is often over shifting deductions from pre-acquisition period to post acquisition period or vice versa Allocation of responsibility - vendor has prior knowledge of the company, but purchasers are reluctant to cede responsibility since it must certify the tax return as being true, correct and complete and it will be responsible for paying the taxes (absent a successful indemnity claim) 27 Calgary Young Practitioners Group 5. Beyond the Boilerplate PSA Provisions Covenants Other Issues Pay all taxes arising up to and including closing date Consider implications of late filed elections Covenant that purchaser will not take any action post-closing to jeopardize vendor s pre-closing tax positions Stated capital consider purchaser s request for pre-closing reduction to accommodate post-closing reorganizations 28 Calgary Young Practitioners Group
6. Management of Risk under the PSA Threshold amount for tax indemnification? Once threshold reached, will indemnity compensate for gross amount of tax payable or is payment reduced by PV of future tax deductions? Difficult to quantify value of future tax deductions May be trade-off between high threshold and no PV reduction for tax deductions Are all indemnity payments (not just for tax reassessments) grossed up to reflect incremental taxes payable on receipt of the indemnity payment Settlement payment taxable under paragraph 12(1)(x) but eligible for subsection 12(2.2) election (CRA Views 2010-0371461R3)? 29 Calgary Young Practitioners Group 6. Management of Risk under the PSA Drafting considerations for indemnification clauses: 1. Which party controls the tax audit process for pre-closing tax periods? 2. Can the vendor contest all tax reassessment for pre-closing periods, or is it limited to specific issues or a minimum amount of taxes? 3. Does the indemnity provision include reimbursement for the cost of professional advisors? 30 Calgary Young Practitioners Group
6. Management of Risk under the PSA Escrow Usually escrow term is relatively short, unless indemnity claim has been filed What investments are permitted for escrow fund? Consider no risk investment vs. conservative investment with slightly higher interest rate (e.g., commercial paper) Typical for the vendor to be entitled to all investment earnings If vendor is non-resident and escrow earnings are interest, then should design escrow terms to avoid the imposition of Canadian withholding tax Poorly drafted escrow arrangements could result in escrow fund being subject to annual taxation as if it were a trust with taxation at highest individual rates 31 Calgary Young Practitioners Group 6. Management of Risk under the PSA Section 116 risks still exist despite TCP amendments Alternatives Indemnity provision Can it be relied upon without sufficient hold back? If escrow used, will escrow period match likely CRA assessment period? Full withholding risk free to purchaser, but affects vendor s cash flow Notice provisions under subsection 116(5.02) is it a realistic compromise? Agreed upon alternative must be drafted into PSA Application of section 116 applies to all subsequent purchase price adjustments e.g., working capital adjustments 32 Calgary Young Practitioners Group
6. Management of Risk under the PSA Rectification Is it a tool for fixing simple mistakes, or can it be used for more substantial changes to the transaction? Traditional Approach An equitable remedy to restore parties to a bargain that accords with their original intention Traditionally, applied as a method to correct transcription errors. Courts refused to rewrite the bargain between parties Self help draft the PSA appropriately! 33 Calgary Young Practitioners Group 6. Management of Risk under the PSA Rectification - Post-Juliar (Income Tax Technical News No. 22) 1. CRA will normally accept rectification orders, especially when CRA has been given an opportunity to contest the order 2. In the absence of a valid rectification order, CRA must assess on the basis of existing documents 3. CRA is concerned about retroactive or revised tax planning in connection with aggressive tax plans, not honest errors 4. CRA must be satisfied of the evidence of the original intention. CRA will not accept a rectification order based on a non-original intention 34 Calgary Young Practitioners Group
6. Management of Risk under the PSA Rectification - Stone's Jewellery Ltd. v. Arora (2009 ABQB 656) Court allowed two land transactions that resulted in unintended substantial income tax liability to be rescinded Court found that, although the applicants asked for rectification, what they were really asking for was to undo the relevant land transfers Court went through the common law remedy of mistake (fundamental errors going to the root of the contract) and the equitable remedies of rescission (something less than fundamental errors but unjust not to correct the error) and rectification For both land transactions, there were fundamental errors because of the intention to have them occur on a tax-free basis Significant case rectification is not the only remedy Consider more recent decision S&D International Group Inc. v. Canada (2011 ABQB 230) 35 Calgary Young Practitioners Group 6. Management of Risk under the PSA Rectification Waiting for SCC hearing on Services Environnementaux AES Inc. (case affecting Agence du Revenu du Québec) The threshold for obtaining rectification is high there must be evidence of an original and continuing intention to achieve the tax result Rectification has been expanded to include situations in which the agreement does exactly what the parties intended but the parties chose the wrong mechanism to achieve their tax intention Courts are now willing to make substantial changes to transactions to help taxpayers achieve their tax intention 36 Calgary Young Practitioners Group
7. Post-transaction Financial Statements & Filings Accounting Implications Canadian GAAP Push down accounting may be applied, which requires the fair value adjustments of acquired assets be reflected in financial statements of the acquired entities, generally with an offset to retained earnings or contributed surplus Results in an increase to future tax liabilities (where accounting basis would increase to FMV) but tax basis does not change Accounting Implications IFRS No push down accounting under IFRS (U.S. GAAP requires push down accounting in certain circumstances), but amalgamation gives a similar result Consider impact of retained earnings on thin capitalization 37 Calgary Young Practitioners Group 7. Post-transaction Financial Statements & Filings Impact on Retained Earnings CRA Views 2007-0232081I7 Push down adjustments change historical cost of assets and liabilities to FMV and the offset is generally to retained earnings or contributed surplus Provided push down accounting is applied under Canadian GAAP, adjusted retained earnings and contributed surplus balances are relevant for thin capitalization purposes However, Canadian GAAP financial statements should not reflect push down accounting entries of a US parent where there is no change in actual control of the Canadian subsidiary (e.g., where control of the US parent was acquired) Consider Retained Earnings CRA Views 2009-0348551l7 A corporation s retained earnings should not be affected by related party transactions Result: a decrease to retained earnings was reversed in considering interest deductibility on money borrowed to pay a dividend 38 Calgary Young Practitioners Group
7. Post-transaction Financial Statements & Filings Goodwill Implications Where an asset purchase, tax deductible goodwill may result, therefore, deferred taxes will arise on the difference between 75% of the accounting basis and tax basis If share transaction, no tax deductible goodwill, no deferred taxes result. Goodwill is not amortized for Canadian GAAP, U.S. GAAP or IFRS, a writedown is required only where the goodwill is impaired A higher allocation of proceeds to goodwill may be beneficial for accounting purposes, since future earnings will be higher as a result of no amortization (as compared to depreciable assets) However, for tax purposes only 75% is deductible at 7% declining balance per year, compared to higher CCA rate classes EPS Impact higher future earnings, provided no goodwill impairment recorded 39 Calgary Young Practitioners Group 7. Post-transaction Financial Statements & Filings File tax election forms as specified in PSA Subsection 85(1) (and 97(2)) asset transfers. Usually vendor will want to control process and determine elected amount, if purpose is to defer taxes Section 22 election accounts receivable Subsection 20(24) election undertaking future obligations Private company election Easy to forget that public company status could be maintained even if stock exchange listing is forfeited Non-compete election (section 56.4) Important for total consideration under PSA to remain unchanged even if re-allocation particular item 40 Calgary Young Practitioners Group