Download Tax Issues in Purchase and Sale Agreements

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
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1. Structure – Fundamental Questions
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Determine the structure of the transaction
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Fundamental questions are:
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Often developed by the client’s internal business group and investment bankers
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
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•
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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
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1. Structure - Fundamental Questions
• Historic rule of thumb – vendors prefer a share transaction and
purchasers prefer an asset transaction
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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
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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
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1. Structure – Asset vs. Share Transaction
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Why Share Transaction:
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Why Asset Transaction:
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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
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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
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Potential tax exemption for non-Canadian
vendors if shares are not Taxable Canadian
Property or are treaty-exempt
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Generally no responsibility for existing
liabilities (actual and undisclosed) of
target company
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Minimizes transaction taxes e.g., land
transfer tax, possibly provincial PST
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Purchaser acquires only the assets it
wants or needs to carry on the business
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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 3rd party consents
or customer loyalty to existing legal entity)
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Reduces uncertain tax treatment of
contingent liabilities
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2. Determination of Purchase Price
• Factors:
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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
•
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Timing of tax treatment and recognition a critical issue if contingent liabilities
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2. Determination of Purchase Price - Adjustments
• Standard Post-closing adjustments
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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
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2. Determination of Purchase Price – Adjustments
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Concern over CRA adjustments if “benefit” conferred under
non-arm’s length transactions
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Risk managed under non-arm’s length transactions by
inserting a purchase price adjustment clause into PSA
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Consider section 69 of ITA and other anti-avoidance provisions under assetrollover provisions
Such adjustments could generate a one-sided re-allocation
Price adjustment clause often ignored if non-arm’s length transaction is
preliminary to arm’s length sale
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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.”
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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
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•
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
•
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This treatment would be consistent for both the purchaser and vendor
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3. Adjustments - Contingent Liabilities/Consideration
• IFRS requires recognition of contingent consideration at fair
market value at the acquisition date
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•
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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
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3. Adjustments - Contingent Liabilities/Consideration
• US comparison
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•
•
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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
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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
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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?
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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?
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3. Adjustments - Contingent Liabilities/Consideration
• Earnouts vs. reverse earnouts
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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
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3. Adjustments - Contingent Liabilities/Consideration
• Application of Earnout clauses:
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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
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4. Purchase Price Allocation
• Starting point for asset allocation is based on Golden
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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
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•
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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
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4. Purchase Price Allocation
• Real bargaining between arm’s length parties is prima facie
proof that allocation is reasonable
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If yes, CRA should accept the allocation
• However, consider Transalta (under appeal to FCA)
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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?
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What if one of the parties is indifferent to the allocation?
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4. Purchase Price Allocation
• Purchase price allocation on an asset purchase
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•
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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
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4. Purchase Price Allocation
• Allocation of values also relevant for share transaction
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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
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5. Beyond the Boilerplate – PSA Provisions
• Definitions
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“Taxes” – Need an expansive definition
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“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
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“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?
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5. Beyond the Boilerplate – PSA Provisions
• Tax Representations
• Given public availability of information has become part of
legal boilerplate
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Tax representations have become standardized, therefore limited ability to
suggest alternative wording
• Must understand rationale for particular clauses
•
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May need to prioritize, especially if the principals to the sale of a private
company insist on a bare-bones agreement
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5. Beyond the Boilerplate – PSA Provisions
• Tax Representations - Key provisions
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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)
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5. Beyond the Boilerplate – PSA Provisions
• Signing Date vs. Closing Date vs. Effective Date
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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
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5. Beyond the Boilerplate – PSA Provisions
• Signing Date vs. Closing Date vs. Effective Date
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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
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5. Beyond the Boilerplate – PSA Provisions
• Signing Date vs. Closing Date vs. Effective Date
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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
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5. Beyond the Boilerplate – PSA Provisions
• Covenants - Preparation of tax returns
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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)
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5. Beyond the Boilerplate – PSA Provisions
• Covenants – Other Issues
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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
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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?
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•
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
•
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Settlement payment taxable under paragraph 12(1)(x) but eligible for subsection
12(2.2) election (CRA Views 2010-0371461R3)?
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6. Management of Risk under the PSA
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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?
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6. Management of Risk under the PSA
• Escrow
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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
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6. Management of Risk under the PSA
• Section 116 risks still exist despite TCP amendments
• Alternatives
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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
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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
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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!
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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
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6. Management of Risk under the PSA
• Rectification - Stone's Jewellery Ltd. v. Arora (2009 ABQB 656)
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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)
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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
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7. Post-transaction Financial Statements & Filings
• Accounting Implications – Canadian GAAP
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•
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
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7. Post-transaction Financial Statements & Filings
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•
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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
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A corporation’s retained earnings should not be affected by related party
transactions
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Result: a decrease to retained earnings was reversed in considering interest
deductibility on money borrowed to pay a dividend
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7. Post-transaction Financial Statements & Filings
• Goodwill Implications
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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
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7. Post-transaction Financial Statements & Filings
• File tax election forms as specified in PSA
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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
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