The following article appeared in the June, 2014, issue of the Hamilton Law Association HLA Journal.
Lawyers who must draft price adjustment clauses (“PACs”) will want to read Income Tax Folio S4-F3-C1 (the ‘Folio’), which the CRA has issued and updated recently to replace the venerable Interpretation Bulletin IT-169. The following article discusses some of the Folio’s highlights.
No Notification
IT-169 required taxpayers to notify the CRA of the existence of a PAC. Paragraph 1.5 of the Folio, which sets out the conditions for the utilization of a PAC, has been amended to remove that requirement.
The CRA Does Not Arbitrate
The Folio states that “the CRA is only concerned with the valuation of property for purposes of administering the Act and determining the tax consequences. It is neither an arbitrator nor a valuator for the parties.” The CRA likely thought it necessary to insert this statement because of Desormiers c. Lalumière,2006 QCCS 2357, or other cases like it. In Desormiers, a son purchased shares from his mother for a note. The share purchase agreement included a PAC. The CRA later took the position that the value of the shares was less than agreed between mother and son. The son (perhaps with too much alacrity) agreed with the CRA and told his mother that her note’s principal amount had been reduced under the PAC. The mother sued on the note, and the Quebec courts sided with her on the basis that a PAC existed merely to prevent double taxation.
The case is troubling because it suggests that an agreement might mean one thing between the parties and another thing when the CRA is involved. The Folio seems to reinforce that notion. One can understand the CRA’s reluctance to involve itself in disputes that might arise between parties. On the other hand, Desormiers is troubling because one of the key principles of our income tax law is that the tax consequences of a transaction are derived from its legal effects. It’s not supposed to be the other way around, and it’s not supposed to be possible for legal relationships to mean one thing in the tax world and another thing in the real world.
In some commentary I wrote on Desormiers, I pointed out that, if the son were required to pay the full amount originally agreed upon with his mother, but the CRA continued to insist that the true fair market value of the shares he purchased was much lower than the agreed amount, then the result would be double taxation for the son. The son would have paid “full price” for the shares, but his tax cost would be the lower amount determined by the CRA. Come the day when he will sell his shares, he will realize a gain in respect of amounts he previously paid for the shares with after-tax dollars.
In light of the foregoing, the question is whether the PAC typically used in reorganization agreements will avoid discrepancies of the kind illustrated by Desormiers. I’m not sure I have a good answer. At the same time, I do not wish to exaggerate the problem: PACs are almost always used in transactions where the parties are not at arm’s length and they have a common interest in avoiding tax problems. The typical PAC will likely suffice because the parties, once they will have done battle with the CRA over value, will usually be content to live with the results. That might not always be the case, however, as Desormiers shows.
Issuing or Redeeming Shares for No Consideration
Some tax advisers believe that a price cannot be adjusted through a change in the number of shares originally issued. The Folio confirms that changing the number of shares originally issued can be used to adjust the price paid:
The price adjustment may also be implemented by issuing additional shares or by cancelling issued shares without payment such that the FMV of the shares reflects the adjusted FMV of the property transferred. However, a price adjustment clause providing for the issuance of additional shares or cancellation of issued shares without payment in order to adjust the value of the consideration received carries with it a number of legal and technical difficulties that are best avoided from the perspective of both taxpayers involved and the CRA. For instance, events like the winding–up, reorganization or amalgamation of the issuer of the share might make the future exercise of the price adjustment clause difficult or impossible.
The CRA has a point, which is why the PAC I use specifies that adjusting the number of shares is just one method for effecting an adjustment. In fact, my PAC does not purport to provide an exhaustive list of the price adjustment methods. Rather, it states that the price will be adjusted by one party paying the amount of the adjustment to the other. The PAC then provides a list of methods that the parties may use to make that payment.
PACs Aren’t Just for Rollovers
Section 1.7 of the Folio reminds us that PACs are not just for rollover agreements. The section says that
where the price adjustment clause relates to the issuance of a note or property other than shares in consideration for the transfer of a property, the adjustment to the price may be implemented in a number of ways, including through a change to the principal amount of the note, the issuance of additional non–share consideration, the cancellation of the note or the return of all or part of the non–share consideration.
If Mr X purchases real property from XCo, a corporation that he controls, he will be well-advised to ensure the purchase agreement includes a PAC. If Mr X does not pay XCo enough for the property, and there is no PAC, Mr X will be required to include the difference in income under subsection 15(1) of the Income Tax Act (Canada) even if he didn’t intend to pay less than fair market value for the property. The taxpayer in Coutre v. The Queen, 2009 TCC 456, with hindsight, likely wished he had included a PAC in a purchase agreement (and that he had made a good faith effort to value the property purchased)..
Intervening Redemption of Shares
What happens if shares are issued on a rollover, subsequently redeemed and then a PAC is triggered that would have adjusted the redemption amount of the shares? A PAC will typically provide for a note to be issued by one party to the other for the difference. The CRA says that, if, as a result of a PAC, the issuer of shares pays an amount to a party that held the shares before they were redeemed, the party will be required to include the amount in income as a deemed dividend in the year of receipt.
