The following article will appear in the next edition of the HLA Journal.
Almost every tax-driven reorganization requires the lawyer implementing it to draft a price adjustment clause (a “PAC”). Most lawyers will have their favourite precedent for such a clause, but a lawyer needs to understand the nature and purpose of PACs—and how the CRA interprets them—so that he or she can use them appropriately in the context of any given set of transactions. This article does not purport to be a complete review of the theory and practice of PACs; it is more like a collection of notes on some of the more important features of a PAC precedent.
Why PACs?
In general, a tax-driven reorganization is effected as between parties dealing with each other not at arm’s length for tax purposes. Why, then, do we need PACs? If Father is implementing a freeze for the benefit of his children, and the CRA later takes the position that the value attributed to Father’s common shares for the purposes of the freeze is too low, the children might very well agree to increase the redemption amount of his freeze shares even without a pre-existing PAC. The CRA, on the other hand, might take the position that, if the corporation increases the value of Father’s shares without a PAC, it will confer a benefit on Father that should be included in his income under section 15 of the Income Tax Act (Canada) (the “Act”).
Nevertheless, given that the parties to a PAC are often dealing not at arm’s length, does the PAC really need to go on and on in describing how the adjustments between the parties are to be made? The tax group at one large Toronto law firm believes that the PAC need not be lengthy, and its precedent contains only a few short sentences. The clause simply states that the parties agree to adjust the consideration given for the property that is the subject of the PAC if it is later determined that the property’s value was other than originally agreed. The clause then states that the parties agree that one side will pay the difference to the other as necessary “nunc pro tunc”. That’s it!
Interestingly enough, however, some professionals are uncomfortable with such a clause because it is too short. They are used to seeing the versions that go on and on. Our own precedent at Simpson Wigle is fairly long at least in part so that we don’t need to argue with other professionals about whether it is effective.
When Are PACs Effective?
Our clause is also longer because we specify in some detail the kinds of determinations that will trigger an adjustment. It makes the usual reference to an agreement with the CRA on value or a final determination by a court. What constitutes an agreement with the CRA for the purposes of the clause? The question is not academic. In Desormiers c. Lalumière, 2006 QCCS 2357, a son purchased shares from his mother and father for $500,000. The purchase and sale agreement stated that the purchase price was subject to adjustment: if the Minister of National Revenue determined that the fair market value of the shares was some other amount, the parties would adjust accordingly. A CRA agent later opined that the value of the shares was nil. The son apparently agreed with the CRA and refused to pay anything further to his mother on account of the purchase price of the shares. The parents probably had nothing to do with the discussions with the CRA. The Quebec Superior Court ordered the son to pay the purchase price originally agreed upon anyway. The Court held—and the Quebec Court of Appeal agreed—that the parties merely intended that the clause should prevent double taxation and that it should not bind the mother.
Seen strictly from a tax standpoint, this decision is incoherent. Most obviously, by refusing to give effect to the clause, the Superior Court ensured that double taxation would result. The son would be required to pay for his shares, but the CRA would take the position that his cost in the shares for tax purposes would be nil because that was their value. In any case, a legal agreement cannot have any effect for tax purposes if it does not impose real rights and obligations on the parties. It is a fundamental principle of our tax law that the tax effect of a transaction is driven by its legal substance. The decision would be less surprising if it merely required that the determination was binding on the parties only if all of them agreed with the CRA valuation. That is, the decision is easier to understand if it is read as requiring the interested party, in the absence of an agreement, to seek a determination of value in the courts.
Adjustment Methods
PACs also generally specify in some detail the method to be used in effecting an adjustment. A typical PAC almost always provides for the adjustment of the redemption amount of special shares issued as consideration “nunc pro tunc” or “retroactively”. The retroactive nature of the adjustment seems to be at the root of why some advisers insist that a PAC be included in the articles of the corporation issuing the special shares. The theory seems to be that, unless the PAC is part of the shares from the beginning, it is impossible to adjust the redemption amount of shares with retroactive effect.
This position attributes to a PAC a legal effect it cannot have. A PAC is simply a contract or agreement that can be effective only retrospectively as between the parties. Several tax cases have discussed the distinction between retroactive and retrospective effects. In Hunter v. The Queen, 2001 CanLII 888 (T.C.C.), Associate Chief Justice Bowman, at paragraph 27, adopted the description of the distinction given by Driedger who stated that “a retroactive statute is one that changes the law as of a time prior to its enactment [while] a retrospective statute is one that attaches new consequences to an event that occurred prior to its enactment.”
Similarly, a PAC can have retrospective, but not retroactive, effect. It is open to Parliament and perhaps the courts to purport to re-write history; private parties have no such power. They can agree, however, to change their legal or economic relationship going forward by reference to a history that they choose to re-write as between themselves. A PAC is just such an agreement. Under the PAC, one party agrees to pay an amount to the other that is measured by a newly-agreed upon value that is assigned to an historical transaction. The PAC does not and cannot change the fact that another amount was originally paid. Seen in this light, it is not necessary (even if it were possible) to take the position that the effect is retroactive.
A PAC is effective, then, even if it is contained only in the contract between the parties and even if giving effect to the PAC requires the filing of articles of amendment to adjust the redemption amount of shares after the final determination of value is made. Indeed, a PAC should be structured in this manner. The PAC should be contained in the relevant agreement of purchase and sale to ensure that the parties to the PAC are legally bound by its terms. The significance of the focus on the parties can be illustrated by way of example. Let’s return to Father in our first example. What happens if Father exchanges the special shares he receives as part of the freeze for special shares of another class and the professionals involved forget to ensure that the provisions of the new class also contain a PAC? Now Father owns shares with a specific redemption amount that is not subject to any legal agreement about its adjustment. The CRA would likely not recognize any attempt to adjust the amount of the new shares if it later challenges the freeze. A well-drafted PAC in an agreement, on the other hand, would make it clear that Father is always entitled to an additional payment if it is later determined that he received inadequate consideration for his shares. The agreement would bind the parties to make the appropriate adjustments in any case, and the adjustment would apply to the shares he received on the freeze and any shares received in exchange for the freeze shares.
In addition, it is better to avoid using formulas in defining the redemption amount of special shares as is common with PACs found in share provisions. The use of a formula might avoid the need to file articles of amendment, but it can also be problematic if the minute book or other records of the corporation are lost and nobody remembers the redemption amount assigned to the corporation’s issued shares. A formula can eliminate the need to file articles of amendment to give effect to a PAC (to amend the redemption amount of special shares), but such a filing is not difficult or expensive, and it will be the least of the problems to be confronted if an adjustment is necessary because of a CRA challenge.
Our standard PAC specifies that an adjustment can be made by the cancellation or issue, for no consideration, of an appropriate number of payment shares. The CRA, however, appears to believe that the consideration cannot be adjusted in this manner. Why poke the CRA bear with a PAC we know they won’t like? We try to avoid circumstances where using this method might be necessary, but they happen. Suppose Mr. A and Ms. B transfer two different properties to Holdco for common shares of that corporation in the right proportions given the relative values of the properties as determined by the parties. What happens if the CRA successfully challenges the value of one property but not the other? The proportion of common shares will be wrong unless shares are issued or cancelled for no consideration.
The correctness of the CRA position on this point is debatable. It is difficult to see any difference between issuing common shares “for no consideration” and adjusting the redemption amount of special shares, also “for no consideration”. In both cases, the corporation is adjusting the claims of the shareholder on the property of the corporation pursuant to the PAC without payment at the time the PAC is supposed to take effect. In any case, we include the clause in case it is necessary to use it; at least we will have the option of making the argument for its use. Merely having the clause in a PAC does not render the entire PAC void.
Summary
This article has addressed some, but not all, of the key features of a PAC. It has argued that, while concision is always welcome in legal documents, it is not always practical or desirable with PACs. Many professionals expect a prolix PAC, and the PAC should specify carefully the circumstances under which it is meant to become effective. The PAC should also address the method by which an adjustment will be made as between the parties. In this regard, this article has argued that it is not necessary to include a PAC in the share provisions of the shares that are to be adjusted. Indeed, it is preferable to insert the PAC in the purchase and sale agreement between the parties. The PAC might also include a clause permitting the issue or cancellation of shares “for no consideration” to allow for flexibility in implementing an adjustment.
