19 April 2001 External T.I. 2000-0051115 - CAPITAL GAINS RESERVE

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues: Whether paragraph 12(1)(g) of the Act applies to a disposition of shares that are sold subject to an earnout agreement in those situations where a taxpayer chooses not to use the "cost recovery method" described in Interpretation Bulletin IT-426.

Position: Yes.

Reasons: Any amounts received pursuant to an earnout agreement will be "an instalment of the sale price" of the shares and therefore be included in income pursuant to paragraph 12(1)(g) of the Act.

		2000-005111
XXXXXXXXXX 	A. Seidel, CMA
(613) 957-2058
April 19, 2001

Dear XXXXXXXXXX:

Re: Capital Gains Reserve

This is in reply to your letter dated October 12, 2000, in which you requested our views concerning the eligibility for a capital gains reserve, pursuant to subparagraph 40(1)(a)(iii) of the Income Tax Act (the "Act"), in the situation where the total proceeds to be received on the sale of shares cannot be determined at the time of the sale by virtue of the fact that a portion of the proceeds will be determined pursuant to the future earnings of the purchaser.

The particular circumstances in your letter on which you have asked for our views appear to be a factual situation involving a specific taxpayer. As explained in Information Circular 70-6R4, it is not this Directorate's practice to comment on proposed transactions involving specific taxpayers other than in the form of an advance income tax ruling. Should your situation involve a specific taxpayer and a completed transaction, you should submit all relevant facts and documentation to the appropriate district tax services office for their views. However, we are prepared to offer the following general comments which may be of assistance.

The Canada Customs and Revenue Agency's ("CCRA") views on the general tax consequences where shares of a corporation have been sold subject to an "earnout agreement" are contained in Interpretation Bulletin IT-426 ("IT-426"). As is stated in paragraph 1 of IT-426, from a legal point of view, it is possible that paragraph 12(1)(g) of the Act would apply to all payments made under an earnout clause, or that paragraph 12(1)(g) of the Act would not be applied and the capital gain or capital loss would be determined at the time of the disposition of the shares using an estimate of the total proceeds of disposition.

Since these two approaches may produce unsatisfactory results for both the CCRA and the taxpayer, the CCRA has taken an administrative position that a taxpayer may use the "cost recovery method" to report the gain or loss on the sale of the shares disposed of subject to an earnout agreement but only in those situations where the conditions in (a) to (e) of paragraph 1 of IT-426 are satisfied. This method effectively defers recognition of all or a portion of the capital gain or capital loss on the disposition of the shares until the point in time when the amounts that are in respect of the proceeds of disposition become determinable.

In any subsequent taxation year, where the aggregate of the amounts established to have become determinable exceed the adjusted cost base of the shares, a reasonable reserve may be claimed for that year in respect of that part of such aggregate that has been determined but is not due until a subsequent taxation year pursuant to paragraph 40(1)(a)(iii) of the Act. Paragraph 7 of IT-426 illustrates the computation of a reasonable reserve under such circumstances.

Where a taxpayer qualifies to use the cost recovery method described in IT-426 to report the disposition of shares subject to an earnout agreement but chooses not to take advantage of this administrative practise, the general rules in the Act will apply to determine the taxable capital gain or allowable capital loss on the disposition of the shares. In very general terms, paragraph 3(b) of the Act will include in income for a taxation year in which a property is disposed of, the amount by which a taxpayer's taxable capital gains exceeds the taxpayer's allowable capital losses. Any amounts received pursuant to the earnout agreement will be considered to be "an instalment of the sale price of property" at that time and will be included in computing the income of the taxpayer in the year received pursuant to paragraph 12(1)(g) of the Act.

The expression "disposition" is defined in section 54 of the Act and includes "any transaction or event entitling a taxpayer to proceeds of disposition of property". The expression "proceeds of disposition" is also defined in section 54 of the Act and includes "the sale price of property that has been sold". In the situation where the sale price of a property is certain, but a portion thereof is not payable to the taxpayer until after the end of the year, the taxpayer may claim a "reasonable amount" as a reserve in respect of this amount pursuant to subparagraph 40(1)(a)(iii) of the Act. This reserve is then included in income in the following taxation year pursuant to paragraph 40(1)(a)(ii) of the Act and a new reserve, if applicable, is determined pursuant to paragraph 40(1)(a)(iii) of the Act.

Where the cost recovery method is not used and the sale price of a property is not certain at the time of the disposition because of an earnout agreement, a taxpayer may estimate the proceeds of disposition and use this amount to compute the capital gain or capital loss pursuant to subsection 40(1) of the Act. Where a taxpayer chooses this method of calculating the capital gain or capital loss in respect of a disposition, it is our view that no amount is deductible as a reserve under subparagraph 40(1)(a)(iii) of the Act by virtue of the fact that clause 40(1)(a)(iii)(C) of the Act only permits a reserve "in respect of such of the proceeds of disposition of the property that are payable to the taxpayer after the end of the year". In this type of a situation, no amount is considered to be "payable" as proceeds of disposition at the time of the disposition. An amount is not "payable" until there is a "legally enforceable" right to receive the amount. The "legally enforceable" entitlement to proceeds of disposition pursuant to the earnout agreement cannot be established until certain future events have occurred such that no amount is "payable" at the time the property is disposed of.

The publications referred to in this letter may be obtained from your local tax services office or from our Internet web site (www.ccra-adrc.gc.ca).

Yours truly,

John Oulton, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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