Identifying the Nature of Conversion Payments and Non-Competition Payments During the Sale of a Business
Wagner v The Queen, 2012 TCC 8
[NOTE that parts of this case have been overturned by legislation. Since the enactment of Section 56.4 amounts received or receivable in relation to a “restrictive covenant” are included in income, unless otherwise included in income from office or employment. This section was added by 2013, c. 34, s. 195(1), applicable to amounts paid/payable/received/receivable after Oct. 7, 2003, other than amounts before 2005 under the grand of a written restrictive covenant before Oct 7, 2003 between arm’s length persons.]
The Taxpayer here entered into an asset purchase agreement with an arm’s-length vendor. The Agreement provided for a conversion of the agreement into a share-purchase agreement at the sole option and discretion of the vendors. The Court dismissed the taxpayers’ appeals.
At issue was:
- Whether amount paid following the conversion of a sale of assets into a sale of shares must be taken into account in computing the proceeds of disposition;
- Whether an amount paid for a non-competition clause should be added to proceeds of disposition of shares.
The Court held that the conversion payment was not stated in the agreement to be for adjustment of the purchase price and no evidence was given as to its calculation. The Court held that the payment to the vendors by the purchaser was part of the proceeds for the vendor, and the payment (by endorsement) by the vendors to the purchaser was not deductable at all.
The Court held that there was no evidence as to how the non-competition payment was calculated, that there was no evidence of the parties engaging in earnest and meaningful negotiations in respect of the value of the non-competition covenants and the allocation of the purchase price, and that the value assigned was not reasonable in the circumstances. The amount was therefore properly part of the proceeds of the share sale and not a separate consideration.
The taxpayers were equal co-owners of the corporation and all sold shares in the corporation that owned a seniors’ residence and vacant land nearby. Originally the sale was planned as a sale of assets for $13,750,000.00 to another corporation. The asset purchase agreement allowed the vendors at the sole and absolute discretion to convert the sale of assets into a sale of shares.
The article allowing the conversion provided that “should [the vendor] determine that income tax savings could be generated from the completion of the transaction by way of a sale of shares, the purchaser would be entitled to convert the Asset Purchase Agreement into a share purchase agreement for the same purchase price and subject to the same terms and conditions for all the capital stock of Château Dollard Inc. and to equally divide between the purchaser and the shareholders the projected income tax savings.” (para 11). The parties entered into a termination agreement for the asset purchase and entered into a new agreement for the share purchase at the same price, but the vendors paid as consideration to the buyers for converting the agreement, a sum of $1,050.000.oo to be paid after the close of the transaction. The shareholders’ obligation to pay to the purchaser the sum of $1,050,000 was fulfilled by means of three cheques of $350,000, each of them drawn on the trust account of Fraser Milner Casgrain s.r.l., LLP, the law firm representing the purchaser, made payable to each of the shareholders and endorsed by the shareholders to Fraser Milner Casgrain in trust. The three cheques were immediately remitted to Fraser Milner Casgrain following the endorsements.
A closing condition under the asset purchase agreement required receiving non-competition agreements from the shareholders. Under the share purchase a similar article provided for this condition, but share purchase provision was different in that it stated that “the non-competition covenants had been provided in consideration for payment by the purchaser to each shareholder of the amount of $1,559,333.33, for a total of $4,678,000”. After exercising the conversion of the sale, the shareholders entered into a non-competition agreement with the purchaser for and received $4,678,000.00 for the non-competition agreement.
The Share Purchase Agreement stipulates a sale price for the shares of $9,072,000 and an amount of $4,678,000 for the shareholders’ non-competition covenants for a total of $13,750,000, that is, the same consideration as the consideration for the sale of assets. Adjustments in the amount $6,605,416 on the purchase price of the shares are also provided for in the contract.
The taxpayers declared a capital gain, but they reduced their taxable capital gain to zero by using the capital gain exemption. The MNR allowed the exemption but applied it against a much higher capital gain leaving taxes payable. The MNR also assessed Alternate minimum tax for each taxpayer for 2003 (the year of sale) as well as 2004,2005, and 2006 tax years.
ANALYSIS Conversion of Asset to Share Sale
The Taxpayers argued that the sole reason for the transaction (conversion) was to allow the purchaser to enhance its ability to borrow money so it could complete the share purchase agreement. The Court noted that the testimony did not shed any light on the calculation of the amount paid for the conversion, but stated that the vendor’s representative stated that the amounts were calculated to leave the same amount in the shareholder’s hands. It was argued that the purchase, by purchasing shares, was receiving depreciated assets that would result in the loss of a future tax benefit.
The Crown argued that the sum was not paid to the purchaser by the taxpayers, and even if it was paid by them, it was not paid for the purpose of effecting the disposition of the shares, and should not be considered for purpose of calculating the capital gain in accordance with ITA paragraph 40(1)(a).
The Court held that the cheques received and endorsed by the vendors from the purchase was an amount received by them, and thus included in the proceeds of disposition.
The Court said that both the share purchase and asset purchase agreements were for the same amount, and the conversion agreement was signed the day following the share purchase agreement. There was no evidence that the $1,050,000.00 was part of the adjustments of the sale price of the shares. The amount was paid by the purchaser to the shareholders, who endorsed the cheques and remitted them to the law firm.
The Court held that “[a]lthough the transaction by which the shareholders endorsed and remitted the cheques to the purchaser resulted from the share sale, it nevertheless constitutes a separate and distinct transaction from the actual share sale. The nature of the transaction resembles a form of compensation which the shareholders provided the purchaser with for the loss of future tax benefits.” (para 39).
The Court concluded that (para 41):
Payment of the amount of $1,050,000 can neither be regarded as deductible in computing the shareholders’ income as said amount was not expended for the purpose of gaining or producing income from a business or property, nor deducted for the purpose of computing the capital gain realized by each of the shareholders at the time of the sale of the shares …
The Taxpayers argued, relying on Fortino v. The Queen, 2000 D.T.C. 6060 (F.C.A.), 1997 D.T.C. 55 (TCC) and Manrell v. The Queen, 2003 D.T.C. 5225 (F.C.A.), 2002 D.T.C. 1222 (TCC), that the noncompetition payments are not taxable when related to the sale of shares of a corporation owned by private individuals. They argue that the amount cannot form part of the consideration for the share disposition since: (1) it was agreed to between shareholders and purchaser after the asset purchase agreement was signed, (2) they were addressed by distinct provisions in the share sale agreement, and (3) they were enforceable and freely negotiated between parties at arm’s length.
The Crown argued that no amount was received that could be attributed to the non-competition agreements and if there was an amount that is attributable it should be the value of the agreement, which the Crown submitted was zero.
The Crown’s appraiser gave evidence that the value of the seniors’ residence (based on income approach) and the vacant land next to it was one that was very close to the total of the purchase price and the non-competition payments combined.
Another CRA business valuator gave evidence that the tax savings lost to the purchaser by using a share sale in this instance was about $1,170,000.00, and the value of the non-competition payment was said to be between $ 0 and $125,000.00.
The Court held that the non-competition payments were not a subterfuge or a sham, but that there was no evidence of the parties engaging in earnest and meaningful negotiations in respect of the value of the non-competition covenants and the allocation of the purchase price. The Court said:
At the time they entered into the Asset Purchase Agreement, the parties were unrelated and were dealing with each other at arm’s length. However, I highly doubt that, at the time of conversion of the Asset Purchase Agreement into a Share Purchase Agreement, the parties could have been deemed as dealing with each other at arm’s length, considering the fact that the parties were working together and had a common interest, that is, that of minimizing as much as possible the tax consequences of the transaction and to divide among them the tax saving on the projected income. An unfavourable inference must be drawn from the purchaser’s absence as it would have been able to provide the Court with important evidence such as the status of negotiations as to the value of the non-competition covenants and the allocation of the purchase price between the shares and the non-competition covenants. In my opinion, the rule to be applied in such circumstances is that a Court must presume that such evidence would adversely affect the appellants’ case.
The Court also noted that the asset purchase price and sale purchase price (including the non-competition payment) were the same and that the value of the non-competition payment was suspiciously high given that the income of the business was $450,000 annually which over five years was much less than the non-competition payment. The Court concluded that the payment cannot be considered as an additional consideration but as part of the proceeds of disposition of the share sale pursuant to subparagraph 40(1)(a)(i) which reads:
40. (1) Except as otherwise expressly provided in this Part
(a) a taxpayer’s gain for a taxation year from the disposition of any property is the amount, if any, by which
(i) if the property was disposed of in the year, the amount, if any, by which the taxpayer’s proceeds of disposition exceed the total of the adjusted cost base to the taxpayer of the property immediately before the disposition and any outlays and expenses to the extent that they were made or incurred by the taxpayer for the purpose of making the disposition, or
The Court did not find it necessary to turn to paragraph 68(a) of the ITA where the entire amount of consideration received or receivable by a taxpayer from a person can reasonably be regarded as consideration for the disposition of a particular property. That paragraph reads:
68. Where an amount received or receivable from a person can reasonably be regarded as being in part the consideration for the disposition of a particular property of a taxpayer or as being in part consideration for the provision of particular services by a taxpayer,
(a) the part of the amount that can reasonably be regarded as being the consideration for the disposition shall be deemed to be proceeds of disposition of the particular property irrespective of the form or legal effect of the contract or agreement, and the person to whom the property was disposed of shall be deemed to have acquired it for an amount equal to that part; and
The Court noted that the legislative provisions adopted following the press release issued on October 7, 2003, by the Department of Finance Canada (release 2003-049), namely, section 56.4 and paragraph 68(c), which have the effect of rendering payments received in consideration for the non-competition covenants taxable, are not applicable in this case as the Share Purchase Agreement and the non-competition covenants were signed before October 7, 2003.
– Sas Ansari, BSc BEd PC JD LLM PhD (exp) CPA In-Depth Tax 1, 2 &3