PURCHASE AND SALE OF AN OWNER-MANAGED BUSINESS

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1 PURCHASE AND SALE OF AN OWNER-MANAGED BUSINESS TO PRIVATE EQUITY Michael Munoz Deloitte LLP Calgary 2015 Prairie Provinces Tax Conference

2 Canadian Tax Foundation Prairie Provinces Tax Conference Purchase and Sale of an Owner-Managed Business to Private Equity Michael J. Munoz INTRODUCTION Canadian private equity groups continue to raise increasing amounts of capital as investors continue to gain confidence in the returns offered by these funds. Much of the capital from Canadian funds will be deployed in Canada, in a wide variety of businesses. Additionally, with the depressed Canadian dollar, Canadian investment opportunities increase in attractiveness for US private equity groups. Needless to say, there is ample private equity capital available for suitable Canadian investments. In 2014 alone, Canadian private equity groups raised a total of $12 billion. 1 While many of the private equity investments in Canada will be large in scale, private equity buy out groups are also a source of liquidity and growth capital to many owner-managed businesses. In fact, small and mid-market transactions tend to dominate private equity M&A activity. In 2014, out of all reported deals, over 75% were under $100 million, and over 35% were under $10 million. 2 Non-private equity buyers generally enter into transactions for reasons that are strategic to their existing businesses, such as a competitor in the same industry looking to secure additional assets, technology or a customer base for an existing business, or a leader in a complimentary business that is seeking to expand into the industry or region. These non-private equity buyers are commonly and appropriately referred to as strategic buyers. Private equity buyers are more concerned with acquiring an existing business and increasing its enterprise value over a holding period of a few years to increase returns and position the business for a future sale to a third party. This difference in primary objective, and various other contextual differences between a disposition to a private equity fund and a strategic buyer can influence various aspects of a transaction, and common tax issues and opportunities emerge. Many of the issues that arise in the sale of an owner-managed business to a strategic buyer are equally applicable to a sale to private equity, and many of these topics are covered elsewhere. The purpose of this paper is to identify those objectives and sensitivities of a private equity fund that may influence a transaction, and to describe some of the commercial and tax issues that follow. The focus of this paper is therefore general in nature and is not intended to revisit the technical details of these issues, but is instead intended only to alert the reader to certain commercial and tax issues that may require additional or differing considerations in the context of a sale to private equity. For the purposes of this paper, an owner-managed business is intended to refer to any business where some or all of the owners of the business also take an active role in the management of the business. These businesses can vary greatly in size and complexity, but a common characteristic of Canadian owner-managed businesses is that they are commonly structured as corporations that qualify as Canadiancontrolled private corporations ( CCPCs ) under the Income Tax Act (Canada) (the Act ). This paper has been structured in three broad sections. The discussion will begin with a short acknowledgment of the principal considerations of an owner-manager that may be most effectively addressed through the flexible transaction structures offered by private equity. Second, the common objectives and sensitivities of a private equity fund will be discussed of how such objectives or sensitivities may influence a transaction with an owner-manager. Third, the paper will close with a discussion of some of the common tax considerations that arise in the context of a transaction between an owner-manager and private equity.

3 COMMON OWNER-MANAGER CONSIDERATIONS An owner-manager may consider a private equity fund as an attractive transaction partner because they can offer flexible transaction structures and can often tailor transactions that meet several different objectives of a particular vendor or different objectives between several vendors. For example, a particular vendor may want to partially cash out, but may also want to continue running the business and could use additional capital in the business. The private equity buyer could offer cash, equity, and a capital injection to the business that could assist with obtaining the growth objectives of the business. As an alternative example, vendors may be looking to split up or pass the management of the business on to a successor group. A private equity fund can structure a deal to cash out some vendors, invite management to continue to hold equity in the business and provide additional capital to the business in order to set new management up for success. Strategic buyers may be able to offer different forms of consideration, but are seldom as flexible as a private equity fund in designing capital structures that work to meet the varying objectives of different owners as well as for the business itself. In many ways, a private equity investment can provide a new future for an ownership group that is looking for a partial cash out, a succession plan or shareholder reorganization, or balance sheet support and growth capital for the business. COMMON PRIVATE EQUITY FUND CONSIDERATIONS While the details of a private equity fund structure are not the focus of this paper, 3 a few general comments on private equity fund structures and considerations are warranted in order to better articulate how these structures influence the transaction objectives of the fund. A private equity fund is generally an investment vehicle through which a fund manager collects capital from a variety of investors, which may include domestic and foreign investors, taxable and non-taxable investors, and the fund manager. This capital is then used to purchase substantial equity positions in portfolio businesses, most commonly private companies. The interests in the fund itself are generally not available to the public or listed on an exchange, hence the name private equity. 4 The common investment strategy of a private equity group is to make an initial portfolio investment in an industry segment, often called a platform investment, and then seek to improve the performance of the platform investment by providing growth capital, making additional complementary acquisitions ( tuckin investments ), or by making other changes to the capital or organizational structure. The objective is to improve the net enterprise value of the portfolio investment and to position it for a later sale or offering to the public after a holding period, often 5 to 7 years. The most common organizational structure of a private equity fund is a limited partnership. The private equity fund itself may be a single limited partnership or a grouping of limited partnerships that segregate investors based on common tax characteristics, most commonly by place of residence for tax purposes. This fund structure provides fund managers with the flexibility to make investments in a tax effective manner for its investors with similar objectives and sensitivities (for example, inserting corporate blocker entities at particular levels of the investment structure to alleviate the administrative tax burden for investors or to manage withholding tax). The limited partnership(s) often contribute capital for a particular investment into a holding level entity, often another limited partnership. The holding level entity would accumulate the fund s equity capital for that investment, third party debt financing, equity capital of any co-investors (investors that do not invest through the fund itself) and potentially the equity capital of the owner-managers of the portfolio investment. This holding structure allows for the

4 alignment of interests among the various stakeholders in a particular investment, as all investor groups at the holdings level would benefit from an increase in enterprise value and a subsequent disposition of the portfolio investment. Accordingly, when determining the legal structure of a private equity investment, commercial and tax considerations arise at the fund level, the holding level, or the portfolio level. The private equity fund manager is compensated by an annual fee or return on equity (commonly based on 2% of committed capital), as well as an equity return on the performance of the fund that is paid only after investors have reached a certain agreed upon target return on their invested capital. The equity return is commonly 20% of the returns of the fund beyond the target return, and is described as the carried interest because it is a return that is financially carried by the capital of the fund. This compensation structure is quite common, and is commonly referred to as a two and twenty compensation structure. The private equity investment structure does not radically change the commercial objectives of an investment, and many of the investment objectives of a private equity investor are the same as a strategic buyer. For example, all purchasers want to acquire their investments at a reasonable price and want to exercise diligence to reduce exposure to unknown or material risks when making their investments. There are however, many commercial objectives that arise from the nature of a private equity structure that create subtle but sometime significant differences from a transaction with a strategic buyer. 1. Private Equity Funds Seek the Ongoing Involvement of Owner-Manager A private equity group will normally look to make a platform investment in a business that is free standing and has the potential for significant growth. One of the most important contextual aspects of a platform investment of a private equity group is that private equity will often seek representation on the board of directors of a portfolio investment but will not take over as operational managers. Accordingly, a common commercial objective of the private equity fund when making an acquisition is to secure the existing management team or insert a new one. In the context of an investment in an owner-managed business, the goodwill, knowhow and relationships of the owner-managers are often considered a critical aspect of the investment. As such, the private equity investor is often motivated to secure the continued involvement and engagement of the key managers. Additionally, since the ongoing relationship between the private equity group and the owner-manager group is a partnering relationship, private equity buyers are generally accommodating of vendor goals and concerns during negotiation. As a result, transactions with private equity buyers may be characterized by greater flexibility in transaction structuring. This flexibility often results in an expansive negotiation of various alternative forms of consideration that can be offered to owner-managers in an effort to design an ideal transaction structure. 2. Private Equity Funds Contemplate a Future Exit Event Another principal commercial objective of a private equity group is the acknowledgement of a future exit from the investment within a reasonably short holding period of 5 to 7 years. Not only does this objective impact the types of investments it makes, favoring opportunities that have several avenues of growth and a capacity to realize such growth within this holding period, it also impacts the legal and operational structure of its investments. A private equity group will favor holding structures that position favorably for commercially simple and tax effective dispositions. The acknowledgment of a future exit is a key aspect of a transaction with private equity, and ownermanagers need to understand that they will be required to efficiently run the business in a manner such that the value will be maximized within the holding period, and that the future exit may be their final

5 liquidity event and personal exit from the business if it is ultimately sold to a third party strategic buyer. From a transactional perspective, continuing owner-managers need to carefully consider their incentive compensation and equity involvement in the structure, aligning their personal goals with that of the private equity fund. This is also a principal reason why many private equity funds insert a holding entity between the fund and their portfolio investments. The portfolio investment must be capable of being sold in its entirety, and a holding entity can provide a level where the commercial considerations among the various stakeholders are segregated from the business, similar in concept to a family holding company inserted to segregate family planning from that of business associates. A third party buyer would simply transact with a single holding level entity rather than the various participants. Additionally, various equity classes can be created at the holding level without adding any complexity to an exit transaction. 3. Private Equity Funds May Prefer Flow Through Structures Private equity fund managers are principally concerned with the delivery of financial returns to their investors. Accordingly, private equity groups may structure their entire funds to accommodate the differing legal, tax and regulatory requirements of their investors. As mentioned above, it is fairly common to see private equity funds structured as several partnerships through which investors with similar characteristics can invest. A principal reason for the use of partnerships is that tax is not generally levied at the partnership level. Rather, income for tax purposes is determined at the partnership level and the partners report their allocated share of income. Investors generally structure their individual investment in the fund in a manner that taxes this income in an efficient manner. The objective to maximize returns for investors will also influence how private equity funds will prefer to structure portfolio level operations. Private equity funds will often prefer to minimize tax at the portfolio entity level in favor of a flow through structure that results in income for tax purposes being realized at the holding level. The income is then allocable to the various investors who can then realize a tax effective solution for their unique tax characteristics. Most notably, non-resident investors may prefer to realize income through a jurisdiction with a lower combined rate of tax than the Canadian statutory rate, and Canadian tax exempt investors would prefer to realize the income directly and take advantage of their exemption from tax under subsection 149(1) of the Act. For these investors, any tax paid at the portfolio level would generally reduce their return on investment. In the context of a purchase of shares by private equity, the fund would commonly try to minimize portfolio level income with the use of leverage. The holding entity would commonly establish a corporation and finance the entity with a large amount of debt (keeping in mind any limitations to rate, thin capitalization limitations, etc.). The target portfolio company would be acquired by the new corporation and the two corporations would subsequently amalgamate. The acquisition financing costs would then generally be deductible against the income from operations, thereby reducing tax at the portfolio entity level. Interest income would be recognized at the holding level which would generally flow through and would be recognized by the investors for tax purposes. However, the use of leverage in this manner is not perfectly aligned with the earnings of the portfolio entity. Ideally, the business would accrue sufficient interest to reduce taxable income to nil, but not create a loss. Accordingly, issues arise related to the effectiveness and appropriateness of the interest rate used. An alternative structure that can create much better alignment is the use of a partnership entity at the portfolio level. Since income for tax purposes is not taxed in a partnership, all of the operational income of the portfolio entity can flow up the organizational chain and would be recognized by the fund investors (or an applicable holding entity). The fund manager would seek to ensure that its taxable investors would not be forced to realize income for tax purposes without receiving sufficient cash to pay the tax on such income. Accordingly, a special distribution of cash often accompanies the income allocation in an

6 amount sufficient to cover an estimated amount of tax on the income allocable in that year, at an agreed upon rate. A leveraged corporation structure or a partnership structure each provide a cash distribution to investors of the fund (or an applicable holding entity) that would otherwise be used to pay tax at the portfolio level. A taxable investor would be economically indifferent to tax paid at the portfolio level or investor level, provided a sufficient amount of cash is distributed to pay such tax. For non-taxable investors however, these cash distributions reflect an additional return on investment. Accordingly, a transaction with a private equity fund will often contemplate the flow through of income for tax purposes to the holding level, especially if Canadian tax-exempt investors make up a significant amount of the fund s investor base. 4. Limited Opportunities to Call Capital from Investors Investors in a private equity fund do not immediately provide their investment capital to the fund. Instead, they provide a contractual obligation to fund such capital when called upon to do so by the fund manager. There are usually restrictions that govern the fund manager s ability to make a capital call. For instance, capital calls must be called by a certain date and are subject to certain restrictions. A private equity fund is therefore a good transaction partner for providing immediate liquidity, growth capital or balance sheet relief, but tends not to be a source of support for operational cash flow. This may create constraints on the cash management of the business. A common characteristic of portfolio investments of private equity funds is that they are operationally leaner than might otherwise be the case. COMMON TAX CONSIDERATIONS Many of the common tax considerations in transactions with private equity funds apply equally to transactions with strategic buyers. However, there are several considerations that may take on added importance when transacting with private equity such that they influence the transaction dynamics in meaningful ways. 1. Assets or Shares? The question of whether to structure an acquisition as a share sale or an asset sale is not unique to a sale from an owner-manager to a private equity group. It is commonly acknowledged that purchasers generally prefer to buy assets and vendors generally prefer to sell shares. This is the widely recognized rule because in an asset sale the purchaser reflects its tax cost in the assets at an amount equal to the purchase price (as opposed to inheriting the tax cost of the target) and does not inherit commercial liabilities. In a share sale the vendor tends to pay capital gains tax rates and may be able to access additional benefits such as the lifetime capital gains exemption. When parties are negotiating the transaction structure as an asset or share sale, the process is quite simply a question of cost vs. benefit to the purchaser. If the additional purchase price required to compensate the vendor for the tax cost of an asset sale is less than the value of additional benefits gained from an asset purchase, then the purchaser ought to pay the additional price for the asset sale. When computing the additional purchase price required to be paid for an asset sale, the vendor would first compute their base case taxability under a share sale (assuming this is the originally contemplated form of transaction). The vendor would then compute their alternative case taxability by determining how much additional consideration would need to be paid in order for the owners to receive the same after tax return on the fully distributed proceeds from an asset sale as they would under the share sale.

7 The purchaser would then quantify the added benefits of structuring the transaction as an asset sale. Most purchasers would tend to be motivated by the additional tax shelter that would be created as a result of an asset purchase. This would reduce the taxable income of the business in future years and the present value of accumulated tax savings would be one of the benefits to a purchaser of moving to an asset sale. The removal of exposure to unknown liabilities is another benefit that is generally enjoyed by all purchasers of assets. Additional benefits could include the ability to subsequently reorganize business units within a corporate organizational chart or dispose of redundant assets with no additional tax cost. However, when selling to a private equity fund, the desire to minimize tax at the portfolio entity level could act as a significant additional motivation to structure a transaction as an asset sale to a partnership structure. As noted above, tax distributions reflect a greater return on investment for non-taxable investors of private equity funds, thereby improving the performance and eminence of the fund relative to other funds competing for capital from the same investor base. This benefit may create a compelling incentive for private equity funds to explore asset purchases and consider paying additional consideration to do so. The announcement of the federal government as part of the 2014 Federal Budget to seek consultation on the eligible capital property regime could lead to new legislation that would create a greater tax differential between a share sale and an asset sale. Currently, when calculating the additional purchase price required to compensate a vendor for altering the transaction structure from a share sale to an asset sale, there is not a material difference between the capital gains tax rate to an individual and a fully distributed gain from the disposition of eligible capital property. Currently, pursuant to subsection 14(1) of the Act, one half of the negative cumulative eligible capital balance is included in the business income of a corporation. In the context of a CCPC, this allows for half of the gain to be added to its capital dividend account and distributed as a capital dividend. The other half is then taxed at business tax rates rather than as aggregate investment income which would be subject to the refundable tax in section Depending on the applicable provincial tax rates, there is often very little difference between capital gains rates and the fully distributed tax rate on a disposition of eligible capital property. The proposed measures to alter the eligible capital property regime suggested the introduction of a separate class of property that would include the cost of eligible capital property which would be eligible for depreciation as capital cost allowance under paragraph 20(1)(a) of the Act. Accordingly, the new measures would alter the tax treatment of a gain on eligible capital property to be a capital gain rather than income from a business. This would increase the tax cost to a vendor of moving from a share sale to an asset sale, and consequently an asset sale would generally cost a purchaser more in order to cover the additional tax cost to the purchaser. These proposed measures have not been advanced, and in the 2015 Federal Budget, the government announced that these changes were still under consultation. An alternative to treating the transaction as either a sale of assets or shares, the transaction could also be structured as a hybrid transaction. Hybrid transactions can vary in mechanics and have been discussed in detail elsewhere. 5 However, the general concept of a hybrid transaction is to structure the transaction in a manner to create a partial share sale and partial asset sale such that the vendor is able to take advantage of some of the tax efficiencies of a share sale (most notably the lifetime capital gains exemption), and at the same time the purchaser is able to take advantage of the tax efficiencies of an asset sale (most notably an increase in depreciable tax cost). A hybrid transaction structure can act as a middle ground whereby the purchaser concedes some of the benefits of a 100% asset purchase in exchange for a more palatable price. Due to the general preference for flow through structures, private equity funds may generally be more willing to fully explore asset sale and hybrid sale alternatives and significant time can be spent negotiating and structuring a mutually agreeable transaction structure.

8 2. Forms of Consideration Another common transaction consideration involves the form of consideration taken back by vendors. Any corporate purchaser may consider funding the purchase price in cash or shares, or a combination of both, and may include other forms of consideration such as debt, earn out payments, restrictive covenant payments, etc. However, a strategic buyer is generally operating a mature business that has an established capital structure. A private equity fund, by contrast, would be establishing the capital structure of a platform investment as part of the acquisition and would therefore have greater flexibility to offer a tailored compensation package to each owner-manager, given their personal objectives, degree of continued involvement in the business, and tax situation. Some of the more common forms of consideration are discussed below with commentary respecting how each of these forms of consideration may serve the particular concerns of private equity buyers. Vendor Take Back ( VTB ) Debt VTB debt is a common form of transaction consideration that can be used to bridge valuation gaps between vendors and purchasers. The use of VTB debt as a valuation bridge would require the vendors of the business to take some portion of their consideration in the form of a note from the acquiring entity. The terms of the note would provide for payments of principal with interest over time, often five years in circumstances where the transaction qualifies the vendor for the capital gains deferral afforded in subparagraph 40(3)(a)(iii) of the Act. The benefit of VTB debt to private equity is that if the vendors accept a deferred payment (with compensation at an agreed upon interest rate), that portion of the purchase price is deferred throughout a portion of the fund s holding period. If the business is ultimately sold earlier than the expiry of the VTB debt, the third party purchaser would ultimately bear the economic cost of this debt. Equity in the holding structure Vendors of businesses often take back equity in a corporate purchaser. In the owner-manager context, a continued equity position allows for the continued participation in the future growth of a business that the owner-manager may have been quite personally invested in. Additionally, equity consideration is a common form of consideration in dispositions to public companies due to the free liquidity of such shares. In the context of a private equity buyer the equity would not be freely tradable. However, due to the anticipation of a future exit event, vendors can be confident of the future liquidity of their investment (either by way of public offering or disposition). By locking up management for the holding period, the managers interests are aligned with those of the private equity fund to maximize value within the holding period. The vendors may be granted the option of receiving equity in the new holding entity as part of a tax deferred transfer. 6 Also, further equity interests may be offered to owner-managers on the same terms as offered to other co-investors. This offer may be a further incentive to management if the owner-managers perceive the future growth potential in the business to be high, and such an offer would not be receivable by the vendor as compensation for the transaction. The precise terms of the equity interests offered to continuing management are a major negotiating point in transactions with private equity funds. It is often the case that the holding entity is structured with multiple classes of equity. One class is often designed to pay out investors such as the fund and any coinvestor in priority. A second class is designed to pay out management only if the business is sold for more than a certain benchmark value. This equity structure is similar in concept to the equity structure of the private equity fund itself, and at this level it is the owner-manager s interest that is financially carried

9 by the fund and co-investors. Several other classes of equity can be established to deal with the unique objectives and needs of the various vendors, such as differing retirement timelines, differing levels of activity in the business, etc. Some considerations in designing an equity package for owner-managers include: 1) Alignment of equity interests with vendor tax and commercial planning. The precise terms and conditions attaching to equity interests would involve a consideration of business succession planning, ensuring that continuing active managers are granted equity interests that are aligned with future growth. Additionally, certain vendors may be granted preferred equity and others may be granted common equity, depending on the particular objectives of each. 2) Valuation of carried interests. As noted above, owner-managers may be offered equity interests that are only entitled to a return if the proceeds receivable for the disposition of the portfolio entity crest a certain value. If these interests are not received by the owner-manager in a tax deferred transaction, there may be tax issues that arise based on the valuation given to these interests. Much like the valuation of common shares after an estate freeze, it is difficult to value equity that is dependent on future growth but currently has no entitlement to the value of the organization. 3) Aligning equity consideration with employment compensation. The terms of ongoing employment of owner-managers can be one of the most intensely negotiated aspects of any business divestiture that is coupled with continued employment. If the ongoing structure provides employment by a CCPC, equity consideration can be issued on a tax efficient basis, deferring the immediate recognition of employment income by operation of subsection 7(1.1) of the Act. 4) Taxable preferred shares. Restrictive or protective share terms require consideration of Part VI.1 tax. This is an additional benefit to a structure that utilizes a partnership at the holdings level, as the preferred share rules do not apply to partnership interests and hence there is greater flexibility to create partnership interests with varying rights to income in varying priorities. While there is little in the way of commercial limitations to the extent of rights and obligations that can attach to a preferred partnership interest, the allocations of income for tax purposes will always be subject to the reasonability limitations of section 103. Accordingly, the allocation of income for tax purposes between holders of different classes of interests ought to be considered as part of the commercial negotiation. 7 However, it should be noted that in the context of a partnership that provides a preference to certain investors for commercial purposes and allocates income or loss for tax purposes in a manner that is aligned with the commercial purpose, the CRA does not generally view such a structure as offensive under section 103 or otherwise, but would assess that provision in the context of the particular facts, including an assessment of any applicable tax motive for a particular allocation methodology. 8 Earn out payments An earn out provision is a very useful commercial tool that can be employed to overcome circumstances where the vendor and purchaser to a transaction are in dispute over the valuation of the target business. In these circumstances an earn out can be used as a method to bridge the valuation gap. A basic earn out operates by having the purchaser fund a base price to the vendor at the time of closing, with the agreement to fund an additional amount if certain performance targets are met during an agreed upon period occurring subsequent to the time of closing. The earn out can be linked to any performance metric (e.g., EBITDA, cash flow, etc.), but the underlying objective of the earn out is to require the purchaser to pay the price calculated on the low valuation at close, with additional payments only to the extent that subsequent events prove the higher valuation (in whole or in part) put forward by the vendors.

10 In the context of a private equity buy out, an earn out can also act as an incentive for the vendors to objectively prove a higher valuation of the business during the period of the earn out. In so doing, the business becomes a more attractive target and positions the business for a potential sale by the private equity fund. Also, similar to VTB debt consideration, the actual payment of an earn out can be deferred and if the exit event occurs prior to the full payout of the earn out, the remaining consideration is economically born by the third party purchaser. There are however, tax complexities that arise with regard to earn out clauses because the precise mechanic of the earn out clause chosen by the parties can result in fundamentally different tax treatment for vendors and purchasers. The parties ought to be cognizant of the expected tax treatment of the earn out to both parties at the time of original negotiation. Many such negotiations occur before the involvement of tax advisors. As a result, the precise tax implications of a particular earn out are often considered later in the process and disputes can arise. An earn out payment is commercially understood to comprise part of the disposition proceeds to the vendor, however it is arguable that it ought to be treated instead as a full income inclusion under paragraph 12(1)(g) of the Act. If so, in circumstances where the disposition proceeds would otherwise be a capital gain (such as a share sale) or otherwise have a favorable tax treatment (such as the sale of goodwill in an asset sale), the use of an earn out payment could subject some of the disposition proceeds to full income treatment, which could result in a material adverse tax impact to the vendors. Purchasers are generally indifferent as any such payment should be added to the cost base of the acquired shares (or assets) at the time the payment becomes due and payable. The key element required for an earn out payment to be caught by the provisions of paragraph 12(1)(g) of the Act is that it is structured as a payment that is dependent on the use of or production from property. The CRA raises this concern with respect to earn out payments in IT-426R: Where shares of a corporation are sold under an agreement whereby the proceeds of disposition are at least partially determined pursuant to an earnout clause in an agreement i.e., the quantum of proceeds is determined by reference to future earnings generated by the underlying assets of the corporation, it is usually impossible to determine accurately, within a reasonable time after the sale, the amount of the gain or loss realized on the sale. From a legal point of view, it is possible that paragraph 12(1)(g) would apply to all payments made under the earnout clause, or that the total proceeds of disposition as at the date of the sale must include the value of the earnout rights. 9 It is the author s view that the terms of most earn out clauses that track the payment to the overall performance of a business should seldom meet this requirement, since the payment is not determined by earnings generated by any particular assets. The phrase dependent upon the use of or production from property is a precisely drafted requirement and the reference to property should not be interpreted so broadly as to include any payment that is somehow indirectly dependent upon the use of a general grouping of property. It is the author s view that this provision ought to specifically require the amount to be dependent upon the use of particular property or production from particular property. As stated by Justice Thurlow in M.N.R. v. Morrison: [D]ependence upon the extent or quantity of production or use and the application thereto of some rate or standard appears to me to be an essential qualification of amounts which fall to be taxed under Section 6(1)(j). 10 The Morrison case dealt with the characterization of income received by a taxpayer in consideration for rock that was removed from his land. The payments were partly for the removed rock and partly to settle a claim for damages. Since there was no clear computation that could link the amounts paid to the

11 amounts of rock removed from the property, the amount was not considered to be dependent upon production from property. While earn out clauses are contractual terms that can vary widely in the manner they are drafted, many earn outs are linked to metrics that indicate the overall performance of a business, such as EBITDA. In such cases, it would be arguable that no applied rate or standard is used that refers directly to use or production from any particular property or class of property. The comments of Justice Thurlow in the Morrison decision would therefore seem to support the argument that such performance metrics are not sufficiently linked to the use or production from any particular property to bring paragraph 12(1)(g) of the Act into application. 11 Despite the above comments, the CRA appears to take the view that all earn out payments are generally subject to paragraph 12(1)(g) of the Act and hence, the tax treatment of such payments ought to be considered whenever an earn out is used. In the context of a share sale the CRA does however provide administrative relief when certain requirements are met. If their requirements are met, the CRA will allow a vendor to report the earn out proceeds on a cost recovery basis, reporting such amounts only to the extent they become receivable, on capital account. The amounts receivable may then be applied against the adjusted cost base of the shares, or as a gain if amounts received exceed the cost amount. In the context of an asset sale, the CRA does not provide administrative comfort by offering a cost recovery method of reporting an earn out payment. As such, in the case of an asset sale the vendor must be sufficiently comfortable that the earn out clause in question does not trigger paragraph 12(1)(g) of the Act. As an alternative, the parties could agree to structure the earn out as a reverse earn out. A reverse earn out works in the same manner as a regular earn out, except that instead of the purchaser holding back a portion of the purchase price, the full price is conveyed on close, and a portion of the purchase price is later refunded if certain metrics are not met over time. The CRA takes the view that this arrangement does not give rise to a paragraph 12(1)(g) amount. The reasoning for this difference in view appears to be due to the fact that unlike in a regular earn out, a reverse earn out does not result in any deferral of tax and the entire amount becomes taxable in the year of closing. 12 A reverse earn out is less desirable for a purchaser because, in its basic form, it requires funding of the entire amount at closing. Contractual protections such as escrow terms would need to be considered. From the perspective of a private equity fund, funding the cash required for a reverse earn out is particularly undesirable because it would be required to draw capital from its investor base which may eventually get returned to the fund. The fund would then be left in the unenviable position of having drawn cash that is not deployed in an investment. For these reasons, private equity funds are generally unwilling to structure an earn out as a reverse earn out that is cash funded at closing. If a promissory note is used to pay the reverse earn out amount instead of cash, the process of settling the reverse earn out may give rise to additional issues. The principal issue when settling a note in satisfaction of a reverse earn out relates to any amount that is ultimately found not to be owing under the terms of the earn out. The portion of the note that is settled without payment may give rise to the debt forgiveness rules. By structuring an earn out as a reverse earn out, the primary tax issues accordingly shift from vendor to purchaser. In summary, while an earn out is an attractive commercial term for vendors and purchasers to employ in the context of a valuation dispute, the risk of assessment under paragraph 12(1)(g) of the Act creates reason for caution whenever the facts of the situation do not fit squarely within the CRA s policy for the cost recovery method. If the precise structure of the earn out is not confronted early in the process the tax implications of an earn out have the potential to create polarized negotiating positions if confronted later in the process.

12 3. Potential Loss of CCPC Status Many owner-managed businesses are structured as CCPCs for tax purposes. One common consideration on the acquisition of a CCPC relates to the consequences of a change in status. In the context of an acquisition by a public company or non-resident, a change in status would result from the acquisition. This may present pre-acquisition tax optimization considerations prior to the change in status as well as timing considerations for the precise point in time that such change in status occurs. In the context of an acquisition of a CCPC by a Canadian managed private equity fund, it is possible that the entity may not cease to be a CCPC. This may be the case even if the majority of investors in the fund are non-residents of Canada. The argument that a corporation remains a CCPC when owned by a Canadian managed private equity fund is consistent with the Bagtech decision. 13 In that case, several non-resident persons and public corporations had collective ownership of more than 50% of all of the issued and outstanding voting shares of Bagtech, but due to the operation of a governing unanimous shareholders agreement they did not have the ability to elect a majority of the board of directors. The question before the court was whether the share ownership of the non-residents, if considered held by one hypothetical shareholder as required by pursuant to paragraph (b) of the definition of CCPC in subsection 125(7) of the Act, resulted in the corporation losing its CCPC status as being controlled by this hypothetical shareholder. The court noted that although the non-residents held a majority of voting shares, they did not have the power pursuant to the unanimous shareholders' agreement to elect more than three out of the seven members of the board of directors. Accordingly, notwithstanding the fact that non-residents or public corporation shareholders held more than 50% of the voting shares, the Tax Court found that the corporation remained a CCPC and did not lose its CCPC status pursuant to the hypothetical shareholder test included in paragraph (b) of the definition of a CCPC in subsection 125(7) of the Act. Arguably, a similar analysis should be applicable to shares held by a limited partnership that is managed by a Canadian general partner. 14 In such a scenario, the limited partners may have an economic entitlement to the underlying shares, but control of such shares is generally considered to reside with the general partner. 15 Accordingly, even assuming the non-resident investors in the private equity fund could be considered to own their pro rata number of shares in the underlying corporation, control of such shares would still reside with the Canadian general partner and the corporation would still be considered a CCPC. If a corporation would remain a CCPC throughout the process, some of the change of status considerations would be alleviated. However, it should also be noted that CCPC status is not always a desirable characterization. For example, a CCPC earning aggregate investment income would be subject to refundable tax on its aggregate investment income. If net earnings are not distributed, this refundable tax may not be immediately recoverable. As a result, careful consideration of the tax characterization of the corporation and the resulting impacts ought to be considered. CONCLUSIONS A private equity buyer can provide a very suitable transaction partner for an owner-manager group. A transaction with a private equity fund can be structured in such a way to accommodate many typical commercial objectives of an owner-manager group. A private equity fund can offer full or partial cash out to some or all shareholders, ongoing equity ownership in the business to align owners interests with the objectives of the fund, and incentive based consideration as part of the transaction. This flexibility

13 can provide an owner-manager group with a better ability to satisfy all of its various objectives from a purchase and sale of the business. When contemplating a transaction with a private equity fund, one should be aware of the subtle differences in objectives and sensitivities that may differ from a strategic buyer. These differences can impact the transaction process and give rise to additional commercial and tax considerations. 1 Canadian Venture Capital Association, 2014 Canadian Private Equity Market Overview. 2 Ibid. 3 For good discussions of private equity fund structuring considerations see Greg Boehmer and Andy Tse, Leveraged Buyouts and Private Equity: Private Equity Structures, Report of Proceedings of Fifty-Ninth Tax Conference, 2007 Conference Report (Toronto: Canadian Tax Foundation, 2008), 9:1-19; and Jocelyn Blanchet, Neil Marcovitz, and Timothy Wach, Structuring Private Equity, Infrastructure, and Hedge Funds, 2013 Conference Report, (Toronto: Canadian Tax Foundation, 2014), 28: While the investments in the fund itself may not be publicly traded, several of the largest fund managers, such as Kohlberg Kravis Roberts & Co. and The Blackstone Group L.P., offer publicly traded equity interests in its fund manager. 5 For illustrative examples of hybrid transactions and a discussion of related tax issues, see Dave Rickards, Hybrid Assets Share Planning when Selling Private Enterprises, 2013 British Columbia Tax Conference, (Toronto: Canadian Tax Foundation, 2013), 8:1-24; and Mark Jadd and Eoin Brady, Structuring the Purchase and Sale of a Business: Some Tips and Traps, 2011 Ontario Tax Conference, (Toronto: Canadian Tax Foundation, 2011), 11: It should be noted that complexities can arise with regard to the applicability of subsection 97(2) in flow through structures. Specifically, the definition of Canadian partnership requires all partners to be Canadian, and a single non-resident investor in the structure may put this treatment in doubt. Canadian blocker entities may be required at higher levels in the structure to avoid the direct participation of non-resident partners. 7 For a discussion of section 103 and what may constitute reasonable allocations of income for tax purposes, see Michael R. Smith, Co-Venture Structures Considerations When Structuring Domestically and in Foreign Jurisdictions, Canadian Petroleum Tax Journal, Vol. 24, See the CRA s response to question 6 in Income Tax Technical News No. 30. Question 6 What is the CCRA's position on preference units, that is, units of a partnership that entitle the holder to a preferential share of the profits or losses of the partnership. For example, consider an arrangement where a partnership issues two types of partnership interests. In consideration for the transfer of property to the partnership or in recognition of its specialized expertise, Taxpayer A acquires a "preferred" partnership interest that entitles it to receive, in priority to some, or all, of the other partners a predetermined amount of partnership income, loss, resource pools or other partnership amounts relevant in the computation of a partner's income for purposes of the Act and a fixed entitlement to partnership capital in the event of liquidation or redemption of such partnership interest. Taxpayers Band C could acquire units that entitle them to a pro rata share of the remaining income, loss, resource pools or other amounts and capital of the partnership after satisfaction of Taxpayer A's interest. Response 6 In our view, there is no impediment to the creation of partnership interests that carry different entitlements to share in the income, loss or other attributes of the partnership. However, the

14 sharing of these tax attributes is subject to section 103 of the Act. In considering the application of section 103, we would examine whether one of the principal reasons for the separate interests was the reduction or postponement of tax, or in the case where two or more members of the partnership are not dealing with each other at arm's length, whether the amount of income or loss allocated to Taxpayer A was reasonable having regard to the circumstances, including capital invested and work performed. 9 Interpretation Bulletin IT-426R, Shares Sold Subject to an Earnout Agreement, dated September 8, 2004, at paragraph [1966] C.T.C. 558, at paragraph 12. Paragraph 6(1)(j) was the predecessor to paragraph 12(1)(g). Paragraph 6(1)(j) stated: 6. (1) Without restricting the generality of section 3, there shall be included in computing the income of a taxpayer for a taxation year (j) amounts received by the taxpayer in the year that were dependent upon the use of or production from property whether or not they were instalments of the sale price of the property, but instalments of the sale price of agricultural land shall not be included by virtue of this paragraph; 11 In circumstances where the earn out is more clearly referenced to the output of particular property, the application of paragraph 12(1)(g) appears more certain. For instance, in Smith v. R TCC 461, the Tax Court of Canada found paragraph 12(1)(g) to apply to earn out payments under an agreement to purchase a client list. In that case, the payments were found to be dependent solely upon the commissions generated from clients on that particular list. The court found this mechanism provided a sufficiently standardized and quantifiable reference to production from the property (commissions generated by the client list) such that the requisite test of paragraph 12(1)(g) was met 12 Subject to the potential for a reserve on a portion of a capital gain under subparagraph 40(1)(a)(iii) of the Act. 13 Bioartificial Gel Technologies (Bagtech) Inc. (Syndic de). v. R., 2012 TCC 120, aff'd 2013 FCA In the context of a corporate general partner it must also be a corporation controlled by Canadian residents. 15 The Supreme Court of Canada in Duha Printers (Western) Ltd. v. R, [1998] S.C.J. No. 41, restricted the sources of evidence that were relevant to the determination of de jure control to the corporate constitution, a trust agreement and a unanimous shareholders agreement. It is at least arguable that a partnership agreement ought to be considered in a de jure control analysis on the same basis as a trust agreement. The CRA adopts the view that a partnership agreement ought to be so considered and that control of a corporation held by a limited partnership is generally controlled by the general partner. See Technical Interpretation , Contrôle par une société de personnes Corporations controlled by a partnership, dated October 6, 2000.