Dean Andrews, division director and head of tax liability insurance in London at BMS Group, discusses cross-border M&A transactions involving sales of shares that are ‘taxable Canadian property’ with Andrew Spiro, tax partner and Annika Wang, tax associate at Blake, Cassels & Graydon.
Dean: What is taxable Canadian property (TCP) and what Canadian tax issues arise with non-residents selling TCP?
Andrew: TCP refers to certain kinds of property that, at a high level, derive their value from real property or resource property situated in Canada. Most notably for this discussion, TCP includes shares of a private company if, at any time in the 60 months before sale, those shares derived more than 50% of their value from real property or resource property situated in Canada (50% asset test). Canada taxes non-residents on gains realised from dispositions of TCP.
Annika: In addition, a purchaser who acquires TCP from a non-resident vendor is generally required to withhold 25% of the gross purchase price (regardless of the non-resident vendor’s actual gain), unless the non-resident vendor obtains a ‘clearance certificate’ from the Canada Revenue Agency (CRA) under section 116 of the Income Tax Act (Act). It can take several months to obtain a clearance certificate, and the non-resident vendor must make a payment on account of any tax owing to obtain the certificate.
Dean: What risk do parties face when purchasing and selling property that has a risk of being TCP?
Andrew: There may be uncertainty as to whether shares being sold by a non-resident vendor qualify as TCP. In some situations the answer is obvious, but in other cases whether the 50% asset test is met depends on the extent to which the target’s assets are considered to be real estate assets and on the relative valuation of the target’s real estate and non-real estate assets. These points can be subject to reasonable disagreement and can be challenging to diligence over the 60-month lookback period.
Annika: The risk to the purchaser is 25% of the gross purchase price, whereas the risk to the non-resident vendor is based on the actual gain on sale and the vendor’s applicable tax rate (in each case plus interest and penalties).
A well-advised purchaser will not take this risk and will generally insist on withholding at closing if a clearance certificate has not been obtained, both because of the quantum of the exposure and because the tax at issue is the vendor’s tax from the sale. The clearance certificate mechanism provides the purchaser with complete protection, but the possibility of substantial withholding from the purchase price at closing and uncertainty on timing for obtaining a clearance certificate can raise significant commercial issues.
Dean: Is it possible to get comfort from the CRA that shares to be sold are not TCP?
Andrew: There is no statutory procedure for the CRA to provide comfort that a property is not TCP. In some cases it is possible to obtain a letter from the CRA advising that they do not believe shares to be TCP, but such letters are not binding. The CRA may also be willing to process a clearance certificate application on the basis that target shares are TCP, even if they may not be, but this requires filings that a non-resident vendor may prefer to avoid and, absent treaty protection, may require the non-resident vendor to pay a meaningful amount of Canadian tax to obtain the certificate.
Dean: What other options do parties have to address this issue when buying and selling shares that might be TCP?
Andrew: It is common for a non-resident vendor to give a representation in the share purchase agreement that shares being sold are not TCP. Such representations are typically backed by an indemnity. This provides the purchaser with contractual protection, but it is up to the purchaser to decide whether that protection is sufficient having regard to the duration of the contractual indemnity and expectations as to the vendor’s ongoing wherewithal to make good on the indemnity if an issue arises (for example, where the vendor is a fund with a short life, such an indemnity may have limited practical value).
Annika: Vendor representations as to TCP status will also be supported by diligence, which may include valuation reports from independent valuators and legal analysis as to the character of certain assets (i.e. whether a particular asset is treated as real estate under Canadian law for purposes of the 50% asset test). However, such reports have their limitations. For example, they may be a snapshot of the company’s assets at or near closing and thus may not account for the full 60-month lookback period.
Dean: How can tax insurance help vendors and purchasers manage the risk of Canadian tax liability on the disposition of TCP?
Annika: Tax insurance can bridge the gap between the parties’ very different levels of risk tolerance, and can be a real win-win. A tax insurance policy that insures the accuracy of the vendor’s representation that the shares being sold are not TCP gives the purchaser comfort to proceed with the transaction without withholding, knowing that it is protected if the CRA subsequently takes the position that the shares were TCP. The non-resident vendor can therefore receive its full purchase price at closing without withholding by the purchaser.
Andrew: This is something we are seeing more frequently in Canadian transactions involving shares that likely are not TCP, but where there is at least some valuation or characterisation risk that may give purchasers pause. Vendors may even seek to pre-arrange a tax insurance solution to address the issue, so as to ensure a smooth and timely closing.
Dean: That certainly coincides with what we are seeing from a broking perspective. We are being engaged earlier and earlier by the sell side on a deal, sometimes as much as six months in advance, in order to provide comfort that there is an insurance solution available for a known risk which could otherwise be detrimental to a deal happening.
This article originally appeared in International Tax Review.