The updated mandatory disclosure rules in the Income Tax Act (Canada) (the "ITA") were enacted in June 2023. In general, they are made up of the reporting requirements pertaining to reportable transactions, notifiable transactions, and uncertain tax treatments. Despite Canada Revenue Agency ("CRA") guidance issued in July 2023 and updated in August 2024, some key questions remain – especially in the M&A context.
In this article, we consider whether an indemnity relating to a pre-closing tax issue is a contractual protection "hallmark" under the rules, potentially triggering a reporting obligation.
For previous articles written on the mandatory disclosure rules, see Reportable uncertain tax treatment rules, New reportable transaction rules receive Royal Assent, Trust planning and the notifiable transaction rules: Where do we go from here?, and Canada Revenue Agency updates its guidance on mandatory disclosure rules.
Background: What triggers a reportable transaction?
The reportable transaction rules require certain parties to file an information return with the CRA if an "avoidance transaction" takes place and at least one of three hallmarks is present:
- Contingent fee arrangement: An advisor or promoter (or a non-arm's length person) has an entitlement (absolute or contingent) to a fee that is based on the amount of a tax benefit, is contingent upon obtaining a tax benefit, or is based on the number of persons who participate in the transaction (subject to certain limited exceptions).
- Confidential protection: An advisor or promoter (or a non-arm's length person) obtains confidential protection, and the prohibition on disclosure provides confidentiality regarding the tax treatment in relation to the avoidance transaction.
- Contractual protection: The person, an advisor, or promoter (or a non-arm's length person) has or had contractual protection in respect of the transaction.
M&A context: A common scenario
In private M&A, vendors frequently carry out pre-closing transactions for tax purposes. Such planning can involve, for example, the pre-sale utilization of lifetime capital gains deductions or surplus stripping transactions. Purchasers are generally willing to allow vendors to undertake such pre-closing transactions (subject to review by purchaser counsel) but seek robust indemnities in respect of any tax implications to the target entity that may arise from such transactions.
Very often, these indemnities are drafted as "stand-alone" indemnities in respect of the pre-closing transactions and do not form part of the omnibus indemnities applicable to breaches of representations or warranties, pre-closing taxes incurred in the ordinary course, or other specific issues inherent in the transaction or business at issue. The nature and context of the tax indemnity in respect of pre-closing transactions raise the issue of whether such indemnity may meet the contractual protection hallmark noted above. In other words, could these indemnities be viewed by the CRA as contractual protection intended to secure a tax benefit — and therefore reportable?
How does the ITA define "contractual protection"?
Under the ITA, contractual protection generally includes indemnities against the failure to achieve a tax benefit from a transaction (or series of transactions). However, there is a notable carve-out:
indemnities that are integral to an arm's-length M&A deal — and primarily intended to ensure the purchase price reflects known business liabilities — are excluded from the definition.
This would appear to exempt many ordinary-course indemnities in a sale agreement. But do tax indemnities for pre-closing tax issues fall within this exclusion?
CRA guidance
The CRA's August 15, 2024, guidance suggests that standard M&A protections — including tax-related indemnities and R&W insurance — are not generally considered reportable. Specifically: "Standard representations, warranties and guarantees between a vendor and purchaser, as well as traditional representations and warranties insurance policies, that are generally obtained in the ordinary commercial context of mergers and acquisitions transactions to protect a purchaser from pre-sale liabilities (including tax liabilities), are not expected to give rise to reporting requirements for reportable transactions."
"A reporting obligation would not arise solely in respect of contractual protection in the form of insurance that is integral to an agreement between persons acting at arm's length for the sale of a business where it is reasonable to conclude that the insurance protection is intended to ensure that the purchase price paid under the agreement takes into account any liabilities of the business immediately prior to the sale and the insurance is obtained primarily for purposes other than to obtain a tax benefit from the transaction or series. Without providing an exhaustive list of examples, a few are outlined below:
- Indemnities related to existing pre-closing tax issues, or the
amount of existing tax attributes (tax pools, capital cost
allowance, etc.).
.... - Indemnities or covenants to a purchaser and/or target in respect of Part III tax liabilities and other adverse tax consequences arising from dividends paid as part of a pre-closing reorganization."
Are pre-closing tax indemnities reportable?
The statutory language in the definition of contractual protection does not clarify or specify that a pre-closing tax indemnity in respect of transactions specifically undertaken by a vendor in contemplation of a sale is excluded from the contractual protection hallmark. While the CRA's guidance (and the statements cited above) offers a bit more comfort in this regard, the guidance is not specific to the issue of pre-closing transactions of this nature.
In particular, it is not clear that the reference to an indemnity relating to a pre-closing tax issue includes an indemnity for taxes in respect of a transaction specifically undertaken in contemplation of a sale, for the benefit of the vendor, and that is outside the ordinary course of business. While the portion of the indemnity that could apply to a liability under Part III of the ITA (in respect of an excessive capital dividend designation) is specifically excluded from the contractual protection hallmark, this does not address broader indemnities that cover all aspects of a pre-closing transaction and are not restricted to Part III penalties.
Key takeaways for advisors
In view of the above, and although not free from doubt, pre-closing tax indemnities may meet the conditions of a contractual protection hallmark, rendering the transactions subject to such indemnities reportable.
Given the penalties at issue for failure to report, counsel acting for purchasers generally seek reporting in respect of such transactions while counsel acting for vendors may be willing to take a more nuanced (and narrower) approach to the legislation and guidance.
There seems to be no clear answer in this regard, and further guidance from the CRA on this specific issue is warranted.
Next steps: What should you do?
If you're involved in an M&A deal with pre-closing transactions and associated tax indemnities, assess the reporting risk early. The consequences of non-compliance — including stiff penalties — can be severe.
Consult with legal counsel from our Tax Group who can help interpret the relevant ITA provisions and provide guidance on your reporting obligations.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
