The Canadian Tax Basis “Bump”: A Non-Technical Perspective on a Valuable Planning Tool

January 28, 2020

A valuable planning tool for purchasers of Canadian companies, the Canadian tax “bump” allows the cost basis of certain corporate assets to be increased (under certain conditions) to their fair market value. This may facilitate an internal reorganization or a potential sale of the “bumped” assets to a third-party on a tax-free basis.

The bump is frequently relied upon by non-resident purchasers who wish to extract foreign subsidiaries from a Canadian target company on a tax-free basis so as to prevent future Canadian tax on dividends flowing from the foreign subsidiaries through Canada, and potential Canadian capital gains tax on any sale of the shares of the foreign subsidiaries in the future.

However, use of the bump is tightly circumscribed by a set of legislative provisions known as the “bump denial rules”. These rules are highly technical and often leave purchasers (and their advisors) scratching their heads about whether a bump is available in their situation or not.

Highlighted below are some threshold questions (in non-technical language) that can be useful in ascertaining whether a bump denial rule applies in connection with a Canadian acquisition – and, by extension, whether the benefits of a bump could be available. As mentioned, these provisions are complicated and a full analysis by your tax and legal advisors should be undertaken if you are considering a bump transaction.

How the Bump Works

To put the threshold questions in context, we’ve created a point-form overview of how the bump works and the rationale behind it:

  • In an arm’s-length share acquisition, the purchaser will typically acquire the shares at a cost base equal to the consideration it paid (i.e. fair market value).
  • However, in such a transaction the assets owned by the acquired corporation will (without the bump) maintain their historic cost basis.
  • The result is that the assets of the acquired corporation will have a built-in tax gain (if they are ever sold) even though there is not an economic gain to the purchaser.
  • The “bump” provisions of the Income Tax Act (Canada) (“Tax Act”) help to alleviate this potential tax issue by allowing an acquiror some leeway (as limited by the rules discussed below) to push the tax cost of the shares of the acquired corporation down to the acquired corporation’s assets.
  • The purchaser may elect an amount (the “bump”) in respect of certain assets of the target (i.e. non-depreciable capital property) so that the effective tax cost of those assets will be the historic cost plus the elected bump amount.
  • The amount of the bump is subject to two limiting factors:
    • global bump room, which constrains the aggregate bump room for all eligible properties (generally, the FMV of the target’s shares less the tax cost of the target’s assets); and
    • particular property bump room, which creates bump limits that apply to each particular eligible property (generally, the FMV of the particular property less its historic cost).

When the Bump is Available

As already noted, however, the availability of the bump is limited by the bump denial rules, which prevent the bump from applying in circumstances where, as part of the series of transactions that includes the acquisition of control of the target corporation, certain classes of people have acquired certain types of property. One reason for this requirement is to prevent the bumped assets of the target (or something linked or derived from those assets) being acquired by former selling shareholders who held (in the aggregate) a significant interest in the target.    

The following threshold questions may assist in determining whether a bump will be allowed or not. As noted above, the bump denial rules will apply when, in the course of an acquisition process, certain types of people have acquired certain types of property. In the tax literature, these are often colloquially called “bad people” and “bad property”.

The two key concepts

Bad people

To determine which shareholders may be “bad people” for purposes of the bump denial rule, it will be helpful to ask certain questions about the target’s major shareholders as well as its management, employees and directors:

  • Major shareholders:
    • Do any shareholders of the target (together with related persons) own more than 10 percent of the shares of a class or series of the target? If so, that shareholder will be a “bad person”.
  • Management, employees and directors:
    • Do any members of management currently own any equity in the target? If so, even though management may hold less than a 10% economic interest in the target, if management is given a separate class of shares, it is possible that a member of management could be a “bad person” if they hold more than 10% of the shares of this class.  

Further, aggregation rules provide that two or more people may be “bad people” if their aggregate shareholdings in the target would, if held by a single person, make that single person a “bad person”. This particular aggregation rule is relevant if the vendor shareholders are to receive equity interests in the purchaser going forward.

Bad property

What must next be determined is whether any of the bad people described above might acquire bad property. Such “bad property” generally includes any property of the target corporation that is distributed to the purchaser as part of the series of transactions that includes the acquisition of control of the target corporation (“distributed bad property”).  

In addition, “bad property” includes broad rules that capture property that derives its value from, or is substituted for, distributed bad property. More technically, it includes property (i) more than 10% of the fair market value of which is attributable to distributed bad property or (ii) the fair market value of which is determinable primarily by reference to the fair market value of distributed bad property.

There are also specific exemptions (too technical to discuss here) that may facilitate ownership of what would otherwise be “bad property”.

Determining whether “bad people” will acquire “bad property”

To determine whether “bad property” may be acquired by a “bad person” in connection with the acquisition, it is helpful to ask two basic questions:

  • What consideration is the purchaser paying for the target shares?
  • Do any shareholders of the target own, or will they own, equity interests in the purchaser?

To begin with the first question, it is important to examine what consideration is being paid by the purchaser as the target shareholders (as a collective) will be considered a “bad person” for purposes of the bump (under the aggregation rule discussed earlier) regardless of whether any one shareholder owns more than 10 percent of a class.

Below, we outline the most common forms of consideration paid by purchasers for shares of a target.

Cash or shares of a Canadian company

Cash or shares of a Canadian purchaser company that are delivered to target shareholders in consideration for their target shares are generally acceptable forms of consideration for purposes of the bump.

Shares of a foreign corporation

Using shares of a foreign corporation as consideration to acquire a target would automatically deny the bump unless the shares meet the 10 percent safe harbour rule (i.e., the shares of the foreign purchaser will not derive more than 10 percent of their value from the Canadian target going-forward) and certain other conditions are met.

Exchangeable shares

Where a foreign purchaser acquires the target in an exchangeable share transaction, shareholders of the target may elect to receive shares of a Canadian corporation (an “exchangeable share”) that may be exchanged into shares of the foreign parent. This exchangeable share structure defers Canadian income tax until the right to exchange is exercised by the shareholder. In most exchangeable share structures, the exchangeable shares themselves may not be viewed as “bad property” in isolation, but because those shares are exchangeable for foreign parent shares (which, subject to the 10% safe harbour, would generally be bad property) it may be difficult to argue that the ultimate acquisition of those foreign parent shares would not occur as part of the same series of transactions that includes the acquisition of target.  

Other types of consideration

Certain contractual rights that are typical in M&A transactions, such as contingent value rights or earnouts, may constitute “bad property”. However, as each contractual right is unique, the terms of each specific instrument must be examined.

In general, the Canada Revenue Agency has given comfort that an earnout or similar agreement will not be considered “bad property” where, absent other mitigating factors, the agreement is clearly for the sole purpose of providing a mechanism to determine the fair market value of the shares of the target (where the fair market value of such shares cannot otherwise be determined). However, the CRA stated that, “this would not be the case where an earnout is used as a mechanism to distribute additional amounts based on the future sale or value of some particular property.”[1] Accordingly, any contractual forms of consideration should be examined very closely. 

Do any “bad persons” own an equity interest in the purchaser? Is there a possibility for a bad person to invest in the purchaser?

Finally, with respect to the second question above, in addition to a target shareholder obtaining equity of the purchaser in consideration for its target shares, it is possible that a target shareholder may already own (or will own in the future) equity in the purchaser or a company related to the purchaser. If this shareholder is a “bad person”, this ownership or acquisition may result in uncertainty as to whether the bump is available (there are some exceptions). This can be a particular concern for purchasers whose shares trade on a public market and for fund-of-fund type investors (who may not have control over who acquires an indirect interest in them).

As can be seen from the above, the application of the bump rules and the bump denial rules is highly specific and fact driven. We highly recommend consultation with your tax advisors when considering a bump transaction.

[1] CRA Document #1999-0010965 – “Earnout clauses and ineligible property” (January 31, 2000).

DISCLAIMER: This publication is intended to convey general information about legal issues and developments as of the indicated date. It does not constitute legal advice and must not be treated or relied on as such. Please read our full disclaimer at

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