Conditional Sale Agreement – What You Need to Know
The plain English definition of a conditional sale is an agreement for the sale of goods where ownership of the goods is retained by the seller until the purchase price is paid in full. This means that title to the goods does not pass to the buyer until the purchase price has been paid. The buyer is in possession of and uses the goods, as though they were the owner. When the purchase price has been paid , full legal and beneficial ownership of the goods passes to the buyer. An example would be a typical financing arrangement for the sale of motor vehicles. The seller may retain ownership of the vehicles until the purchase price is fully paid.
A conditional sale agreement is distinguishable from a license pursuant to which a party is permitted to use tangible property belonging to another, but does not obtain title or even a possessory interest in the property or a right of sale. An example would be a computer lease where the lessee has no right to sell or encumber the computer. A license is a separate agreement governed by different jurisprudence than a conditional sale agreement.
Benefits of Conditional Sale Agreement
Conditional sale agreements have a number of advantages for both a buyer and seller. These agreements are beneficial for transactions involving high value goods. They also offer flexibility for the buyer and seller so that they can include specific technical and financial features to suit their individual requirements.
The buyer is given the option of paying for the goods in installments, with the balance payable upon delivery or installation. Critical to this type of agreement and its superiority over other forms of buying or selling is that the seller/creditor maintains its ability to take back the goods. Unlike leasing, in a conditional sale agreement, the risk of loss lies entirely with the seller/creditor and the burden is on the buyer/debtor to insure or otherwise protect against that risk. Because title to the goods has not transferred, in the event of damage to the goods prior to delivery, the seller is entitled to a payment calculated on the basis of the value of the goods at the time of the damage (if the goods are repairable).
The conditional sale agreement offers the advantages of both lease and loan financing while avoiding some of their disadvantages. The buyer receives the advantage of the capital which will assist in accomplishing desired goals, obligations to be concerned about and possible financial constraints. In the long run, however, the buyer has avoided the tax liability under the lease agreement or the interest liability under a loan. The seller is obviously assured of title to the goods upon performance of his obligations by the buyer.
The Terms of a Conditional Sale Agreement
The key components of a conditional sale agreement include purchase conditions, payment terms, and additional clauses that protect the seller and purchaser.
Purchase Conditions. The most common right of a seller under a conditional sale agreement is the right to retake possession of the goods at any time before the goods have been paid for in full, without notice, if some condition set out in the agreement is observed. Conditions such as a failure to pay taxes, the purchaser having gone bankrupt or a material change in the purchaser’s financial position may constitute default. A seller may also have the right to reject any materials supplied by the purchaser if they do not meet the requirements of the conditional sale agreement. In other cases, the seller only gets to retake possession of the goods after a failure to pay the full purchase price by the due date. Or the seller may have to give the purchaser notice of its intention to retake possession of the goods before it does so.
Payments. The payment provisions of a conditional sale agreement are typically straightforward instalment payments. They can require a down payment followed by regular payments of a specific sum on a prescribed schedule. Usually the agreement allows for the seller to vary the schedule if the purchaser is behind on any payments. Payment provisions of a conditional sale agreement are often set up to conform to the relevant sales tax scheme so that the purchaser pays just the right amount of tax on every instalment. However, conditional sale agreements may also provide for all kinds of payment structures from the purchaser (for example, balloon payments, equal payments, payment upon delivery, etc.). Conditional sale agreements need to strike a balance between flexibility for the purchaser if cash flow becomes problematic and ensuring that the seller retains its priority if the purchaser goes bankrupt (in spite of the extra cash flow flexibility).
Collateral Clauses. Conditional sale agreements will often contain provisions that the purchaser acknowledges certain legal principles to put all concerned on notice as a matter of law that the form of the transaction is a conditional sales agreement and sets out other commercial provisions that facilitate the conditional sale agreement. For example, the agreement may contain a clause that acknowledges that the conditional sale agreement is "not a lease" or "not a security agreement", or is the "equivalent of an outright sale". Other clauses routinely found in conditional sale agreements include clauses that the purchaser has entered into the conditional sale agreement on the basis of its own due diligence and is not relying on any representation, statement or warranty from the seller (with the exception of what is expressly set out in the conditional sale agreement), or pre-printed clauses that the purchaser appoints the seller as its agent to pick up the goods after default or might provide that no right of retention or mortgage is created through the conditional sale agreement.
Legal Requirements and Implications
Contractual obligation and risk of default are central to conditional sale transactions. Title to the goods remains in the vendor until the purchaser pays the full purchase price for the goods, which places the purchaser at a lower risk than in most sales transactions. However, conditional sales transactions are not credit sales where the conditional seller has more access to the purchaser’s assets. The conditional sale vendor, especially when making a substantial loan to a customer to purchase goods, wants to protect itself from a potential default by the purchaser.
In addition to a security interest, a conditional sale agreement must contain a grant of property rights to the purchaser as buyer until all sums due are paid. This would typically include a right to possess and use the goods and a warranty on the conditional seller’s title to the goods. There must be a reciprocal consideration given by the conditional seller in return at time of entry into the agreement. Courts will require evidence of a mutual intention to create an interest in goods and likely view the conditional sale agreement as a waiver of the res vendita rule by the parties in circumstances where there is a close connection between the purchaser’s possession and the conditional seller’s possession and either of the following factors exist:
A conditional sale transaction must be in writing and signed by the parties under the Statute of Frauds or it will be unenforceable. The Statute of Frauds will preclude oral conditional sale agreements. Often, standard or pre-printed contracts are used and these should contain the conditional sellers name and address, a more or less precise description of the goods and the price, and should have a place for both parties to sign or place their mark. This contractual requirement has historically not been very strictly enforced by the courts. However, the formal requirements for a conditional sale relationship prior to delivery or payment are being more rigorously applied in order to prevent fraud.
It should be noted that although conditional sales agreements are still used today, the use of that term and legal framework is largely superseded by the PPSA. That legislation has its own requirements for the type of transactions which fall within its ambit. In lieu of a stand-alone conditional sale, there are secured party rights that fall under a general security agreement that can be a much simpler option as it applies to all encumbered goods, whereas a conditional sale agreement is specific to a particular item of personal property.
Legal Risks Associated with Conditional Sale
Conditional sales present various risks and challenges for the parties involved. These can manifest in a number of ways, including problems with title registration or enforcement issues in the event of a dispute. Without careful planning, parties may fall into common pitfalls that lead to unnecessary complications down the road. The following are some of the most common areas of risk and how parties can mitigate them through careful negotiation and drafting.
One of the major risks with conditional sales is the possibility of inadequate security in the event of a default by the purchaser. Since the seller retains title of the asset until the last payment is made, they are placed in a vulnerable position should the purchaser fail to make payments as required under the agreement. The following series of steps can help ensure the seller has adequate remedies available in the event of a default, thereby helping mitigate the risk that a default will lead to protracted litigation and/or significant economic loss required to remedy the situation.
A conditional sale is a commitment for the sale of property in the future, with a clear intention to transfer ownership. Therefore, it is critical that the agreement creates a trusting and enforceable relationship between the purchaser and seller. Since conditional sales often involve high-value goods , this can be a source of contention if there is a dispute regarding the ownership of the asset. The stakes are often significant enough that purchasers and sellers may be willing to fight litigation regarding ownership. Therefore, the parties must ensure that all provisions are carefully considered and agreed upon in the CSA to help establish a relationship that is productive and precise. A few key considerations include:
It can be difficult to recover possession of an asset without the conditional sale agreement creating an unambiguous chain of title. There are various competing commercial laws and local statutes that will dictate the resolution of a dispute, so it is imperative that the agreement does not leave any room for interpretation. It also must satisfy any registration requirements to help ensure a clear transfer of title under the law. Failure to comply with registration requirements can lead to adverse possession disputes.
Communicate contract terms clearly and concisely: Both parties should ensure they understand the terms of the agreement and can communicate them clearly and concisely to avoid confusion.
Keep contracts precise and unambiguous: Contracts should leave no room for interpretation and should keep the terms as simple as possible.
Carefully draft warranties and indemnities: As conditional sales often involve a high level of risk, careful drafting of warranties and indemnities can help lower that risk, particularly if the asset is of limited commercial value.
Conditional Sale Agreement in Real Estate
Conditional sales are also frequently used in the real estate sector to reduce the tax cost on a sale. In a purchase and sale transaction, a conditional sale is often used by the vendor as a last resort to reduce or defer its tax liability. Of course, as always, there are significant non-tax factors built into a conditional sale, such as cash flows, economic transactions, previous contractual arrangements, stakeholder expectations, etc. These factors need to be analyzed to fully understand an existing sale arrangement and possible ways to achieve the desired commercial results.
In Real Estate, one of the players in a real estate deal may be a developer or contractor that requires the use of the land for construction. The developer or contractor can enter into a conditional sale pursuant to which it has the right or option to acquire the land before the use is initiated. The vendor in the conditional sale becomes the property owner liable for capital gains tax, development levies and property taxes until the deed is registered. There are advantages in structuring the sale in this way, particularly where the developer or contractor requires the use of the land for a short period of time, or where the purchase and sale contract is subject to conditions, such as securing a zoning or a financing arrangement, before certain work can start, the costs of which will be born by the vendor, as opposed to the purchaser. However, the vendor and purchaser should consider the effect of GST/HST, if any, payable on the deemed disposition, as well as the second designated sale and the ITC issues that may arise.
While there have been two significant decisions in the last five years where the CRA lost on its attempts to recharacterize a sale as a security, requiring a significant change to the CST on securities, there are several court decisions from the last decade where the courts have, on the facts before them, determined that a conditional sale (option or installment) sold real property right not the underlying property rights. In particular, the decisions of Arndt v. Canada (1999), 176 D.L.R. (4th) 287 (F.C.A.), and Dodd Properties Ltd. v. Canada, [2007] F.C.J. No. 86, 2007 D.T.C. 5017 (F.C.A.), have rejected the CRA’s views and analyses of conditional sales.
Courts have also found that the passive or agency arguments presented by the CRA in a conditional sale context have some traction. These arguments have been used by the CRA in arguing that by virtue of the agency relationship, both conditional sale contracts are in fact security agreements. The facts in the above-noted cases suggest the passive argument is important because once the right or option vests, the payments under the agreement may not be regarded as the purchase price but merely a "security interest" in the form of an "instalment purchase price". The agency argument, in this context, has gained considerable support in several decisions, thus far.
The Agency noted that conditional sales are often a structured hybrid of a sale and lease. Most of the cases have determined that the transaction is a sale. The line between a lease and a sale continues to blur. But the courts have acknowledged this is a factual determination so long as the intended outcome is achieved, i.e., legal ownership resides elsewhere than the economic interests in the property, which are elsewhere.
While conditional sales continue to be a popular structure, and can have a helpful role in certain business objectives, the tax treatment of the sale, as is reflected in the cases noted, can be applied in wide variety of manners that may have unintended consequences. These cases continue to make it clear that the courts will respect the contract as long as they are not couched in terms of security. But as in any other corporate transaction, there are a many other considerations that will factor into a business or corporate decision.
Negotiating a Conditional Sale Agreement
Negotiating a conditional sale involves a series of discussions and compromises between the buyer and the seller. Clarity and mutual agreement on all key terms are critical when entering into a conditional sale agreement. Without clarity, disputes may arise down the road about various aspects of the agreement. Common aspects of conditional sales that should be clearly defined include:
(a) what specifically is being bought and sold;
(b) what price is being paid;
(c) how payment of the price will occur (ie. cash purchase, installment payments or an assumption of debt); and
(d) what additional cash consideration will be involved to complete the sale.
The price is obviously a critical part of the conditional sale negotiations and often becomes the main subject of disagreement . Both parties should do their homework on what the business is worth before coming to the negotiating table. Ideally, an appraisal will be obtained for the property or business being sold.
It is also important to recognize the difference between selling assets and selling shares when negotiating a conditional sale. If shares are being sold, the transactional structure must be clear about whether the seller or the buyer is responsible for tax payable. The same is true for assets.
Buyers and sellers must both be diligent in their negotiations. There can be many potential pitfalls in failing to understand the value of the asset being sold and the obligations of the parties. If a buyer or seller has concerns about the potential liability associated with a conditional sale agreement, they should obtain independent legal advice before entering into the agreement.