A Guide for Buyers and Sellers of Canadian Businesses

Navigating the Tax Maze

As a lawyer specializing in business transactions, I often find that one of my clients’ most complex and intricate challenges is navigating the web of tax considerations that come with buying or selling a business in Canada. Understanding these tax implications is not just crucial, but it’s a daunting task that requires professional guidance. In this guide, I’ll walk you through the essential tax factors to consider, helping you make informed decisions that optimize your financial outcomes.

Understanding Transaction Structures

When buying or selling a business, the transaction can primarily be structured in three ways: as a sale of assets, a sale of shares, or a combination of both. Each structure has its own set of tax implications, influencing whether it’s more advantageous for you as a buyer or seller.

Asset Sale

In an asset sale, specific business assets are sold to the buyer. This option allows buyers to step up the tax basis of the acquired assets, benefiting from increased depreciation deductions. However, sellers might face higher tax rates because the proceeds from selling certain assets can be fully taxable.

Share Sale

A share sale involves the transfer of ownership of the company by selling its shares. Sellers typically prefer this structure due to the favorable capital gains tax treatment. Here, only 50% of the capital gain is taxable. Additionally, individuals can take advantage of the Lifetime Capital Gains Exemption (LCGE), which allows them to receive a significant portion of capital gains tax-free.

Combination

Sometimes, transactions are structured as a mix of both asset and share sales, depending on the specific goals and circumstances of the parties involved.

Seller’s Preferences and Considerations

As a seller, your preference might lean toward a share sale due to the advantageous tax implications. The Lifetime Capital Gains Exemption can shelter up to $913,630 (indexed annually for inflation) of capital gains from tax when selling qualified small business corporation (QSBC) shares. This makes share sales particularly appealing if your corporation meets the necessary criteria.

However, there are scenarios where an asset sale might be more beneficial. For instance, if the tax cost of the assets (Inside Basis) exceeds the tax cost of the shares (Outside Basis), an asset sale might be preferred. This situation could also arise if you have non-capital loss carryforwards, such as business investment losses or allowable business investment losses, to offset the income realized on the sale of assets.

Buyer’s Preferences and Considerations

Buyers usually favor asset purchases because they can allocate the purchase price to individual assets, increasing their tax cost base. This allocation enhances depreciation deductions, providing a valuable tax shield. However, share purchases may be attractive if the target company has valuable tax attributes, such as non-capital losses, that can be utilized post-acquisition.

Moreover, share purchases avoid sales taxes and land transfer taxes (LTT), which are typically levied on asset transfers. Thus, if an asset purchase would create substantial tax liabilities, acquiring shares instead might be a more cost-effective option.

The Importance of Purchase Price Allocation

For both buyers and sellers, how the purchase price is allocated among the various assets can significantly impact the tax outcomes. Sellers often aim to allocate the purchase price to assets with lower inclusion rates, such as non-depreciable capital property, to minimize taxable income. Buyers, on the other hand, prefer allocations that maximize immediate tax benefits, such as inventory and depreciable property with high capital cost allowance (CCA) rates.

However, it’s essential to ensure that the allocation aligns with the fair market value of the assets. The Canada Revenue Agency (CRA) can challenge allocations that deviate significantly from an asset’s fair market value, so it’s crucial to approach this aspect carefully.

Tax Planning Strategies in Share Transactions

Sellers can employ several tax planning strategies to optimize outcomes in share transactions, potentially leading to significant financial benefits:

Lifetime Capital Gains Exemption (LCGE): This exemption allows individuals to shelter a substantial amount of capital gains from tax when selling QSBC shares. It’s essential to ensure your corporation qualifies as a QSBC to take full advantage of this benefit.
Safe Income Planning: This involves extracting value from the target company to reduce the gains realized on share sales. Surplus stripping transactions, facilitated by intercorporate dividend deductions, can be an effective approach.
Capital Dividends: These are paid from a capital dividend account and are tax-free for shareholders. The capital dividend account is increased by 50% of a corporation’s capital gains and reduced by 50% of its capital losses, offering a tax-efficient way to distribute profits.

Leveraging Tax-Deferred Rollovers

The Income Tax Act (ITA) offers provisions for tax-deferred rollovers, helping sellers defer taxes on property dispositions under certain conditions. Notably, ITA Section 85 allows for tax-deferred transfers of eligible property to a taxable Canadian corporation, provided the consideration includes shares of the buyer and a joint election is filed. Similarly, ITA Section 85.1 applies to share transfers in exchange for buyer shares, facilitating rollover treatment without the need for an election form.

These rollovers can defer tax liabilities until the transferred property is eventually disposed of, providing flexibility in managing tax exposure and planning for future financial scenarios.

Acquisition of Control and Its Tax Implications

When control of a corporation is acquired, several tax consequences are triggered. These include a deemed taxation year-end and restrictions on capital loss carryforwards. Understanding these implications is crucial, as control is typically acquired by owning more than 50% of voting shares, with specific rules governing deemed acquisitions.

The document also highlights opportunities for tax planning through the ‘bump’ rules. These rules allow for an increase in the tax cost base of non-depreciable capital assets to their fair market value. This provides a valuable planning tool for buyers, particularly if the conditions for the bump under ITA Section 88(1)(d) are not satisfied. Essentially, the ‘bump’ rules allow the buyer to step up the tax basis of the assets, potentially reducing future tax liabilities.

Navigating Sales Taxes

The application of GST, HST, and PST in business transactions varies depending on the nature of the sale. Share sales are exempt from these taxes, whereas asset sales may be subject to them unless exemptions apply. An election under Section 167(1) of the Excise Tax Act (ETA) allows some transactions to be free of GST/HST, provided specific conditions, such as both parties being GST/HST registrants and the buyer using the property in their commercial activities, are met.

Considerations for Non-Resident Sellers

For non-resident sellers of taxable Canadian property (TCP), such as certain real estate and shares, it’s crucial to comply with Canadian tax obligations. Non-residents must notify the CRA and secure a clearance certificate to avoid the buyer’s withholding obligations. This ensures compliance with Canadian tax law and helps avoid potential legal complications.

Conclusion

Navigating the tax implications of buying or selling a business in Canada can be complex, but with the right strategies and understanding, both buyers and sellers can optimize their transactions for financial success. Whether you’re considering an asset sale, a share sale, or a combination of both, it’s crucial to consider all commercial, legal, and tax factors. By planning strategically and leveraging available tax provisions, you can ensure that your business transaction aligns with your financial goals.

If you’re contemplating a business transaction, I encourage you to seek professional legal and tax advice to explore all available options and tailor a strategy that best suits your needs. With careful planning and informed decision-making, you can navigate the tax maze and achieve a successful business transaction.

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