Tax considerations for the purchase or sale of a business

As a business owner, you may have thought about selling your company as part of your long-term business strategy. A range of motivators, such as retirement planning, new entrepreneurial opportunities, or uncertain market challenges may influence your plans. Despite the recent economic slowdown, people are still buying businesses and now may be a good time to sell. Regardless of the reason, once a sale has become the chosen exit strategy, tax considerations should be at the forefront of any seller's mind.

There are two primary methods to sell an incorporated business in Canada ─ through the sale of shares or the sale of assets ─ and the way in which a business is sold has a number of short and long-term tax implications. However, there is also a third option that many business owners overlook: a hybrid sale, which combines elements of both share and asset sales to balance risk and tax costs.

Each of these options have different benefits and tax considerations for both buyer and seller, which need to be understood and carefully weighed before moving forward with a sale or purchase.

Share sale

In a share sale, the current owner sells the shares of the company to the purchaser. This option is often the preferred choice of sellers because of the favourable tax implications.

If you as an individual sell your shares in the company, your proceeds ─ in excess of the adjusted cost base of the shares and certain expenses incurred to sell the shares ─ results in a capital gain which is only 50% taxable. Additionally, if these shares count as qualified small business corporation (QSBC) shares, generally you can claim a lifetime capital gains exemption to shelter all or part of the gain from tax. This lifetime capital gains exemption for QSBC shares is $883,384 in 2020 and is only available to individuals who are Canadian residents.

To qualify as QSBC shares, your Canadian-controlled private corporation generally must meet three conditions:

• At the time of sale, 90% or more of the fair market value of the corporation's assets must be used principally in an active business carried on primarily in Canada (either by the corporation or by a related corporation), be shares or debt in a connected small business corporation, or be a combination of both.
• In the 24-month period immediately preceding the sale, more than 50% of the fair market value of the corporation's assets must have been used principally in an active business carried on primarily in Canada, invested in shares or debt of a qualifying connected corporation, or a combination of both.
• The shares must not have been owned by anyone other than the individual seller or a person or partnership related to the seller during the 24-month period immediately preceding the sale.

If the shares being sold are owned by a holding company rather than an individual, the capital gains exemption will not be available on the sale of shares unless shares of the holding company are sold as only individuals can claim the capital gains exemption.

While many buyers prefer to purchase business assets over shares, there are reasons that could motivate a share purchase, most notably the brand and reputation of your business. Tax considerations such as available tax pools, including non-capital loss carry-forwards and investment tax credits, may also provide motivation. However, such considerations generally require that the same or similar business be carried on with a reasonable expectation of profit in order to be claimed by the buyer after the acquisition. Therefore, these motivating factors may only apply in certain situations.

Through a share purchase, the purchaser also acquires any outstanding liabilities, including tax and legal liabilities, which opens the buyer to a higher level of risk. Buyers are encouraged to conduct a rigorous due diligence process to ensure that their purchase doesn't come with unexpected skeletons in the closet. Protective clauses for tax and legal liabilities may also be added to the purchase and sale agreement as a standard part of a share sale.

It's also important to keep in mind that a share sale generally results in a lower purchase price than would an asset sale for the same business, given the greater level of risk on the part of the buyer. In this scenario, the seller must weigh the tax benefits against the overall selling price.

Asset sale

As the name indicates, the buyer in an asset sale purchases ownership of a company's assets such as inventory, equipment, and accounts receivable. It's easy to see why many buyers prefer this method of purchase, which lets the buyer pick and choose which assets to buy and limits their risk exposure.

Another advantage of an asset purchase for buyers is that they can increase the tax cost of the acquired assets to their current market value. This minimizes the buyer's tax going forward because there is a higher depreciable asset basis or a higher cost to reduce gains on a future disposition compared to the tax cost of the assets within the corporation that would generally apply when a share purchase occurs. However, keep in mind that sales tax and land transfer tax may be applicable on the purchase of assets.

Income tax considerations can make asset sales a less appealing approach from a seller's perspective. Sellers face two levels of tax upon an asset sale: tax paid by the corporation on the sale of assets with an accrued gain over the tax cost of the assets and tax paid by the owner when the net proceeds are distributed.

After the sale of assets at the corporate level, the net proceeds are generally distributed to you, the owner, as dividends which are subject to tax at your applicable marginal tax rate. However, where there is a gain in the value of assets over their original cost, the corporation may be able to pay capital dividends on the non-taxable portion of capital gains realized on the sale of assets, which has the benefit of being tax-free to the recipient individual.

Of particular importance to both buyers and sellers in an asset sale is the purchase price allocation. This will dictate your taxes payable and after-tax proceeds as the vendor. The purchase price allocation should be agreed upon and stipulated in the purchase and sale agreement, and is often a key negotiation point in asset sales.

Buyers are generally motivated to allocate more of the purchase price to inventory or depreciable property to minimize their future taxable income. In contrast, sellers want to minimize income on the sale of inventory and recapture of capital cost allowance previously deducted on depreciable property.

Negotiations between an asset versus share sale generally see the purchase price set somewhere in the middle, essentially with the value of the lifetime capital gains exemption that would have otherwise been available on a share sale split between both parties.

Hybrid sale

Often overlooked, a hybrid sale combines the sale of both shares and specific business assets, with the overall goal of creating an acceptable balance of benefits and tax costs to buyer and seller alike. This third option should be given careful consideration depending on business type and circumstances.

There are many ways to structure a hybrid sale, and the best route forward depends on the individual business, as well as the specific needs of both buyer and seller.

In one commonly used hybrid approach, the business shares are sold for a gain, and the seller can claim the capital gains exemption on the share sale if the shares qualify for the exemption. Next, business assets with an accrued gain are sold through an asset sale, which allows the purchaser to have a stepped-up cost basis in those assets. The purchaser can then consolidate both the shares and individual assets through a reorganization. Note that the specific steps needed to achieve a satisfactory result are more complex than presented here.

Other considerations

There are many factors to consider when selecting the right method of sale for your business, not least of which is selling price. Prior to moving forward with a sale, calculate and compare the after-tax result of selling company shares versus selling company assets. Not only will this analysis assist in understanding the ramifications of each choice, it also provides you with additional information that may assist in price negotiations.

If you are considering a sale of your business within the next few years, you may also wish to conduct a detailed company review to identify obstacles that could influence either the sale or the tax resulting from that sale. If any potential issues are found, there may be actions you can take now, such as a reorganization or restructuring shareholdings, that will help achieve an optimal tax result in the future.

You should be mindful that our discussion above focuses on the tax implications to the owner-manager. Where there are additional shareholders involved, such as family members, consideration will need to be given to the tax on split income (TOSI) rules. Where an amount is considered to be split income, the amount is subject to tax at the highest marginal rate and personal tax credits are restricted.

Generally, taxable dividends from private corporations and gains from the disposition of property, including shares of a private corporation that are not eligible for the lifetime capital gains exemption, could be considered split income when realized or received by certain related individuals.

The TOSI rules are very complex and are beyond the scope of this article. Owners of private corporations with more than one shareholder or those who are considering a hybrid sale are especially recommended to seek external guidance to mitigate risk areas and ensure that the business and sale are structured to minimize taxes and optimize after-tax proceeds.

You need to sell or transition your business, we're here

When it comes time to sell your business, planning and foresight will help you achieve your goals and reduce your overall tax burden. Our Tax and Transaction Advisory Services teams support owners when selling their business. We provide strategic advice before, during, and after the transaction process.

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