Tax considerations for the purchase or sale of a business

Asset sale

In an asset sale, the buyer acquires ownership of business assets including, but not limited to, accounts receivable, inventory, equipment, and the business’s goodwill. Buyers tend to prefer this method of purchase, as it allows them to select which business assets to buy and, since liabilities of the business are not generally acquired as part of the asset sale process, it allows the buyer to limit their risk exposure.

Another advantage to buyers of a business asset purchase is the associated increase to market value in the tax cost of the acquired assets. This increased tax cost minimizes the buyer’s tax going forward, as it generally results in a greater tax depreciation which may be used to reduce the buyer’s future taxable income. However, non-income tax considerations such as sales tax and/or land transfer tax must also be carefully reviewed to determine if they apply in a business asset purchase.

From a seller's perspective, a business asset sale is generally less appealing because the seller faces two levels of tax upon an asset sale: first, tax paid by the corporation on the sale of assets (including recaptured depreciation and the potential for capital gains on the business asset sold) and second, tax paid by the owner when the net proceeds are distributed by the corporation to the shareholder.

Net proceeds are generally distributed to individual shareholders as ordinary dividends which are subject to tax at the shareholders’ applicable marginal tax rate. However, where a capital gain was triggered within the distributing corporation, the corporation may be able to pay a capital dividend on the non-taxable portion of capital gains realized on the sale of assets. This capital dividend has the benefit of being tax-free to an individual recipient.

From a negotiation perspective, the purchase price allocation (PPA) embedded in the asset purchase agreement will be of particular importance to both buyers and sellers. The PPA apportions the seller’s proceeds across the business assets sold, which drives the vendor corporation’s taxes payable and after-tax proceeds. Similarly, PPA apportions the buyer’s purchase price across the assets acquired, which drives the tax cost, and future tax depreciation deduction available to the buyer. 

Generally, buyers are motivated to allocate more of the purchase price to inventory or depreciable property to minimize their future taxable income. In contrast, sellers often seek to minimize the corporation’s taxable income triggered by the business asset sale by allocating purchase price to internally developed assets (like goodwill) with nominal or low tax cost. As such, the PPA is often a key negotiating point in business asset sales and should be clearly documented to ensure consistent tax reporting by both the buyer and seller. The buyer and seller should be mindful that the documented PPA is reasonable in all circumstances as CRA may put forward a challenge.

Practically speaking, given the tax and risk advantages to a buyer associated with a business asset sale, and the fact that a seller forgoes their right to the lifetime capital gains exemption that’s otherwise available upon a share sale, this generally results in a higher purchase, as the parties attempt to make the sellers whole on an after-tax perspective.

Hybrid sales

Less common than a share or asset sale (given their additional complexity), a hybrid sale aims to combine a 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.

There are many ways to structure a hybrid sale, with the best structuring option depending on the specific facts and circumstances, as well as the needs of both buyer and seller. This structuring is further complicated by recent developments in tax case law with regards to the underlying assets of the shares being sold as part of a hybrid deal. As such, careful consideration must be taken from a tax perspective when structuring such a sale.

Selling your business to the next generation (intergenerational business transfers)

In 2021, Bill C-208 legislation was enacted to make it easier for business owners to sell the shares of their corporation to the next generation. Prior to this legislation, it was generally more favorable from a tax perspective to sell to an arm’s length third party than to sell to one’s children due to the application of rules in the Income Tax Act affecting related party transfers of shares. 

As a result of Bill C-208 and amendments to the Income Tax Act, it is now easier to sell the shares of one’s business to a child or grandchild and claim the lifetime capital gains exemption on a portion of the capital gain realized, provided the relevant criteria have been met. Recently announced amendments to the initial legislation included in Bill C-208, which are effective after January 1, 2024, have modified previously enacted legislation. 

In general, the legislation includes provisions stipulating the following requirements:

• that the shares being sold are shares of a QSBC or shares of a family farm or fishing corporation;
• that the parents transfer and transition their ownership and managerial involvement in the corporation over a period of time;
• that the children or grandchildren purchasing the shares of the corporation are at least 18 years of age and that they obtain both legal and factual control of the corporation;
• that the children or grandchildren taking over the business are actively involved in the management of the corporation subsequent to the transfer of ownership for specified periods of time; and
• that all parties to the transaction to sign a joint election that will be filed with the CRA in respect of the business transfer.

As with all related party transfers, a proper valuation supporting the transfer amount is recommended. 

In addition to the requirements of Bill C-208, business owners should ensure the sale of their business to the next generation fits within their overall estate planning objectives. Careful consideration needs to be given to one’s overall financial plan before implementing a significant transaction such as selling a business to one’s children. 

Selling your business using an Employee Ownership Trust

New amendments to the Income Tax Act, effective January 1, 2024, will provide business owners with an additional option of selling the shares of their corporation to the existing employees of the business over time, using an Employee Ownership Trust. 

Under the revised legislation, an Employee Ownership Trust will be required to comply with a complex set of rules, including the establishment of a trust that is subject to various control, governance, and other criteria. In addition, only shares of a qualifying business (as defined within the legislation) will be eligible for this type of business transition plan. 

Whether the amendments will create a business transition plan that works in accordance with your objectives will require careful consideration from a tax perspective.

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, consider calculating and comparing 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 with 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 the comments above focus on the tax implications to an 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 the TOSI rules apply, amounts received by family members may be considered to be split income, with such amounts subject to tax at the highest marginal rate and restrictions on personal tax credits.

The TOSI rules are very complex and are beyond the scope of this article. Owners of private corporations with more than one shareholder, those who are considering a hybrid sale, or those who plan to sell their business to a child or grandchild 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.