Many buyers of Canadian businesses understand that doing their research to ensure they pay a fair price for the business needs to be a priority. Tax considerations for the purchase of a business should form an integral part of this process.
Whether you are looking to purchase your first business or pursue another acquisition, a few critical areas can affect your immediate tax outcomes and long-term business strategy.
Structuring the purchase
As discussed in our article “Tax considerations for the purchase or sale of a business,” there are two primary ways to structure the purchase of a business: a share purchase or an asset purchase. Each option has different tax implications for the buyer and the seller. The right choice is highly dependent on the particular business being purchased, your reasons for purchasing, and your individual situation.
Many purchasers prefer buying assets directly as this allows them to select which assets they want and which liabilities are acceptable to assume. This minimizes their risk while reducing the overall complexity of the transaction. In addition, when assets are purchased directly, the tax cost of the asset will be the amount paid for the asset, assuming the buyer and seller are dealing at arm's length with each other.
Buying shares may be a good path forward if the company has a strong reputation and brand, and you want to ensure you are purchasing the entire business. When purchasing shares, the tax cost of the assets within the corporation is not increased automatically from the carrying tax cost of the assets to fair market value. However, with proper restructuring after a purchase, it may be possible to achieve this result for non-depreciable property with an accrued gain at the time of purchase.
A share purchase would also be necessary if you are looking to buy a company for its tax attributes, such as non-capital losses, scientific research and experimental development, or resource expenditure pools, and investment tax credit carry-forwards. Various tax rules could reduce these tax attributes, as well as the tax cost of depreciable assets and capital losses if the purchase of the company results in an acquisition of control.
In general terms, a vendor will prefer to sell shares and a purchaser will prefer to buy assets. This is particularly the case if the vendor can claim the capital gains exemption on a share sale. Given the overall increased risks of buying shares as compared to assets, a point of negotiation may be a reduction of the purchase price if you buy shares and therefore allow the vendor to achieve tax savings by claiming the capital gains exemption on a share sale.
Depending on the target business and the situation, you may also want to consider a hybrid sale, which combines elements of both purchase types to balance risk, opportunity, and tax burden for you and the seller. In particular, the vendor can benefit from the capital gains exemption and the purchaser can still increase the tax cost of some of the assets purchased.
Many other circumstances can factor into the decision made between the purchaser and the vendor to buy or sell assets or shares, such as the tax status of the buyer or seller. For example, the tax attributes of Canadian-controlled private corporations, other private corporations, public companies, or non-resident entities can vary, as can the tax rate a vendor is required to pay on sale proceeds.
Due diligence and valuation
Before making a final purchase decision when buying shares, it's advisable to conduct a due diligence process to avoid any unwanted surprises. Even with reputable companies, unexpected tax or legal liabilities might affect your purchasing decision—or provide a strong basis to push for a lower purchase price.
The depth and extent of the due diligence required will be dependent on the business, and whether you are choosing to purchase company assets, shares, or a combination of both. Generally, the due diligence process for an asset sale will be relatively simple, as buying assets means you will not be taking on the disclosed and undisclosed liabilities of the purchased corporation.
With a share purchase, a more comprehensive due diligence process is required. From a tax perspective, this process should begin with a general examination of past tax and information returns for all non-statute barred years. Depending on the company, you should also look at areas of higher exposure such as business activities outside Canada and cross-border transfer pricing.
By conducting a thorough tax due diligence process, you should be able to identify potential undisclosed tax liabilities prior to purchase and be able to effectively evaluate the quality of tax attributes being acquired. For a more detailed discussion of the benefits of performing a comprehensive tax due diligence examination prior to purchasing a new business, read our article “The importance of tax due diligence when buying a business.”
Along with undertaking a tax due diligence process, it's also important to get an objective view on the value of the business through a formal valuation process. The Chartered Business Valuators who make up BDO's Valuations team can assist you with undertaking a formal valuation.
Where there is difficulty in agreeing on the value of the assets (such as goodwill) to be purchased, or the value of the shares of a company, a buyer can request the purchase price be varied based on future events. This may be in the form of an earn-out—when total proceeds are dependent on future earnings. Another approach, if it is a share purchase, would be to ask for an indemnity against undisclosed tax liabilities.
These types of purchase price adjustments add complexity to a purchase transaction and are an area where the BDO Transaction Tax team can be of assistance.
Purchase and Sale Agreement
The Purchase and Sale Agreement (PSA) is a complex document that often requires significant negotiation. There are, however, a few areas and potential tax issues that a buyer should keep in mind. Purchase price allocation is a very important consideration for both the purchaser and the vendor when buying business assets. As a buyer, you should look within reason to allocate higher values to assets that can be deducted relatively quickly for tax purposes, such as inventory and depreciable property. At the same time, the seller will be motivated to minimize income on the sale of inventory and recapture of capital cost allowance previously deducted on depreciable property.
The Canadian courts have generally indicated that the agreed-upon purchase price allocation between arm's-length parties will govern the allocation of the purchase price for tax purposes. Evidence of real bargaining between arm's-length parties is also proof that the allocation is reasonable and should be accepted by the Canada Revenue Agency (CRA). If instead the sale is between non-arm's-length parties or between arm's-length parties where one of the parties is indifferent to the allocation within the PSA (for example, a non-tax-paying entity such as a municipality or charity), you will need to take extra care to establish a reasonable allocation that will stand up to scrutiny. Note that the CRA has the power to re-allocate proceeds if they are of the view that the initial purchase price allocation is not reasonable.
For the purchase of shares, the common practice is for the PSA to include tax-specific representations, warranties, and indemnities. These are designed to ensure that all tax liabilities that exist or may arise pertaining to the period before the sale closes will remain solely with the seller. It's also in your best interest to specify which party (buyer or seller) will be responsible for filing all pre-closing tax and information returns. If the vendor takes on this task, make sure to request that they make these items available for your review in a timely manner. This will allow you to ensure that appropriate returns are filed and are consistent with your plans.
Share purchase cost and tax planning
If you are purchasing shares, you should assess the most effective method to structure the acquisition of those shares, as different methods can have different tax results.
One area to consider is structuring how the purchase is financed to maximize the use of tax deductions on interest paid. For many corporate purchases, a common method is to borrow money to buy the target corporation. In this situation, the interest will be deductible. However, in some situations, you may want the acquisition debt and the assets of the target corporation to be in the same corporation so that interest can be deducted directly from the business income of the acquired company. To achieve this, common practice is to set up a new corporation to purchase the target corporation with borrowed funds. Then the new company and the target corporation can be merged on a tax-deferred basis. As part of this merger, it may also be possible to increase the tax cost of non-depreciable property of the target company from the tax cost of the assets at the time of acquisition to their fair market value at the time of the acquisition.
If you are buying shares as an individual and from an arm's-length party, you can transfer these shares to a new corporation and take back debt as consideration. As above, if the new corporation is then combined with the target corporation, it may be possible to increase the tax cost of the target company's non-depreciable assets in a similar manner. Essentially, this allows you to convert tax cost to debt and withdraw future earnings as tax-free debt repayments. You should note that this planning will likely not work where you buy shares from a non-arm's-length party. Further planning may be required for these purchases.
Non-resident entities buying Canadian businesses will have additional factors to consider when structuring the purchase, such as tax rules in their country of residence, as well as the Canadian tax rules in place to tax non-residents on repatriation of profits and certain capital gains.