Shelley Smith:
The first point of advice I can give is plan, plan, plan. Make sure you have the proper planning in place, and the proper structure in place before you go ahead and sign contracts with your accountants, with your lawyers, with your brokers, et cetera.
Danvir Roopra:
Welcome, everyone, to another episode of the Cross-Border Tax Podcast Series. I'm your host, Danvir Roopra, leading the national tax due diligence practice here at BDO Canada.
In today's exciting episode, we're diving into a critical topic in the realm of sales tax - maximizing ITCs when selling your business. Costs associated with selling your business can be substantial, but with thoughtful planning, you may recover the sales tax tied to these expenses. Joining me to share their insights are Darren Taylor and Shelley Smith, partners in our indirect tax practice.
Darren, Shelley, welcome.
Shelley Smith:
Thank you.
Darren Taylor:
Thanks, Danvir. Nice to be here. We worked closely, over the past three years, on a lot of your tax due diligence files. Sales tax is something a bit of a pinch point, but always a very exciting piece of due diligence. When it comes to people who are wanting to sell their business, we're happy to be a part of the process and help maximize the returns, and help smooth the deals, so that they close properly and to everybody's expectation. It's always cool to be a part of these really interesting projects.
Shelley Smith:
Thanks, Darren. I'm Shelley Smith. I'm really glad to be here today. I'm an indirect tax partner in our BDO Montreal office. I deal with GST/HST, but I also deal with Quebec Sales Tax. We work with a lot of private companies on their strategies on how to maximize the amount of GST and QST that they can recover on all their eligible expenses.
Something that's really important to me is that I really work hard to make sure our clients recover the maximum possible of the sales tax that they pay. After all, our GST system is a VAT, a value added tax system. It's not supposed to be a cost for doing business, for most businesses at least.
Danvir Roopra:
Perfect. Shelley, thanks for that. Darren, thanks for the intro. Let's dive into this.
Shelley, what advice do you have for business owners regarding ITCs when they're preparing to sell their business?
Shelley Smith:
The first point of advice I can give is plan, plan, plan. Make sure you have the proper planning in place, and the proper structure in place before you go ahead and sign contracts with your accountants, with your lawyers, with your brokers, et cetera.
Just for those of you who are not as familiar with the lingo that we deal with on a daily basis, input tax credits. What is that? It basically is the sales tax on the expenses that you pay on your business inputs. If you are a taxable business, and most businesses in Canada are, you want to make sure that you're recovering your ITCs. You're putting money back in the business, which is ended up in a more competitive landscape. Where the GST is fully recovered, your cashflow is increased, your profitability is maximized, and therefore you're enhancing the value of your business.
When you're looking to sell a business, or purchase a business in the case of a due diligence, so you're very often looking to ensure that there's no sales tax risk, and ensuring that all issues dealing with sales tax have been mitigated prior to the sale. This obviously enhances the sales process.
Darren, I'm sure you can agree with me. We have lived through many due diligence processes with sales tax. Sometimes, these things are put on the backburner until a due diligence issue is raised. Unfortunately, sometimes it could either result in price reductions, additional reps and warranties, and sometimes even the deal being canceled. On the same side, when you structure your business for a sale, and there's a lot of income tax planning that goes into how to best set up the company for sale, sales tax is not always at the top of mind. With proper planning and circumstances, the sales tax paid on all the significant costs associated with the sale, such as your broker fees, your legal and accounting fees, those may be recoverable.
How do we go about and do that, Darren?
Darren Taylor:
As a starting point, of course, you know that I always agree with you with everything you say, so this will be no different today. The key points there, when it comes to selling the business, is there might be a CCPC, a Canadian controlled private corporation, so a business that's grown up over time. Shareholders have accumulated perhaps significant wealth in the business and value there. Selling it to another party, exiting and moving on to, say retirement and having the business taken over, obviously the value proposition is significant. And so, making the business ready, a lot of fees incurred in getting it ready to do that. Making sure that the right entities are being billed for services and the tax credits can be claimed. But also, just ensuring a smooth path for the sale process and the closing process.
It does look over the fence a little bit, to the purchaser's side. Because again, both parties have a vested interest, the purchaser and the vendor, to make sure that the deal closes successfully and with maximum value. And so, ensuring that this significant component of what can be very complicated deals is taken care of properly. Like you said before, plan, plan, plan. It really comes to bear here in these situations. It's really helpful to, in advance, in contemplation of selling a business, maybe to do a diagnostic, a sales tax review, to make sure all of the issues hiding away in the closet that might come out and have to be resolved as part of a due diligence process. Because a purchaser doing due diligence will dig into all of the facets of the business, including sales tax. If you end up with an issue that maybe has to be resolved as part of the closing procedures, it can put a lot of pressure into a file and into a transaction.
Being a part of that process is really important. Important when we have Danvir's team at BDO, that this is what they do. The desktop knowledge that we bring to the file for these deals is really, really, really high. It's great to work with these kinds of teams, because these deals are done better when you have good horsepower, having the tax professionals as a part of the file for the purposes of the due diligence and the part of the purchase and sale process.
Danvir Roopra:
Thanks, Darren. Appreciate that.
Shelley, can you please elaborate on any special rules that business owners should be aware of to obtain a recovery?
Shelley Smith:
Yeah. This is probably the crux of our podcast today. Just to explain to individuals, that are either looking to purchase or sell their business, typically under the sales tax system, under the GST/HST system, when you are a holding company, and all you do is own an interest or have debt in an operating company, then you are considered under the legislation to be carrying on an exempt business.
What does that mean? It means that you do not charge on your revenues. So any dividends, interest income from debt, et cetera, any pick up of equity interests, there's no sales tax on that. But unfortunately, you're treated as the final consumer, which means you're not allowed to recover any sales tax on any of the related business expenses. Typically, a holding company, as we'll call it, cannot recover sales tax on its expenses. However, there are special rules that can apply when you're dealing with expenses incurred as part of the sale of your business. This is where people need to be aware and do proper planning in advance to get those entities registered.
Obviously, there's some specific rules that must be met. The sale of the business, you must be an owner of at least 50% of that business. You must be what we refer to in the income tax lingo as related, so common control of at least 50% of the operating company. That operating company has to be a taxable business. So one that charges sales tax on its revenues and claims input credits. If you are in that scenario, what we look to do is make sure that the holding company is registered before closing is the one that signs the contracts with the brokers, accountants, and lawyers, incurs the fees, which I believe for income tax purposes, is normally reflected in the shareholders and not the operating company, and then can actually recover the sales tax that they're paying on these business expenses.
These rules have been expanded to include shareholders that are trusts, as well as shareholders that are partnerships. Again here, they have to be related, or controlled. They have to actually control the operating company. The operating company, again, must be carrying on what we call, in our GST language, commercial activities, so taxable businesses.
I bet, Darren, you've seen a few of these situations in our practice over the last few years?
Darren Taylor:
Yeah, definitely have. I think just stepping back from the conversation a little bit, it's really easy in some ways to go look, you got a parent company holding the shares of a subsidiary company. Maybe it's the shares of the sub are being sold to the new buyer. In simple terms, it's like okay, parent, sub, sell the sub, shares get sold. Decent planning around that, and that's all fine.
But a lot of times, we see some of these larger deals, like for example, private equity coming in, and taking in an interest or taking out an interest in say a larger corporate group, they may be taking out a holding company that, itself, might have five, six, 10 subsidiaries. They're taking out a whole block of a business. Looking downstream into the subsidiaries, they're complicated structures. We have to look carefully at the tax that's being paid and at what level. Ultimately, the buyer will want to make sure that they get ITCs going forward.
That's what these holdco, and these look through holdco ITC rules that have just gone through some revisions by Finance and obviously the CRA. These are an interesting set of rules. But they have limits in some cases as to where input tax credits can actually be claimed. We have to be careful with, for example the related party test. We have some purpose and property tests that are in there. I think some of the fine-tuning in this new round of legislation, the new policy, is actually better as it helps clarify for businesses where they can claim their ITCs in these selling of business or takeover situations. Because there had been some case flaw that I think previously resulted in the CRA very, very much limiting the scenarios in which input tax credits could be claimed for these types of purchase and sale corporate transactions.
Not always the best answer, but at least clarity helps with the new holdco ITC legislation. That's what we're actively working with now. We're always mindful of changes in legislation to make sure that we can see the best path forward for these types of transactions. But again, we do all sorts of buy and sell transactions, or due diligence transactions, that we get involved with. Some are fairly simple. Others are larger corporate groups. The dollars can be significant, especially when you look at lawyers, structuring accountants, valuation opinions, so on and so forth. There's considerable resources being invested in acquisition or takeover of businesses. Again, this is just a very important part of that, that we can help make the transaction go more smoothly.
Shelley Smith:
Yeah. Actually, I just jotted down a few summary points for anyone who is contemplating selling their business. One is to be careful who is signing the engagement letter for the work, which entity within the group is signing. Again, because GST and HST is very document driven, that is a very important factor. Who is potentially going to be able to recover the sales tax or claim the ITC on these expenses? Who are the vendors? Are they registered for GST? If they're in Quebec, are they registered for QST? How do you get them registered, if they're only holding shares or debt? As I had mentioned earlier, you're an exempt business. How do you go about and get them registered? That's where we come in to help in the process. Are they related? What is the nature of the expenses? Do you need any special agreements in place?
These are all points that we look at very carefully. We work with Danvir, and your group as well, when we're structuring these deals for our clients.
Darren Taylor:
I was going to say, just one more comment that I'll throw in here as well, too. We've been talking in the realm of the sale of the shares of a business from one person to another acquirer. There may also just be a situation where the assets of the business are being acquired, and not the shares of the corporate entity as well, too. There's other rules around that. For example, our tax jargon is the 167 election. That's the business-to-business rollover election, if you will, for a GST-relieved transfer, where all or substantially all of the assets of the business or property in the business is being acquired by the purchaser and carried on.
There's other provisions as well too here, that are of interest if we're not doing a share deal. And instead, for example, are doing an asset deal. Also, lots of considerations there. Really easy things, from a planning point of view up front, to make sure that our Ts are crossed and our Is are dotted, to make sure that the entity, where the recipient entity is ready, set up properly to acquire the assets instead of the shares. And to make sure that the elections that apply get filed properly, timely, and all those kinds of good things as well, too. Another role that we have is in reviewing of the purchase and sale agreement, to make sure that our asset purchase agreement, to make sure that the sales tax provisions line up with what is expected to be in place to make sure that both parties interests are served so that risk on sales tax is minimized.
Danvir Roopra:
I think you guys have covered this already. But I was going to also ask for any other strategies for maximizing input tax credits before the sale, and any common mistakes that you guys see, in terms of your transactions? And how certain business owners should avoid them, when it comes to input tax credits.
Darren Taylor:
I'll jump in with the easy one. Shelley can come up with all the hard ones. No.
Some of this is just good principles. But where we find, and sometimes it's after the fact. CRA comes in after the fact and audits an acquiring entity. A lot of people know, CRA might do an integrity review, which is a light touch audit, where there might be something that's different on a GST return. A large input tax credit, or no taxable revenue in a quarter, something like that. There's something unusual on a return. Or a return of a first-time filer. A lot of times, with these purchase and sales of the business, a target entity is in fact a first-time filer for GST purposes. CRA scrutiny something comes nearby, or quite a bit down the road, when it comes to perhaps an audit.
We can run into difficulties. For example, if professional services, so lawyers, accountants, advisors, so on and so forth, may have been instructed or have been engaged with one entity. And yet, we have services that are probably maybe need to be born in a target entity, a different entity. One of the key things about claiming input tax credits, for GST and QST purposes, is the name on the invoice has to line up with the person who has to pay the tax. For example, invoices going to a parent company where the expense and the input tax credit is claimed downstairs in an operating company is probably offside, because the parent company is not the legal entity downstairs.
Now sometimes, we can fix it. There's a supply for resupply, and parent bills services down. Sometimes that works. Other times, what happens is the subsidiary might be disallowed the input tax credit because the name doesn't line up on the invoice. It's just a tax cost right there. Now it should be claimed upstairs by the parent. But we need to be careful, again, with these holdco ITC rules. We often think, "Fine, it's a wash transaction. We can probably fix it and eventually get to zero on the tax." But not always the case. And particularly after the fact, if an audit is happening later on, CRA in general can look back four years. Something that happened three years ago is not as easy to recall. Some of the legacy knowledge within the organization might not be there. And documentation, if it doesn't line up, it's very difficult to realign the documentation properly to ensure you claim your input tax credits after the fact.
It's very difficult, for example, to go back to a supplier and say, "Hey, oops. You billed this entity, we should have had you billed that one. Do you mind changing your invoice?" It sounds easy. But practically speaking, can actually be quite difficult to achieve because the supplier, especially if it's any years hence kind of thing. It's just not that easy to do, so up front, making sure the right people are being billed the right tax and claiming their ITCs properly, getting it right up front has such a benefit for compliance and tax mitigation.
Shelley, I know you've got some things to add to that too, I'm sure.
Shelley Smith:
I think you've said it all. My final comment would be don't forget about the sales tax. It's important. It's recoverable if things are set up properly. I think I'm going to leave it at that. We're here to help.
Darren Taylor:
I'll add a point, too. When we look at our deals that we do, Canada has a number of sales tax jurisdictions. The GST is Federal across Canada, HST in the harmonized provinces. Quebec, which more or less mirrors the Federal system, is nonetheless a separate system. Also, out in the West here, I'm based in Vancouver, so BC, Saskatchewan, and Manitoba also have provincial sales tax. Which generally, if all we're dealing with is the sale of shares when somebody's selling their business, it's a non-issue. But there are other corporate transactions that may happen later. For example, amalgamation, or a winding up or preparatory transactions prior to the sale of the business. Again, out West, we have this other layer that we have to keep our eye on as well to, to help business owners with this whole process of possibly selling their business. And making sure, again, we're lined up for maximum value and a smooth transaction when the deal comes to close.
Danvir Roopra:
Perfect. Well, thank you, Darren and Shelley. This has been very informative and a bunch of great advice. Unfortunately, this is all the time we have today for today's episode. Do make time to check out a previous episode on Section 186, input tax credits on the purchase or sale of a business.
I do want to take the opportunity to say thank you both, for joining me today, and sharing your insights. And for the audience, if you're considering selling your business and want to maximize your input tax credits, please do reach out to myself, Shelley, or Darren. Thank you for tuning in today. Don't forget to hit follow or subscribe to stay updated on our upcoming episodes. This is Danvir Roopra, signing off for today. Thank you.