Middle market businesses across Canada and the United States are experiencing impacts from the economic uncertainty related to COVID-19. Supply chain shocks, forced closings, reduced production capacity, halted sales and diminished workforce mobility are only a few items on the laundry list of adverse consequences cascading to business owners.
While the scene being painted by many is somber, middle market business leaders who are quick to adapt and proactive in their approach may discover opportunities to make the most of a challenging situation.
Immediate tax considerations
1. Liquidity planning: Many businesses are experiencing significant disruptions to their business operations and challenges to short-term liquidity. Businesses may want to secure liquidity quickly by borrowing, with capital raises, or by repatriating funds.
The tax consequences of borrowing are numerous and can be complex. Issues like shareholder loans, thin capitalization, foreign exchange, interest rate deductibility, interest rate determination, debt capacity, withholding tax, deemed distributions, among others, will be important depending on the taxpayer’s specific situation.
Capital raises in the form of equity can introduce further complexities related to deemed loss restriction events, withholding taxes and specific cross-border investment rules. Foreign affiliate dumping rules are one example of how non-resident investments into Canada can result in adverse tax consequences to the unwary.
Similarly, repatriations of funds from subsidiaries and foreign affiliates can raise questions related to retained earnings, safe income on hand, surplus and deficit balances, how repatriations are funded, and withholding taxes. Compliance obligations are also an important consideration. For example, repatriations may require significant reporting, supporting calculations (e.g., importance of maintaining complete surplus calculations for your foreign affiliates), or that certain elections be made within prescribed periods.
As businesses seek liquidity in this climate, tax risks and compliance considerations should be assessed to ensure that capital is structured in a tax-efficient manner.
2. Employee mobility and tax implications: Canadian businesses that host international employees for domestic projects may need to re-evaluate workforce strategies in the face of closed borders.
The restricted movement of human capital may result in more local hires or outsourcing to Canadian third parties. Further, these travel restrictions may also require some international employees on assignment to stay in Canada longer than originally planned. This would result in Canadian payroll obligations and require a consideration of the permanent establishment rules in respect of the nonresident’s stay in Canada and ultimately, the employer’s (perhaps unexpected) Canadian tax exposure.
3. Insurance policy review: Some commercial insurance policies will include business interruption insurance, which compensate an owner for loss of profit and extra expenses incurred as a result of an insured peril or event. In general, most business interruption policies require that direct physical damage occur to trigger coverages, which unfortunately may exclude most COVID-19 related impacts. However, there are some policies and endorsements that will include coverage against business losses as a result of COVID-19. The Canadian federal income tax treatment of insurance proceeds received in lieu of lost revenues from business, property or employment generally follows that of the revenues that the proceeds are meant to replace.
Events that may trigger coverage related to COVID-19 include:
- Event cancellation insurance (insures the cancellation of an event such as a concert or conference)
- Interruption by civil authority (government ordered restriction typically limited to two to eight week indemnity)
- Infectious disease (typically an endorsement purchased by the policyholder)
- Contingent business interruption (losses to a policyholder from a supplier or customer who cannot operate due to an insured peril)
Canadian business owners should review their insurance policies to understand the coverages their policy may afford and how the claims process works. They must also review their insurance policies to understand if COVID-19 and business interruption events may trigger an insurance claim.
Medium-to-long-term tax considerations
1. Tax loss planning: Canadian businesses may need to consider opportunities for optimizing their existing tax attributes, e.g., net operating losses, tax credits, scientific research and experimental development (SR&ED) pools, etc. Similarly, corporate groups should consider loss consolidation planning to manage the group’s overall effective tax rate.
2. Deal restructuring: As access to capital for nonresident buyers may become expensive or limited for in-process deals, nonresident buyers will have to consider alternative deal structures to bridge gaps on value expectations without re-pricing the deal (i.e. more purchase consideration being replaced by buyer equity, earn outs, etc.). Sellers should consider tax consequences arising from these alternative deal structures.
3. Tax reserve modeling: Income tax restriction rules may apply when control of a corporation is acquired. Taxpayers who entered into mergers and acquisition transactions may need to consider the loss restriction rules that apply to capital and non-capital losses.
4. Transaction costs: Canadian businesses must review transaction costs, including those related to deals that were ultimately abandoned, and consider whether the cost should be expensed or capitalized or a combination of both. Given Canada Revenue Agency’s (CRA’s) audit history in this area, it is imperative to analyze transaction costs incurred by a business and segregate between deductible and non-deductible components.
5. (Re)Freeze/Thaw: Canadian businesses expecting a prolonged impact to profitability should consider whether now would be an appropriate time to freeze/re-freeze/thaw value to manage estate tax considerations, allow for shareholder introductions, and execute shareholder level transactions that would otherwise carry additional tax cost.
6. Taxable reorganizations: Canadian businesses that were planning to carve out, rationalize or split up operations may benefit from lower valuations where such reorganizations cannot occur on a tax-deferred basis.
7. Transfer Pricing planning: COVID-19 will cause business interruptions and for many entities, will result in lower than expected profitability or unexpected losses.
- Managing global effective tax rate: Transfer pricing governance and strategies should consider global effective tax rates. Changes in profitability may present opportunities for tax efficient planning where appropriate substance and facts exist.
- Customs/duties: To the extent subsidiaries have guaranteed returns (i.e., target margins), and COVID-19 results in year-end transfer pricing adjustments, an opportunity to recover customs/duties paid will exist in Canada. This opportunity will be most prevalent for tangible good importers and resellers. Further, Canadian importers should consider the new Canada-United States-Mexico Agreement (CUSMA) that was ratified by Canada on March 13, 2020 to understand the key considerations for a Canadian importer.
- Transfer pricing compliance: Given the impact COVID-19 will have on many companies’ operating results, it will be important to document the impact to protect yourself from tax authority-initiated transfer pricing adjustments, resulting penalties, and secondary adjustments.
- Credit rating analysis: Corporations facing a decline in sales and profitability may also experience a decline in their credit rating. This can impact their lending capacity and the applicable rate of interest should the corporation need to borrow funds.
In addition to these tax planning ideas, middle market businesses should consider the numerous relieving measures that the federal and provincial governments have released in the wake of COVID-19. These governmental and administrative initiatives are summarized in RSM Canada’s Tax Alert and Economic Plan Summary.
As the going gets tough, the tough gets going
These are challenging times but there is a silver lining. Savvy taxpayers will have an opportunity to recalibrate their tax positions by deploying applicable tax planning tools and the one-time benefits offered by the government and tax authorities.