The tax implications on the sale of a Canadian private company are important to consider from the outset as they may inform the deal structure and the parties’ tax motivations. While each deal is unique with its own complexities to navigate, the following provides an overview of the more common tax considerations.
- Key tax drivers for sellers
- Key tax drivers for buyers
Transaction structure
A sale of a business is generally completed in the form of either a share sale, an asset sale and, in fewer cases, a combination of both, often referred to as a hybrid sale. Public offerings, reverse take-overs, plans of arrangement and amalgamations are other methods to effect a business combination, but are more common in the context of a public company transaction and aren’t addressed here.
In a share sale, the corporation’s equity is sold to a purchaser in exchange for the sale proceeds. In an asset sale, the vendor corporation, which carried on the business, transfers the assets required to operate the business (i.e. equipment, working capital, employees, intellectual properties, customer contracts, etc.) to the purchaser in exchange for sale proceeds.
Transaction proceeds
The proceeds from a sale can take many forms, including cash and non-cash consideration such as assumption of mortgages, purchaser equity, and contingent consideration (i.e. earn-outs, amounts in escrow, etc.). Proceeds are usually some combination thereof to strike the right balance between financing the transaction and addressing any uncertainty in the valuation. The tax treatment to the seller of the various types of sale proceeds differs depending on the nature of the consideration, terms and timing of the receipt. Sellers will generally attempt to structure proceeds to be treated as capital gains (only one-half of which are subject to tax) and ensure any tax impacts related to upfront non-cash proceeds are deferred until such consideration is converted to cash (e.g., upon a sale of purchaser equity proceeds or settlement of mortgages). Similarly, a purchaser may also be subject to differing tax treatments on payments made, which may not necessarily mirror those of the sellers.
Key tax drivers from seller's perspective
CAPITAL GAINS TREATMENT
- Where sale proceeds are needed personally by the selling shareholders, a share sale generally results in favorable capital gains treatment to a seller whereby only one-half of the gain will be taxable as compared to an asset sale, which may have a higher tax cost upon distribution of the sale proceeds to individual shareholders
LIFETIME CAPITAL GAINS EXEMPTIONS (LCGE)
- Individual shareholders may also be able to access their available Lifetime Capital Gains Exemption (LCGE) to shelter all or a portion of the resulting capital gain from tax where the shares being sold meet certain criteria at that time.
- In a share sale, sophisticated sellers may have structures in place which allow the LCGE to be multiplied across other individuals. Accordingly, a preference for a share sale where access to the LCGE is possible is heavily favoured by eligible Canadian sellers where the use of multiple exemptions can have a material impact on the personal after-tax cash proceeds. As the transaction size grows, the tax savings may become less important relative to other deal drivers, such as maximizing purchase price and available corporate tax deferral opportunities
- In an asset sale, individual shareholders are not able to claim their LCGE as the company is the seller and corporations are unable to claim the LCGE. A hybrid sale may be used to bridge the tax objectives of both parties, such that the individual shareholders can utilize their LCGE and the buyer will be able to partially increase the tax cost of the assets purchased.
INDIVIDUAL REQUIREMENTS FOR SALE PROCEEDS
- In an asset sale, proceeds are used to settle the liabilities of the selling corporation before distribution to the shareholders. Individual shareholders may also be subject to a second layer of tax on the distribution of remaining proceeds, but could choose to reinvest proceeds in the seller corporation and defer the individual level tax. Asset sales can also carry additional tax complexity where there are multiple shareholders with different objectives to be managed.
- In a share sale, shareholders receive proceeds directly from the purchaser and therefore can generally manage their own tax plan independently of other shareholders.
PURCHASE PRICE ADJUSTMENTS
- A share sale may give rise to greater purchase price fluctuations to reflect any liabilities to be assumed on closing and working capital adjustments.
PURCHASE PRICE ALLOCATIONS
- In an asset sale, the purchase price allocation to various assets may result in a portion of the sale proceeds being taxable as income (for example, contingent future sale proceeds, recaptured tax depreciation on real property or equipment, etc.) as opposed to capital gains. Having corporate proceeds taxed as a capital gain provides a more tax-efficient distribution to individual shareholders as one-half of a corporate capital gains can generally be distributed tax-free to individual shareholders resident in Canada. Proceeds not subject to tax as capital gains will generally have a higher tax cost upon distribution to an individual shareholder
CONTINUED RESPONSIBILITY FOR KNOWN AND UNKNOWN LIABILITIES OF THE COMPANY AND ADDITIONAL TAX FILINGS AND MAINTENANCE
- In a share sale, the purchaser inherits both known and unknown liabilities of the business and will often conduct additional due diligence to cover off any legal and tax risk. Buyers may not want to assume potential historical liabilities that can come with an operating business. If assumed, these risks are normally addressed in the purchase and sale agreement.
Key tax drivers from buyer’s perspective
LIABILITY
- An asset purchase protects the buyer from any known or unknown liabilities of the company other than those which they choose to assume in connection with the business, including tax liabilities.
TARGET BUSINESS COMPLEXITY
- A share sale often facilitates a less complex transaction for both parties notwithstanding the lost tax-shield to the purchaser. However, as the deal size, business complexity and risk increase relative to any tax benefits the sellers may enjoy, an asset sale may become a preferred option for both parties to maximize their tax values.
- In an asset sale, buyers can ‘carve-out’ the specific assets, liabilities and employees they wish to acquire if there are redundancies or synergies in their existing business. This is common with a larger strategic or private equity buyer that may already have a similar or complementary business that can be combined with the acquired business (i.e. employees, equipment, executive and administrative functions, etc.).
POST-CLOSING TAX COSTS
- Where a corporation has valuable tax attributes such as losses that will survive a share purchase (although certain loss restriction rules apply on a change of control), it may further incentivize a purchaser to undertake a share acquisition.
- In a share sale, a purchaser may need to reorganize the target business assets post-closing to align to their strategy. This may result in additional tax liabilities being realized by the purchaser on a subsequent sale or reorganization which could otherwise be avoided on an asset purchase. For example, the absence of a step-up to the underlying tax cost of assets in a share purchase could result in a second layer of tax if those assets were to be removed from the corporation post-closing.
TAX ACCOUNT ADMINISTRATION
- An asset purchase can be time consuming and costly to establish. This is due to mergers of existing payroll, income tax and sales tax systems and reporting functions
TRANSACTION CONSENTS AND APPROVALS
- A share sale may be the only viable option where certain agreements are not easily assignable without renegotiation.
TAX SHIELD AND EQUALIZATION PAYMENTS
- Buyers will prefer an asset purchase when the purchase price is largely allocated to depreciable assets because they will benefit from higher tax depreciation claims going forward. Conversely, in a share sale, buyers inherit the existing tax cost of any underlying assets of the corporation thereby limiting the amount of depreciation shield available post acquisition. Unlike in the U.S., there is no mechanism in Canada for a buyer to allocate the price paid for the shares to the underlying depreciable assets of the corporation, therefore, there is no ability to ‘step-up’ the tax cost and create additional depreciable tax shield.
- Purchasers who insist on an asset sale may be requested to increase the purchase price to make sellers ‘whole’ for any additional tax burden arising from an asset sale, usually from the loss of LCGE access. The hybrid sale option noted above may help bridge this gap for both parties.
Deal structuring depends on the specific facts
Maximizing after-tax cash-flow through structures which provide increased tax shield and interest deductibility generally drive purchaser behaviours, whereas maximizing after-tax retained capital will generally influence a seller.
Once transaction terms have been agreed upon, proposed changes to the sale/acquisition structure that are introduced later in the mergers and acquisitions process can create friction between the parties and delays in closing. As such, the tax issues are best considered and negotiated well in advance of a transaction and as part of the drafting of preliminary deal terms.
