Tax considerations on troubled business acquisitions
Transaction forms and tax losses
INSIGHT ARTICLE |
This article was originally published by The Lawyer’s Daily (www.lawyersdaily.ca), part of LexisNexis Canada Inc.
The global pandemic has created an unprecedented environment of uncertainty. Despite the downturn in many sectors of the economy, dealmakers forge ahead hoping to find opportunities amidst the storm. For middle market private businesses, the tax considerations can often weigh heavily on how a deal is structured and indeed, the viability of the transaction in some instances.
Generally, purchasers prefer asset purchases and vendors prefer share transactions. However, in the context of troubled business acquisitions, share purchases can be favoured because they may allow access to meaningful tax attributes such as unused losses, tax credits, and research and development pools, among others.
While these attributes can be attractive enough to outweigh the risks of a share purchase, buyers should be cognizant of the restrictions on the use of these same tax attributes subsequent to an acquisition of control (AOC).
Acquisition of control and tax losses
Tax losses principally exist in two forms – capital losses, and non-capital or operating losses (NCLs).
Where there has been an AOC, a target corporation is subject to a number of “deemed” events for tax purposes, some of which are designed to discourage profitable corporations from acquiring the losses of other businesses (referred to as loss trading). The list below includes some of the common deeming events that have a direct, or indirect adjustment, to the losses of a target business.
- Deemed taxation year end at the time of the AOC, resulting in acceleration of loss expiration
- Deemed recognition tax losses in the pre-AOC period on inventory where the value has declined below cost
- Deemed recognition of tax losses in the pre-AOC period that were suspended/deferred due to certain non-arm’s length transactions
- Deemed recognition of losses in the pre-AOC period on depreciable property and capital property other than depreciable property where the value has declined below cost
- Deemed recognition of losses in the pre-AOC period from doubtful debts
- Access to Scientific Research & Experimental Development (SR&ED) expenditures made before an AOC are restricted post-AOC which may increase pre-AOC losses
- Restrictions on ability to access unused investment tax credits post AOC
- Debt forgiveness as a consequence of an AOC which may reduce available losses being acquired;
- Restrictions on the carryforward of NCLs and net capital losses
Same or similar business and NCLs
Post AOC NCLs can only be applied against income from the “same or a similar business” that originally generated the loss, assuming it continues to be carried on with a reasonable expectation of profit. This framework also applies when assessing the availability of SR&ED expenditures and Income Tax credits subsequent to an AOC.
The interpretation of “same or similar business” is a question of fact and is a concept that is often oversimplified in practice.
Factors the Canada Revenue Agency (CRA) considered when assessing if the “same” business is continued include:
- The location of the business carried on before and after the AOC
- The nature of the business
- The name of the business
- The nature of income-producing assets
- The existence of a period or periods of dormancy
- The extent to which the original business constituted a substantial portion of the activities of the corporation in the allocation of time and financial resources
NCLs are generally considered one of the most valuable tax attributes, as they can be applied to reduce any type of taxable income to nil in a particular year.
It is important to understand if there has been a previous AOC in the target’s corporate history or any other discontinuance, reorganization or retooling of operations which could restrict the use of any of the company’s NCLs. As “property losses” are not available for use post-AOC, consideration should also be given to whether any amount related to property losses are included in the NCL balance.
If NCLs are determined to be available, the 20-year carryforward period does not reset as a consequence of an AOC. As such, buyers should review when a return to profitability is expected for the purchased business. Transactions that create additional tax year-ends, such as AOCs, may further accelerate the expiration of NCLs.
Where the acquired company had been in receivership or bankruptcy, it will be a question of fact as to whether the receiver or trustee continued to carry on the business during that time prior to the AOC.
A corporation is deemed to have realized any accrued capital losses immediately before an AOC occurs. Any capital losses carryforward including the deemed losses permanently expire if not utilized in the final pre-acquisition taxation year.
Do your due diligence and plan accordingly
Tax due diligence is a critical tool in uncovering potential issues and planning opportunities relating to the losses and other tax attributes being acquired.
Where uncertainty exists around the ability to utilize of all or a portion of tax losses before they expire, pre-transaction planning should be considered to utilize the losses prior to expiry or restriction. Typically, opportunities to increase the tax cost of assets to fair value would be considered. While this may not provide the flexibility and immediate deduction afforded by losses, it does provide a tax shield in the form of depreciation deductions or an increased cost basis to shelter gains on a future sale.
As the expiring losses have little value to the sellers, they should generally not have any objections to supporting such planning. Where there is significant concern over access to the tax attributes, purchasers may prefer an asset sale transaction due to the higher risk and limited benefit of a share purchase.