Last month, we shared an Insight on some of the most common exit strategies for business owners. If you’ve made the decision to sell your Canadian private corporation, it’s important to carefully consider the tax implications of the sale, as this will influence the transaction structure.
There are two primary methods of selling a private incorporated business in Canada: a share sale and an asset sale.
In a share sale, an individual (or individuals) sells their shares of a private corporation directly to a buyer. A share sale involves the sale of the company itself, with the buyer essentially taking over the business. In a typical share sale, all assets and liabilities remain with the company and transfer to the new owner.
In an asset sale, a company sells some or all of its business assets (which can include inventory, equipment, buildings, working capital, A/R, intellectual property, contracts, etc.) to a buyer, but the company itself is not sold. In an asset sale, the seller retains ownership of the company as a legal entity.
Each method has tax implications for both seller and buyer. Generally, share sales are preferred by sellers to take advantage of favourable capital gains treatment, while asset sales are preferred by buyers to minimize risk.
In some cases, a hybrid sale — which combines elements of both a share sale and an asset sale to balance risk and tax implications ─ may be possible.
While every transaction is unique, below is an overview of some of the most common tax considerations associated with selling a private incorporated business in Canada:
A share sale is usually preferred by sellers, as it generally results in a favorable capital gains treatment. If an individual sells their shares in a company, the proceeds ─ in excess of the adjusted cost base of the shares and certain expenses incurred to sell the shares ─ result in a capital gain, which is only 50% taxable.
Additionally, if the shares are considered Qualified Small Business Corporation (QSBC) shares, the seller may be able to shelter all or part of the resulting capital gain from tax by claiming their Lifetime Capital Gains Exemption (LCGE). In 2020, the LCGE for QSBC shares was $883,384.
That said, a share sale will often result in a lower selling price versus an asset sale for the same business. This is due to the fact that share sales generally represent increased future tax liabilities and higher levels of risk to buyers.
It is important for a seller to weigh the tax benefits of a share sale against the overall selling price. A good exercise is to calculate and compare the after-tax result of selling company shares versus selling company assets. For larger companies and more complex deals, the capital gains tax advantages may become less important relative to maximizing purchase price and available corporate tax deferral opportunities.
Share Sales – the buyer perspective
In a share sale, the buyer assumes all known and unknown liabilities of the business. Because of this, a buyer may request a protective clause in the transaction agreement to avoid responsibility for any pre-sale tax or legal liabilities. A seller may be asked to provide extensive warranties, indemnities and personal guarantees for a significant period of time.
In additional to liabilities, a buyer also inherits the existing tax cost of any acquired assets, which limits the amount of depreciation available to them in the future. When compared to an asset sale ─ which allows a buyer to increase the tax cost of acquired assets to their current market value ─ the tax disadvantages of a share sale for a buyer can be significant.
Although not usually the first choice of buyers, there are some factors that might motivate a buyer to pursue a share purchase. If there is meaningful value in a company’s brand and reputation, and the buyer intends to carry on the same or similar business, a share purchase might be an appealing option.
There are also certain tax attributes that might make a share purchase attractive to a buyer ─ such as non-capital loss carry-forwards and investment tax credits.
One of the key disadvantages of selling a business through an asset sale is that ─ since the company is party to the transaction ─ the individual seller can’t claim any of their available LCGE.
An asset sale may also result in a double tax hit to a seller. In an asset sale, proceeds are transferred from the buyer to the business, which must pay corporate tax on any accrued gains and settle any outstanding liabilities before distributing the net proceeds (usually as a dividend) to the seller as a shareholder. The dividend would then be subject to tax at the seller’s personal marginal tax rate.
If a buyer insists on an asset sale, a seller should request a higher purchase price to compensate for the increased tax burden.
Asset Sales – the buyer perspective
Many buyers prefer to purchase business assets over shares. One of the main reasons for this is the decreased level of risk involved with an asset sale. The buyer gets to pick and choose the specific assets they are interested in and they aren’t responsible for any liabilities associated with the existing business ─ other than those they deliberately elect to assume.
Also, in an asset sale, unlike in a share sale, a buyer can increase the tax cost of any depreciable property to its current market value. This ‘stepping-up’ of the tax base of acquired assets decreases a buyer’s future tax burden, as it allows for greater deductions of capital cost allowance (CCA).
Purchase Price Allocation
How the purchase price is allocated across specific assets plays an important role in an asset sale. Buyers are generally motivated to allocate more of the purchase price to inventory or depreciable property in order to benefit from higher tax depreciation claims going forward. On the other hand, sellers want to minimize income on the sale of inventory and recapture capital cost allowance previously deducted on depreciable property. Negotiations between an asset sale versus a share sale generally result in the purchase price allocation set somewhere in the middle, essentially with the value of the seller’s lost LCGE split between the two parties.
Depending on the unique circumstances of the business and transaction, a hybrid sale may be an effective way to bridge the tax objectives of seller and buyer. By combining the sale of both shares and specific business assets, the seller may be able to utilize their LCGE while the buyer partially increases the tax cost of purchased assets.
Here is a simplified explanation of a common hybrid sale approach: A seller sells their shares to a buyer for a gain in order to claim the LCGE. The seller then sells business assets with an accrued gain through an asset sale, which allows the buyer to have a stepped-up cost basis in those assets. The buyer then consolidates both the shares and the individual assets through a reorganization.
Note: The actual steps involved in a hybrid sale are considerably more complex, and there are a number of provisions within the Income Tax Act that can affect a hybrid transaction. To avoid any negative tax consequences, it’s important to consult with an expert and consider all possible tax and business implications before moving forward.
There are numerous factors to explore when deciding on the optimal sale method for your business. Tax issues are best considered well in advance. If you are considering selling your business within the next few years, it’s a good idea to conduct a detailed company review in order to uncover any potential obstacles or opportunities. There may be actions you can take now—such as a reorganization or restructuring of shareholdings—to help you achieve an optimal result in the future.
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