Tax Efficient Strategies for Selling a Business

Zoran Vranjkovic, CPA, CA, CFP, TEP

Senior Tax Manager – Welch LLP

Welch LLPChartered Professional Accountants

Agenda

1. Asset sales

2. Share sales/Capital gains exemption

3. Section 84.1 planning

4. Hybrid sale transactions

5. Earnout payments

Asset SalesPurchaser

• Bump in cost of assets

• ½ year CCA

• Goodwill

• Allocation of purchase price

• No risk of hidden liabilities

Asset SalesVendor

• Recapture

• No CCA

• Goodwill

• Allocation of purchase price

• Personal tax to extract funds from corporation

• Greater tax liability

Share SalesPurchaser

• No bump in cost of assets (other than non-depreciable capital assets)

• Acquisition of control issues

• Risk of hidden liabilities

Share SalesVendor

• Capital gain

• Capital gains exemption

• Tax minimization

• Tax deferral

Capital Gains Exemption (CGE)

• $400,000 deduction (offsets $800,000 capital gain)

• Deduction available to individuals resident in Canada throughout the year

• Disposition of shares

• Qualified small business corporation (QSBC) shares at time of disposition

• Potential tax savings – up to $185k - $198k per exemption

CGE Limiting Factors

• Previous use of deduction

• Cumulative net investment loss (CNIL)

• Allowable business investment loss (ABIL)

• Other capital losses in year

QSBC Shares Basic Conditions

• Determination Time Test (90% rule)

• 24 Month Ownership Test

• Holding Period Asset Test (50% rule)

QSBC SharesDetermination Time Test

• Must be a Canadian-controlled private corporation (CCPC)

• All or substantially all (90%) of the FMV of the assets at that time attributable to assets that are:a) Used principally (50%) in an active business carried on primarily

(50%) in Canada by the particular corporation or a corporation related to it;

b) Shares in or indebtedness of one or more small business corporations that are connected with the particular corporation; or

c) Assets described in (a) or (b).

QSBC SharesOwnership Period Test

• Throughout 24 months immediately preceding disposal, share must not have been owned by an unrelated party.– Individuals– Partnerships– Corporations– Trusts

• Exceptions:– Shares issued in exchange for other shares– Shares issued in exchange for assets of a business– Shares issued in exchange for partnership interest (where assets used in

business)– Shares issued as a stock dividend (provided shares on which dividend

declared meet test)

QSBC SharesHolding Period Test

• Throughout 24 months preceding disposal, at least 50% of corporation’s assets must be used in active business

• Intercorporate shares and debt subject to similar rules

• Watch for unusual transactions/assets

QSBC SharesTiming Issues

• 24 month Holding Period Test– Watch for new shareholders (Trust/Spouse/Children)

• Accrual of value– Value to date of reorganization can’t be shifted– Allow time for value to accumulate

• Consider structure up front– Age of children?– Cost?

Capital Gains ExemptionAlternative Minimum Tax (AMT)

• Capital gains are a tax preference item

• Maximum AMT on CGE claim – approx. $40k

• Salary of $265,000 – no AMT on full CGE claim

• AMT credits – 7 year carry-forward

Capital Gains ExemptionAlternative Minimum Tax (AMT)

• Annual income required to recover AMT (over 7 years):

– Salary - $43,500

– Interest - $40,000

– Capital gains - $355,000

– Dividends (eligible) - $193,500

– Dividends (non-eligible) - $207,000

Capital Gains ExemptionAlternative Minimum Tax (AMT)

• Plan for recovery of AMT

• Consider mitigating steps:– Crystallize portion of gain prior to sale (straddling December 31)– Stagger sale to straddle December 31– Consider OAS clawback impact

• Worst case – portion of capital gain taxed at 5%

Share Sales – Sample Scenario

• X is married

• 3 minor children

• Opco value = $4 million

CGEProblematic Structure #1 – Sole Shareholder

Opco

X

Common shares (FMV - $4M)

• CGE only available to X

•No tax efficient mechanism to purify

CGEProblematic Structure #1 – Solution

1. Establish discretionary family trust

2. X freezes value of Common shares ($4 million)

3. Trust subscribes for new Common shares (nominal value)

• Watch for:– 24 month holding period (trust)– Enough time for value to accrue to trust?

CGEProblematic Structure #1 – Solution

•Trust may sell Opco shares

•X and family may access CGE

•Surplus funds may accumulate in Holdco

Opco

Family Trust

HoldcoXX

Family

Common shares (nominal)

Common shares

Preferred shares ($4M)

CGEProblematic Structure #2 – Purification

•Trust may sell Holdco/Amalco shares

•X and family may access CGE

•No tax efficient purification of Holdco or Opco

Opco

Family Trust

#1

Holdco

XX Family

Common shares ($4M)

Common shares ($4M)

CGEProblematic Structure #2 – Solution

1. Establish new discretionary family trust

2. Holdco & Opco amalgamated

3. Old trust freezes value of Common shares ($4 million)

4. New trust subscribes for new Common shares (nominal value)

• Watch for:– 24 month holding period (new trust)– Enough time for value to accrue to new trust?

CGEProblematic Structure #2 – Solution

•Trusts may sell New Opco shares

•X and family may access CGE

•Surplus funds may accumulate in Holdco

New Opco

Family Trust

#2

HoldcoX and X Family

Common shares (nominal)

Common shares

Preferred shares ($4M)

Family Trust

#1

CGEProblematic Structure #3 – Business Real Estate

Opco

Family Trust

XX Family

Business

•Purchaser may not want real estate

•Vendor may not want to sell real estate

•Difficult to spin out real estate prior to sale of Opco

•May preclude use of CGE

Real Estate

Holdco

CGEProblematic Structure #3 – Solution

1. Create a new corporation to purchase real estate in first place; or

2. Take steps to spin out real estate into separate corporation:➢ Can’t be in contemplation of sale➢ Valuation➢ Cost➢ Land transfer tax

CGEProblematic Structure #3 – Solution

Opco

Family Trust

XX Family

Business

•May sell Opco and/or Business Realco

•May sell one corporation and retain other

•Both corporations’ shares may qualify for CGE

•May facilitate succession planning Real Estate

BusinessRealco

Holdco

CGEProblematic Structure #4 – Foreign Activity

Opco

Family Trust

XX Family

Canadian Business

•Is Opco’s business primarily (50%) carried on in Canada?

•Same issue if use a foreign subsidiary

•May preclude use of CGE

Foreign Business

Holdco

CGEProblematic Structure #4 – Solution

Opco

Family Trust

XX Family

Canadian Business

•May sell Opco and/or Foreign Opco

•Shares of Opco may qualify for CGE

•Shares of Foreign Opco will not qualify for CGE

•Best to set up initially

Foreign Business

ForeignOpco

Holdco

Section 84.1 Planning

• Provision of Income Tax Act

• Anti-surplus stripping rules

• Planning combines section 84.1, RDTOH and CDA to provide tax deferral

• No advance planning required

• Consider where CGE not available and/or large capital gain

Section 84.1 PlanningExample

• Assume:- $10 million capital gain on sale- No capital gains exemption

• Without planning:- $7,500,000 after-tax funds- All held personally

• With planning:- $8,750,000 after-tax funds (½ personally; ½ in holding company)- Tax deferral of $1.25 million

Section 84.1 PlanningExample

Opco

Holdco

VendorPurchaser

Common shares

Common shares

Cash

($4.375 million)

Cash

($4.375 million)

Hybrid Sale Transactions

• Combination of asset and share sale

• Purchaser – advantages of asset purchase

• Vendor – advantages of share sale

• Many variations depending on specific circumstances

• Common characteristics:➢ Vendor sells shares of Target corporation to purchaser➢ Target corporation sells assets to purchaser

Earnout PaymentsShare Sale

• Option #1 – Determine value of earnout at time of sale➢ How to determine?➢ Additional amounts received – fully taxable➢ Capital loss – only carry back up to three years

• Option #2 – Cost recovery method➢ Capital gains treatment➢ Amounts received reduce ACB of shares➢ Amounts received in excess of ACB of shares – capital gain➢ Based on amounts determinable

Earnout PaymentsShare Sale – Conditions for Cost Recovery Method

• Arm’s length capital transaction

• Due to difficulty in valuing underlying goodwill

• Ends no later than 5 years after end of corporation’s tax year in which disposition occurred

• Notify CRA

• Vendor is Canadian resident

Earnout PaymentsGoodwill

• Purchase price adjustments – fully taxable per s. 12(1)(g)

• Guaranteed minimum:➢ Cumulative eligible capital treatment

➢ Consider limiting upside in exchange for higher minimum?

• Consider reverse earnout:➢ Sets maximum

➢ Repayment by vendor if targets not met

➢ Issue of determining FMV up front

Thank you!