INCOME TAX LAW: A Share Purchase vs. an Asset Purchase of an Incorporated Business
This article is attempting to illustrate the type of reasoning necessary in order to decide if an asset purchase or share purchase of an incorporated business is best. As well as what short of spin-offs, butterflies or other divisive reorganizations for tax planning would be advantageous when purchasing a company that may have more than one location or subsidiaries etc… And then finally the process in preparing a request for an Advance Ruling from CRA and what the CRA looks for when providing you with an answer.
There are two basic methods for structuring the purchase and sale of an incorporated business: either the assets of the business are purchased, including the name, goodwill, etc., or the shares of the corporation that owns the assets are purchased. The decision as to the structure of the transaction (i.e. asset purchase versus share purchase) will depend on the circumstances. And the advantages associated with each circumstantial decision may not be shared by both the vendor and the purchaser. Thus, as is often the case, income tax considerations will result in the vendor preferring to sell shares and the purchaser preferring to purchase assets. Vendors, of course, will want to minimize their tax consequences in the year of the sale. If the transaction is structured as a share sale, any gain will be treated as a capital gain and, therefore, taxed at your personal tax rate on 50% of your net capital gain for that year. Further, at the individual level and as the vendor you are entitled to the $750,000 capital gains exemption. That is, up to $750,000 of the gain arising from the sale may be entirely exempt from tax. Also, if the transaction is structured as a share purchase, the purchaser will acquire all of the assets of the business, whether the purchaser wants them or not, and, more importantly, all of the liabilities of the business, both known and unknown. Thus, the seller will for the most part relieve him/herself from the business liabilities (including how employees would be affected and your obligations under the Employment Standards Act). Otherwise, if the transaction is structured as an asset purchase, the purchaser will be able to choose which assets the purchaser wishes to acquire and which liabilities the purchaser wishes to assume from among the total assets and liabilities of the business. Any assets that the purchaser does not purchase and any liabilities that the purchaser does not assume will remain with the vendor.
If, on the other hand, the transaction is structured as an asset sale, there will be two levels of taxation: first, when the corporation sells its assets and, second, when the corporation distributes the proceeds to its shareholders (you). Prior to the distribution, there is typically some amount of ordinary income taxable in the hands of the corporation. In particular, there is often the recapture of capital cost allowance on depreciable property (where, for example, equipment has been depreciated on the books of the vendor to an amount less than that allocated to it on the sale) and profit realized on the sale of inventory. Given the figures on your balance sheet an asset sale will surely generate a considerable amount of recaptured depreciation, capital gains, income inclusion on disposition of goodwill as eligible capital property and taxable dividends to shareholders, as well as land transfer tax, goods and services tax, and retail sales tax.
Thus, by choosing to effect the sale by way of a share sale, it would only prove worthy if we can ensure that we maximize tax-free distributions, minimize regular taxable income and taxable dividends, and maximize income as capital gains. While at the same time maximizing on the lifetime capital gains exemption (where OpCo [for example an Offered Private Corporation or “OpCo” for sale] is a Qualified Small Business Corporation (QSBC) given that it is a Canadian Controlled Private Corporation (CCPC) where its assets are used in an active business carried on in Canada for at least two years prior) for each of you (as specified in section 110.6 of the Canadian Income Tax Act (ITA)). Further, because OpCo has already been established as a QSBC that is not a professional corporation, a specified financial institution or involved primarily in real property activities, you (as individuals) also qualify for the Eligible Small Business Corporation Deferral (ESBC) should you choose to reinvest your proceeds from the sale of OpCo within 120 days of the sale or 60 days from the end of year into replacement ESBC shares, thereby deferring the capital gains tax on the original disposition of OpCo until you dispose of your newly acquired shares sometime in the future (as specified in section 44.1 of the ITA). Thus, given the nature of the offer by PurchaseCo (for example the purchasing company) to only acquire the business in Location Y, and in light of keeping with the intention to effect the sale as a share sale, it would necessitate the need to, in theory and form, spin-off the location into a separate corporate entity while maintaining the same respective shareholder interests, proportions and capital values in order to defer and prevent the onset of taxable deemed dispositions and other unfavorable tax consequences for both you and the acquirer.
It is my understanding that there is not a need to split-up the assets of OpCo so that there are two corporations and no one of you holds shares in more than one corporation, thereby a single-wing butterfly divisive reorganization will not be necessary. Instead, a spin-off divisive reorganization will allow you to spin-off the assets in Location Y so that there are two corporations each of which will be equally owned by the two of you exclusively. This will give you the freedom to sell your shares in Location Y as a separate corporate entity affording you all the business and tax benefits available through a share sale.
When preparing an advance ruling for any proposed transactions, such as spin-offs or single-wing butterflies for the sale of a corporation, it is important to remember that its effect is only administratively binding on the CRA as a matter of practice in order to maintain its goodwill with the taxpayers. Thus, although a good source of security and insurance against unpredictable tax consequences – so long as the transaction is carried out exactly according to the way specified in the request and no judicial change in the law or interpretation of it or substantial legislative changes have occurred in the interim – they cannot be relied upon as a matter of law and nor will the doctrine of estoppel bind the Crown for incorrect interpretations of the law by Crown officials. Thus, the CRA is immune to the consequences of its own mistakes even if the taxpayer who made the request relied on the ruling to his/her own detriment. Most advance rulings of today are primarily used to see how contemplated transactions will be affected by anti-avoidance rules, particularly the General Anti-Avoidance Rules (section 245 of the ITA), since at this level of law and administration most transactions are of sound formulation however its substance is of question.
The statutory rules for spin-offs, butterflies or other divisive reorganizations are found in paragraph 55(3)(a) and (b) of the ITA. Historically, the only example provided of a failure to comply with the object and spirit of the provisions is if a transferee does not receive its proportionate share of each type of property of the corporation. Otherwise, such transactions would not have GAAR (General Anti-Avoidance Rules) apply. Further, both the rules that apply for a butterfly or spin-off reorganization are affected by whether or not the owners are related and the residency of both the purchaser and vendor. Thus, given that both of you, for purposes of this transaction are so-called un-related persons as the original principle shareholders of the partially targeted single entity, OpCo, a Canadian resident corporation, (and as the intended vendors of it) and assuming that PurchaseCo is as well a Canadian resident corporation and not related to OpCo or you, the following “spin-off” divisive reorganization will prove most worthy in effecting the sale in the most tax-effective or advantageous manner, only after the fact (after the divisive reorganization has been transferred between the original shareholders at the end, and does not include the share-sale to an unrelated party as part of the original intentional series or events/transactions or course of actions necessary for this reorganization). However, the object of these divisive reorganizations is purely intended for so called reorganizing, separating and dividing up family or principal shareholders’ businesses. That is, the final divisive reorganization has to include the original shareholders as the principles of the new entities, in the same original manner and to the same degree as it was prior to the effect. Hence, a transferee (buyer, in this case), who is unrelated (as in this case) cannot, as part of a butterfly or spin-off, acquire 10 percent or more of the FMV of the assets or shares by the end of the divisive transaction. If the transaction involves a sale of shares to an arm’s length purchaser as part of the “entire series” (or course of events), it would not comply with the requisite use of paragraph 55(3)(a) and/or 55(3)(b) (and prevented by para. 55(3.1)(b)) of the ITA. This would be the case should immediately following the reorganization PurchseCo acquires a significant interest in one of the corporations. Hence, because the intent of your divisive reorganization is to create the opportunity for a share-sale of one of the final corporations, the advance ruling request will most likely not be granted (since you must disclose this intent within the request), unless the entire scheme falls under a permitted acquisition, exchange or redemption.
Don’t lose out because you weren’t prepared. Call the lawyers at Levy Zavet PC for information and assistance regarding your tax law rights and obligations.