Selling the business is part of the long-term plan for many small business owners. While many things can motivate a sale, thoughtful planning well in advance of a sale can help you save on taxes and prevent costly and unexpected tax issues. As the vendor, there is often a preference from a tax point of view to sell shares of the business, while the purchaser will often prefer to buy assets. In certain cases, a compromise can be made using a hybrid sale, which involves the sale of both assets and shares. In a previous article, "Tax considerations for the purchase or sale of a business," we discussed the implications of a share sale and an asset sale, as well as the option of a hybrid sale. In the discussion below, we will review tax considerations for vendors of an incorporated business in more depth. Whether you are planning years into the future or are in the process of selling your business right now, there are some important areas that you should consider to protect your interests and reduce your overall tax burden.
Preparation for a sale of your shares
A key step to take when getting ready for a share sale is to review the company's balance sheet and determine if there are assets that are not required to carry on the business. This generally involves selling or removing non-business assets to lower the value of the business and decrease the purchase price, thereby reducing the capital gains tax you will need to pay on the sale. This process can also help ensure that the shares of the corporation will qualify for the capital gains exemption and is discussed in more detail under "Qualified Small Business Corporation shares" below.
There are a number of ways to remove non-business assets from the corporation. For example, if the company has a capital dividend account balance, this should be paid out prior to the sale. The distribution will be tax-free and reduces the overall company assets and value. Similarly, shareholder loans should be paid off before the company is sold; however, if the valuation is based on net assets, there would be no impact to the purchase price as the assets and liabilities will decrease by the same amount.
Another strategy is to restructure shareholdings from individuals to a holding company. This may be considered in a variety of situations, such as when your lifetime capital gains exemption has already been claimed, or when the capital gain from the sale would be in excess of the exemption amount available. In these situations, thought may be given to whether it makes sense to extract "safe income" prior to a sale as a tax-free intercorporate dividend, which will lower the value of the company and thus reduce the capital gains tax on the sale. Safe income planning is complex and you should consult with your BDO tax advisor who can help you avoid unintended tax consequences.
An additional planning idea involves having shares of the corporation held by a family trust that includes one or more beneficiaries that are corporations. This allows far more flexibility as it is possible to flow dividends to the beneficiary corporation on a tax-free basis to keep the corporation purified while capital gains on qualifying shares can be allocated to individuals so that they can claim their capital gain exemptions. Note that the recently expanded tax on split income (TOSI) rules will need to be considered for any capital gains on shares that don't qualify for the capital gains exemption or dividends that are flowed to individual beneficiaries. If the TOSI rules apply, they will have a negative tax impact as such gains and dividends would be taxed at a high rate.
Qualified Small Business Corporation shares
As discussed in our previous article, selling shares of a qualified small business corporation (QSBC) can enable an individual shareholder to claim the capital gains exemption to shelter all or part of the resulting gain from tax.
Another benefit of ensuring the shares of the corporation qualify as QSBC shares is that family members who own the shares will generally not be subject to TOSI on the taxable capital gain resulting from the sale of such property. This means that even if the capital gains exemption has been fully utilized, an exclusion from the TOSI rules will be available if shares of the company qualify as shares of a QSBC at the time of disposition. Therefore, if the TOSI rules are a concern for any individual shareholders (for example, family members who are not active in the business), it may be advisable to ensure the shares qualify as QSBC shares in order for those individuals to rely on this exclusion from the TOSI rules. Note that this exclusion will not apply to capital gains realized by minors on non-arm's-length transfers.
As the shares of some corporations do not meet all of the requirements to qualify as QSBC shares, purification may be required before the sale. In fact, depending how far offside the corporation is, the purification may have to occur 24 months before the sale.
In particular, one requirement to qualify as QSBC shares is that 90% or more of the business' assets must be used in an active business in Canada. If your company fails to meet this requirement, you can address the issue by removing assets not used in the active business, such as excess cash or investments. Alternatively, you can buy new active business assets to tip the balance in your favour, use non-qualifying assets to pay off debts early, or pay out capital dividends. In some cases, even paying taxable dividends may make sense.
The process to meet other QSBC share requirements may take more time. For example, QSBC shares must not have been owned by anyone other than the individual seller, or a person or partner related to the seller, during the 24-month period immediately preceding the sale. So, in some cases, the sale may have to wait if claiming the capital gains exemption is crucial.
Finally, if you have an unincorporated business, you should not assume that you can't claim the capital gains exemption. First, some farming and fishing assets may qualify. Also, if certain conditions are met, it is possible to incorporate your business and then sell the shares of a corporation that qualifies as a QSBC.
In a share sale, the buyer will no doubt conduct a due diligence process to ensure that the company is in compliance with tax legislation both domestically and internationally. To prepare for this situation, and to uncover any potential issues that may be deal breakers or could result in the buyer pressing for a lower price, you should conduct a due diligence review of your own. This would include not only reviewing tax compliance, but also ensuring that the company has addressed and documented tax filing positions related to any contentious tax issues, unusual or significant transactions, and/or any items under audit by a tax authority. This will allow you to deal with these sorts of issues before a third-party due diligence process commences.
Planning for an asset sale
If you are selling business assets personally or through a corporation, the planning opportunities are more limited. Where assets of a corporation are being sold, the main tax planning steps will be related to finding tax-efficient ways to distribute the sale proceeds to the shareholders. Where assets are sold for a gain, a tax-free capital dividend may be paid to the shareholders. Other ways of distributing funds on a tax-free basis that may be available, depending on the circumstances, include repayment of shareholder loans and a return of paid-up capital. When these options have been utilized (or are not applicable), another alternative to consider is the payment of taxable dividends and whether to take advantage of a personal tax deferral by spreading out their payment over time.
Purchase and Sale Agreement considerations
Purchase and Sale Agreements (PSAs) for the sale of a business can be complex and vary depending on the type of sale, the nature of the corporation, and the circumstances of the shareholders. However, there are three areas of this agreement to which sellers should pay particular attention to avoid potential tax complications, as well as to identify planning opportunities.
1. Purchase price instalments
If agreed to by both parties, a fixed amount of the purchase price of the shares or assets of a business may be paid in instalments. Generally, tax is payable in the year the business is sold rather than when payment is received; however, if the payment is structured so that some or all of the proceeds are not receivable until after year end, you may be able to claim a reserve on capital gains based on the amount of the unpaid portion. This can spread the capital gain over several years, to a maximum of five. If you are selling to your children and if other conditions are met, the gain can be spread over a maximum of ten years.
Please note that an amount that is claimed as a reserve at the end of one year must be included as income in the following year, and a new reserve can be claimed if eligible. This process of claiming a reserve and deferring income may be continued until all proceeds have become receivable or until the time limit above has been met.
2. Non-competition agreement
It is common for the buyer to request a non-compete clause in the PSA, and such clauses generally fall under the restrictive covenant tax rules. If an amount is granted to the seller for the restrictive covenant, then that amount is generally deemed to be income and subject to full income tax. However, there is a complex series of exceptions. Some individuals attempt to bypass this issue by stating that the amount of the sale price allocated to the restrictive covenant is nil or only a nominal amount; however, the CRA has the ability to reallocate an amount they deem reasonable to the restrictive covenant and will tax this amount unless one of the exceptions apply. Given the unfavorable tax consequences of income treatment, the vendor will want to carefully consider whether the exceptions can be met so that the restrictive covenant payment can be taxed on capital account instead. This would involve addressing the issue with the purchaser and ensuring that any necessary elections are filed where applicable.
3. Earn-outs and reverse earn-outs
It is common for a portion of the purchase price to be tied to the performance of the business for a period of time after the sale, with the amounts and time period stipulated in the PSA. Such agreements generally fall into one of two categories—an earn-out or a reverse earn-out—and are used to help bridge the gap between the buyer's and the seller's valuation of the company. In an earn-out, the buyer typically pays a base amount on closing and additional payments based on performance against an agreed target. In a reverse earn-out, the full amount is payable to the seller, but if performance targets are not met, the proceeds for the seller will be reduced. In these situations, the purchase price is often payable in instalments, so the amount of future instalments may be reduced.
For an asset sale, a potential tax issue with an earn-out agreement is that the variable payments may be subject to tax as income rather than capital gains. In such a case, you may wish to consider a reverse earn-out agreement to help ensure the payments received will be taxed as capital gains. Note as well, the CRA has a specific beneficial administrative policy dealing with earn-out agreements and share sales. It is highly advisable to meet the conditions of this policy on a share sale to avoid unintended tax consequences.
The sale of any business is a long and complex endeavour, with issues such as timing, selling price, and shifts in the market all affecting the approach to the sale. Yet, with careful planning and guidance, you can effectively sell the business and ensure that tax doesn't claim the lion's share of your profit. For comprehensive assistance in selling your business, please talk to your BDO advisor.
The information in this publication is current as of October 21, 2019.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.