The sale of a privately held company can result in a sizable amount of tax.
The greater the growth, the more significant the pain from a tax perspective, as the government takes a larger cut of the purchase price. But with a little foresight and tax planning, this cut can be reduced.
Tax on capital gains (the increase in value of an asset since it was purchased) is largely unavoidable, but there are ways to reduce it. While there are a number of complex tax strategies that can be instituted on the sale of a business, what follows are some of the more simple approaches.
Broadly speaking, a sale of a business will be of shares or assets. With some exceptions, vendors typically prefer share sales to make use of the cost in their shares, capital loss carryovers and their qualified small business corporation (QSBC) capital gains exemptions.
Conversely, buyers typically prefer asset sales, which allow them to depreciate the assets and save tax over time.
On a share sale, the simplest way to reduce tax is to use the shareholder’s QSBC exemption. This relief was enacted in 1986 as a broad $500,000 exemption on capital gains realized by Canadian residents.
The application of this exemption is now limited to certain types of capital property, including QSBC shares, but the amount has increased to $824,176 and is now indexed to inflation.
There are a number of requirements that must be met in order to use this exemption, but, if satisfied, the result is an exemption of $824,176 on the gain on the shares.
With early planning, this exemption can be multiplied among family members. A shareholder can undertake a freeze of her shares and have a family trust subscribe for shares holding the future value of the company.
On sale of these shares, the trustee of the trust may allocate the gain from the sale to the beneficiaries.
The trust may then use the QSBC exemptions of the beneficiaries of the trust. In a four-person family, the exemption could thus be multiplied to just over $3.25 million, assuming sufficient growth since the freeze date.
Tax can also be saved by tax-free transactions to move out cash and reduce the value of the company.
Examples include repaying shareholder loans and issuing tax-free dividends out of the company’s capital dividend account. Planning can also be undertaken to issue tax-free intercorporate dividends to the extent of the company’s “safe income.”
These transactions must be undertaken carefully to avoid tax, but if done correctly the tax savings or deferral can be substantial.
On an asset sale, the simplest way to avoid tax is to allocate the purchase price efficiently, away from assets that give rise to full income inclusion or recapture. Where there has been genuine bargaining, the Canada Revenue Agency typically respects such allocations but may attempt to reallocate the purchase price if the allocation is unreasonable.
Trusts can also be useful on an asset sale. The end result after the company sells its assets is a company holding cash.
This cash may be distributed as a dividend among the beneficiaries of the trust, as the trustee chooses, making use of each beneficiary’s graduated tax rates.
These are a selection of the tax-saving or deferral options available. Some, such as hybrid deals, involving a combined asset and share sale, are more complex.
Others, such as the eligible small business corporation rollover, are simpler. But many of these structures require planning before sale, and there is no better time than now to consider how to save on tax. •
Jonathan Wright is a lawyer at Wright Legal practising in the areas of tax and corporate law.