Transaction structure and taxation

An adviser without a working understanding of transaction structure and taxation negotiates with incomplete information. The adviser does not provide tax advice, which is the responsibility of the client's accountants and legal counsel, but must understand where value is transferred, since the amounts involved frequently exceed any difference achieved on price.

Share sale and asset sale

Sellers generally prefer a share sale. In Canada, an individual disposing of qualified small business corporation shares may be eligible for the lifetime capital gains exemption (LCGE), which may shelter a substantial portion of the gain from tax. The value of the exemption may justify a meaningful reduction in the headline price in exchange for a share sale.

Buyers generally prefer an asset purchase. An asset purchase leaves unknown liabilities with the seller and may allow the buyer to obtain a stepped-up tax basis in the acquired assets, generating additional capital cost allowance over subsequent years.

The same headline price therefore has different after-tax values to each party depending on the structure, and an exchange is generally available: the seller accepts a share sale at a lower price than it would require for an asset sale, and both parties achieve a better outcome than a negotiation confined to price.

The adviser's role is to identify and quantify this exchange, and to refer both parties to their own advisers for confirmation.

Purification and timing

For shares to qualify for the exemption, the corporation must generally satisfy asset tests requiring that its assets be used principally in an active business carried on in Canada rather than held as passive investments. A corporation holding excess cash, an investment portfolio or surplus real estate may fail these tests.

Purification, the removal of passive assets, requires time and is subject to holding-period requirements. A seller who becomes aware of the requirement shortly before completion may no longer be able to satisfy it. This illustrates the importance of commencing sell-side preparation well in advance, and identifying the issue early is among the more valuable contributions an adviser can make.

Common structures

Holding company sale. The buyer acquires the holding company rather than the operating company, which simplifies certain matters but transfers all of the holding company's liabilities.

Hybrid transaction. A combination of asset and share sale that divides the tax outcome between the parties, commonly used where the parties are close on price but divided on structure.

Rollover. The seller receives equity in the acquiring entity in place of part of the cash consideration, deferring tax and retaining exposure to future value. Rollovers are frequently sought by private equity buyers that wish to retain the owner's involvement, and they materially change the seller's risk position.

Earn-out. The tax treatment of earn-out consideration varies by structure and jurisdiction. An earn-out taxed as income rather than as a capital gain may be materially less valuable than its nominal amount suggests.

Cross-border transactions

A foreign buyer introduces considerations including withholding tax, treaty application, transfer pricing, foreign investment review and currency exposure. These are not matters for the adviser to resolve, but they should be raised before the letter of intent rather than during due diligence.

Guiding principle

The adviser should have sufficient knowledge to identify the issue, estimate its approximate magnitude and raise it early, and should then state explicitly that it requires the advice of the client's tax adviser and ensure that adviser is engaged. An adviser who offers speculative tax guidance exposes both the practice and the client to risk.