Tax efficiency is a key element in any successful cross-border investment. In acquiring or investing in a Canadian business, finding a tax-efficient transaction structure and working through the tax consequences of potential financing arrangements are critical steps. This two-part series examines some of the tax issues that typically influence decisions about how to structure and finance acquisitions of, or investments in, Canadian businesses. In this first installment, we look at how tax-efficiency considerations can affect deal structures.
Part 1: General structuring considerations where a non-resident acquires a Canadian business
- Asset or share purchase?
- All else being equal, a non-resident purchaser will usually prefer to buy assets, while a vendor will generally favour a share sale.
- A purchaser will prefer an asset acquisition because a purchaser that acquires assets will get a step-up in the cost base of those assets, which should (i) increase the deductions that are available to the purchaser in respect of depreciable assets (including goodwill) and (ii) reduce its gains should it subsequently sell any of the assets.
- Vendors of Canadian businesses typically prefer to sell shares because individual shareholders may be able to take advantage of Canada’s lifetime capital gains exemption (a one-time exemption of approximately $800,000 that can be claimed by individual shareholders, including where they hold shares through a family trust, on the sale of certain Canadian company shares). Transactions can be structured as a hybrid share/asset sale so that vendors sell enough shares to claim the exemption, while the purchaser buys the assets directly and gets the benefits of an asset purchase.
- While vendors will typically have reasons for preferring a share sale, the cost to them of proceeding by way of an asset sale may not be very significant and is often less than the value of an asset sale to the purchaser. In fact, in many cases, an asset sale currently provides a significant tax deferral advantage to vendors (although recent legislative changes proposed in the federal budget would significantly reduce this deferral opportunity after 2016). In view of this, the economically efficient answer will often be to structure transactions as an asset sale or a hybrid share and asset sale while, if appropriate, increasing the purchase price to compensate the vendor for any incremental tax as a result of the change in structure.
- When the purchaser is a non-resident, additional factors may come into play. Generally speaking, in the case of a non-resident purchaser, an asset sale will provide greater flexibility from a structuring perspective. As discussed below, a non-resident purchaser may prefer not to hold the assets in a Canadian corporation for either Canadian or non-Canadian tax reasons. Similarly, a non-resident purchaser may prefer to acquire certain assets using a Canadian corporation and certain assets using a non-resident entity. If the non-resident purchaser acquires shares, it may be impossible to take the non-Canadian assets out of the Canadian corporation post-closing without triggering significant Canadian tax. Therefore, in cross-border acquisitions, there is even greater incentive to structure the deal as an asset sale than in domestic acquisitions.
- Asset purchase: branch or subsidiary?
- A non-resident acquiring assets of a Canadian business may do so directly through a branch or through a subsidiary, which could be a regular Canadian corporation or a Canadian “unlimited liability corporation” (ULC). The decision of which type of entity to use will be based largely on non-Canadian considerations, including U.S. or other foreign tax implications.
- Branch option: A non-resident that carries on business in Canada is subject to Canadian income tax (subject to an exception where a tax treaty applies to the non-resident, and the non-resident has no “permanent establishment” in Canada). Generally, a non-resident carrying on business in Canada through a branch will compute its income and pay tax in the same manner and at the same rates as if it were a Canadian resident. In addition, the non-resident will pay “branch tax” on any profits not re-invested in Canada. This branch tax is intended to mirror the dividend withholding tax that would be paid on dividends from a Canadian corporation to the same non-resident.
- Subsidiary option: From a Canadian income tax perspective ordinary Canadian corporations and ULCs are treated identically. Nova Scotia, British Columbia and Alberta have ULC legislation. However, U.S. investors may prefer to use a ULC because ULCs may be treated as disregarded entities for U.S. tax purposes. Special “anti-hybrid” rules in the Canada-U.S. Tax Treaty apply to hybrid entities like ULCs. Certain steps need to be taken in order to access certain benefits under the Canada-U.S. Tax Treaty, and it may not be possible to access certain benefits (particularly if the shareholder of the ULC is a U.S. LLC). The anti-hybridity rules should be considered when deciding whether to use a ULC. Also, due to the fact that US corporate tax rates are generally higher in the U.S. than in Canada, there may be tax deferral advantages of using a regular (non-ULC) Canadian corporation that outweigh the other benefits of using a ULC.
- Non-resident acquirors will typically prefer to acquire Canadian assets through a subsidiary as doing so is usually cleaner from an administrative and compliance perspective. However, some investors may prefer a branch. One significant consideration is whether the non-resident expects to sell the Canadian business in the future. If it does, acquiring through a Canadian subsidiary may be preferable since non-residents are not subject to Canadian tax on the sale of shares unless the shares are “taxable Canadian property, whereas a non-resident would generally be subject to Canadian tax on the sale of a branch. It may be possible however, to incorporate the branch immediately before the sale to avoid Canadian tax on the sale where the owner of the branch is resident in a jurisdiction that has a tax treaty with Canada.
- Share purchase:
- Acquisition company: Typically a non-resident investor acquiring shares of a Canadian company will benefit from making the acquisition through a Canadian acquisition company. The following considerations are significant:
- Generally speaking, a Canadian corporation can return paid-up capital (PUC) without any non-resident withholding tax. PUC is generally a corporation’s stated capital for corporate purposes, subject to specific adjustments and limitations in the Income Tax Act (the ITA) and generally represents amounts contributed to the corporation in exchange for shares. PUC is determined on a class-by-class basis. Accordingly, if a non-resident buys shares from a shareholder, the PUC of the acquired shares will be the historical PUC of the shares, notwithstanding that this amount is likely less than the amount the non-resident will have paid to acquire the shares.
- To make sure that the non-resident has full PUC and can get all of its investment back without any Canadian withholding tax, a new Canadian acquisition corporation can be set up. The non-resident will subscribe for shares of the acquisition company, and will have cross-border PUC equal to the full amount contributed for the shares. The acquisition company will then acquire the target shares. The acquisition company and target can be amalgamated post-closing (which results in both corporations continuing as a new amalgamated or combined entity).If no amalgamation occurs, going forward the target should be able to pay dividends to the Canadian acquisition company without triggering tax because generally dividends between Canadian corporations are not subject to tax (subject to several exceptions). Going forward, the Canadian company can return paid-up capital to the non-resident in an amount equal to the non-resident’s investment without attracting any Canadian withholding tax.
- Rollovers and exchangeable shares: If a purchaser acquires a Canadian business for consideration that includes issuing its own shares, it will usually be important to the vendor that it obtains a rollover in respect of the share portion of the consideration. In the case of a non-resident acquiror, achieving this result for the vendor is complicated by the fact that the ITA provides for a rollover on share exchanges only if the vendor receives shares of a Canadian corporation. A common (albeit complicated) workaround that generally preserves a rollover for Canadian tax purposes is an “exchangeable share” structure. Generally, this requires the Canadian vendor to accept payment (or partial payment) in shares of a Canadian corporation that are exchangeable for shares of the non-resident purchaser. Exchangeable shares are intended to be the economic equivalent of the purchaser shares, e.g. they typically have a dividend entitlement that mirror dividends paid on the purchaser’s shares. By using exchangeable shares, the Canadian vendor will typically be able to defer payment of Canadian tax until such time as those shares are exchanged for the non-resident purchaser’s shares (as would happen, for example, prior to a subsequent sale). There are a number of corporate and tax points to consider with respect to an exchangeable share structure, but in many cases such a structure can be implemented to the satisfaction of all sides.
- Bump: If a non-resident acquires shares of a Canadian corporation and wishes to take certain assets out of the target post-closing it may be possible to do so on a tax-free basis if the purchaser can “bump” the cost base of the assets in the target on the acquisition. This “bump” in cost base is only available with respect to non-depreciable capital assets, such as land and shares (therefore it cannot be used to take goodwill or most other operating assets out of a corporation). Often when a non-resident acquires a Canadian target with a foreign subsidiary the non-resident will benefit from bumping the shares of the foreign subsidiary and distributing them out of the target so that they are no longer held by the Canadian company. Determining the availability of the “bump” is very complicated and fact-dependent and there are a number of limitations on when the bump can be used.
Cross-border transactions involve a number of tax considerations and planning opportunities. It is important to consider all of the facts related to the status and business of the target and the purchaser in order to find the most efficient structure to achieve everyone’s commercial objectives. Another important and related piece of the puzzle is the financing of the acquisition. Financing considerations will be discussed in Part 2.