Acquisitions (from the buyer’s perspective)

Tax treatment of different acquisitions

What are the differences in tax treatment between an acquisition of stock in a company and the acquisition of business assets and liabilities?

Purchasers generally prefer to purchase assets and sellers generally prefer to sell shares.

The main features of a stock purchase for a foreign purchaser using a Canadian acquisition vehicle (Canadian holdco) are:

  • the cost of the shares will not be deductible in the calculation of income since it will be an expenditure on account of capital, not income. Instead, the purchased shares will have a tax cost equal to the price paid for the shares. On a subsequent sale of the shares the purchaser can deduct the tax cost of the shares from the proceeds in the calculation of the purchaser’s gain, 50 per cent of which is included in income;
  • it is possible for the Canadian holdco to wind up the target and to ‘bump’ the tax cost of the target’s non-depreciable capital property by an amount equal to the lesser of the fair market value of the property and the tax cost of the shares. Bump planning is not available to create any additional tax shelter in respect of depreciable capital property or inventory;
  • if the share purchase results in an acquisition of control of the target, the ability of the target to use non-capital loss carry forwards will be restricted to income arising from the same or similar business. Capital loss carry forwards will be lost;
  • where the target is a Canadian-controlled private corporation (CCPC), the acquisition of control rules make it advisable to defer signing a share purchase agreement until closing if possible; and
  • the seller will receive capital gains treatment on a share sale. Fifty per cent of the seller’s gain on the sale of the shares is included in the seller’s income. If the target is a CCPC and the seller is an individual, approximately C$913,630 of the capital gain may be exempt from tax. If the seller is a corporation, the seller can reduce the capital gain on sale if the seller causes the target to pay a tax-free inter-corporate dividend from tax-paid retained earnings prior to the sale. These features of a share purchase largely explain the seller’s preference for a share sale.

 

The main features of an asset purchase for the foreign purchaser using a Canadian holdco are:

  • the Canadian holdco generally gets a step-up in the tax cost of the purchased assets. The types of property relevant for the step-up are depreciable capital property, non-depreciable capital property, and goodwill and intangible property. The Canadian holdco can deduct capital cost allowance (depreciation) calculated as a percentage of the stepped-up tax cost of the depreciable property. The rates of the allowance vary depending on the type of property concerned. Goodwill and intangible property can be depreciated at the rate of 5 per cent per year against the stepped-up tax cost. The stepped-up tax cost of non-depreciable capital property is deducted from the proceeds realised on a subsequent sale in the calculation of the capital gain (or loss). These features of an asset purchase largely explain purchasers’ preference for an asset purchase;
  • the seller’s capital and non-capital loss carry forwards cannot be purchased – they are tax accounts of the seller;
  • the liabilities of the seller’s business will generally be assumed by the purchaser as part of the purchase price, sometimes on a selective basis;
  • special treatment is available for the purchase of accounts receivable, prepaid expenses, reserves and warranties; and
  • to the extent that the purchase price allocated to each asset exceeds its tax cost, the seller will have an income inclusion. To the extent that past depreciation is ‘recaptured’, the income inclusion will be 100 per cent of the excess. For capital gains, the inclusion will be 50 per cent of the gain.

 

There are several features of the treatment of share acquisitions and asset acquisitions that are the same, namely:

  • the interest paid on funds borrowed to finance the purchase of shares or assets, and related financing charges, are deductible, subject to certain restrictions. On a share purchase, if the target is wound-up into or amalgamated with the Canadian holdco, interest on funds borrowed to finance the acquisition can be deducted from the income generated by the business;
  • special treatment is available for earnouts in the case of both share and asset purchases. It is not uncommon for an asset sale to be accompanied by earn-out provisions. From the purchaser’s perspective, the earn-out payments will be added to the tax cost of the shares or assets. From the seller’s perspective, deferral treatment is available subject to restrictions; and
  • special treatment is applied to non-competition payments. For the purchaser, non-competition payments generally qualify as an expenditure on goodwill depreciable at 5 per cent per annum. The seller is required to include 100 per cent of non-competition payments in income unless certain restrictive exceptions are engaged, in which case 50 per cent is included in income.
Step-up in basis

In what circumstances does a purchaser get a step-up in basis in the business assets of the target company? Can goodwill and other intangibles be depreciated for tax purposes in the event of the purchase of those assets, and the purchase of stock in a company owning those assets?

A step-up in basis is generally available in the case of an asset purchase and is only available in the case of a share purchase in respect of capital property pursuant to bump planning.

On an asset purchase, the purchaser and seller can agree to allocate the purchase price to various assets, and provided the allocation is reasonable the tax authorities will generally respect it. The main categories of assets for this purpose are depreciable capital property, non-depreciable capital property, and goodwill and other intangibles. In each case, the purchaser’s tax cost will be equal to the amount allocated by agreement to that asset. Depreciation at varying rates is available against the stepped-up tax cost of depreciable capital property and goodwill. The stepped-up tax cost of non-depreciable capital property is deducted from the proceeds on a subsequent sale to calculate the capital gain (or loss). Certain tax planning using sign-now, close-later deals to avoid the tax on investment income will be impacted by the new substantive CCPC rules.

Domicile of acquisition company

Is it preferable for an acquisition to be executed by an acquisition company established in or out of your jurisdiction?

It is generally preferable for a foreign corporation investing in Canada to enter Canada by first incorporating and capitalising a wholly owned Canadian-resident acquisition company (Canadian holdco). Canadian taxation rules permit the tax-free return of corporate stated capital to shareholders regardless of residence. Cross-border stated capital can be returned in priority to the repatriation of corporate earnings, which would be subject to dividend withholding tax, which can be paid using the (after-tax) earnings of the Canadian holdco.

It may be advisable in some circumstances to enter Canada from another jurisdiction other than the jurisdiction of the non-resident to take advantage of a more favourable double taxation convention between Canada and that other country. However, pursuant to recent changes in certain Canadian treaties due to the adoption of the Organisation for Economic Co-operation and Development’s (OECD) Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, Canada will now apply a principal purpose test to deny treaty benefits where one of the principal purposes of an arrangement was to obtain the benefit of a treaty in a way that is not in accord with the purpose of the treaty provision. Because of this change, it is generally considered that structuring of this type carries risk.

Company mergers and share exchanges

Are company mergers or share exchanges common forms of acquisition?

It is not possible under Canadian corporate law for a company incorporated in Canada to amalgamate with a company incorporated in a foreign jurisdiction. It is possible for a company incorporated in Canada to migrate, or ‘continue’, into a foreign jurisdiction, and then enter into a merger arrangement under the laws of the foreign jurisdiction. If the corporate continuance is accompanied by a change in tax residence, the migrating company would be subject to a tax of 25 per cent times the difference between the fair market value of its assets and the paid-up capital of its share. As a consequence, it is not common for foreign acquisitions to occur in that fashion.

The sale of shares by a Canadian resident for cash will give rise to a taxable event for the Canadian resident. There is a tax deferral available for situations where a Canadian resident exchanges their shares for other shares of the same corporation or for shares of another taxable Canadian corporation. However, there is no such deferral available where the shares owned by the Canadian resident are exchanged for shares of the foreign corporation. As a consequence, it is not common for foreign acquisitions to occur by share exchanges directly with a foreign corporation.

Tax benefits in issuing stock

Is there a tax benefit to the acquirer in issuing stock as consideration rather than cash?

Share exchanges involving the issuance of shares of the foreign purchaser in exchange for the shares of the target are taxable to the Canadian resident shareholder. However, where such a share exchange is desirable, it is possible to put in place a structure that facilitates a deferral for the Canadian resident shareholder. The Canadian shareholder can exchange their shares for shares of the target that are exchangeable into the shares of the foreign purchaser at some future date and that, in the meantime, track the economics of the foreign purchaser’s shares. Considering the costs to set up and maintain a share exchange structure, this solution is only considered where the tax deferral amounts are significant and span several years.

Transaction taxes

Are documentary taxes payable on the acquisition of stock or business assets and, if so, what are the rates and who is accountable? Are any other transaction taxes payable?

There are no stamp taxes or registration taxes levied on the acquisition of stock or business assets in Canada.

There may be land transfer tax imposed on a purchaser if the acquired assets include real property, although exemptions may be available. Under Ontario’s Land Transfer Tax Act, exemptions may be available for transactions involving ‘affiliated’ corporations or certain ‘butterfly’ transactions. No exemptions are available under the Quebec Act Respecting Duties on Transfers of Immovables.

There are federal and provincial indirect or sales taxes levied in Canada on most purchases. The primary indirect tax is imposed at the federal level as either the goods and services tax (GST) or the harmonised sales tax (HST), depending on the province or territory in which a supply is made or deemed to be made. Quebec has its own broadly based multi-stage value added tax, the QST, which is similar to the GST and HST. British Columbia, Manitoba and Saskatchewan impose a standalone provincial sales tax (PST) in addition to the federal GST. Depending on the province in which the supply is made, the rates of GST, HST, QST or PST range from 5 per cent to 15 per cent. These taxes are generally imposed on a purchaser and collectable by a seller.

There are generally no indirect or sales taxes imposed on an acquisition of stock.

On an acquisition of assets, there may be GST or HST if the assets acquired were used previously in activities that involved the making of taxable supplies. The purchaser will generally be eligible to recover the tax through the input tax credit mechanism, provided the assets are consumed, used or supplied in the course of activities that involve the making of taxable supplies. However, in certain circumstances where assets are transferred as a business or part of a business and the transferee acquires ownership, possession or use of all or substantially all of the property that can reasonably be regarded as being necessary for the transferee to be capable of carrying on the business or part of a business, the transferor and transferee can make a joint election under section 167 of the GST and HST legislation to have GST and HST not apply to the transfer of assets. Similar rules apply to the QST. For the provinces that impose PST, the tax may apply, depending on the location and nature of the assets transferred and the structure of the transaction. There are generally PST exemptions for the sale of raw materials and finished goods inventory, as well as manufacturing and production equipment.

Net operating losses, other tax attributes and insolvency proceedings

Are net operating losses, tax credits or other types of deferred tax asset subject to any limitations after a change of control of the target or in any other circumstances? If not, are there techniques for preserving them? Are acquisitions or reorganisations of bankrupt or insolvent companies subject to any special rules or tax regimes?

Net operating losses incurred by a corporation in a taxation year can generally be carried forward for 20 years or carried back for three years. To limit trading in loss corporations, the Income Tax Act (ITA) contains provisions intended to restrict the use of loss carry-forwards in situations where there has been an acquisition of control of the corporation that generated the losses. Generally, an acquisition of shares sufficient to ensure the acquirer’s ability to elect a majority of the board of directors will trigger an acquisition of control under the ITA. Net operating losses can only be used following an acquisition of control if the corporation continues to carry on the business that generated the losses, and then only to reduce income from that business or a similar business. The ITA also contains provisions designed to prevent the artificial avoidance or deferral of an acquisition of control. An acquisition of control can also restrict future utilisation of investment tax credits, resource expense balances, and scientific research and development expenses. Net capital loss carry-forwards expire on an acquisition of control.

Acquisitions or reorganisations of bankrupt or insolvent companies will often attract the application of the debt forgiveness rules in the ITA, which generally provide that where debt is settled for less than its principal amount, the forgiven amount will reduce certain tax attributes of the debtor (eg, loss carry-forwards, resource expense balances, undepreciated capital cost balances, etc). Any remaining forgiven amount will generally result in an income inclusion for the debtor and be subject to tax as a capital gain.

Interest relief

Does an acquisition company get interest relief for borrowings to acquire the target? Are there restrictions on deductibility generally or where the lender is foreign, a related party, or both? In particular, are there capitalisation rules that prevent the pushdown of excessive debt?

Generally, reasonable interest paid or payable on borrowings used for the purpose of earning income from a business or property is deductible in computing income under the ITA, subject to thin capitalisation restrictions.

The Canadian thin capitalisation rules generally limit the debt owed by a Canadian corporation to non-residents owning 25 per cent or more of the corporation’s shares by restricting the deductibility by the debtor corporation of interest if the ratio of such debt to the corporation’s equity exceeds 1.5:1. The amount of the denied interest is deemed to be a dividend to the non-resident shareholder that is subject to withholding tax. The thin capitalisation rules also apply to non-resident corporations that carry on business in Canada (namely, through a Canadian branch), with certain modifications.

The thin capitalisation rules also address back-to-back loan arrangements, which typically interpose a third-party intermediary (eg, a foreign bank) between two related taxpayers (eg, a non-resident parent and its Canadian subsidiary) to avoid the rules that would have applied if the loan were made directly between the two related taxpayers, by deeming all or a portion of the loan to be owing by the Canadian subsidiary to the related taxpayer. These rules may apply to structures where, for instance, a non-resident parent of a Canadian subsidiary pledges a property to a third-party lender (the intermediary) as security for a loan made by an intermediary to the Canadian subsidiary.

The 2021 Canadian federal budget proposed a new earnings-stripping rule that would limit the amount of interest that certain businesses can deduct in computing their taxable income. Similar rules have already been adopted by other members of the Group of 7 (G7) and the European Union member states following the recommendations of the OECD in its Action 4 of the Base Erosion and Profit Shifting (BEPS) Action Plan. The purpose of this rule is to protect the Canadian tax base from erosion due to excessive debt and interest expense for situations not already covered by other measures such as the thin capitalisation rules. Excessive debt or interest expense can occur in many situations, such as where Canadian businesses bear a disproportionate burden of a multinational group’s third-party borrowings. The rule could apply to deny the deduction of interest that is otherwise deductible under the thin capitalisation and transfer pricing rules.

The proposed earnings-stripping rule would limit the amount of net interest expense that a corporation may deduct to no more than a fixed ratio of tax earnings before interest, taxes, depreciation, and amortisation (EBITDA), which is that corporation’s taxable income before taking into account interest expense, interest income and income tax, and deductions for depreciation and amortisation. The measure of interest expense would exclude interest that is not deductible under the thin capitalisation rules or other existing income tax rules. Interest expense and interest income related to debts owing between Canadian members of a corporate group would generally also be excluded. The new rule would be phased in, with a fixed ratio of 40 per cent for taxation years beginning on or after 1 January 2023 but before 1 January 2024 (the transition year), and 30 per cent for taxation years beginning on or after 1 January 2024. Interest denied under the proposed rules could be carried forward for up to 20 years or back for up to three years. Denied interest could be carried back to taxation years that begin prior to the effective date of the rule, to the extent the taxpayer would have had the capacity to deduct these denied expenses had the proposed rule been in effect for those years. Other relieving measures would allow Canadian members of a group to transfer unused capacity to deduct interest to other Canadian members of the group who would otherwise be limited by the proposed rule. A ‘group ratio’ rule would also be introduced to allow a taxpayer to deduct interest in excess of the fixed ratio where it can demonstrate that a higher deduction limit would be appropriate in light of the consolidated group’s ratio of net third-party interest to book EBITDA.

Trusts, partnerships and Canadian branches of non-resident taxpayers would also be subject to the new earnings-stripping rule. Exemptions would be available for:

  • Canadian-controlled private corporations, together with any associated corporations, that have taxable capital employed in Canada of less than C$15 million (referred to as the ‘small CCPC exception’);
  • groups of corporations and trusts whose aggregate net interest expense among their Canadian members is C$250,000 or less (referred to as the ‘de minimis exception’); and
  • certain standalone Canadian resident corporations and groups consisting exclusively of Canadian-resident corporations that carry on all or substantially all of their business in Canada, do not have any foreign affiliates, do not have any specified shareholders who are non-resident persons, and pay all or substantially all of their interest and financing expenses to persons other than tax-indifferent investors (referred to as the ‘domestic exception’).
Protections for acquisitions

What forms of protection are generally sought for stock and business asset acquisitions? How are they documented? How are any payments made following a claim under a warranty or indemnity treated from a tax perspective? Are they subject to withholding taxes or taxable in the hands of the recipient? Is tax indemnity insurance common in your jurisdiction?

In a business asset acquisition, the purchaser does not assume the general tax position of the vendor. Therefore, extensive representations and warranties are typically not seen in the context of a purchase and sale of business assets.

A transaction involving the purchase and sale of shares, on the other hand, customarily allocates to the vendor the tax liabilities of the target corporation that arise at any time prior to closing, and the purchaser will be responsible for the tax liabilities of the target corporation arising after closing. Representations and warranties are intended to reflect this allocation of tax liabilities. A vendor will generally be asked to provide a standard representation that all tax returns required to be filed as at the date of closing have been filed, and that all taxes have been paid. There are a number of other representations and warranties that are standard (eg, timely withholding and remittance of source deductions, existence of tax reserves or deferrals) and applicable to the relevant tax history and attributes of the target corporation (eg, absence of historic debt forgiveness events or loss restriction events). In general, tax representations and warranties survive closing until such time as the relevant assessment or reassessment period for pre-closing tax periods expires under the statutory limitations.

It is typical for a purchaser to require that the vendor indemnify the purchaser for any additional tax that is payable by the target corporation with respect to pre-closing tax periods or any tax that is payable as a consequence of an error in a representation and warranty given by the vendor. The parties will generally agree in the purchase and sale agreement that any such indemnity payment be treated as an adjustment to the purchase price, and as such would not be subject to withholding taxes or taxable in the hands of the purchaser on receipt.

The availability of representation and warranty insurance has increased in Canada in recent years and is becoming a more common feature of merger and acquisition transactions. Such insurance is designed to provide protection against unidentified tax risks, and underwriters, therefore, require fulsome due diligence to be completed prior to issuing coverage, with any issues identified during the due diligence process excluded from coverage. Other typical exclusions in the Canadian market include transfer pricing issues and issues relating to the restriction of tax losses.

The Department of Finance released draft legislation on 4 February 2022 implementing the mandatory disclosure rules announced in the 2021 Canadian federal budget. Among other things, the draft legislation expanded the already existing reportable transactions rules under the ITA. The draft legislation has not yet received Royal Assent. However, as currently drafted, where a vendor provides indemnity for pre-closing taxes, the vendor, its advisers and any promoters with respect to any tax planned pre-closing reorganisation could be required to report the reorganisation to the Canada Revenue Agency. The draft legislation provides an exemption for contractual protection that is offered in the normal commercial transactions context to a wide market. This suggests that obtaining representation and warranty insurance for pre-closing taxes would not cause a pre-closing transaction to be reportable.

The 2021 Canadian federal budget proposed a new earnings-stripping rule that would limit the amount of interest that certain businesses can deduct in computing their taxable income. Similar rules have already been adopted by other members of the G7 and the European Union member states following the recommendations of the OECD in its Action 4 of the BEPS Action Plan. The purpose of this rule is to protect the Canadian tax base from erosion due to excessive debt and interest expense for situations not already covered by other measures such as the thin capitalisation rules. Excessive debt or interest expense can occur in many situations, such as where Canadian businesses bear a disproportionate burden of a multinational group’s third-party borrowings. The rule could apply to deny the deduction of interest that is otherwise deductible under the thin capitalisation and transfer pricing rules.

The proposed earnings-stripping rule would limit the amount of net interest expense that a corporation may deduct to no more than a fixed ratio of tax EBITDA, which is that corporation’s taxable income before taking into account interest expense, interest income and income tax, and deductions for depreciation and amortisation. The measure of interest expense would exclude interest that is not deductible under the thin capitalisation rules or other existing income tax rules. Interest expense and interest income related to debts owing between Canadian members of a corporate group would generally also be excluded. The new rule would be phased in, with a fixed ratio of 40 per cent for taxation years beginning on or after 1 January 2023 but before 1 January 2024 (the transition year), and 30 per cent for taxation years beginning on or after 1 January 2024. Interest denied under the proposed rules could be carried forward for up to 20 years or back for up to three years. Denied interest could be carried back to taxation years that begin prior to the effective date of the rule, to the extent the taxpayer would have had the capacity to deduct these denied expenses had the proposed rule been in effect for those years. Other relieving measures would allow Canadian members of a group to transfer unused capacity to deduct interest to other Canadian members of the group who would otherwise be limited by the proposed rule. A ‘group ratio’ rule would also be introduced to allow a taxpayer to deduct interest in excess of the fixed ratio where it can demonstrate that a higher deduction limit would be appropriate in light of the consolidated group’s ratio of net third-party interest to book EBITDA.

Trusts, partnerships and Canadian branches of non-resident taxpayers would also be subject to the new earnings-stripping rule. Exemptions would be available for:

  • Canadian-controlled private corporations, together with associated corporations, that have taxable capital employed in Canada of less than C$15 million (referred to as the ‘small CCPC exception’);
  • groups of corporations and trusts whose aggregate net interest expense among their Canadian members is C$250,000 or less (referred to as the ‘de minimis exception’); and
  • certain small standalone Canadian-resident corporations and groups consisting exclusively of Canadian-resident corporations that carry on all or substantially all of their business in Canada, do not have any foreign affiliates, do not have any specified shareholders who are non-resident persons, and pay all or substantially all of their interest and financing expenses to persons other than tax-indifferent investors (referred to as the ‘domestic exception’).