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Until 2017, the tax treatment of the sale of a company had been quite favourable to owners of Canadian businesses. Whether through the utilization of the lifetime Capital Gains Exemption (LCGE) on the sale of shares, or through taking advantage of low corporate tax rates on active income on an asset sale, vendors did not have to fork over substantial portions of the sale proceeds to the Canada Revenue Agency (CRA).
Since January 1, 2017, vendors haven’t been so fortunate when it comes to the sale of assets (share sales are largely unchanged, aside from an increase in the LCGE available). In the March 2016 Federal Budget, the government announced key changes to tax legislation that affected the after-tax proceeds to be retained when business owners sell their company’s assets. The new rules affected Canadian-Controlled Private Corporations (CCPCs); specifically, rules surrounding Eligible Capital Property (ECP). ECP includes intangible assets such as trademarks, customer lists, licenses, franchise rights, and most importantly, goodwill.
For many business owners, goodwill is one of the most substantial assets they have to sell. Developed over the lifetime of the company, it represents the value of your business, often associated with brand recognition, reputation with customers, and patents or proprietary technology, whether purchased or developed internally.
Under the old rules, half of the proceeds allocated to the sale of goodwill were subject to tax as active business income; currently 12.2% on income below $500,000 and 26.5% on income above $500,000 in Ontario. The other half of the proceeds were added to the company’s Capital Dividend Account (CDA), out of which dividends could be paid to shareholders with zero personal tax implications whatsoever. This allowed owners to distribute a portion of the sale proceeds tax-free, while deferring personal taxes on the remaining proceeds, which were taxed at the low active corporate rates.
Under the new rules, this tax deferral has disappeared. Sale proceeds allocated to goodwill are now subject to tax as inactive investment income in the form of capital gains, as opposed to active business income. This means that the effective tax rate of 6 – 13% in Ontario previously applied to a sale of goodwill has been increased to an effective tax rate of approximately 25%.
What should you do when selling assets or shares?
There are two ways to sell a company: sell the assets owned by the company, or sell the shares held in that company. There are also more complex hybrid models that are beyond the scope of this article. In general, buyers prefer to purchase assets, whereas vendors would rather sell shares for both tax and non-tax reasons. Under asset deals, buyers get to pick and choose the assets and liabilities they want and they benefit from being able to allocate fair market values to what they are buying. This can lead to tax savings in the form of higher depreciation and minimizing the impact of capital gains on asset sales down the road.
Vendors on the other hand would prefer to take advantage of the LCGE which, for 2021, exempts up to $892,218 of the capital gain from any personal tax whatsoever (aside from possible alternative minimum tax), assuming the company’s shares qualify at the time of the sale.
Under the rules introduced in 2017, vendors have an even stronger incentive towards share sales. Therefore, purchasers who want an asset sale may have to compensate the vendor for the additional taxes associated with such a deal.
If you are considering a sale of your business in 2021, it is worth reviewing your corporate structure first. Modifying the structure of your business may allow for partial sheltering of the capital gain and tax minimization on a sale.
Virtually no transaction is as significant as selling your business. Cashing out on a lifetime’s hard work should be an exciting time for any entrepreneur and one that keeps as much of the proceeds generated in your pocket as possible.
Deals can be complex and there are many ways to put them together. Given the changes brought in in 2017, there is even more reason to ensure careful attention is afforded to the process.
When contemplating such a substantial transaction, consulting with a tax professional can help ensure things go according to plan and that there are no unwelcome surprises, such as sharing more of the fruits of your labour with the tax authorities than necessary.
This article has been updated. It was first published in the December issue of the OCA Construction Comment magazine.
