If you are considering selling your small business corporation it is important to plan whether a sale of assets or a sale of shares is most optimal. An effective way to do so is to compare the net cash retained from each alternative.
Sale of Shares
For individuals who are looking at selling their shares, there is the Lifetime Capital Gains Exemption (‘LCGE’) that is potentially available. The 2013 Federal Budget increased the LCGE to $800,000, and for subsequent years the exemption has been indexed to inflation. For 2021, the LCGE is $892,218 – this means up to $446,109 of taxable capital gains can be sheltered from any tax (because only half of capital gains are taxable).
To be eligible to claim the LCGE, it must be determined if the shares being sold are Qualified Small Business Corporation (‘QSBC’) shares. The definition of a QSBC share can be found in subsection 110.6(1) of the Income Tax Act (‘ITA’) and is quite complex. Please reach out to your Welch advisor if you have any questions in regards to QSBC shares and qualifying for the LCGE.
After determining if shares sold are QSBC shares, personal taxes payable can be determined at the applicable marginal tax rates. Because the Canadian personal tax system is a progressive system, the tax rate payable will depend on a person’s level of income. For income over $220,000, the marginal tax rate on taxable capital gains would be 26.77% (50% x 53.53%).
For a sale of shares, the net cash retained can be calculated as follows:
|Proceeds of disposition – P
|Adjusted cost basis (ACB)
|Lifetime capital gains exemption (if applicable)
|Capital gain – A
|Taxable capital gain (50%) – B
|Personal taxes payable (marginal tax rate %) – C
|NET CASH RETAINED
|P – C
Sale of Assets
For a sale of assets, the corporate taxes must be calculated on the asset disposition first. This can be somewhat complicated as the sale of assets can generate both business income and capital gains that are taxed at different corporate tax rates. The corporation would pay tax on the taxable capital gain based on the following framework:
- The taxable capital gain (50% of the capital gain) is subject to a corporate tax rate of 50.2%
- The corporation adds 30.7% of the taxable capital gain to its Refundable Dividend Tax on Hand (‘RDTOH’) account
- A full recovery of RDTOH means that the net corporate tax on the taxable capital gain is 19.5% [50.2% minus 30.7%]
- Refundable tax is recovered at a rate of 38.3% of dividends paid, i.e. a taxable dividend of $100,000 would lead to a $38,300 refund to a corporation, provided that its RDTOH pool is at least this amount
Then, the funds available to distribute (net of corporate taxes) are assumed to be all paid out to calculate the applicable personal taxes. This provides the ability to compare apples to apples, or in this case, the net cash retained by you under both alternatives.
The most tax-effective way to distribute the excess funds would be to maximize any tax-free capital dividends (coming from the 50% tax free portion of the capital gain) that can be paid out of the Capital Dividend Account (‘CDA’). Then the remaining net proceeds are distributed out as taxable dividends. First, if there is any General Rate Income Pool (‘GRIP’) (business income taxed at the higher non-small business tax rate) available, eligible dividends would be paid to the extent of available GRIP. Eligible dividends are taxed at a lower rate compared to non-eligible dividends, because higher corporate business tax rates were paid on that income. After, CDA and GRIP pools are fully utilized, the remaining distributions are assumed to be paid out as non-eligible dividends. Again, the marginal tax rates on the taxable dividends would depend on a person’s level of income. For income over $220,000 the eligible dividend rate would be 39.34% and the non-eligible dividend rate would be 47.74%.
For a sale of assets, the net cash retained can be calculated as follows:
|Proceeds of disposition – P
|Less: Capital dividends paid
|Corporate taxes payable
|Net corporate taxes – A
|Personal taxes payable (marginal tax rate %) – B
|NET CASH RETAINED
|P – A – B
Tax Planning Considerations
Here are some other tax planning items to consider when contemplating a share or asset deal:
Earnout sale (share sale or asset sale):
An earnout sale is when part of the purchase price would be subject to an earnout, i.e. part of the proceeds is at risk if certain milestones are not achieved. The tax reporting with an earnout can be complex, however, it can include a favorable CRA policy that earnout proceeds are only reported, for tax purposes, when earned in a subsequent year, resulting in a deferral of tax. However, the CRA policy only applies when a business is sold as a share deal.
For asset deals subject to an earnout, the total potential proceeds may have to be reported initially and would separately require a capital loss to be reported if some proceeds are ultimately not collected. The preceding would be a cash-flow issue for a long earn out period as taxes would have to be paid on total potential proceeds, even when not yet all received. For asset sales subject to an earnout, it would be advantageous in negotiations to try and shift as much of the proceeds to be paid at closing date, rather than in the future. However, it may be possible to structure this in way to allow for reporting a portion of the income in subsequent years to achieve a deferral of some of the tax to be paid.
Tax shield benefit (asset deal):
When a buyer purchases assets, a portion of the asset cost may be amortized for tax purposes – the amortization is beneficial because it offsets business income and therefore saves future tax. A purchase of a business as a share deal would not create the same opportunity because the cost of the purchase would be in the cost basis of the shares acquired – this does not lead to an amortization opportunity for the purchaser.
It is important to consider future tax liabilities when agreeing to a purchase price for assets or shares. It might be necessary to contemplate a reduced selling price if the buyer is willing to purchase shares wherein some of the tax savings are shared with the buyer. This may be acceptable to you, particularly if you are paying much less tax on a share deal if you can claim the LCGE.
Closing date hovering year-end (share deal):
If you are considering selling your shares near the end of the calendar year, if the transaction can be deferred until the following year, you will benefit from an increase to your available LCGE. As mentioned above, the exemption is indexed to inflation and will increase each year until it reaches $1 million.. Additionally, you will be able to delay the payment of any tax by an extra year.
If you are looking to sell your business, it is a complicated matter that involves many considerations in addition to those addressed here, so make sure you reach out to your Welch advisor as we are always here to help.