Business Adviser

Buying a Business? – Check the Closets for Tax Skeletons

By Liz Murphy
Partner, Mergers & Acquisitions Tax, KPMG Enterprise, Toronto

For many private companies planning to grow, acquiring another business can be an important step toward achieving their goals. But if your company is considering buying another company, keep in mind that you are likely acquiring the other company’s tax liabilities too.

One way to minimize potential tax issues is to acquire a business’ assets rather than its shares. But if your sellers are entitled to the small business capital gains tax exemption on their shares, they may not agree to sell the assets.

If you’re planning to buy the shares of a business, it makes sense to “check the closets” for any potential tax problems that can affect the company’s value so you can negotiate terms to mitigate these issues before you finalize your deal.

Based on my experience with private company acquisitions, here are some questions to ask:

Are all tax payments up-to-date and are deductions well documented?
You’ll want to know that all your target company’s tax payments are up-to-date – ask to see tax returns and their supporting schedules for all open years. Tax deductions should be well supported in case the CRA challenges them. For example, the CRA has recently paid special attention to deductions such as reorganization or transaction costs and management fees paid to business owners’ personal holding companies.

Don’t forget sales taxes – recently we’ve seen the CRA looking at businesses’ compliance for GST/HST, including self-assessed GST on imports and input tax credit claims.

Are any asset transfers happening?
If your seller is planning any pre-sale transactions, you’ll inherit any tax obligations that arose from the transfer. You’ll want to be prepared for the CRA to question how any transferred assets were valued for tax purposes. It’s riskier to rely on internal valuations – you’ll have stronger evidence for the value of the assets if you have external valuations.

Does the company have tax losses?
If your target company has carried forward any losses, you may be able to use these losses after you acquire the company. But you’ll have to carefully consider the rules for doing so – for example, the losses may be deductible if the business continues to operate and it sells similar products and services.

Are there cross-border transactions with related companies?
Another recent interest for the CRA is transfer pricing. If your seller has transactions with related companies in other countries or even other provinces, you’ll want to confirm that their transfer pricing documentation is up-to-date and appropriately reflects pricing as if the companies were dealing at arm’s length.

Does the company have sales or other business in the US?
If your target company has sales in the US, you’ll need to investigate whether they met their US sales tax obligations and have good documentation to support this. We’ve seen the US tax authorities aggressively pursue Canadian companies that have US sales tax liabilities.

Also, have the company’s activities in the US made it liable for US income tax? For example, ask whether the company has signed contracts in the US, how much time its employees spend there and what their activities there involve. If a Canadian employee spends a substantial amount of time in the US, his or her presence there can actually create a “permanent establishment” of the company, making it liable for US tax.

Is a holding company involved in the deal?
If your sellers are entitled to the small business capital gains exemption, they may want to sell the shares of holding companies that in turn own the shares of the business you want. If so, you’ll need to look at the holding companies’ tax issues as well, including any pre-sale transactions the sellers may be planning.

Will your corporate group go over the small business deduction limit?
If your company is now entitled to the lower tax rate under the small business deduction, keep in mind that this rate starts to be phased out when a corporate group’s taxable capital exceeds $10 million. Your ability to claim refundable R&D tax credits at a higher rate can also be affected by an increase in the group’s capital or income. If your new acquisition puts your corporate group over these thresholds, you may want to keep potentially higher tax costs in mind when considering how much you want to pay for the company.

Are you protected from surprise tax costs after the sale?
As part of your deal, you may want an escrow arrangement including vendor take-back loans or a price reduction to account for tax liabilities, if warranted, along with an indemnity. Consult your lawyer to ensure you’re protected.

Acquiring another business is certainly an effective option for your private company to grow, whether you’re looking to eventually go public, get a private equity investor or remain with the same owners. Considering potential tax issues as part of your acquisition plans can help you make sure you pay a fair price for your new company and you don’t face costly tax surprises after the deal is done.