As Canada’s economy experiences an unprecedented wave of business transitions, mergers and acquisitions (M&A) and family succession planning are taking center stage. Whether buying, selling, or passing down a business, effective tax and structural planning is not just beneficial – it’s essential.
The below outlines the core considerations, risks, and strategies for Canadian entrepreneurs and advisors navigating ownership transitions.
1. Understand the Target Before Structuring the Deal
Successful M&A or succession starts with thorough due diligence. Key factors to investigate include:
- The target’s legal and regulatory environment,
- Shareholder structure (especially for Canadian Controlled Private Corporations – CCPCs),
- History of SR&ED claims, intercompany management fees, and tax attributes,
- Non-resident ownership or subsidiaries, which may require a transfer pricing review, and
- Tax department strength and internal controls.
Understanding the target’s tax posture helps inform structuring decisions and anticipate deal-breakers, such as aggressive tax positions or regulatory issues.
2. Asset vs. Share Sale: The Core Tax Decision
Asset Sale Benefits:
- Purchasers receive a step-up in asset tax cost, enabling future tax deductions.
- Greater control over what liabilities and assets are acquired.
Share Sale Benefits:
- Simpler transactions with fewer transfers of contracts or licenses.
- May allow vendors to claim the lifetime capital gains exemption (currently $1.25 million per shareholder for QSBC shares).
- Preferred by vendors, particularly when seeking to extract value with minimal tax.
The choice significantly impacts future depreciation, goodwill treatment, and overall tax burden. Hybrid structures (e.g., via “Newco”) can bridge gaps between buyer and seller goals.
3. Tax Due Diligence: Identifying Risks Early
Due diligence should assess:
- CRA reassessment history and audit exposure,
- Reasonableness of SR&ED claims,
- Intercompany transactions and fee arrangements,
- Loss carry forwards and their usability post-acquisition, and
- GST/HST, PST, and other indirect tax exposures.
A scope of work should be clearly defined, including which entities will be reviewed, access to data rooms, and the role of foreign advisors for international deals.
4. Structuring with Acquisition Companies (AcquisitionCo)
Using a Canadian AcquisitionCo offers multiple advantages:
- Facilitates PUC step-up, allowing tax-free repatriation of capital to non-resident investors.
- Enables bump planning to step up the ACB of non-depreciable capital assets, like shares or land.
- Allows post-acquisition amalgamation with the target to match interest deductibility with business income.
This is particularly important in international deals to avoid dividend withholding tax traps or inefficient “sandwich structures.”
5. Financing the Deal: Who Should Borrow?
Financing structures can involve:
- The foreign parent borrowing and subscribing capital,
- AcquisitionCo borrowing directly (with interest deductibility for tax purposes), and/or
- Target or post-amalgamated “Amalco” borrowing to align deductions with income.
Canadian rules do not allow consolidated tax reporting, so entity-level planning is essential to ensure interest deductibility and optimize financing costs.
6. The Power—and Pitfalls—of the Bump
When a Canadian company acquires another and then amalgamates or winds it up, it may “bump” the cost of eligible capital property (like shares or land) to fair market value.
Use Cases:
- Eliminate unrealized gains embedded in subsidiaries’ assets.
- Prepare for future tax-efficient dispositions.
Beware of Bump Denial Rules:
If a vendor or related party reacquires “bumped” property or substituted property (directly or indirectly), the bump can be denied. Detailed rules aim to prevent backdoor butterfly reorganizations and aggressive step-up planning.
A precise understanding of “specified shareholders,” “substituted property,” and “attributable FMV” is essential.
7. Post-Acquisition Integration and Tax Compliance
After the deal closes, integration continues through several key steps:
- Filing bump elections,
- Aligning fiscal year-ends,
- Tracking PUC, ACB, and CDA balances, and
- Ensuring ongoing compliance with cross-border tax rules and CRA requirements.
This is also the time to evaluate whether amalgamations or asset transfers are needed to streamline the structure.
8. Surplus Stripping: Non-Resident Traps
One of the most nuanced tax risks in cross-border M&A planning aims to prevent non-residents from extracting corporate surplus as capital instead of dividends. In a typical trap scenario, a non-resident parent reorganizes ownership of Canadian subsidiaries, triggering a deemed dividend or a paid-up capital (PUC) grind.
Key points:
- Using a Canadian AcquisitionCo is often essential to preserve PUC when acquiring Canadian subsidiaries.
- The FMV minus PUC test determines the deemed dividend amount.
- Rules apply even if no consideration is exchanged, creating phantom dividend issues.
Care must be taken when transferring Canadian shares between related entities or when doing internal reorgs involving foreign affiliates.
9. Restrictive Covenants: Taxable or Capital?
When a seller agrees to a non-compete, it may result in ordinary income unless properly structured. Proper elections can allow the covenant to be treated as part of the capital gain on the sale if:
- The seller and buyer are at arm’s length,
- The non-compete is linked to preserving goodwill,
- No direct proceeds are received for the covenant, and
- A proper election is filed.
Mischaracterizing or ignoring restrictive covenants can lead to unnecessary tax. Valuing these properly and reflecting them in legal agreements is key.
10. Earn-Outs and Contingent Consideration
Earn-outs allow part of the purchase price to depend on future performance. Under CRA administrative policy (IT-426R), cost recovery method can defer tax until amounts become determinable, provided:
- The parties deal at arm’s length,
- The earn-out relates to unquantifiable goodwill,
- The term ends within five years, and
- The vendor requests this method with their return.
Reverse earn-outs, where price can be reduced post-close, may result in capital treatment if structured carefully. Failure to meet conditions can shift income treatment or trigger tax earlier than necessary.
11. Surplus Pool Optimization: CDA, GRIP, RDTOH, and Safe Income
Tax-efficient distributions after an acquisition rely on careful management of several key accounts:
- Capital Dividend Account (CDA): Enables tax-free distributions.
- General Rate Income Pool (GRIP): Allows for the payment of eligible dividends.
- Refundable Dividend Tax on Hand (RDTOH): Recovers refundable taxes.
- Safe Income: Supports intercorporate dividend tax-free status.
Effective planning around timing, designations, and elections is crucial to maximize these benefits.
12. Year-End Planning and Elections
Changes in control (AOC) or amalgamations can trigger year-end changes. An election can allow a deemed AOC year-end to align with the transaction timing if completed correctly. Amalgamations may trigger multiple year-ends and require careful tracking of pre-closing transactions. These year-ends affect loss carryforwards, dividend pools, and the availability of CCPC benefits.
Conclusion: M&A and Succession Are About More Than the Deal
In Canada, a successful business sale or transition is not simply about valuation and negotiation. Tax strategy is deeply embedded in every phase, from due diligence and entity selection, to financing and post-closing integration.
Whether transitioning to a family member or selling to a third party, business owners and their advisors must invest time in understanding:
- The tax character of the target,
- The goals of the buyer and seller,
- The structural options available, and
- The evolving complexity of anti-avoidance and bump denial rules.
By doing so, business owners not only maximize after-tax value but also preserve operational continuity and future flexibility. To talk further about your unique situation, please contact a Cardinal Point financial advisor.