January 1, 1999
By Canadian Consulting Engineer
About 20 years ago, Harold Bloom and two younger men founded a firm of consulting engineers. The firm has grown substantially. It now employs 15 people but the original partners have retained control....
About 20 years ago, Harold Bloom and two younger men founded a firm of consulting engineers. The firm has grown substantially. It now employs 15 people but the original partners have retained control.
Harold came to see me in January. “We’ve received a letter of interest from a company that wants to take us over,” he said. “The company that approached us is a multi-national. Its head office is in Germany. If we join with them, it’s likely we could develop some interesting work. In the meantime, they want to purchase our shares.”
“On what terms?” I asked.
“That is the interesting part. If they bought the shares for cash, I understand we would owe tax on the capital gain. They’ve suggested that we exchange our shares for shares in the parent company. That way we could avoid income taxes.”
“Slow down a bit,” I said. “There are a couple of ideas you need to reflect on. It is true that you can defer taxes on certain types of share-for-share exchanges, but not on all of them. For example, the shares you receive in exchange for your shares must be from a Canadian corporation. You mentioned that you were talking with a German company. Are they offering you shares in a Canadian corporation or a foreign one?”
“It’s my impression that they are talking about shares in a German company,” Harold said.
“Then you are unlikely to get a tax-free rollover. But even if the transaction can be structured to obtain tax free status, it may be a mistake for you and your partners to exchange your shares for a minority interest in a company you don’t know much about. You’ve always been able to make your own decisions. As minority shareholders you may not get a voice in company affairs. You might be better advised to take the cash and pay your taxes.”
“How much tax would we owe?” Harold asked. “I was told it might be 40% of the value of our company–which we figure to be worth about $2 million.”
“The tax on capital gains is about 40%,” I said. “However, I think that you would qualify for a capital gains exemption on the sale of your shares.”
“I thought the capital gains exemption died some time ago.”
“It did–for most assets,” I replied. “But it still exists for the sale of shares of a qualifying small business corporation, or SBC. An SBC is a Canadian-controlled private corporation which at the time of sale is using at least 90% of its assets carrying on an active business in Canada. In order to qualify for the exemption, you must have owned your shares for at least 24 months before the sale.”
“About $500,000 of our company’s value is made up of term deposits that we have built up over the years. Does that present a problem for the 90% rule?” asked Harold.
“Although the assets used in the active business must be 90% of the value at the moment of sale,” I replied, “for the 24 months before the sale more than 50% of the assets must have been used in the active business. You seem to pass that test, so at first blush I think you would qualify for the exemption as long as we do some planning.”
“I guess that’s good news,” Harold said. “But as I recall the capital gains exemption limit was $100,000. That amount won’t save us much money on a $2 million capital gain.”
“The capital gains exemption for SBC’s is $500,000 and it is available for each shareholder. So if each of the vendors owns one-third of the business, a maximum of $1.5 million might be exempt. Furthermore, we might be able to arrange a deal in such a way that you would defer tax on your $500,000 in term deposits–that means you might receive $1.5 million in cash and still pay little or no tax.”
“That sounds great. I have to say that it is a better result than I was hoping for.”
“Don’t bring out the champagne yet, Harold,” I said. When dealing in these sections of the Income Tax Act there are always serious issues to be examined. Several provisions of the Act might restrict your ability to claim part or all of the exemption. A sale of this nature must be structured very carefully to avoid pitfalls.”
“It sounds as if you’re warning me to expect some hefty accounting fees,” he said.
“Legal fees, too,” I replied. “Before structuring the deal you will need competent professional advice well in advance. In fact, it would be sensible to begin work now to determine the best way to sell the company before you progress very far with your purchaser. You should determine how much after-tax money you are able to take away from the table before you begin negotiating. If it’s not enough, why bother to talk? And if you require the sale to be structured in a specific way, you should present that plan early on before the purchaser becomes attached to an alternate structure that might benefit him or her more.”
HENRY T. BULMASH, C.A.