2016 Issue No. 16 4 April 2016 Tax Alert Canada Federal budget 2016-17 consequences for Canadian private company sale transactions EY Tax Alerts cover significant tax news, developments and changes in legislation that affect Canadian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY or EY Law advisor. On 22 March 2016, federal Finance Minister Bill Morneau tabled his first budget. The following is the executive summary highlights of Budget 2016 that are relevant to the purchase and sale of private companies. For a comprehensive and detailed review of all Budget 2016 measures, please read our Tax Alert 2016 Issue No. 14 on the 2016-17 federal budget. Eligible capital property (ECP) Sellers and potential sellers of businesses carried on by private corporations should be aware that changes proposed in Budget 2016 will potentially have significant negative tax consequences for transactions that close in 2017 and later. A fundamental consideration in virtually all Canadian private company sale transactions is whether the parties wish to structure the deal as either: A sale of net-tangible and intangible assets used in a business The sale of shares of the corporation carrying on the target business The sale of the shares of one or more personal holding companies that, directly or indirectly, own shares of a company carrying on the target business
While traditional views have generally held that purchasers will always prefer to buy the assets of the target business while sellers favour a sale of shares, it is possible in some circumstances to combine certain aspects of both asset and share sales to achieve a desirable result for both parties. A purchaser s bias to an asset transaction is based on an ability to amortize intangible and depreciable assets based on their fair market value purchase price and the reduced risks associated with inheriting the unknown liabilities of the corporation acquired. A seller s bias to a share deal is generally rooted in a lower tax rate for capital gains, flexibility in tax planning and the availability to shelter a portion of the sale proceeds from tax by the use of the shareholders lifetime capital gains exemption (CGE) on the sale of certain qualified small business corporation shares. Under current rules, where the resulting gain on the asset sale involves a significant goodwill component and/or where there are significant corporate tax attributes (e.g., operating losses), the effective tax rate on the sale of the net assets of the target business by a Canadian corporation is often more advantageous than a share sale. The sale of goodwill results in 50% of the proceeds being subject to tax, with the other 50% being available for tax-free distribution to shareholders as a capital dividend. The taxable portion of the proceeds on the sale of goodwill is taxed as active business income, while a share sale by a private corporation results in a capital gain that is taxed as investment income. Investment income is subject to an additional refundable tax in a Canadian-controlled private corporation (CCPC) that is refunded only when taxable dividends are paid to shareholders. Consequently in an asset transaction, if not all of the proceeds of the sale are distributed to individual shareholders, but are in part retained in a personal holding company, a significant tax deferral will result. This deferral opportunity has become a common tax planning technique which provides sellers with a significant portion of the cash proceeds available for their personal use and enjoyment while the balance of the after-tax proceeds can be invested in a holding company. The after-tax investment income earned on those funds is available for distribution to individual shareholders on a relatively tax-neutral basis and available to finance the business owner s retirement. Consequently, structuring a transaction as an asset deal often provides the sellers with greater after-tax proceeds (at least on a partially distributed basis) while at the same time providing the aforementioned tax and commercial benefits to the purchaser. Legislative changes Budget 2014 announced a consultation process to change the ECP regime which determines the taxation of goodwill and other intangibles on the sale of business assets. The Department of Finance has stated that the new proposals were intended to simplify the Income Tax Act by merging intangible assets into the same system as depreciable property. Budget 2016 includes a portion of the long-expected draft legislation to repeal the ECP regime (which treats the taxable 50% portion of the goodwill gain as business income) effective 1 January 2017. Under these proposals, purchasers will continue to enjoy the tax benefits of acquiring assets with the purchased Federal budget 2016-17: consequences for Canadian private company sale transactions 2
goodwill being amortized at similar rates under the capital cost allowance (CCA) system that currently exists for depreciable property. However, for sellers the proceeds related to the sale of goodwill will first recapture any amortization of previously purchased intangible assets, with the excess taxed as a capital gain subject to the additional refundable tax for CCPCs. Accordingly, dispositions of goodwill on or after 1 January 2017 will no longer benefit from the deferral opportunities as described above and consequently significantly reduce the capital to invest in new or existing businesses. In addition, it should be noted that CCPCs and their entrepreneurial shareholders will be the only group to see a reduction in the after-tax proceeds available from a sale of business assets as a result of these proposed changes. Entrepreneurs generally do not have funded pension arrangements and rely entirely on the sale of their business to provide income throughout their retirement. What are the likely consequences of these proposed changes? Sellers will likely wish to pursue a sale of shares which traditionally provides use of the CGE and other tax planning opportunities, and also avoids the commercial complexities that may arise on a sale of business assets. Sellers will look to purchasers to increase the price on asset transactions to share a portion of the tax benefit that a purchaser will enjoy from an asset structure compared to a share deal. If an asset sale is the preferred alternative, consideration should be given to closing the transaction (or realizing the gain on goodwill through a corporate reorganization) prior to the effective date for the new rules. Conversion of tax-deductible inter-corporate dividends into capital gains (section 55) Budget 2015 included proposals to deal with perceived abuses of the rules contained in section 55 of the Income Tax Act. These proposals are intended to expand the circumstances where a tax-deductible intercorporate dividend is recharacterized as a capital gain. These rules are an important consideration for most corporate distributions and a common technique for effectively managing the tax consequences on a sale of shares or the distribution of the after-tax proceeds on a sale of assets. The original proposed amendments and subsequent modifications to the proposed legislation contain numerous technical anomalies that arguably could result in inappropriate tax consequences for many transactions. Interested parties continue to provide comments to the Department of Finance to suggest changes that would provide a more equitable result for taxpayers. Budget 2016 makes reference to the fact that the government intends to introduce the previously announced measures, as modified to take into account consultations and deliberations since their release. Federal budget 2016-17: consequences for Canadian private company sale transactions 3
Transfers of life insurance policies Often the sale of shares of a private company requires a pre-closing distribution of certain assets that are not to be acquired by the purchaser. This may include certain investment assets which often will include various life insurance policies on the lives of the existing shareholders. Under existing legislation, a sale or distribution of a life insurance policy to a non-arm s-length corporation or partnership is deemed to occur at the policy s cash surrender value, notwithstanding that the corporation or partnership may pay the full value of the policy. Budget 2016 proposes to limit the tax benefits of such transfers, as well as retroactively adjust certain benefits associated with policies transferred before 22 March 2016. Budget 2016 proposes for dispositions of life insurance policies that occur after 21 March 2016 to include the fair market value of any consideration given in the policyholder s proceeds of disposition and the acquirer s cost. In addition, if there is a contribution of capital to a corporation or partnership, any increase in paid-up capital of a corporation or adjusted cost base in a partnership interest will be limited to the amount of the policyholder s proceeds of disposition. Budget 2016 also proposes to reduce the inclusion to the capital dividend account for private corporations and adjusted cost base for partnerships on an insurance policy death benefit payout for the excess consideration (the value of the policy in excess of the cash surrender value at the time of transfer) for policies transferred before the budget date, and in respect of a death occurring on or after the budget date. As well, any increase in paid-up capital of a corporation s shares or adjusted cost base of a partnership interest issued in satisfaction of the policy transfer will be limited to the proceeds of disposition. Other observations Corporate tax rates: No changes are proposed to the general corporate income tax rate. Budget 2016 proposes that the small-business tax rate remain at 10.5% after 2016. The small-business tax rate had been scheduled to be reduced to 9% by 2019. See Appendix A for a complete listing of 2016 corporate income tax rates by province. Personal income tax rates: Budget 2016 does not propose any further changes to personal income tax rates or income tax brackets. The changes to tax brackets and the increase in the highest federal marginal personal income tax rate from 29% to 33% in December 2015 remain in effect. See Appendix B for a listing of the combined federal and provincial top marginal personal income tax rates by province. Capital gains inclusion rates: It was speculated prior to Budget 2016 that the capital gains inclusion rate, currently 50%, was to be increased. Budget 2016 does not propose any amendments to the capital gains inclusion rate. Stock option benefits: It was speculated prior to Budget 2016 that there would be changes to the stock option benefit rules. Budget 2016 does not propose any amendments to the stock option rules. The issuance of shares or options to acquire shares to employees continues to be an effective tool to enable employees to benefit on a private company sale on a tax-effective basis. Federal budget 2016-17: consequences for Canadian private company sale transactions 4
Repeal of previously announced personal tax measures Previously announced measures and draft legislation relating to the exemption of capital gains on donations of proceeds arising from the sale of real estate and certain private company shares has been eliminated. These measures were scheduled to come into force on 1 January 2017 and would have provided a very tax-efficient method for donating private company sale proceeds for philanthropic purposes. About EY s Transaction Tax Services EY s Transaction Tax group consists of professionals focused on providing tax advice to purchasers and sellers in M&A transactions. Our sell side practice primarily advises private business owners on the various tax and estate planning strategies that should be considered in light of this significant monetization of family wealth. We work collaboratively with the business owner s team of financial and legal advisors to implement the planning that is most appropriate given their unique business and family circumstances. Learn more The proposed amendments to the ECP regime, if enacted, will have a significant impact on the strategies that may be appropriate on a private business divestiture. For more information and insight please contact your EY or EY Law advisor or one the Transaction Tax contacts listed below: Toronto Steve Landau +1 416 943 2067 steve.landau@ca.ey.com Craig Roskos +1 416 943 2309 craig.roskos@ca.ey.com Dave VanVoorst +1 416 941 7793 dave.a.vanvoorst@ca.ey.com Charanjit Girn +1 416 943 4454 charanjit.girn@ca.ey.com Matthew Mammola +1 416 943 2779 matthew.mammola@ca.ey.com Quebec Christian Desjardins +1 514 879 3551 christian.desjardins@ca.ey.com André Lortie +1 514 879 6686 andre.lortie@ca.ey.com Prairies Doron Barkai +1 403 206 5209 doron.barkai@ca.ey.com Kabir Sarda +1 403 206 547 kabir.sarda@ca.ey.com Vancouver Janette Pantry + 1 604 648 3699 janette.pantry@ca.ey.com Elise Rees + 1 604 643 5420 elise.rees@ca.ey.com And for up-to-date information on the federal, provincial and territorial budgets, visit ey.com/ca/budget. Federal budget 2016-17: consequences for Canadian private company sale transactions 5
Appendix A 2016 combined corporate income tax rates (as at 22 March 2016) Corporate income tax rates for active business income Corporate investment income tax rates Income eligible for small business deduction (SBD) (%) (generally up to $500,000) Manufacturing and processing (M&P) income not eligible for federal SBD (%) (greater than $500,000) General income not eligible for SBD (%) (non- M&P income) Investment income earned by CCPCs (%) Investment income earned by non-ccpcs (%) % % % % % Federal only 10.50 15.00 15.00 38.67 15.00 British Columbia 13.00 26.00 26.00 49.67 26.00 Alberta 13.50 27.00 27.00 50.67 27.00 Saskatchewan 12.50 25.00 27.00 50.67 27.00 Manitoba 10.50 (up to $450K) 22.50 ($450K- $500K) 27.00 27.00 50.67 27.00 Ontario 15.00 25.00 26.50 50.17 26.50 Quebec 18.50 26.90 26.90 50.57 26.90 New Brunswick 14.50 27.00 27.00 50.67 27.00 Nova Scotia 13.50 (up to $350K) 26.50 ($350K to $500K) 31.00 31.00 54.67 31.00 Prince Edward Island 15.00 31.00 31.00 54.67 31.00 Newfoundland and Labrador 13.50 20.00 29.00 52.67 29.00 Northwest Territories 14.50 26.50 26.50 50.17 26.50 Nunavut 14.50 27.00 27.00 50.67 27.00 Yukon 12.00/13.50 17.50 30.00 53.67 30.00 Federal budget 2016-17: consequences for Canadian private company sale transactions 6
Appendix B 2016 maximum combined personal marginal income tax rates (as at 22 March 2016) Ordinary income Eligible dividends 2016 Ordinary dividends Capital gains % % % % Federal only 33.00 24.81 26.30 16.50 British Columbia 47.70 31.30 40.61 23.85 Alberta 48.00 31.71 40.24 24.00 Saskatchewan 48.00 30.33 40.06 24.00 Manitoba 50.40 37.78 45.69 25.20 Ontario 53.53 39.34 45.30 26.76 Quebec 53.31 39.83 43.84 26.65 New Brunswick 58.75 43.79 51.75 29.38 Nova Scotia 54.00 41.58 46.97 27.00 Prince Edward Island 51.37 34.22 43.87 25.69 Newfoundland and Labrador 48.30 38.47 39.40 24.15 Northwest Territories 47.05 28.33 35.72 23.53 Nunavut 44.50 33.08 36.35 22.25 Yukon 48.00 24.81 40.17 24.00 Federal budget 2016-17: consequences for Canadian private company sale transactions 7
EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization and may refer to one or more of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. About EY s Tax Services EY s tax professionals across Canada provide you with deep technical knowledge, both global and local, combined with practical, commercial and industry experience. We offer a range of tax-saving services backed by in-depth industry knowledge. Our talented people, consistent methodologies and unwavering commitment to quality service help you build the strong compliance and reporting foundations and sustainable tax strategies that help your business achieve its potential. It s how we make a difference. For more information, visit ey.com/ca/tax. About EY Law EY Law LLP is a national firm of Canadian tax lawyers, allied with Ernst & Young LLP, specializing in tax litigation and tax counsel services. For more information, visit couzintaylor.com. 2016 Ernst & Young LLP. All Rights Reserved. A member firm of Ernst & Young Global Limited. This publication contains information in summary form, current as of the date of publication, and is intended for general guidance only. It should not be regarded as comprehensive or a substitute for professional advice. Before taking any particular course of action, contact EY or another professional advisor to discuss these matters in the context of your particular circumstances. We accept no responsibility for any loss or damage occasioned by your reliance on information contained in this publication. ey.com/ca Federal budget 2016-17: consequences for Canadian private company sale transactions 8