Technology companies – in fact most small businesses – often have difficulty taking advantage of the recently enriched lifetime capital gains deduction. When first introduced the capital gains deduction was targeted the first $500,000 of capital gains on family farms and qualified small business corporation shares (“QSBCs”). Since then the lifetime capital gains limit has been increased to $806,800 for QSBCs and $1 million for family farms.
However it is always difficult for sellers to sell shares. Buyers prefer to buy assets for 2 reasons:
- The cost of shares is not deductible by the buyer against income – while most assets are at least partially deductible
- Shares of small business corporations are much more complex beasts to acquire and may include undisclosed liabilities or other “surprises” that buyers are understandably nervous about acquiring
Buyers and their legal representatives will typically discount the purchase price if the vendor insists on selling shares. In some cases buyers simply won’t consider acquiring shares.
Many small, private corporations have at least a few skeletons in their closets. Closely-held companies often operate a little too close to the line and sophisticated buyers will often engage professionals to uncover at least some of these.
As a former senior manager with PwC LLP in Vancouver I was seconded to a due diligence team looking at the potential acquisition of a technology company. As it happened, the target company was one of a number of companies owned by the same entrepreneur. The entrepreneur had separate accounting firms handling each of his companies.
The problem was that he never informed his accountants of the existence of the other companies. Each year he filed for refundable SR&ED tax credits with one of his companies. Presumably his accountants were unaware of the existence of these other companies, since they were not disclosed on the tax returns as “associated” corporations.
Because of the amount of taxable income of the associated group, the corporation would not have been entitled to high-rate refundable tax credits. Thus any purchaser could be on the hook for undisclosed tax liabilities – and penalties – in the millions of dollars.
Of course it isn’t only undisclosed tax liabilities that could surface after an acquisition. There could be problems with employees, former employees, customers or suppliers. With small corporations eligible for the lifetime capital gains exemption, financial statements are often merely compiled with little or no assurance from the public accountants drafting the statements.
For that reason most accounting and legal professionals will advise buyers of QSBCs to purchase assets – or to discount the purchase price and conduct significant due diligence before determining that price.
CAPITAL DIVIDENDS AS AN ALTERNATIVE STRATEGY
Technology entrepreneurs looking to sell their companies should understand that the value of their companies is most often determined by the value of their IP.
Selling intellectual property developed by a technology company now results in a capital gain. With capital gains, only 1/2 of the gain is taxable. The remaining un-taxed half can be distributed tax-free to shareholders via an amount paid out of the capital dividend account (“CDA”).
So rather than selling shares – typically at a discount – the entrepreneur keeps the company and sells the IP within the company. So the sale price is higher, the sale is only partially taxable and may even be shielded by non-capital losses, SR&ED ITCs or SR&ED expenditure pools within the company. When the proceeds are distributed, the company can elect to pay dividends from the CDA account.
While this works well for technology companies that have IP, it can also work for any corporation selling goodwill as well. Usually buyers will attempt to structure their purchase so that proceeds are allocated more to tangible assets which can be depreciated more quickly. This may result in fully taxable “recaptured” depreciation.
For entrepreneurs that have done this before, be aware that the rules around gains on the sale of what used to be “eligible capital property” have changed in the last few years. Clearly each company’s particular circumstances will be unique. So it pays to get advice from a tax professional that you trust.