Commercial Transaction - Buying a Business
After you and the client have decided on a business structure, you may be called upon to draft an agreement to buy an existing business. How the purchase is structured will have immediate cost consequences and will influence how the ongoing business operates.
BASS Rule of Thumb
There are a number of areas where the interests of a purchaser and a vendor naturally diverge in the buying and selling of a business. There is a general rule of thumb known as Buy Assets Sell Shares (BASS). Generally, purchasers want to buy assets and vendors want to sell shares.
There are exceptions to the BASS rule and you must always take the nuances of your client’s particular transaction into account. For example, if a business is being sold that predominantly owns real property, then the purchaser may want to buy shares because of the opportunity to avoid property transfer tax, which may make assumption of the liabilities associated with a share purchase “worth the risk”.
In general, it is usual for a vendor to want to sell shares to take advantage of capital gains exemptions available on the sale of shares (although the exemptions are not available in all circumstances and tax advice should always be obtained to confirm their availability in your circumstances). Purchasers often want to buy assets in order to avoid the claims that follow the shares in a company. As well, buying assets allows the value being paid for the assets to be allocated to them and depreciated for tax purposes over the life of the assets – it is not uncommon for even very valuable assets to have been significantly depreciated by a vendor on the vendor’s own books and where shares are purchased the book value for those assets is what the purchaser inherits for tax purposes even if the price being paid for the shares reflects the higher actual value. An asset purchase also allows the purchaser to easily acquire only a portion of the assets owned by the vendor, if for example, there are assets in the vendor company which are not core to the business.
A purchase of shares means that the buyer is buying the company, including all of its rights and benefits as well as its warts. These liabilities may include ongoing or potential litigation, income tax and other tax liabilities, products liabilities and other obligations – the list goes on.
The different tax and liability implications for a purchase of assets versus a purchase of shares means that negotiation of the structure of the transaction often proceeds in concert with negotiation of the purchase price. Given the vendor’s better end position with a share sale, the purchaser may be able to negotiate a lower purchase price for shares than they might for assets as a way of offsetting the lost future depreciation, deductions, and potential liabilities associated with the company.
Other factors will also influence the choice of structure for the sale. For example, a purchase of shares may be desirable to a purchaser where the nature of the business is such that transferring its assets will pose practical challenges – a trucking company with a fleet of vehicles and operating licenses in several jurisdictions may be much more attractive as a share purchase that can be implemented with few simple resolutions when the alternative is a multitude of individual vehicle transfers, applications for new operating licenses in several jurisdictions, etc.
For further information on the issue of whether a business acquisition should be accomplished by a share purchase or asset purchase, please refer to Buying and Selling a Business – Annotated Precedents (looseleaf, The Continuing Education Society of BC). Excerpts from Chapter 1 are included in this module.
Allocation of Purchase Price
If an asset purchase/sale is being made, the purchaser will generally want to allocate the highest price to the depreciable assets and the vendor will want to allocate the highest price to the non-depreciable assets. (A common example of this is in a sale of commercial real estate. The vendor wants most of the price allocated to the land while the purchaser wants most allocated to the building.)
If the portion of the purchase price allocated to particular assets exceeds the depreciated value for those assets on the vendor’s books, the vendor may have to pay “recapture” income tax. Therefore, the vendor will usually want to keep the purchase price allocation to each asset at no more than the depreciated value carried on the vendor’s books, while the purchaser will want to keep the price allocation high for the assets with the most favourable depreciation rates. Again, these competing objectives can result in corresponding changes to the negotiated purchase price.
Goods and Services Tax (GST) is payable on equipment, leasehold improvements, inventory and goodwill, but in many cases the parties may agree to a joint election pursuant to section 167(1) of the Excise Tax Act if the sale is a supply of all or substantially all of the assets of a business – thus avoiding the need to pay the tax at closing. In order to qualify for this election both parties must be GST registrants at the time of closing, so if the purchaser is a newly-formed company you must ensure that it has registered for GST purposes (the vendor will most often already be a registrant in order to carry on the business). Where the Vendor is not registered for GST, however (as for example, a dental practice), the section 167(1) election is not available. If there are any assets being excluded from the purchase, it is prudent to obtain tax advice regarding whether the GST election will still be available, as Canada Revenue Agency has policies regarding what constitutes “substantially all” of the assets. Consideration also needs to be given to those assets that are subject to Provincial Sales Tax (PST).
If a share purchase and sale is being made and there are multiple classes of shares involved, the agreement should indicate how the parties have agreed to allocate the purchase price among the different classes of shares.
It is generally advisable that the purchase agreement identify, ideally with the input of a financial advisor, the allocation of the purchase price to the various classes of assets or shares. Parties frequently don’t consider these issues, so pay immediate attention to these issues if you become involved only after the agreement has been signed.