Buying and Selling a Business

Transcription

1 Corporate Commercial Section 8 Contents Professional Advisors... Corporate-8-1 Your Role as Legal Counsel... Corporate-8-1 The Role of Other Advisors... Corporate-8-1 Assets or Shares - Introduction... Corporate-8-2 Tax Issues... Corporate-8-6 Tax Issues on the Purchase of Assets... Corporate-8-6 Tax Issues on the Sale of Assets... Corporate-8-9 Tax Issues on the Purchase of Shares... Corporate-8-12 Tax Issues on the Sale of Shares... Corporate-8-13 Acquisition of a Business Purchase of Shares... Corporate-8-15 Introduction... Corporate-8-15 Purchase of Shares... Corporate-8-17 Initial Steps and Searches... Corporate-8-18 Documents to be Examined... Corporate-8-19 Other Legal Considerations... Corporate-8-20 Drafting the Agreement... Corporate-8-20 Closing... Corporate-8-23 Post-closing... Corporate-8-24 Sample Documents and Checklists... Corporate-8-24 Acquisition of a Business Purchase of Assets... Corporate-8-24 Introduction... Corporate-8-24 Initial Steps... Corporate-8-25 Searches... Corporate-8-25 Documents to be Examined... Corporate-8-27 Legal Considerations... Corporate-8-28 Drafting Issues... Corporate-8-29 Closing... Corporate-8-31 Post-closing... Corporate-8-31 Sample Documents and Agreements... Corporate-8-31 No part of this material may be reproduced, in whole or in part (in any manner), without the specific written permission of The Law Society of Saskatchewan. (2009 The Law Society of Saskatchewan.) Corporate 8 i

2 2009 The Law Society of Saskatchewan Allocation of Economic Risk Between a Purchaser and Vendor in a Transaction Involving the Purchase and Sale of a Business or Shares...Corporate-8-32 Use of Co-covenantors...Corporate-8-32 Execution of Sale Agreement...Corporate-8-33 Liability Under Representations and Warranties...Corporate-8-33 Material...Corporate-8-34 Best of Knowledge...Corporate-8-34 Schedules...Corporate-8-35 Non-competition Agreement...Corporate-8-35 Deposit on Purchase Price...Corporate-8-35 Allocation of Purchase Price Among Purchased Assets...Corporate-8-36 Accounts Receivable...Corporate-8-36 Environment Matters...Corporate-8-36 Condition of Equipment...Corporate-8-37 Software Licences...Corporate-8-38 Basket Representation and Warranty...Corporate-8-38 Survival of Representations and Warranties...Corporate-8-38 Survival of Indemnity...Corporate-8-39 No Ambush...Corporate-8-39 Limitation of Warranty Claims...Corporate-8-39 Employees...Corporate-8-40 Covenant to Use Best Efforts...Corporate-8-40 Due Diligence...Corporate-8-41 Unassignable Contracts and Novations...Corporate-8-41 Conditions of Closing and Failure to Satisfy Conditions of Closing...Corporate-8-42 Precedents: Agreement for Purchase of Shares (Example 1)... Corporate-P-8-1 Share Purchase Agreement (Example 2)... Corporate-P-8-16 Share Sale/Purchase Agreement (Example 3)... Corporate-P-8-25 Share Sale/Purchase Closing Agenda... Corporate-P Share Sale/Purchase Checklist... Corporate-P Agreement for Purchase of Assets (Example 1)... Corporate-P Asset Purchase Agreement (Example 2)... Corporate-P Corporate 8 ii

3 2009 The Law Society of Saskatchewan Precedents (continued) Asset Sale/Purchase Agreement (Example 3)...Corporate-P Asset Sale/Purchase Closing Agenda...Corporate-P Letter of Intent...Corporate-P Confidentiality Agreement...Corporate-P Shareholders Resolution (Sale of Assets)...Corporate-P Directors Resolution (Sale of Assets)...Corporate-P Directors Resolution (Purchase of Assets)...Corporate-P Directors Resolution (Transfer of Shares Corporation)...Corporate-P Directors Resolution (Transfer of Shares Director)...Corporate-P Directors Resolution Authorizing Transfer of Shares...Corporate-P Directors Resolution (Transfer of Common Shares)...Corporate-P Certificate as to Corporate Documents...Corporate-P Resignation of Officer and Director...Corporate-P Release of Director by Corporation...Corporate-P Release of Corporation by Director...Corporate-P Release of Shareholder by Corporation...Corporate-P Release of Corporation by Shareholder...Corporate-P Certificate as to Representations, Warranties and Performance...Corporate-P Incumbency Certificate...Corporate-P Officer s Certificate (to Vendor s Solicitor)...Corporate-P Officer s Certificate (to Purchaser s Solicitor)...Corporate-P Confidentiality and Non-competition Agreement...Corporate-P Due Diligence Search List...Corporate-P Corporate 8 iii

4 2009 The Law Society of Saskatchewan Corporate 8 iv

5 2009 The Law Society of Saskatchewan Professional Advisors Your Role as Legal Counsel There are basically four stages where counsel is involved in the sale or purchase of a business: assisting where appropriate in preliminary analysis and negotiating; committing to writing the agreement between the parties; closing; and post-closing. Bear in mind that: the client makes the business decisions; clear and accurate instructions must be obtained and the limit of the retainer determined at the initial meeting; ensure that accounting and tax advice is sought prior to structuring the deal; establish a time frame during which to complete the deal on a timely basis; do not be a slave to precedents. Each deal is unique and drafting is a skill some precedents are out of date or contain poor drafting; and The Law Society of Saskatchewan has passed the No Cash Money Laundering Rule which restricts cash transactions to less than $7, in most instances (see Rule 909). The Role of Other Advisors Buying or selling a business involves many professionals. Clients may retain tax professionals, appraisers, valuators and accountants to complete the deal. The lawyer is one member of the client s team. Competent accounting and tax expertise is required to protect the client s interests. Business valuators can be useful in assisting the client in finding a business to purchase, or in selling one, assisting in the preparation of documents, negotiating, and determining a fair price and terms of payment. Corporate 8 1

6 2009 The Law Society of Saskatchewan Assets or Shares - Introduction The acquisition of an unincorporated business can only be accomplished by the purchase of all of the assets used in carrying on the particular business. If the business is incorporated, the acquisition can be accomplished either through the purchase of the corporation's assets or the purchase of the shares of the corporation. The decision to acquire the assets or the shares of an incorporated business will involve a number of business considerations, not the least of which is the income tax considerations. GST GST is payable where operating assets are purchased directly. This applies whether the business was carried on in the form of a proprietorship, partnership, corporation or another entity. A seller and buyer can jointly elect to treat the taxable supply as if it were zero-rated where all or substantially all (generally 90 percent by value) of the business assets are being sold (Excise Tax Act, R.S.C. 1985, c. E-15, section 167(1)). If this election is made, the buyer is deemed to have acquired all of the assets of the business for use exclusively in a commercial activity. Consequently, any assets of the business that are subsequently sold will be taxable. Tax is also payable if a buyer begins to use any of the assets in an exempt activity or for personal use. Shares are an exempt financial instrument and GST is not payable on the acquisition of shares of an operating company or a holding company. Liability A buyer who is acquiring all of the shares in a corporation does not acquire the assets or the liabilities of the corporation. A buyer of shares acquires the right to vote those shares, to receive a dividend when declared on those shares, and to receive in a winding up of the corporation a distribution of the remaining assets of the corporation after the payment of the corporation's liabilities. These rights can, of course, be altered in the articles of incorporation or in a unanimous shareholder agreement. The value of the shares acquired by a buyer is dependent on the value of the assets of the corporation less the liabilities of the corporation, known and unknown. Corporate 8 2

7 2009 The Law Society of Saskatchewan A share purchase agreement must address two issues: the shares to be purchased; and the underlying assets and liabilities of the corporation. The corporation s liability is not that of the buyer of its shares. A buyer of shares must take into account all of the corporation s liabilities. A corporation s responsibility to, for instance, clean up its property to comply with environmental laws and regulations will reduce the value of the shares purchased. A person who purchases assets acquires only the liabilities that the buyer expressly assumes from the seller or those liabilities that are "attached" to an asset (An example of a liability "attached" to an asset is the purchase of a parcel of contaminated land requiring an environmental cleanup). The purchase of assets offers more certainty to a buyer with respect to the liabilities being assumed. Employees and Employment Benefits Share purchase transactions do not change the status of the employment relationship between the employer corporation and its employees, unless any employee agreements specifically provide for a change in employment relationship if the corporation s shares are sold to a third party ("golden parachute" employment agreement). Asset purchase transactions are not so straight forward. Pursuant to The Labour Standards Act, where a business is sold, the service of employees affected is deemed continuous and uninterrupted by the sale. For good order, the seller will, as part of the such transaction, usually insist upon the buyer assuming all oral or written employment contracts with employees of the business or offering such employees employment on the same terms and conditions as such employees were employed by the seller in order to avoid a claim for wrongful dismissal and statutory severance (under The Labour Standards Act) being made against the seller if such employment contracts were not assigned to and assumed by the buyer or new contracts on the same terms offered to such employees. Also, under The Trade Union Act, if a business is sold, the buyer is automatically bound by all orders of the Labour Relations Board relating to employees of the business and any collective bargaining agreement in place governing the terms of their employment. Such orders and collective agreement are transferred to the buyer by operation of law and do not need to be assigned to the buyer in order to bind the buyer but good practice usually dictates that such orders Corporate 8 3

8 2009 The Law Society of Saskatchewan and collective bargaining agreements be assigned buy the seller to the buyer at closing. A share purchase does not affect existing pension plans or other benefit programs; however, where employees are offered continued employment in an asset purchase transaction, it may be necessary to continue to offer benefit plans or be subject to claims for constructive dismissal. Third Party Consents Consent of a third party may be required before certain equipment and other hard assets can be conveyed to the buyer. Franchise and lease agreements usually require third party consents prior to assignment to the buyer. All other consents to be assigned to the buyer will need to be reviewed in order to determine if third party consent is required in respect of any of them as well. Corporate Structure A corporation may operate in segregated divisions. Acquisition by asset purchase allows a buyer to acquire a division or the assets of a division rather than the entire corporation. Simplicity and Complexity of the Transaction Both share and asset purchase transactions must be preceded by a number of investigations to determine the status and value of that being purchased. Share purchase transactions appear, at first glance, to be less complex since the underlying assets and liabilities of the purchased corporation remain with the corporation and are not transferred to the buyer of the shares. Once all investigations and transactions are complete, there may be little difference in the legal costs of either method of acquisition. Tax Issues Part of being alert to any hidden obligations on a corporation whose shares are being purchased means reviewing its tax payments to verify that installments are current for all taxes, including corporate income, sales taxes, GST and employee source deductions. When acting for a buyer, ensure that the corporation's tax returns are filed to date and obtain the appropriate warranties with respect to any reassessments that may be made for taxation years in which the seller was operating the business. Corporate 8 4

9 2009 The Law Society of Saskatchewan In an acquisition of assets, the buyer could, through the allocation of the purchase price, take over the assets at a higher capital cost than that at which the assets were carried on the buyer corporation's books. This will result in the ability to claim higher capital cost allowance in the future than would have been the case if the shares of the seller corporation had been acquired. Where assets are purchased and the buyer is financing the purchase by way of a loan, interest expenses can be used to reduce the income of the business. Subject to some exceptions, any interest expenses incurred in the purchase of shares will be deductible by the shareholders and not the corporation. From the seller s point of view, the decision to sell assets or shares will depend on the after-tax return. On a sale of shares, the seller has to pay tax on one-half of the capital gain arising on the sale. Where the seller is an individual resident in Canada, and the corporation is a small business corporation (within the meaning of the Income Tax Act, R.S.C. 1985, c.1 (5th Supp.) ( ITA )) the first $500,000 of the capital gain on the shares may be reduced by the "lifetime capital gains exemption" if it is applicable. A sale of assets by a seller corporation will result in the payment of tax on the assets sold and the seller will be subject to tax when the sale proceeds are extracted from the corporation. Accordingly, calculations will be required to compare the aftertax position of the seller on a sale of assets by the corporation versus a sale of shares. The seller of a corporation with tax losses that can be carried over to future years may prefer to sell assets so that he or she can retain the corporation and may make use of those losses in future years. It is clear that the method to be used in acquiring an incorporated business requires consideration of a number of facts. It is not possible to simply rely on any rule of thumb. From a tax point of view, detailed calculations are required to confirm the tax implications that will result from any proposed acquisition. It is essential that you seek expert advice when determining which approach is more advantageous for the client. Some of the other considerations which may determine whether a transaction is structured as a purchase and sale of shares or of assets include whether it is less expensive for the buyer to acquire assets rather than shares, whether it is customary in the industry for assets to be sold rather than shares, whether the corporation which is the subject of the sale is a private (non-distributing) corporation or is a public corporation which is traded on the stock exchange, the relative bargaining power of the buyer and the seller, and other similar considerations. Corporate 8 5

10 2009 The Law Society of Saskatchewan Tax Issues Tax Issues on the Purchase of Assets Allocation of Purchase Price A purchase and sale agreement should allocate the total purchase price of the assets being acquired among the various asset classes under the ITA. Any allocation is subject to revision by the Minister of National Revenue where no allocation was originally made or where the original allocation between the parties was unreasonable (section 68). Depreciable Capital Property Under section 1100(2) of the Income Tax Regulations, C.R.C., c. 945 the capital cost allowance deduction in the year an asset is acquired is limited to one-half the normal rate otherwise allowed. To the extent possible, a buyer should attempt to negotiate for an allocation of the purchase price to those classes of depreciable assets with the highest annual capital cost allowance rates. Each rental building acquired by a buyer at a cost in excess of $50,000 must be included in a separate class. (Income Tax Regulations, section 1101(1ac)). A seller s property included in classes 19, 20, 21, 24, 27, 29 and 34 may not be included in these classes by an arm's length buyer. As a result, the buyer will not be permitted to claim accelerated write-offs with respect to the property. Inventory Inventory is often sold at book value. Any tax consequences are minimal. It is to a buyer s advantage to allocate as much of the purchase price as is reasonable to inventory since this will result in a lower future profit for tax purposes. The portion of the purchase price allocated to inventory is deductible when the inventory is sold. Any gain or loss arising on the sale is treated as income not capital (ITA, section 23(1)). Corporate 8 6

11 2009 The Law Society of Saskatchewan Accounts Receivable When a business is acquired through the purchase and sale of assets, its accounts receivable are often left with the seller for collection. In such circumstances, the buyer agrees to assist with collection for a stated period of time (usually from three to six months). In other circumstances, the buyer may agree to acquire the accounts receivable. In the absence of an election under section 22(1) of the ITA, any excess of the purchase price paid for the receivables over the amount ultimately realized on them will be treated as a capital loss to the buyer and not as an ordinary business loss. The effect of an election is that a discount from the face value of the receivables is included in the buyer s income and the buyer is permitted to deduct a reserve for doubtful debts with respect to the receivables. In addition, the buyer is entitled to deduct any bad debts as they occur and which the seller has not previously claimed. The election is usually filed when the accounts receivable are sold as part of the sale of the assets. The election may only be made when the corporate seller sells all or substantially all of its assets. Prepaid Expenses The amounts paid by a buyer for a seller s prepaid expenses are not deductible in the year in which they are paid for. Rather, they are deductible in the year in which the taxpayer benefits from the prepaid expense (ITA, section 18(9)). Goodwill and Other Intangibles When a business is acquired through the purchase of its assets, the buyer often buys its "goodwill" at a nominal purchase price. If however the goodwill associated with the assets has a greater value, then accounting and tax issues will be considered in structuring the transaction so as to give value to the seller for that goodwill. Assuming that the goodwill is purchased for more than a nominal amount: three-quarters of the amount paid for goodwill and other non-depreciable intangible properties like customer lists, copyrights and technical knowledge is deductible at the rate of 7 percent per annum on a declining balance basis (ITA, section 20(1)(b)); and due to this slow rate of deduction, a buyer should attempt to allocate as little of the purchase price as reasonably possible to assets of this type. Corporate 8 7

12 2009 The Law Society of Saskatchewan Reserves In structuring a purchase of assets, consider whether to establish a reserve or holdback to deal with any unexpected liabilities that may be associated with the assets or business being purchased. Establishing a reserve is common in larger transactions. Where a buyer assumes the seller s liability for goods and services not yet delivered or rendered, consider having the seller pay the buyer for assuming such liability. An election can then be filed under section 20(25) of the ITA to allow the buyer to claim a reserve under section 20(1)(m) relating to those goods or services. Blended Payments If a portion of the purchase price is to remain outstanding for a period of time, the agreement of purchase and sale should specify that portion of the purchase price that represents interest. In the absence of such a specification, the seller must show as income the amount that can be reasonably regarded as an amount of an income nature (ITA, section 16(1)). Non-resident Seller The buyer, whether a resident of Canada or not, purchasing any of a non-resident's taxable Canadian property or Canadian resource properties, other than certain "excluded property", is liable to withhold and remit tax on behalf of the non-resident seller unless the seller has obtained the appropriate certificate under section 116 of the ITA or the buyer, after reasonable inquiry, had no reason to believe that the seller was not resident in Canada. The maximum withholding amount is 25 percent of the sale proceeds for the property. The buyer is liable even though the seller may not be taxable pursuant to the provisions of an applicable tax treaty. Note that the definition of taxable Canadian property includes real property situated in Canada, as well as any other capital property used in carrying on a business in Canada (ITA, section 115(1)(b)). Corporate 8 8

13 2009 The Law Society of Saskatchewan Non-Arm's Length Buyer When a buyer has acquired property in a non-arm's length transaction for an amount in excess of its fair value, the buyer is deemed to have acquired the property at its fair market value. Capital cost allowance will be calculated on that fair market value even though the seller will be subject to recapture on the actual purchase price paid (ITA, section 69). Options If a buyer exercises an option to acquire property, any amount paid for the option is included in the cost of the property to the buyer (ITA, section 49(3)). If a buyer allows an option to expire, the buyer will be deemed to have disposed of the option and will normally realize a capital loss if the buyer received or paid value to acquire the option (ITA, section 54). Tax Issues on the Sale of Assets Depreciable Capital Property A seller must include as income the amount of capital cost allowance "recaptured" on the sale (ITA, section 13(1)). Where a seller has non-capital loss carry-forwards, consider creating, to the extent possible, recaptured capital cost allowance to use the loss carry-forwards. Consider the restrictions on terminal losses on buildings contained in section 13(21.1) of the ITA. This provision was designed to counter the result in Malloney's Studio Ltd. v. The Queen, [1978] F.C.J. No. 308; 78 D.T.C (F.C.A.), aff d [1979] 2 S.C.R. 326; 98 D.L.R. (3d) 683 (S.C.C.). In that case, the buyer bought land and buildings with the intention of demolishing the buildings and erecting new ones. The agreement of purchase and sale required the seller to demolish the existing buildings prior to closing. The result was that the entire proceeds were allocated to the land, increasing the seller s capital gain in respect of the land and creating a terminal loss. Corporate 8 9

14 2009 The Law Society of Saskatchewan Inventory Under section 23(1) of the ITA, a sale of inventory upon a seller "disposing of or ceasing to carry on a business" is deemed to have taken place in the course of carrying on the business. The result is that any gain on the sale will be treated as ordinary income and any loss as a deductible business loss. Accounts Receivable In the absence of an election under section 22(1) of the ITA, the amount received by a seller for its business accounts receivable is treated as a capital gain. The result is that any discounting of the accounts receivable is a capital loss even though the seller must include in its income the previous year's reserve for doubtful accounts. The effect of an election is to allow the seller to deduct from income the amount of any discount on the accounts receivable. Reserves A seller can claim a reserve, under section 20(1)(n) of the ITA, related to proceeds from a sale of inventory that is not due for more than two years after the date of sale. The reserve cannot be claimed if at the end of the taxation year, or the immediately following taxation year, the seller is not resident in Canada and does not carry on the business in Canada. The reserve is prohibited if the sale occurs more than 36 months before the end of the year (ITA, section 20(8)). Under section 40, a seller can claim a reserve relating to the unpaid purchase price of capital property. The reserve cannot be claimed if the seller is not resident in Canada at the end of the taxation year or at any time in the immediately following taxation year (ITA, section 40(2)). Section 40(1)(a)(iii) of the ITA provides for a maximum five-year reserve by requiring that the capital gain be taken into income at a rate of at least 20 percent each year including the year of sale. Corporate 8 10

15 2009 The Law Society of Saskatchewan Goodwill and Other Intangibles A seller must reduce the balance, if any, of the cumulative eligible capital account by three-quarters of the sale proceeds which could be allocated to goodwill and other non-depreciable intangible capital assets. To the extent that three-quarters of those proceeds exceed the balance in the cumulative eligible capital account, that excess is included in income (ITA, section 14(1)). Warranties Under section 42 of the ITA, a seller s proceeds of disposition of capital property include any amount received by the buyer as consideration for any warranty given relating to the disposition. Payments subsequently made by a seller under such a warranty are treated as capital losses. Options An amount received by a seller for the granting of an option to purchase is treated as a capital gain unless the option is exercised in the year in which it is granted, in which case, the amount received by the seller for granting the option is added to the proceeds of disposition of the property sold (ITA, section 49(1)). If an option is exercised after the year in which it was granted, the consideration received by the seller (other than a seller who is an individual) for granting the option is added to the proceeds of disposition for the year of sale and the seller files an amended income tax return to exclude the consideration from the seller s income for the year in which the option was granted (ITA, sections 49(3) and (4)). Non-Resident Seller If the seller is a non-resident, the seller must obtain appropriate certificates under section 116 of the ITA so that the buyer is not required to withhold the maximum withholding amounts based on the gross proceeds of sale. Corporate 8 11

16 2009 The Law Society of Saskatchewan Payments Based on Production or Use Where the total purchase price for the assets is dependent on the future profitability of a business, there is a danger that the total purchase price (or a portion thereof) could be treated as ordinary income to the seller under section 12(1)(g) of the ITA. To avoid this problem, the purchase price should be paid by fixed amount installments to be paid on prescribed dates. This may be impossible where the purchase price is tied to future profitability. Tax Issues on the Purchase of Shares Loss Carry-forwards Under section 111(5) of the ITA, non-capital losses cannot be carried forward to be deducted against future income if: control of the corporation has changed; and the corporation no longer carries on the business in which the losses arose. "Change of control" has generally been judicially interpreted to mean acquisition of more than 50 percent of the voting shares of the corporation. Section 111(5) of the ITA imposes two rules limiting the deduction of non-capital losses after a change in control. Under those rules, non-capital losses are deductible after a change in control: only if the business giving rise to the losses was carried on throughout the part of the year that is after the acquisition of control and thereafter, with a reasonable expectation of profit; and only to the extent of the business income, or the income from a business whose income was substantially earned from the sale of property or the rendering of services similar to those of the loss business. Section 111(5.1) of the ITA restricts the deduction of capital cost allowance where control has changed and the undepreciated capital cost of a class of assets exceeds the fair market value of such assets at the time of the change in control. The excess would be treated as a non-capital loss and subject to the rules relating to the deduction of non-capital losses after a change in control. Corporate 8 12

17 2009 The Law Society of Saskatchewan Net capital losses cannot be carried forward for deduction against future capital gains if there has been a change in control. Accordingly, consider triggering capital gains that can be offset against existing net capital losses prior to the change in control (ITA, section 111(4)). Associated Corporations Consider whether an acquisition will result in the corporation being "associated" with other Canadian-controlled private corporations, necessitating a sharing of the "annual business limit" for purposes of the small business deduction. Corporations may be associated under section 256 of the ITA. Under the antiavoidance rules, two or more corporations are deemed associated with each other in a year where it may reasonably be considered that one of the main reasons for their separate existence is to reduce the amount of taxes that would be otherwise payable. Non-Resident Buyer Where a buyer is a non-resident, consider the "thin capitalization" rules in sections 18(4), (5) and (6) of the ITA. Briefly, those rules will deny the deduction of interest paid to "specified nonresidents" where at any time in the year the greatest amount of the corporation's debt to "specified non-residents" exceeds two times the corporation's equity. Where a non-resident buyer is acquiring shares that are "taxable Canadian property" from a non-resident seller, the appropriate certificate is required under section 116 of the ITA. Tax Issues on the Sale of Shares Capital Gains Tax Liability The sale of shares will result in a capital gain or capital loss to the seller unless it is a trader in securities or the disposition can be characterized as an adventure in the nature of trade. The tax rate on capital gains is more favourable than ordinary tax rates. Capital gains are now taxed at one-half of the ordinary tax rates (ITA, section 38). If the seller is an individual, resident in Canada, and the corporation is a small business corporation with the meaning of the ITA, a portion of the capital gain may be reduced by a capital gains exemption, if applicable. Corporate 8 13

18 2009 The Law Society of Saskatchewan Shares in a buyer corporation received by a seller in consideration for the seller s shares will be proceeds of disposition and will generally be tax deferred and will not result in any immediate capital gain or capital loss to the seller (ITA, sections 85(1) and 85.1(1)). A share sale avoids the two levels of tax since proceeds are paid directly to the shareholder. Reserves A seller will be entitled to claim a reserve with respect to proceeds not yet receivable. The Canada Revenue Agency ( CRA ) has taken the position that it will not apply the income inclusion provisions of section 12(1)(g) if: the seller and buyer are dealing with each other at arm s length; the gain or loss on the sale is clearly of a capital nature; it is reasonable to assume that the earn-out features relate to goodwill, the value of which cannot reasonably be expected to be agreed on by the seller and buyer at the date of sale; the duration of the sale agreement does not exceed five years; and the seller submits, with the return of income for the year in which the shares were disposed of, a copy of the sale agreement, a letter requesting the application of the cost recovery method to the sale, and an undertaking to follow the procedure of reporting the gain or loss on the sale under the cost recovery method set out in Interpretation Bulletin IT-426, Shares Subject to an Earn-out Agreement. Earn-outs Where the ultimate purchase price for a seller s shares is dependent on the future profitability of the corporation, take care to ensure that the seller s capital gain is not turned into ordinary income under section 12(1)(g) of the ITA. Also consider structuring the transaction as a "reverse earn-out" where the purchase price is fixed at a specified, maximum potential purchase price that may be reduced if certain financial or other targets are not met by the company after the transaction. A properly structured reverse earn-out ensures that the proceeds are treated as capital proceeds and not an ordinary income payment. Corporate 8 14

19 2009 The Law Society of Saskatchewan Options Any consideration received by a seller for granting an option will result in a capital gain in the year it is granted. Non-Resident Seller A non-resident seller disposing of shares of a private corporation resident in Canada or more than 25 percent of the shares of a public corporation should obtain the appropriate certificate under section 116 of the ITA so that buyer does not withhold a portion of the purchase price. Anti-Avoidance Provisions Beware of the General Anti-Avoidance Rules ( GAAR ) contained in Part XVI of the ITA. The Courts or CRA will determine what is "reasonable in the circumstances" where GAAR is found to apply. Such provisions could increase the amount of the seller s income otherwise determined. Acquisition of a Business Purchase of Shares Introduction Parties may prefer a purchase and sale of shares in an incorporated business rather than its assets for various reasons: From a Buyer s Point of View The initial purchase price when purchasing shares is often lower than an asset purchase. There is no GST payable on a purchase of shares. The purchase is an exempt transaction (if substantially all the assets are purchased the buyer can file GST Form #44 and avoid the payment of GST). This type of transaction avoids the payment of sales tax levied by jurisdictions that have a sales tax. Corporate 8 15

20 2009 The Law Society of Saskatchewan Processing the transaction may be less expensive because the buyer will not incur certain fees (land titles registration costs associated with transferring title to real property or filing a caveat for the lease). A share purchase can allow a buyer to acquire the underlying assets without effectively paying fair market value. A share purchase generally requires less documentation than an asset sale or purchase. A share purchase minimizes disruption to customers, suppliers, and employees of the business. From a Seller s Point of View A seller may receive more net after tax sale proceeds in a share sale when compared to an asset sale/purchase transaction. This is especially the case if the capital gains exemption is partially or totally available to the seller on the proceeds of the sale of the shares. A sale of shares minimizes disruption to customers, suppliers, and employees of the business. While, in some cases, restrictions can exist that will stop a sale of assets, there are no such restrictions on the sale of shares. For example, a business may operate in leased premises that are key to the success of the business. The lease may contain a provision that the premises cannot be assigned without the consent of the landlord. A sale of shares, however, will not require that consent. From a seller s perspective, a sale of shares may be easier, with less documentation. Risks Involved A buyer may not be receptive to the purchase of shares of a business for reasons including these: negative income tax consequences, for instance, no step-up in the cost base of the assets to allow for a higher capital cost allowance; and the buyer may not be willing to take on both known and unknown potential liabilities, for instance potential claims of unknown aggrieved parties or claims by the CRA for possible reassessments. Corporate 8 16

21 2009 The Law Society of Saskatchewan Purchase of Shares In a share purchase transaction, a buyer acquires the shares of a corporation that owns assets and carries on business. The shares bring with them the right to vote, the right to a dividend, and the right to receive the net assets (after payment of liabilities) of the company if it is wound up. The buyer of the shares does not directly or indirectly acquire the assets or liabilities of the company whose shares are being sold. However, the value of the shares depends on the underlying value of the assets and liabilities of the company. Those assets and liabilities are an important part of a share purchase agreement. By buying shares the complexity of asset conveyancing is avoided. There is also no opportunity to allocate the purchase price to the various assets. Counsel for the buyer must still examine the value of and title to each of the company's assets, the extent and status of its liabilities, and the rights of any security holders to ensure that the buyer is getting full value. When a corporate client acquires shares in another corporation, and that acquired corporation owns non-depreciable capital property (for instance, land or shares of another corporation); the adjusted cost base of the shares acquired can be added to the adjusted cost base (subject to the limits of the ITA) of the nondepreciable capital property in limited circumstances. This can be done either through a winding-up of the acquired corporation into the buyer corporation under section 88(1)(d) or through an amalgamation of the buyer corporation and the acquired corporation under section 87(11). It is common in a share purchase agreement to include as a schedule the most recent financial statements of the acquired corporation, prepared by the corporation s accountant. The seller of the shares provides warranties and representations that all of the corporation s assets and all of its liabilities, known and unknown, contingent and otherwise, are set out in those financial statements. The share purchase agreement usually requires that as at closing, either there have been no changes to the assets and liabilities as disclosed in the financial statements other than in the ordinary course of business, or an updated financial statement (generally prepared internally by the acquired corporation) is provided at closing showing the changes in the assets and liabilities from the date of the last financial statements prepared to the closing date. In the latter case, the agreement may require an adjustment to the purchase price to take those changes into account. Corporate 8 17

22 2009 The Law Society of Saskatchewan Many companies do not have audited financial statements because the shareholders have waived the appointment of an auditor. In that case, the statements will have been prepared by an accountant on either a "review engagement" basis or a "compilation" basis. (A corporation s external accountants do the greatest level of review in an audit engagement and the least level of review in a compilation engagement). An important issue for both the buyer of the shares and the seller of the shares is the extent to which the seller "guarantees" the corporation s financial statements. Initial Steps and Searches Counsel for a buyer will usually draw up the necessary documents for the transaction. The first step is to prepare a confidentiality agreement pursuant to which the buyer will agree to keep information obtained about the seller during its due diligence investigation confidential. Following an initial due diligence investigation, the next step is either a letter of intent or a formal offer with more formal and complete documentation to follow. If proceeding by way of letter of intent containing provisions as to price, method of payment, closing date and other purely business matters, it must be clear that the transaction is subject to a formal agreement approved by the parties, so that there is no legal liability if the letter is withdrawn or breached, save and except for obligations which are intended to be binding on the parties to such letter of intent, like for example, a no shopping around covenant by the seller for a specified period of time or a confidentiality covenant by the buyer. In the course of acting for a buyer under a share purchase agreement, you will need to conduct a number of public registry searches both before and at the date of closing to ensure that the shares being purchased are clear of encumbrances. Prepare a checklist of the searches to be done, which will depend on the status of the seller (an individual, corporation or partnership) and the nature of the business, assets and liabilities of the corporation whose shares are being sold. Initial searches you will likely want to perform are: search for registrations against the seller in the Personal Property Registry; search at the Office of the Superintendent of Bankruptcy (Ottawa) in respect of petitions or assignments in bankruptcy by the seller; Corporate 8 18

23 2009 The Law Society of Saskatchewan if the seller is a corporation, search at Corporate Registry to determine all of the corporate names by which the corporate seller has been known (so that all of the prior corporate names of the seller are searched in the Personal Property Registry) and to ensure that the corporation has corporate status in Saskatchewan; search the Bank of Canada in respect of section 427 of the Bank Act, S.C. 1991, c. 46; search at Land Titles Office in respect of real property owned or leased by the corporation; search at such other public registries and public offices where searches or inquiries are made as if the nature of the transaction was a purchase of the assets of the corporation, rather than a purchase of the shares of the corporation itself; Courthouse searches for actions against the corporation or Writs; and Workers Compensation Board for unpaid amounts (a Clearance Certificate should be requested in any event). Additional searches will be required during the course of the transaction to determine the status of the company s assets (ownership and encumbrances). Environmental assessments may be necessary. The solicitor has an ongoing obligation to be duly diligent and alert to matters which should be brought to the attention of his or her client. The requisite searches and examinations will vary from file to file. Checklists are helpful, but one size does not fit all purchases or sales. Documents to be Examined The corporation s minute book should be examined to ensure that the corporation was properly incorporated and organized, and that the minute book is complete. The share registry should show that shares were properly issued to the shareholders, and that any transfers of shares from the time that the shares were first issued to the present time were properly made and recorded. If there is a unanimous shareholder agreement it must be examined in detail to ensure that the buyer is fully aware of its provisions. Franchise agreements, leases, equipment rental leases, warranties, or options should all be carefully scrutinized and explained to the client. Corporate 8 19

24 2009 The Law Society of Saskatchewan Other Legal Considerations Is the sale one which would require notice be given to Investment Canada? Is any share consideration subject to The Securities Act and Regulations? In the case of a public company listed on a stock exchange, determine the requirements of the appropriate stock exchange. If the business is one regulated by statute or requiring municipal, provincial or federal licenses (e.g., funeral homes, used car dealers, liquor lounges, restaurants, etc.), determine that appropriate licenses have been issued and whether the licenses are in good standing. If a competitor is being acquired, or if the size of the transaction is large, consider whether the transaction is affected by the Competition Act, R.S.C. 1985, c. C-34. Determine whether there are any assets (such as leases) that trigger forfeiture of the asset or other consequences if there is a change in control of the corporation without first obtaining the consent of the other party to the contract. Are there environmental concerns? Are there federal licensing concerns? Drafting the Agreement Certain standard provisions should be included in the draft in the form of a representation or obligation on the part of the parties, and some standard documents are incorporated by reference into the agreement: reference the results of searches performed; financial statements should be current and incorporated by reference with representations, warranties and indemnities from the seller with respect to the facts set out in the statements. There should be a representation that the statements were prepared in accord with Generally Accepted Accounting Principles, and that they are accurate as of the date of the agreement with no substantial change as of closing; Corporate 8 20

25 2009 The Law Society of Saskatchewan warranties and representations should be obtained from the seller on several matters including: the status of shares and assets, as of the date of the agreement, and at closing; accounts receivables must be allocated between buyer and seller, with the seller agreeing to a hold back or payment for uncollectible receivables; the assets of the company are in good operating condition; the company has good title to all its assets subject only to such adverse claims, security interests, liens and encumbrances as are disclosed in the financial statements or in the agreement; that the company is not in default in respect to any agreements (i.e., leases, mortgages, etc. and there are no outstanding disputes arising out of them); the company and its business comply with applicable legislation; that between the date of agreement and closing the business has been conducted in the ordinary course; the appropriate director and shareholder approval of the sale have been given; the sellers are Canadian residents (ITA, section 116); the agreement, and its completion, does not put the company in default under any contract; the amount of the company s authorized and issued capital due to incorporation of the company and compliance with all necessary corporate filings in all jurisdictions where it carries on business; names and shareholdings of all shareholders; the seller's shares are not subject to any adverse claims, security interests, liens and encumbrances, nor would the sale of those shares give rise to any breach of an agreement with others; there are no outstanding options, warrants or rights to acquire any shares or securities in the company; there is no actual, potential, or apprehended litigation involving the company; there are no undisclosed liabilities of any kind; all tax returns have been filed and there are no outstanding assessments; no dividends or distributions have been made to shareholders prior to closing; Corporate 8 21

26 2009 The Law Society of Saskatchewan there are no outstanding guarantees and no loans or advances to shareholders, directors or employees; and the financial and corporate records are complete and correct in all material respects. the buyer should warrant that it (or they) are not non- Canadians under the Investment Canada Act, R.S.C. 1985, c. 28 (1st Supp.), and where farmland is involved the buyer will also need to do so under The Saskatchewan Farm Security Act. If they are non-canadians, the buyers must obtain the appropriate approvals for the sale and warrant the approvals (with any documentation incorporated by reference); opinions may be given by solicitor for the buyer and solicitor for the seller. The opinions will likely address such issues as whether the agreement has been duly and properly authorized, executed and delivered, whether the shares which are the subject of the sale have been properly issued by the corporation and duly transferred to the buyer, compliance with the Investment Canada Act (if applicable), and the controversial opinion as to whether the share purchase agreement is binding and enforceable upon the parties. Good commercial practice requires that the form of the opinions be discussed and agreed upon as early as possible, and not left until the time of closing; conditions precedent, subsequent, and remedies for breach of minor and major terms; warranties and representations are to survive the closing of the transaction and, when or if they are to expire; liability which survives the closing (whose and duration); adjustments for bad debts; physical inspection of inventory and equipment prior to closing with a provision for price adjustments; covenants not to make corporate changes or pay dividends before closing; access to the business and its records prior to closing (subject to the buyer first signing a confidentiality agreement); retention of employees and allocation of responsibility for the cost of terminations; assignment of employment and other contracts if required, with warranties of the continued presence of the employee, and damages payable if the employee elects to depart within a specific period of time; Corporate 8 22

27 2009 The Law Society of Saskatchewan release of personal guarantees; statutory withholding amount under section 116 of the ITA; non-competition reasonable with respect to time and geography; confidentiality agreement (non-disclosure of customer lists or proprietary information); an arbitration clause may be useful in resolving disputes respecting accounting and valuation issue; method of payment of purchase price, with appropriate adjustments and reserves; and releases by the selling shareholders, officers and directors of any claims they may have against corporation or buyer. These comments are not meant as an exhaustive list of considerations in drafting and executing a share purchase and sale agreement. The list is merely illustrative of the many issues that would ordinarily be addressed. Each sale is unique. Following precedents or checklists will not likely meet the standard of diligence expected of a solicitor with respect to any particular sale. Closing Often, agreements for sale of shares will have a reasonable interval between the time of the agreement and the closing date. In the interim, searches will have to be updated and further investigations made to ensure that the agreement is correct and that nothing material has changed from the time the agreement was signed. There must be a mechanism built into the agreement to address pre-closing problems or changes. From a seller s perspective pre-closing problems can be avoided if the share purchase agreement is signed and closed contemporaneously, which may be an option where regulatory or other approvals or consent are not required in order to close the transaction. Counsel will agree upon a closing agenda which sets out all of the documents to be delivered and by whom, the various opinions required, actions to be taken and registrations effected at or prior to closing so that the closing can be conducted in an orderly manner. (See the Sample Share Sale/Purchase Closing Agenda included in the precedents for this section.) Corporate 8 23