Acquiring a Canadian Business
A non-resident of Canada considering the acquisition of an entity resident in Canada or a Canadian business has a variety of issues to consider. Separate and apart from the Canadian tax issues applicable to any Canadian acquisition (whether by a domestic or foreign buyer), cross-border mergers and acquisitions (M&A) create various incremental issues, due to more than one country being involved:
- more choices as to where to incur expenses (e.g., interest on acquisition debt financing);
- more tax claims on funds repatriated to investors or realized on an eventual sale;
- more post-closing cross-border intra-group payments and the tax issues they create;
- possible tax treaty claims to reduce Canadian and acquirer home country taxation; and
- layering the foreign acquirer’s CFC (controlled foreign corporation) regime on top of the Canadian tax rules.
The ITA has seen several technical amendments in recent years designed to prevent erosion of the Canadian tax base on foreign investment into Canada, such as the following:
- tightening of the “thin capitalization” rules limiting interest expense on debt owing to non-arm’s-length non-residents;
- strengthening of the Canadian withholding tax regime for Canadian-source payments such as interest and royalties, including back-to-back anti-avoidance rules;
- reinforcing of anti-surplus stripping rules such as s. 212.1 (applicable to non-arm’s length transfers of shares of Canadian corporations) and enacting the foreign affiliate dumping (FAD) rules;
- amendments establishing the primacy of Canada’s transfer pricing rules relative to other ITA provisions, as well as aggressive enforcement of those rules by the CRA to protect the Canadian tax base; and
- enactment and ratification in Canada of the OECD Multilateral Instrument (MLI) and the additional constraints it creates on claiming treaty benefits to reduce Canadian tax.
The various Canadian tax issues for a foreign buyer of a Canadian business are discussed at length here. This article reviews issues such as:
- different stages of the acquisition process, allocation of responsibilities for tax issues and tools for identifying and managing tax risks;
- tax structuring considerations for buyers and sellers on share and asset purchases;
- possibilities for non-recognition treatment and gain deferral for sellers;
- the use of earn-outs and the tax issues they create;
- important buyer planning considerations;
- the effect of an acquisition on the target corporation and its tax attributes; and
- typical seller tax planning strategies.
Amongst the considerations of particular importance in a cross-border acquisition are the following:
1. Paid-up Capital Maximization
Paid-up capital (PUC) is especially important for foreign buyers. This is because PUC represents the ability to extract value out of Canada as a non-dividend equity distribution that does not attract Canadian dividend withholding tax, facilitating repatriation of profits and post-acquisition restructurings. Moreover, PUC is a component of “equity” in the thin capitalization rules that restrict a Canadian corporation’s ability to deduct interest on debt owing to non-arm’s-length non-residents. PUC represents a very valuable tax attribute for foreign purchasers. In most cases, a non-resident purchaser can maximize PUC by ensuring that it funds a Canadian corporation and has that entity act as the direct buyer, rather than the non-resident itself making the Canadian acquisition.
2. The FAD Rules
The FAD rules may apply to acquisitions of Canadian corporations the assets of which are predominantly foreign (non-Canadian) subsidiaries. Moreover, even if the FAD rules are not applicable on the acquisition itself, they may apply going forward post-acquisition if the Canadian target corporation has or acquires significant (10%+) share interests in non-Canadian corporations.
3. s. 88(1)(d) “Bump” Planning
The cost basis “bump” allowed under s. 88(1)(d) is a powerful tax planning tool that is particularly important for foreign purchasers of Canadian corporations. Conceptually similar to the U.S. §338 IRC basis step-up, a s. 88(1)(d) “bump” allows a foreign purchaser (when using a Canadian corporation as the direct acquirer) of a Canadian corporation to reduce or eliminate the target company’s accrued but unrealized capital gains on its non-depreciable capital property (i.e., land or shares of other corporations). This tax planning tool is particularly valuable where the target entity has foreign subsidiaries that can be “bumped” and extracted out from under the Canadian tax system, and is discussed in detail here.
4. Debt Financing
If external debt is being used to finance the acquisition, a foreign buyer needs to consider in which country that debt should be located (i.e., in Canada or elsewhere). Relevant factors in this analysis include whether:
- interest will be deductible for tax purposes in a particular country (taking into account thin capitalization rules);
- the Canadian entity will have positive taxable income against which to actually use any interest deduction; and
- withholding tax will apply on payments of interest (taking applicable tax treaties into account).Even if no external debt financing is being used, a foreign purchaser may still wish to put intra-group debt into the Canadian entity from a related foreign lender within the group, in order to create tax-deductible interest expense in Canada.
5. Share Consideration for Sellers
To some degree foreign acquirers operate at a disadvantage to Canadian buyers, because it is significantly harder (as a Canadian tax matter) for foreign acquirers to use their own shares as currency in structuring a Canadian acquisition. To begin with, there is no tax-deferred rollover on a foreign share-for-Canadian share exchange – the only ITA provisions that allow selling shareholders to obtain non-recognition treatment in Canada on a share-for-share exchange require the sellers to receive shares of a Canadian buyer. 1 A temporary deferral can be obtained by giving Target shareholders “exchangeable shares,” being shares of a Canadian subsidiary of the foreign buyer that can only be exchanged (on a taxable basis) for shares of the foreign buyer: see [hyperlink to .pdf] Suarez and Samtani, “Using Exchangeable Shares in Inbound Canadian Transactions”, Tax Notes International, December 24, 2007, p. 1281. Moreover, Canadians are taxed at lower rates on dividends received on shares of a Canadian corporation compared to dividends on shares of foreign corporations. Finally, substantial constraints exist on a foreign acquirer that issues shares to selling shareholders in being able to use the s. 88(1)(d) “bump” (see 3., above), relative to those applicable to shares of a Canadian corporation.
6. Bridging Valuation Gaps
Buyers and sellers frequently disagree on the value of particular businesses or assets and use various tools to try and bridge those gaps, such as earn-outs, contingent value rights (CVRs), and spin-outs of unwanted or hard-to-value assets. The use of these tools in a cross-border context is often more challenging, for example in creating potential withholding tax issues and concerns over possible timing/character mismatches between the relevant countries on value-bridging payments and instruments.
7. Canadian Acquisitionco
When a foreign buyer is acquiring a Canadian target company, the typical planning advice is to use a Canadian subsidiary of the foreign buyer as the direct purchaser of the Canadian target. This is done to maximize cross-border PUC (see 1., above), enable the use of a s. 88(1)(d) “bump” (see 3., above) and facilitate putting some of the debt financing the Canadian acquisition into Canada (see 4., above). However, there are circumstances where using a Canadian corporation as the direct purchaser may be sub-optimal. Examples include where the existing PUC of the Canadian target’s shares exceeds the purchase price to be paid, or where the FAD rules (see 2., above) would apply to a direct acquisition by a Canadian corporation because 75% or more of the Canadian target’s assets consist of shares of foreign subsidiaries.
8. Foreign Exchange
A non-resident buyer will have foreign exchange (F/X) issues to deal with, since various payments between it and its Canadian subsidiary will need to be denominated in Cdn.$ or another currency. Unless the Canadian subsidiary is eligible to elect to use another permitted currency as its “qualifying currency” for Canadian tax purposes, it will have to express all amounts in Cdn.$ terms for Canadian tax purposes and will thereby be exposed to F/X gains and losses for tax purposes on all non-Cdn.$ transactions.
9. Foreign Buyer Repatriation Alternatives
Whenever funds or other property are to be repatriated from the Canadian target entity, there are a number of issues to be considered. These include deductibility to the payer, Canadian withholding tax, transfer pricing constraints, and the potential impact on the Canadian payer’s “equity” base for thin capitalization purposes.
10. Foreign Acquirer Home Country Tax Regime Overlay
various aspects of the foreign acquirer’s home country tax regime (and their interaction with the applicable Canadian tax rules) must be factored into the analysis so as to produce the best overall result, not merely the optimal Canadian one. These include home country tax provisions relating to:
- controlled foreign corporations (i.e., when income earned by CFCs is imputed back to the foreign shareholder, and how that income is taxed in the foreign shareholder’s home country);
- transfer pricing;
- foreign tax credits;
- timing/character mismatches with Canadian rules (e.g., U.S. earnings & profits rules on Canadian equity distributions, hybrid entities/transactions, etc.).
Foreign buyers should obtain Canadian legal advice on these and other matters relating to potential Canadian acquisitions, and do so on a confidential and privileged basis. The CRA routinely demands copies of sensitive and potentially prejudicial tax materials prepared in the context of acquisitions (e.g., tax diligence reports, planning memoranda, etc.), which are only protected from disclosure by lawyer-client privilege if prepared by a lawyer (not accountants or others), as explained here.