“Diligence is the mother of good luck…”
– Benjamin Franklin, The Way to Wealth(1758)
Performing appropriate due diligence procedures prior to the acquisition of a business contributes significantly to informed decision-making and investment success. Navigating the corporate income tax implications of an acquisition can complicate the process, however. A considerable amount of tax due diligence may be required in a share purchase transaction, for example, since a purchaser would be acquiring not only a target company’s shares, but also its tax history.
What follows is a review of some Canadian corporate income tax issues that commonly arise during the course of a due diligence investigation.
Reasonableness of intercompany management fees
In the context of owner-managed businesses, the payment and deduction of intercompany management fees is a relatively common practice. However, problems can arise on the acquisition of a business that has paid such fees, if the fees are considered unreasonable in the circumstances.
For example, where a parent corporation has paid management services fees to a subsidiary (perhaps to use up non-capital losses of the subsidiary and shelter income from tax) but no management services have, in fact, been performed, the Canada Revenue Agency (CRA) has, in some cases, disallowed the deduction of such fees as unreasonable pursuant to Section 67 of the Income Tax Act (the Act), resulting in additional taxes payable to the parent corporation. Where management fees are disallowed, the CRA will generally allow the recipient of the fees an offsetting deduction to prevent double taxation. Note, however, that this is an administrative position only. In the event of a CRA reassessment, abusive intercompany management fee schemes could trigger a punitive assessment of income in both companies, with the CRA disallowing the original deduction and choosing not to apply the offsetting deduction to the recipient, resulting in double taxation.
Care should be taken, therefore, when assessing a target company’s intercompany management fee arrangements and any supporting legal documentation to determine whether the substance of these arrangements reflects the underlying economic activity of the companies involved. Depending on the nature and amount of intercompany management fees paid, the CRA may determine that a target company has a significant unrecorded tax liability in this regard.
Family trust ownership structures – multiplication of the SBD
When looking at a family-owned corporate group of companies, it is not uncommon to see ownership structures that involve the control of each operating company within the group being held (directly or indirectly) by a separate trust—each for one member of the family as a single beneficiary. Structures are set up this way, in part, to maximize the small business deduction (SBD) that’s available to each operating company within the family-operated corporate group; if they were held under common control, these operating companies would be associated for the purposes of the Act and would be required to share the SBD.
When it comes to determining whether corporations controlled by family trusts are associated with each other, the trust association rules are complex. Depending on the particular case facts, there is a risk that the CRA could consider the trust association or de facto control rules to apply to pre-acquisition taxation years of the operating companies that are not yet statute-barred. Such a determination would deem the operating companies to have been associated, triggering a denial of all or a portion of the SBD each operating company may have claimed separately in prior taxation years; this, in turn, would generate a potentially significant tax liability for the corporate group as a whole in the form of reassessed and unpaid income taxes, along with prescribed interest and any corresponding penalties.
Regulation 105 withholding
Subsection 105(1) of the Income Tax Regulations states that every person who pays to a non-resident person a fee, commission, or other amount in respect of services rendered in Canada must withhold and remit 15% of such an amount. Nevertheless, exposure to Regulation 105 withholding tax is often overlooked during the normal course of a target company’s tax compliance process, particularly in the case of an owner-managed business, which may not employ a robust internal tax compliance function.
For example, a withholding tax exposure can arise in a situation where a target company resident in Canada enlists an unrelated non-resident to perform certain services in Canada on its behalf. If the non-resident does not receive a Regulation 105 waiver (issued by the CRA), such services would be subject to Regulation 105 withholding tax, which the target company would be responsible for withholding and remitting.
Depending on the value of the service payments and the length of contract activity in Canada, non-compliance can give rise to significant additional taxes payable in the event of a CRA reassessment post-acquisition; these costs may include a 10% penalty on the required withholding amount for failure to withhold and remit, in addition to the applicable prescribed interest. Therefore, in such situations, it is important to:
- Assess the nature of the contracted business activities being undertaken by a target company;
- Determine the residency of any persons engaged to perform such contracted business activities for the target company; and
- Ascertain whether any of the persons who are non-resident have been issued Regulation 105 waivers.
Payroll compliance and independent contractors in the office
In general, remuneration paid by a Canadian resident company to an employee is subject to Canadian payroll withholding and remittance requirements, including employment insurance (EI) and Canada pension plan (CPP) contributions. Whether an individual is an employee of a company is a question of fact, and there are numerous considerations in determining their status, including the degree of control they have over their work, their level of financial risk, and their ownership of any equipment used in the course of their work.
In owner-managed business situations, it’s common for a target company to engage its key management and sales personnel on a contract basis. There’s a risk in doing so, however; the CRA could consider such personnel to be employees of the company, thereby triggering withholding tax liabilities for EI and CPP contributions. In practice, the CRA may refrain from reassessing the amount of income tax the employer failed to deduct; however, the CRA is not bound to do so, which means it is entirely possible for a target company to be reassessed for additional income tax deductions as well.
In short, it’s important to obtain a clear understanding of how a target company has enlisted its key management and sales staff in order to assess the risk of additional taxes payable that may arise if the CRA conducts a review post-acquisition.
A final word of caution
These are just a few of the common Canadian corporate income tax issues that may arise during the due diligence process prior to a business acquisition. Those looking to make an acquisition of a taxable Canadian corporation should consider carefully the tax implications of such a transaction and the inherent tax attributes of the business—so, too, should Canadian owner-managers who may be planning to sell their businesses. The existence and nature of any unrecorded tax liabilities can significantly affect the investment risk (and therefore the value) of a business, substantially altering the landscape in which the negotiation of a sale and purchase agreement takes place; the result could be the need for additional holdback provisions, income tax indemnification clauses, and other similar contractual arrangements.
Guthrie Hurd is a manager in the transaction tax services group of Ernst & Young LLP in Toronto, where he specializes in providing Canadian corporate income tax advisory services to clients pursuing the acquisition or sale of a business, and other corporate restructuring transactions.