OPTIONS FOR THE SALE OF A BUSINESS

There are, generally, three options for the sale of a business – corporate reorganization, share sale and assets sale.  Assuming that your business grew from the nominal value to its current fair market value:

• Corporate reorganization will result in taxable dividend income;
• Share sale and assets sale will result in taxable capital gain:
• In the share sales the lifetime capital gain exemption (the “LTCG Exemption”) will shelter the resulting capital gains;
• In assets sale, the LTCG Exemption is not available.

Corporate reorganizations are useful when you want to transition your business to your kids, who do not have the funds to pay to acquire the business outright, and you wish to retain control over the business while they learn how to run it.

Share and asset sales are normally used between unrelated parties that can pay or get financing.  Sellers prefer share sales, as they can take advantage of the LTCG exemption, and buyers like to acquire assets, as this way they do not acquire the corporation and its liabilities.

Another way of transferring the business was introduced in Budget 2023 – employee ownership trust (the “EOT”).  In this option, the shares are sold to a newly established trust, beneficiaries of which are the employees of the business.  The shares are sold for their fair market value, the employees may borrow funds from the company to pay to the seller.

 

Section 86 reorganization

This is a reorganization of the authorized capital of the company that consists  of creation of new classes of common and preferred shares, exchange of your old common shares for new preferred shares worth the entire value of the business and subscription for new common shares by the new owner at a nominal price.

That allows for tax deferral on such disposition until the preferred shares are redeemed.  When the preferred shares are redeemed, you receive dividends, which are taxed in your hands.

• Your liability: If you resign as a director, you should have no liability;
• Your control over the business: the new preferred shares (or new common shares) issued to you will have voting rights to ensure your control over the business until all of the preferred shares are redeemed.  New common shares issued to the new owner may be put in escrow before the PURCHASE PRICE is fully paid;
• Funding of the purchase price: the buyer does not have to come up with the funds for the purchase price at once, the payments maybe made over time;
• Tax Liability: you will receive the purchase price as dividends, thus, will be taxed on the resulting dividends.  Taxes may be managed by controlling the timing of distribution of dividends.

Sale of shares

You can sell your shares for the purchase price, including working capital (a reasonable amount of cash).

• Your liability: If you resign as a director, you should have no liability;
• Your control over the business: the sold shares can be put into escrow before the purchase price is fully paid;
• Funding of the purchase price: the buyer will have to come up with the funds for the payment of the purchase price, at least a down payment, the rest can be a vendor’s mortgage and paid overtime (maximum deferral period for inclusion of the proceeds of sale into your income is 5 years, see in more detail below);
• Tax Liability: you will receive the purchase price as capital gain.  Use your LTCG Exemption to shelter the resulting capital gains.  If the entire cash that is in the business at the time of the closing is included in the purchase price as working capital, it will be taxed as capital gain.  If some of the cash is not included in the purchase price, it will need to be paid out as dividends, which will be taxable.

Sale of assets

Only assets of the business (equipment, inventory, furniture, lease, good will) are sold, you keep the corporation, its cash, and accounts.

• Your liability: the business will be in another person’s name (individual or corporation), after closing you will have no liability;
• Your control over the business: if the purchase price is fully paid, there is no need for control.  If there is still a vendor’s mortgage, the assets may serve as security for the full payment of the purchase price;
• Funding of the purchase price: the buyer will have to come up with the funds for the purchase price at once, at least a “downpayment”, the rest can be vendor’s mortgage and paid overtime (maximum deferral period for inclusion into income is 5 years, see in more detail below);
• Tax Liability: you will receive the purchase price as capital gain, but the LTCG Exemption will not be available (as it is only available for the sale of shares) to shelter the resulting capital gains.  You will still have the cash in the company’s accounts that will need to be paid out as dividends.  Thus, there most likely will be capital gain tax and dividend tax.

 

Employee Ownership Trust

Shares of the business are sold to a new trust that is the EOT.  The EOT is a form of employee ownership where a trust holds shares of a corporation for the benefit of the corporation’s employees.

The process is the same as for the share sale described above, with the only difference being that shares are sold to a trust.  Thus, there is an additional step of creating trust to qualify as the EOT.

The benefit of selling to the EOT is that the trust can borrow funds from the company to buy its shares.  Such a loan will be interest free to the buyer and will need to be repaid by the buyer to the company within the next 15 years.  These are very attractive borrowing terms.  If the buyer decides to borrow from the company, you may receive a down payment up to the amount of cash in the company with the rest paid out over time.  The repayment period can be any length; however, you will need to report the proceeds of sale in your income tax returns during the next 10 years.  If any amount of the PP remains outstanding after 10 years, you would have reported this amount before you received it.

The LTCG Exemption for the sale to the EOT is increased to $10 million. That comes with qualifications, of course – see below section on disqualifying events and consequences.

 

Additional information about the EOT

The EOT

A trust would be considered an EOT if it is a Canadian resident trust and has only two purposes:

• to hold shares of qualifying businesses for the benefit of the employee beneficiaries of the trust; and
• to make distributions to employee beneficiaries, where reasonable, under a distribution formula that could only consider an employee’s length of service, remuneration, and hours worked. Otherwise, all beneficiaries must generally be treated in a similar manner.

The EOT property

An EOT would be required to hold a controlling interest in the qualifying business.  At least 90% of an EOT’s assets must be shares of qualifying businesses.  Al least 90%  of the fair market value of its assets are attributable to assets used in an active business carried on in Canada.

Beneficiaries of the EOT

Beneficiaries of the trust must consist exclusively of qualifying employees.  Qualifying employees would include all individua3rd party employed by a qualifying business and any other qualifying businesses it contro3rd party, with the exclusion of employees who are significant economic interest holders or have not completed a reasonable probationary period of up to 12 months.

When an existing business is sold to the EOT, individua3rd party and their related persons who held a significant economic interest in the existing business prior to the sale would not be able to account for more than 40% of:

• the trustees of the EOT; or
• directors of any qualifying business of the EOT.

Trustee of the EOT 

The trustee must be Canadian resident. Each trustee will be elected every 5 years by the active employee beneficiaries of the EOT.

Taxation of the EOT

The EOT would be a taxable trust and would be subject to the same rules as other personal trusts. Undistributed trust income would be taxed in the EOT at the top personal marginal tax rate, whereas trust income distributed from an EOT to its beneficiaries would not be subject to tax at the trust level but at the beneficiary level.

Qualifying Business

A qualifying business is a Canadian-controlled private corporation with 90% of the fair market value of the assets of which are used principally in an active business carried on primarily (at least 50%) in Canada.

Qualifying Business Transfer

A qualifying business transfer would occur when a taxpayer disposes of shares of a qualifying business for no more than fair market value to a trust that qualifies as the EOT immediately after the sale.

Ten-Year Capital Gains Reserve

When taxpayers receive proceeds of a sale of capital property on a deferred basis, they are permitted to defer recognition of the capital gain until the year in which they receive proceeds.  A minimum of 20% of the gain must be brought into income each year, creating a maximum 5-year deferral period.  The 5-year capital gains reserve is extended to a 10-year reserve for qualifying business transfers to the EOT.  A minimum of 10% of the gain would be required to be brought into income each year, creating a maximum 10-year deferral period.

Exception to Shareholder Loan Rules

Taxpayers who receive a shareholder loan are generally required to include the loaned amount in income in the year the loan is received unless the loan is repaid within a year.  If the EOT were to borrow from a qualifying business to finance the purchase of shares in a qualifying business transfer, the repayment period is extended from one to 15 years for amounts loaned to the EOT from a qualifying business to purchase shares in a qualifying business transfer.

Exception to 21-Year Rule

To prevent the indefinite deferral of tax on accrued capital gains, certain trusts are deemed to dispose of their capital property at 21-year interva3rd party.  The EOT is intended to allow for shares to be held indefinitely for the benefit of employees.  The EOTs are exempt from the 21-year rule.  If a trust no longer meets the conditions to be considered an EOT, the 21-year rule would be reinstated until the trust next meets the EOT conditions.

The 2024 Federal Budget

These measures would apply to qualifying dispositions of shares that occur between January 1, 2024, and December 31, 2026. 

$10 million income tax exemption

The conditions provided by the 2024 Federal Budget that must be satisfied for an individual (other than a trust) to claim the $10 million income tax exemption in respect of capital gains realized on a sale of shares to an EOT are as follows:

• The individual disposes of shares of a corporation (excluding shares of a professional corporation);
• The transaction is a qualifying business transfer in which the trust acquiring the shares is not already an EOT;
• Throughout the 24 months immediately prior to the qualifying business transfer:
• the transferred shares were exclusively owned by the individual claiming the exemption; and
• over 50% of the fair market value of the corporation’s assets were used principally in an active business;

• At any time prior to the qualifying business transfer, the has been actively engaged in the qualifying business on a regular and continuous basis for a minimum period of 24 months;
• Immediately after the qualifying business transfer, at least 90% of the beneficiaries of the EOT must be resident in Canada.

Disqualifying events

There are certain disqualifying events that would cause the exemption to be unavailable or denied and could cause tax liability for the EOT following the transfer. A disqualifying event would occur if:

• the EOT loses its status as an EOT; or
• less than 50% of the fair market value of the shares of the qualifying business is attributable to assets used principally in an active business at the beginning of two consecutive taxation years.

The EOT would be deemed to realize a capital gain equal to the total amount of exempted capital gains unless the disqualifying event occurs within 36 months of the transfer, in which case the exemption is not available and is retroactively denied for the individual who claimed it.

An election is required in order for an individual to claim the exemption whereby the EOT would be jointly and severally, or solidarily, liable for any tax payable by the individual in circumstances where a disqualifying event has occurred within 36 months of the transfer.  The normal reassessment period of an individual claiming the exemption would be extended by three years for the exemption.

• Your liability: will not be for the business but for taxes – if the EOT is disqualified within 36 months of the closing, tax exemption will be retroactively denied.  However, you may have enough room in your LTCG Exemption to shelter the capital gains;
• Your control over the business: will be lacking, even if you keep some of the shares (up to 40%);
• Funding of the purchase price: the buyer does not have to come up with the funds for the purchase price at once.  The buyer may borrow from the company to pay you a downpayment (up to the amount of cash in the business), which must be repaid by the buyer overtime (maximum of 15 years).  The rest can be paid overtime (maximum deferral period for inclusion into income is 10 years);
• Tax Liability: you will receive the purchase price as capital gain, that will be sheltered by the LTCG Exemption.  If the cash in the company’s accounts is considered a working capital and part of the purchase price, the proceeds of sale will be capital gain to you.

Summary

	Section 86	Sale of shares	Sale of assets	EOT
Business liability	None	None	None	None
Control	Yes: keep shares with voting rights	Yes: keep sold shares in escrow	Yes: register mortgage	No: max 40%
Payment	Redemption of the preferred shares over time	Downpayment + vendor’s mortgage to be repaid in 5 years	Downpayment + vendor’s mortgage to be repaid in 5 years	Downpayment + vendor’s mortgage to be repaid in 10 years
Tax	Dividend tax	Capital gain tax sheltered by LTCG Exemption*	Capital gain tax, no LTCG Exemption, dividend tax	Capital gain tax sheltered by LTCG Exemption*

* cash is a working capital and included into the purchase price

 

Share sale to 3^rd party or to the EOT

• Both options will result in capital gains for you, which can be sheltered by the LTCG Exemption.
• If the cash can be included in the purchase price, there will be no need for dividends and resulting dividend tax will not be payable.
• You will likely receive the proceeds over a period of years, which will require sustainable and predictable cash flow.  In either case you will have to place your trust in a 3^rd party to operate the business so as to be able to fund the purchase price and/or repay the loan to the company.
• If you resign as director, your liability for business can be eliminated in both options.

SHARE SALE	PROS	CONS
3RD PARTY	Can retain control over the business until the purchase price is fully paid	Down payment will be limited by what amount 3rd party can personally pay
	Lower legal costs, including the transactional ones and future compliance	3rd party can borrow from the company, but must repay within a year or pay interest at least at the prescribed rate (currently 6%)
		Possible that not all capital gains will be sheltered by the LTCG Exemption
EOT	3rd party can borrow from the company to pay you the down payment, which maybe the entire amount of cash in the business, only limited by how much of it 3rd party will be willing to borrow	No control over the business after the sale
	Loan can be repaid within 15-year period with no interest	More expensive, including the transactional legal costs and future compliance by the buyer
	10-year deferral for capital gain inclusion	Disqualifying events may jeopardize availability of the LTCG Exemption
	The LTCG Exemption should shelter all the capital gains