When engaging in the purchase or sale of a privately held company, one must decide between two primary transaction structures: asset sales and share sales. Each has distinct legal, tax, and practical implications that influence the choice of structure. Understanding these differences is crucial for both buyers and sellers to ensure an optimal transaction.
Asset Sale
An asset transaction involves the purchase of a business’s assets. In this scenario, the assets are precured and extracted from the existing corporate vehicle and dumped into a new corporation. The assets typically under sale are inventory, fixtures, furniture and equipment, customer lists, supplier lists, goodwill, accounts receivable, accounts payable, trade names, contracts, leasehold improvements, licenses, domain names, telephone numbers and more.
The benefit of an asset acquisition is that a buyer can select the select specific assets and liabilities they wish to acquire while leaving the undesirable liabilities behind. Usually, a buyer acquires all assets and necessary operational liabilities of the business such as its accounts payable and the balance of its contractual obligations. Liabilities such as lines of credit or term loans remain with the seller and are typically paid from the sale proceeds.
Asset sales involve more intense legal components as each asset must be identified, valued, and transferred individually. This can involve considerable administrative effort, including assignments of contracts, transfer of permits and licenses, and conveyance of real property. For example, if a target company has ten delivery vehicles, each vehicle must be identified, safety certified, insured, taxed and title transferred individually at Service Ontario.
Since assets are transferred individually, third-party consents may be required for the transfer of contracts, leases, and other agreements. This can sometimes pose a significant hurdle if key contracting parties are unwilling to provide consent. To the extent those contracts go to the value of the target business under sale, the number of contracts and high customer concentration will be a factor to determine whether to opt for a share sale as opposed to an asset deal.
It is important to note that employees cannot be regarded as assets under law, and therefore are not automatically transferred to the buyer in an asset sale. The target company must notify its employees of the impending sale and terminate their contracts. New employment contracts must be renegotiated by the buyer to the employees. The buyer will typically offer the same employment to all employees on substantially similar terms, however sometimes a buyer will choose to select only some employees to offer employment and leave the rest. This can lead to potential liabilities for severance or termination under the Employment Standards Act or applicable provincial employment standards legislation.
Tax Considerations
Since the assets are purchased directly from the vendor target company, the purchase price is allocated amongst the assets themselves (as opposed to the shares of the corporation holding the shares) and therefore the buyer can benefit from a step-up in the tax basis of the acquired assets, potentially leading to increased depreciation deductions moving forward. This can be a significant tax advantage. It is important to note however that buyers aim to acquire assets at the highest possible undepreciated capital cost (UCC) to maximize future tax deductions. Sellers prefer a lower allocation to minimize capital gains tax and avoid recapture tax if assets are sold above their UCC.
An asset sale will also be subject to GST/HST unless both parties elect under s.167 of the Excise Sales Tax Act to file a joint election GST44, to the extent both parties qualify.
Finally, the target company will pay capital gains tax on the sale of its assets. The nature of the assets sold (e.g., inventory vs. capital property) will affect the tax treatment inside the corporation. One should note that since the target (vendor) most often is a corporation, there will be two levels of tax to contend with – the first at the corporate level for capital gains tax and the second at the shareholder level to the extent the shareholder wishes to extract earnings over and above the capital dividend account.
Share Sale
A share sale involves purchasing the ownership of the corporation that operates the target business. In a share sale, the seller steps out of the shoes of the owner of a corporation and the buyer steps into those shoes. There are no changes that occur within the corporation itself.
Purchasing shares of a corporation means acquiring the corporation itself, including all of its internal assets and liabilities. Sellers prefer this method to avoid retaining liabilities of the business under sale. While this seems beneficial, standard indemnities can shift some liabilities back to the seller. Where necessary, a holdback of sale proceeds can provide support for the indemnity.
Share sales are generally simpler from an administrative perspective since the ownership of the company changes, but the company’s operations and contracts remain intact. There is no need to individually transfer each asset.
With respect to employees, these remain employed by the same legal entity, thus avoiding the complexities of renegotiating employment contracts.
Tax Considerations
As far as tax implications, sellers will prefer to sell shares as they will benefit from the Lifetime Capital Gains Exemption (LCGE) which will shelter $1,250,000 from capital gains tax per shareholder, subject to conditions under the Income Tax Act.
From the buyers perspective however, they will prefer an asset purchase since with shares, the buyer will inherit the tax cost of the corporation’s non-depreciable and depreciable capital assets. If assets have a low UCC, future tax deductions may be limited, increasing taxable income. Unlike asset sales, there is no step-up in the tax basis of the company’s assets in a share sale. This can result in lower depreciation deductions. More than this, if the capital property of the corporation has a low ACB and high FMV, the buyer is purchasing a corporation with a bloated capital gain that will be triggered when the asset is sold within the corporation. One may consider discounting the purchase price for this reason.
Comparing the Two
Choosing between an asset sale and a share sale is complex, as the parties involved often prefer opposing structures due to tax consequences and potential liabilities. Typically, sellers prefer share sales, while buyers prefer asset purchases.
From the buyers perspective, they often prefer asset sales to avoid inheriting unknown liabilities and to benefit from a step-up in the tax basis of acquired assets. However, the complexity and potential requirement for third-party consents can be deterrents.
Sellers generally favor share sales to achieve a cleaner exit, transferring all liabilities to the buyer and potentially benefiting from favorable capital gains tax treatment and the LCGE.
Conclusion
Choosing between an asset sale and a share sale requires careful consideration of tax implications, liabilities, and personal preferences. It is crucial to hire a qualified lawyer experienced in both asset-based and share-based transactions to ensure the best outcome. If you have questions about the implications of each type of transaction, please contact us and speak with one of our lawyers.
Shira Kalfa, BA, JD, Partner and Founder
Shira Kalfa is the founding partner of Kalfa Law Firm. Shira’s practice is focused in corporate-commercial and private M&A law including corporate reorganizations, corporate restructuring, mergers and acquisitions, commercial financing, secured lending and transactional law.
© Kalfa Law Firm , 2024
The above provides information of a general nature only. This does not constitute legal or accounting advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.
