Acquiring a company’s shares means inheriting its tax history: 5 risks to watch

When you buy a company’s shares, you also buy its past tax obligations, including those no one has identified yet. That is why tax due diligence is a key step in any acquisition.

Its role goes beyond identifying risks. It also allows you to have certain issues corrected before closing, have the sellers bear the costs or negotiate the purchase price. This is where tax advisory support creates real value for the buyer.

Here are some examples of major tax risks we frequently identify in our due diligence engagements and that can have a significant impact on a transaction.

What is tax due diligence?

Tax due diligence involves reviewing the key elements of a target company’s tax position. It helps identify the tax liabilities the buyer could inherit, measure their impact on the transaction and determine whether they should be corrected before closing, reflected in the purchase price or covered by representations and warranties or specific indemnities.

1. US sales tax: a risk that often catches buyers off guard

A Canadian company may have sales tax obligations in the United States even if it has no subsidiary, office, warehouse or employees there. It all depends on whether it has a sufficient connection with a state, known as “nexus.”

Nexus can take two forms:

• Economic nexus, created when sales in a state exceed a threshold set by that state (often US$100,000 per year).
• Physical nexus, which can result from employee travel, participation in trade shows, the presence of agents, work performed at customer sites or the temporary storage of inventory.

When nexus exists, the company may be required to register, file returns, and then collect and remit tax on its taxable sales. The risk is especially high when it has not obtained the required exemption certificates, for example for sales for resale or to manufacturers. Without valid documentation, sales that could have been exempt may be presumed taxable. A person who is registered, or required to be, may also have to file tax returns with local authorities. When a company does not file the returns it is required to file, the statute of limitations does not apply: the liability can therefore span several years.

What due diligence makes possible: identifying states at risk, distinguishing taxable sales from truly exempt sales and assessing possible corrective measures, such as obtaining certificates, completing the required registrations or using a voluntary disclosure program, which often limits the period covered and the penalties.

2. Independent contractor or employee: a risk that can be costly

If the target company pays amounts to subcontractors or unincorporated independent contractors, the tax authorities could, during an audit, consider some of them employees. That is why we systematically review this aspect in our engagements.

To assess the risk, we look in particular at the reality of the working relationship, rather than only the classification used in the contract. The analysis covers, among other things, the control the company exercises over tasks, schedule and compensation, ownership of tools and equipment, the ability to subcontract, the real chance of profit and risk of loss, and the degree to which the worker is integrated into the company’s operations. We also consider the exclusivity and continuity of the relationship, access to employee benefits and whether the worker operates a genuine separate business on their own account.

Misclassification can have significant consequences. If an independent contractor is reclassified as an employee, the company could have to pay the source deductions that should have been withheld, including both the employer and employee portions, plus interest. At the federal level, a penalty generally equal to 10% of the amounts not withheld may be added, and it can reach 20% in certain circumstances.

3. Transfer pricing: transactions between related companies must respect the arm’s length principle

In a group operating in several countries, the Canadian company often carries out transactions with related companies abroad: sales or purchases of goods, management services, expense reimbursements, royalties, loans or financial guarantees.

Section 247 of the Income Tax Act is based on the arm’s length principle. The terms of these transactions must match those that independent parties would have agreed to. When they do not, the Canada Revenue Agency (CRA) can adjust the Canadian company’s income or expenses. Additional tax and interest then become payable. A 10% penalty on certain net adjustments may also apply when the threshold set out in the Act is exceeded and the CRA considers that the company did not make reasonable efforts to determine arm’s length prices.

Transfer pricing documentation is the main way to demonstrate those efforts. The deadline to provide it to the CRA following a written request is now 30 days, rather than three months, while the number of audits in this area keeps rising.

Also check: Form T106. It must be filed when the total value of reportable transactions with related non‑residents exceeds $1 million in a taxation year. Late filing can result in a penalty of up to $2,500 per form. In the case of a false statement or omission made knowingly or under circumstances amounting to gross negligence, a $24,000 penalty may be imposed.

4. Intercorporate dividends: not always tax free

In some transactions, the sellers hold the operating company through holding companies. To allow them to claim the capital gains exemption, the transaction may be structured so that the buyer also acquires the shares of these holding companies.

However, these holding companies have often received dividends from the operating company over the years. It is commonly believed there is no risk, since an intercorporate dividend is generally tax free. That is not always the case.

Subsection 55(2) of the Income Tax Act may apply when one of the purposes of the dividend is to significantly reduce an unrealized capital gain on shares. The dividend can then be recharacterized as a taxable capital gain, creating tax payable in the company that received it, namely the holding company you are buying.

The main protection against this rule is the safe income exception. Safe income is determined through a detailed tax calculation that identifies the portion of the company’s accumulated earnings after tax that is attributable to the unrealized gain on the shares in question. An intercorporate dividend can generally be paid tax free up to the amount of safe income. Any excess risks being recharacterized as a taxable capital gain.

It is therefore important to assess whether dividends paid to the holding companies in the past present a risk, especially since a large dividend is often paid just before a transaction.

5. Transaction costs: watch their deductibility

For a buyer, the tax treatment of professional fees related to transactions, including legal, tax, financial and accounting fees, must be analyzed from two angles:

• The target company’s past transactions. When the target has previously completed an acquisition, a tax reorganization or another major transaction, you need to check whether the professional fees were treated correctly. If a deduction claimed in the past is denied after closing, the buyer inherits the tax liability.
• The current transaction. When the target company incurs or pays professional fees related to the transaction, their tax treatment should be addressed in advance in the share purchase agreement. Otherwise, the sellers could claim a deduction that may later be denied by the tax authorities, while the buyer would inherit the tax liability after closing.

Due diligence therefore helps identify a historical liability, but also determine who can claim deductions for professional fees on the current transaction and who will bear the risk if they are denied. The purchase agreement can then address these issues: capping the amounts the sellers can deduct, prohibiting certain deductions without the buyer’s consent or providing for an indemnity or price adjustment if they are denied.

Planning an acquisition?

Our multidisciplinary tax due diligence team brings together specialists in Canadian taxation, sales tax, transfer pricing, and US and international taxation. We help you identify risks, measure their impact and factor them into your negotiation.

Talk to our specialists to secure your next transaction.