Buying a business: a tax due diligence checklist

Decide what you are actually buying

Most tax questions in a purchase follow from one choice: you either buy the assets of the business or the shares of the corporation that owns it. The CRA describes the difference plainly. When you buy the shares, the corporation remains a separate legal entity that owns its property, so the tax values of its assets do not change. When you buy the assets, you set a new cost for each one, and that cost drives your capital cost allowance and your cost of goods sold.

Sellers and buyers often want opposite things here, so raise it early with your accountant and lawyer rather than after the price is agreed. This checklist covers the tax checks that apply to both routes and points out where they split. It does not replace legal due diligence on contracts, leases, permits and litigation, and it is not a valuation. If you also plan to run the business through a new corporation, see the checklist on moving from sole proprietor to corporation.

Ask for the tax records before you commit

Request the last several years of the business’s tax returns and notices of assessment, its financial statements, its GST/HST returns, and its payroll remittance and T4 filing records. For a sole proprietorship the returns are the owner’s personal returns with the business statements attached, so expect to review some personal information and agree on how much the seller will share. Reconcile what you receive to the bank statements and the general ledger. If the three do not agree, ask why before relying on any of them.

The point of the review is to find out whether returns were filed, whether balances are owing and whether the reported income looks like the cash that actually moved. Ask the seller to confirm in writing that all returns are filed and all source deductions and sales tax have been paid, and discuss with your lawyer how any unpaid amount that turns up should be handled in the price or in the agreement. A corporation you buy keeps its own history, including any unpaid tax or open reviews, so a share purchase calls for more care here than an asset purchase.

Also read the seller’s numbers critically. Check that owner wages, personal expenses run through the business and one-time items are separated from normal operating costs. Your accountant can help you restate profit on a basis you are comfortable paying a multiple of.

Allocate the purchase price

In an asset purchase you generally pay one price for the whole business. The CRA says that if the agreement sets a reasonable price for each asset, you can use those prices to claim capital cost allowance. If it does not, you have to decide how much of the price belongs to each asset, how much to inventory, and how much to goodwill. The amounts should match what the seller reports on the sale, so agree on the numbers together and put them in a schedule attached to the agreement.

Use fair market value for each identifiable asset and treat what is left as goodwill. As an illustration with round numbers, suppose you pay $300,000, and the identifiable assets are receivables of $50,000, inventory of $40,000 and equipment of $90,000. That leaves $120,000 for goodwill. Equipment goes into the appropriate capital cost allowance classes, and goodwill goes into Class 14.1, which replaced the old eligible capital property system on January 1, 2017. Inventory is treated as a purchase of goods for resale and flows through cost of goods sold.

The seller has a mirror-image result. Depending on the numbers, the seller can have a recapture or a terminal loss of capital cost allowance on the assets sold. That is one reason the allocation is negotiated: a dollar moved from equipment to goodwill changes both sides’ tax.

Check the GST/HST position

A sale of assets can carry GST/HST, which on a large purchase is real money to fund and recover. If you acquire a business, or a part of one, and take over all or substantially all of the property needed to run it, generally at least 90%, you and the seller may be able to jointly elect on Form GST44 so that no GST/HST is payable on the sale. Any property the buyer still needs but does not acquire in the agreement has to stay within the remaining 10% of fair market value.

There are limits. You cannot use the election if you buy only individual assets, or if the seller is a registrant and you are not. You have to file the form on or before the due date of the GST/HST return for the first reporting period in which you would otherwise have paid tax, and the CRA also accepts it online through its account services. Even with the election, GST/HST can still apply to taxable services the seller supplies, to leases and licences, and to a taxable sale of real property if the buyer is not a registrant. In a share purchase, the sale of the shares is generally not subject to GST/HST.

Plan the CRA accounts and the first months

Changes of ownership affect your accounts. Depending on the structure, a change in owners, partners or directors can require a new business number and new program accounts, and the CRA asks you to contact your tax services office when an owner of a sole proprietorship, a partner or a director changes. For corporations, the CRA needs the correct name and social insurance number of each director. When you update the GST/HST account you need to give the name and social insurance number of at least one owner, director or partner, and the business activity. If the business has employees, find out which payroll account will pay them after closing, and how final and opening payroll will be handled.

Agree on a closing date and a clean cut-off for sales, inventory and payables. Ask your bookkeeper to set up opening balances from the closing statement, with the allocation schedule behind them. Keep the agreement, the schedule, the election copy and the seller’s records together, because you will need them for the first return and for any later review.