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Managing Commodity Taxes and Cash Flows in a Transaction

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Managing Commodity Taxes and Cash Flows in a Transaction

You have just finalized the terms and conditions for the sale or acquisition of a business. The parties have agreed that a sale and purchase of assets would be better than a sale of the shares.

You now need to consider a whole range of factors, such as financing, sale price adjustments, employee transfers under the new ownership, representations and warranties regarding goodwill and traffic, non-competition clauses, etc.

On the transaction closing date, a colleague asks you THE crucial question: “Do GST and QST apply to the transaction?” So, what’s the story?

Basic Rules

The supply of goods and services in Canada/Quebec is subject to GST and QST. The purchaser may be entitled to recover both taxes through a federal input tax credit (“ITC”) or Quebec input tax refund (“ITR”).

However, it can take a number of months between the time the purchaser pays the commodity taxes to the vendor and the time the purchaser receives the refund. Given the large sums involved, this can have a negative impact on the purchaser’s cash flows.

Possible Solutions

The Excise Tax Act (“ETA”) and the Quebec Sales Tax Act (“QSTA”) contain some elections and options to minimize the adverse effect of commodity taxes on cash flows summarized as follows:

1. Election under sections 167 ETA and 75 QSTA – Supply of assets of business

2. Election under sections 156 ETA and 334 QSTA – Transactions between closely related parties

3. Option of deferring tax payments

4. Option of financing taxes

However, certain conditions must be met as explained below:

1. Election under sections 167 ETA and 75 QSTA – Supply of assets of business

This election is only possible if the requirements under the ETA and QSTA are met. Among other things, the vendor must supply all or substantially all (defined to be greater than or equal to 90%) of a business it has established, operated or acquired after another person has acquired or operated it, and the purchaser must acquire all or substantially all of the property that can reasonably be considered necessary to operate the business or the part of the business involved.

2. Election under sections 156 ETA and 334 QSTA – Transactions between closely related parties

Certain conditions must be met for this election to be possible. Among other things, the purchaser must have acquired property or provided taxable supplies before the election is made. This condition can be a problem when assets are sold to a new entity that has had no business activities prior to the proposed acquisition.

3. Option of Deferring Commodity Tax Payments

A registrant (vendor or purchaser) must file a commodity tax return no later than the end of the month following its reporting period. The registrant may choose to file before the end of the month following the end of its reporting period.

The parties could therefore agree that for a transaction completed on June 1st, for example, the purchaser will file its return on July 1st and the vendor will file its return on July 31st.

Since the purchaser can claim the ITC and ITR on the assets acquired (even if they haven’t yet been paid), there is a chance that the purchaser may receive its refund before the vendor has to pay the commodity taxes to the tax authorities.

The parties could also agree that the purchaser will pay the commodity taxes to the vendor when the vendor is obliged to remit them to the tax authorities. This solution will help reduce adverse effects on the purchaser’s cash flows. In the example above, the commodity taxes would become payable on July 31st rather than June 1st.

4. Option of Financing Taxes

Should the parties prove unable to agree on the time when the commodity taxes become payable or insist that a transaction must take place at the end rather than the beginning of a month (e.g. December 31st), a purchaser with a tight cash flow might be obliged to finance the commodity taxes payable on the assets acquired.

However, the purchaser should not automatically assume that the taxes payable should be added to the amount to be financed for the transaction. It would be in the purchaser’s interest (no pun intended) to finance the commodity taxes, if necessary, over a shorter period of time than the assets acquired to coincide with the expected receipt of the ITC and ITR. The purchaser would then be able to repay the entire loan related to the commodity taxes as soon as the refunds are issued by the tax authorities. This short-term loan (comparable to a “bridge loan” in real estate) is another way for the purchaser to minimize the adverse effect of the purchase on cash flows.

Conclusion

There clearly are solutions to minimizing the impact of commodity taxes on cash flows in an asset transaction. As is often the case in taxation, it’s better to anticipate the problem and solve it at the negotiation stage, not when the transaction is final.