Toronto business and technology lawyer, Sukhi Hansra, of Hansra Law, provides insight into the key differences between an asset purchase and a share purchase.
What Are The Main Ways Of Selling A Business?
At the heart of all business transactions are two main methods of buying or selling a business: the asset purchase and the share purchase. Each method has its own positives and negative business, financial and tax implications. However, there is also a third method that many business owners often overlook: the hybrid sale, which is the sale of both assets and shares of a business. A hybrid sale allows for the most flexibility between the balance of business risk and tax burden. Hybrid sales are unique enough to warrant a separate Legal Guide and will not be discussed here.
Deciding between an asset purchase and a share purchase is a complicated matter. Each of these methods has different benefits and drawbacks for the buyer and seller. Typically, sellers prefer to sell shares to limit their liability in the sale of the business. Buyers prefer to only purchase the assets of the seller’s business, so that the buyer does not take have to take on any liabilities and responsibilities of the seller’s business. The ultimate consideration may often come down to the liability risk and tax consequences of each method.
1. What Is An Asset Purchase/Sale And How Is It Structured?
As the name indicates, an asset purchase involves the purchase or sale of some or all of a company’s assets, such as inventory, equipment, property, contracts, customer lists and lease agreements. The buyer can pick and choose the assets it wants and, more importantly, identify what liabilities it wants to take or avoid (for example, loans on equipment or accounts payable). The ability to selectively choose is the main reason that buyers prefer to structure a transaction as an asset purchase instead of a share purchase. In an asset sale, the seller’s corporation remains with the seller.
An asset purchase is more complex than a share purchase because each asset must be transferred using separate documentation. For example, contracts with suppliers and customers cannot be automatically transferred to the buyer in an asset purchase. Similarly, employment contracts must also be specifically transferred or assigned to the buyer. As discussed in more detail below, if the employees are unionized, there will be further needs to address between the buyer and seller because of the Ontario Labour Relations Act.
Some contracts, such as a lease or permit, may have what is referred to as a change of control clause. A change of control clause means that the seller must first get the permission of the other party in the contract before the seller can transfer the contract to the buyer. If the seller does not get permission before transferring the contract, the contract may be forfeited.
Why Do Buyers Prefer Asset Sales?
As stated above, the main reason that buyers prefer an asset purchase is because it allows the buyer to selectively choose the assets and liabilities it wants to purchase while avoiding those that it doesn’t want. For example, a buyer may only be interested in the seller’s inventory and equipment and may only make an offer to only purchase those assets. The seller would then have a choice to accept the offer, decline the offer, or counteroffer with the sale of all of the assets or nothing.
Why would a buyer want to take on liabilities? The choice to take on liabilities is a very important tax consideration for the buyer. By taking on the seller’s liabilities, the buyer can apply the liabilities as a tax deduction against future business income earned from the purchased assets. For example, certain assets, such as a vehicle used for business purposes, are considered depreciable assets in accounting terms. In simple terms, the cost of a vehicle used for business purposes ($20,000) can be divided up over the course of a few years ($20,000 / 4 years = $5,000 per year) and applied as a cost of business, thereby reducing the business’s taxable income for each of those years (annual profit – $5,000 = taxable income). This is one strategy that helps the buyer reduce its overall tax burden from the purchased assets.
A buyer may also prefer an asset purchase because it involves less liability risk. In Ontario, a buyer is required by law to take on liability for union employees and environmental contamination of the lands (under Ontario’s Environmental Protection Act). However, the buyer does not need to take on the liability for non-union employees unless the buyer offers these employees a new contract. This can be a little messy, because the seller will sometimes demand that the purchaser offer similar contracts to existing employees so that the seller avoids wrongful dismissal claims. Despite strategies to avoid these kinds of risks, it is important for the buyer to make the appropriate inquiries before the transaction takes shape.
What Are The Tax Consequences for the Seller in an Asset Sale?
Income tax consequences are the main reasons sellers try to avoid an asset sale. Sellers in an asset sale must pay two levels of tax on any assets that are sold: (1) tax paid by the seller’s corporation on the difference between the sale price and depreciable accounting cost of the asset (see above for more information on depreciation), and (2) tax paid by the seller (as the business owner/shareholder of the corporation) when the seller’s corporation transfers the profits of the asset sale to the seller.
Taxes for the seller can get a little confusing. For example, if the asset sells for more than its original cost, the seller’s corporation may be able to pay out some of the proceeds of the sale tax-free to the seller. A good first step would be to speak with someone who has been through it, or someone who has had experience helping buyers or sellers in a transaction – such as an Accountant or a Business Lawyer.
Allocating the Purchase Price to Reduce Tax Liabilities
Another key area to consider is how much of the purchase price for the assets will be allocated to each particular asset category (i.e. inventory or equipment). The amount allocated to each asset category can change the taxes payable by both the buyer and the seller. This is why the allocation of the purchase price is often a key consideration that is negotiated and inserted into the Asset Purchase Agreement.
Buyer in an asset sale will generally want to allocate more of the purchase price to inventory and depreciable assets to reduce future taxable income. On the other hand, sellers in an asset sale want to minimize purchase price allocations to inventory because this will cause them to pay tax on that amount.
2. What is a Share Purchase/Sale and how is it structured?
A share purchase means a purchase or sale of some or all of a company’s shares. In a partial share sale (anything less than 100%), the buyer will become a shareholder alongside the other shareholders of the company. This could occur when a selling shareholder decides to exit the company, or the buyer might receive shares for investing in the company. In a total share sale (100% of all shares), the seller first valuates what the business is worth and the buyer then buys out all of the shares of the business at or around that value (depending on their negotiations). In a total share sale, the buyer is buying out the seller’s company in its entirety, becoming the sole owner of all assets, liabilities and obligations of the company.
When compared to an asset sale, a share sale is less complex when it comes to transferring key contracts to the buyer. Instead of preparing separate transfer documents for each asset category and contract, the buyer simply becomes the new owner of the business. This means that there is no need to enter into new contracts with employees, landlords or suppliers. The only transfer documentation required in a share sale is the transfer of shares, as well as the occasional transfer of any outstanding shareholders loans. A shareholder loan occurs when a shareholder has not yet paid the company for the value of their shares.
Why Do Sellers Prefer Share Sales?
Sellers prefer a share sale because it allows them to (1) take advantage of personal income tax benefits under the Income Tax Act and (2) avoid being left with unwanted assets and liabilities. Under the Income Tax Act, the proceeds of a share sale are taxed as capital gains, which means that only 50% of the seller’s proceeds are taxed as income. This advantage is so significant that sellers often offer a lower purchase price for the business if the buyer is willing to agree to a share sale.
Sellers prefer to transfer as much uncertainty and liability as possible to the buyer. This often makes buyers a little hesitant to agree to a share sale because the buyer will be taking on all of the company’s liabilities along with its assets. This is risky for buyers because liability is often unknown or unforeseeable at the time of the transaction. Liability risks could include anything from past and present lawsuits, outstanding debt, accounts payable to suppliers and unpaid wages.
Buyers in a share sale should always make appropriate inquiries into the potential liabilities and history of the company before committing to the transaction. Some common due diligence inquiries are title searches, tax inquiries, zoning compliance and litigation searches.
Whether you are looking to purchase or sell a company, there is a lot to consider when choosing between an asset or share transaction. It is vital that you conduct the appropriate investigations and searches to avoid any potential liabilities and tax consequences.
While buyers typically prefer asset transactions and sellers prefer share transactions, each transaction is unique and may require a change of preference to achieve your desired outcome. A good first step would be to speak with someone who has been through it, or someone with experience advising buyers and sellers in various transactions – such as a Business Broker or Business Lawyer.
Below is a brief summary of the factors discussed in this article when choosing between an asset purchase and a share purchase.