How to Allocate the Purchase Price in an Ontario Business Sale

In an asset sale, the headline price is only the start. How it is divided among equipment, inventory, goodwill and other items decides who pays how much tax.

Buyers and sellers often want different splits. This article explains why, and what the CRA expects.

Why the split matters

Under section 68 of the Income Tax Act, where an amount can reasonably be regarded as partly paid for property, services or a restrictive covenant, each part is treated separately. The part reasonably attributable to a property is that property's proceeds for the seller and its cost for the buyer.

In a share sale, the buyer buys the corporation itself and the tax values of the corporation's assets do not change. In an asset purchase the buyer records each asset at its allocated cost, which is why buyers often prefer assets.

On the seller's side, the amount allocated to an asset feeds into the tax calculation for that asset. Only one-half of a capital gain is taxable. Adjusted cost base is usually the cost of the property plus expenses to acquire it, and outlays and expenses to sell it, such as commissions, legal fees and advertising, are subtracted from the proceeds when calculating the gain. A taxable capital gain is added to income and taxed at the combined federal and Ontario marginal rates.

How the CRA approaches allocation

If the sale agreement sets reasonable prices for individual assets, those prices are used. If not, the price is allocated to each asset at fair market value, then to inventory, and the remaining balance to goodwill. The buyer's allocation should match what the seller reported.

Putting reasonable figures in the agreement, rather than leaving it silent, gives both sides certainty.

Fair market value matters here. For tax purposes, the CRA defines it as the highest price obtainable in an open and unrestricted market between knowledgeable, informed and prudent parties acting at arm's length, with neither party under compulsion to transact. For a business as a whole, it is generally the greater of its liquidation value and its going concern value.

The CRA treats the earnings method and the asset value method as the two most generally accepted bases of valuation. The earnings method is used mainly for operating businesses that make or sell products or services, while the asset value method suits businesses that earn income mainly from their assets rather than from the owners' personal efforts. To justify a price, the factors include the nature and history of the business, the industry outlook, the balance sheet, earnings record, goodwill and other intangibles, and underlying asset value.

What it does to each side

Class 14.1 replaced eligible capital property on January 1, 2017. How the price is allocated changes the buyer's future deductions, while allocating more to depreciable equipment can raise the seller's tax. That tension is the heart of the negotiation.

Because the two sides' interests pull in opposite directions, each side's accountant will usually want to see the numbers before the price is fixed. How this plays out depends on your facts, so it is worth confirming with an accountant.

Elections that go with an asset sale

• Accounts receivable election: where a seller sells all or substantially all the property used in a business, including receivables, to a buyer who proposes to continue it, both may jointly elect in prescribed form, and their joint statement of the receivables price binds both.
• GST/HST election on Form GST44: seller and buyer can jointly elect that no GST/HST is payable if the buyer acquires all or substantially all (at least 90%) of the property needed to carry on the business and can continue operating it.
• The GST44 form must be filed by the due date of the buyer's GST/HST return for the first reporting period in which tax would otherwise have been payable.

The GST44 election cannot be used if the seller is a GST/HST registrant and the buyer is not. Even with the election, GST/HST still applies to taxable services supplied by the seller and to taxable leases or licences of property. A share purchase is generally not subject to GST/HST, while an asset purchase can be, unless the parties elect.

What to do next

• Get an asset list and a fair market value estimate for each item.
• Gather records of what each asset cost, since the cost of the property affects the seller's gain.
• Ask both accountants to model the tax result of a few allocations.
• Write the agreed allocation into the purchase agreement.
• Confirm whether the receivables and GST/HST elections apply, and diarize their filing dates.
• Have a lawyer review the agreement before signing.

Frequently asked questions