Purchase Price Allocation in an Ontario Business Sale Explained

In an asset sale, the buyer is not buying one thing. It is buying equipment, inventory, goodwill and often other items, and the tax system wants to know how much was paid for each. That split is the purchase price allocation.

Buyers and sellers often want opposite answers, which is why the allocation deserves attention early, not on the closing day. This article explains how it works in Ontario and what each side should watch.

What allocation means and where the rule comes from

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.

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.

Fair market value is the key idea 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.

To justify a price, the CRA lists factors that include the nature and history of the business, the industry outlook, the balance sheet, the earnings record and earning power, and goodwill and other intangibles. How these apply to a particular business depends on the facts, so it is worth confirming with a lawyer or accountant.

Why the buyer cares

In an asset purchase the buyer records each asset at its allocated cost, which is why buyers often prefer assets. The class an asset falls into then drives future deductions.

How the price is allocated therefore changes the buyer's future deductions.

Why the seller cares

If, at year end, the sale proceeds credited to a CCA class make its undepreciated capital cost negative, the excess (recaptured depreciation) is included in the seller's income in full. Allocating more of the price to depreciable equipment can therefore raise the seller's tax.

By contrast, only one-half of a capital gain is taxable. A capital gain is generally the proceeds less the adjusted cost base and the outlays and expenses of selling, such as commissions, legal fees and advertising. Which assets carry the price therefore affects whether the seller reports income, a capital gain, or both.

Where a company is selling its assets, the tax picture for the shareholders is different again, and a lawyer or accountant should review the structure.

Elections that sit alongside the allocation

• 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 the business, both may jointly elect in prescribed form, and their joint statement of the price paid for the receivables binds both.
• GST/HST election (Form GST44): seller and buyer can jointly elect that no GST/HST is payable on an asset sale 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.
• Limits on the GST44 election: it cannot be used if the seller is a GST/HST registrant and the buyer is not, and GST/HST still applies to taxable services supplied by the seller and to taxable leases or licences of property.

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.

What to do next

• Ask for an asset list early, with fair market value estimates for equipment, inventory and goodwill.
• Raise the allocation in the letter of intent, not after the price is agreed.
• Put the agreed allocation in the sale agreement as a schedule.
• Confirm that the buyer and seller will report the same figures.
• Have your accountant model the seller's recapture and the buyer's deductions under two or three allocations.
• Ask a lawyer whether the receivables election and the GST44 election apply to your deal.

Frequently asked questions