Working Capital Adjustments in a Business Purchase Price in Ontario

The price on the first page of a letter of intent is rarely the amount that changes hands. Many Ontario business sales include a working capital adjustment, which lets the price move up or down once the real numbers at closing are known. If you are buying, it protects you from paying full price for a business that has been drained. If you are selling, it can reduce your proceeds if the business is short on the closing date.

This article explains in plain words how a target and a closing adjustment work, what tends to be argued about, and how the adjustment connects to tax rules on price allocation and sales tax. The exact mechanics always come from the agreement, so use this as a guide to the questions to ask.

What a working capital adjustment is

Working capital is, roughly, the money a business needs to run from day to day. It usually means the short-term items the business is owed or holds, such as receivables and inventory, less the short-term items it owes, such as supplier bills. The buyer expects to receive a business with a normal level of these items, so the parties agree on a target figure.

At closing, the actual working capital is measured against that target. If it is higher than the target, the price goes up. If it is lower, the price goes down. The adjustment is a contract term; it is not a tax rule or a legal requirement, so it only exists if your agreement includes it.

How the target and the closing adjustment work

Most agreements follow the same steps. The details, including timing and who prepares what, vary from deal to deal.

• The parties agree on a target working capital figure, often based on a period of the seller's past financial statements.
• A good-faith estimate is made shortly before closing, and the price paid on closing is adjusted by the difference from the target.
• After closing, the buyer (or sometimes the seller) prepares final closing figures.
• The other side reviews them and can dispute items within a set period.
• A true-up payment is made once the final figure is agreed, or decided by an independent accountant if the agreement says so.

The target matters most. A target set too high means the seller pays through a price reduction even when the business is running normally. A target set too low lets the buyer take over a business that needs more cash than expected. Seasonal businesses need particular care, because working capital on one closing date can look very different from another.

What goes into the calculation

Disputes usually come from definitions rather than arithmetic. The agreement should say exactly which accounts are in and which are out, and which accounting policies apply.

For tax purposes, the price for goods and property is looked at in parts, and the part reasonably attributable to a property is that property's proceeds for the seller and its cost for the buyer. So a price adjustment tied to inventory or receivables is not just a number. It can feed into how each side reports the sale.

How it connects to tax and price allocation

The tax effect depends on whether the deal is a share sale or an asset sale. In a share purchase, the buyer buys the corporation itself, and the change in share ownership does not change the tax values of the corporation's assets. In an asset purchase, the buyer records each asset at its allocated cost.

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. A later working capital adjustment can change those numbers, so the agreement should say how an adjustment is allocated.

Allocation changes real results. In an asset purchase, fixed assets go into their capital cost allowance classes, goodwill goes into Class 14.1, and inventory is treated as goods for resale in cost of goods sold. On the seller's side, allocating more of the price to depreciable equipment can raise the seller's tax, because recaptured depreciation is included in income in full.

• Where the 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 on the prescribed form, and their joint statement of the price paid for the receivables binds both parties.
• The parties 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.
• That election cannot be used if the seller is a GST/HST registrant and the buyer is not.

What to do next

Before you sign, work through the adjustment clause as carefully as the headline price. A small difference in definitions can move the final amount by more than a modest change to the price itself.

• Ask how the target was set and which months or period it is based on.
• Confirm which accounts are included and which are excluded, with a sample calculation attached to the agreement.
• Fix the accounting policies to be used, and what happens if they differ from past practice.
• Set the timeline for the closing statement, the review and any dispute.
• Name who decides disagreements, such as an independent accountant, and who pays for it.
• Decide whether there is a cap or floor on the adjustment.
• Ask your accountant how the adjustment affects the allocation, the receivables election and the GST/HST election.
• Have a lawyer review the clause before you sign.

Frequently asked questions