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Canada is looking particularly attractive to business buyers and investors these days. Recent M&A activity across the Canada-U.S. border indicates a strong and growing inflow of investments from U.S. entities.
During the past three years, mid-sized transactions, those under $500 million, represented nearly 90% of investment activity. A timely combination of circumstances make Canada an appealing target for U.S. mid-market dealmakers. Along with a welcoming business environment, political and economic stability, an educated workforce, reasonable business tax rates, and a competitive research and development environment, Canada typically offers attractive value with a favourable foreign currency exchange and valuation multiples that are lower than those in the U.S. All of these factors enhance the potential for profitable business acquisitions and growth.
While Canada is well positioned for U.S. investors to purchase and build businesses and to expand internationally, it is a competitive market. Pension funds, strategic buyers and international investors are all currently seeking investment opportunities here. So it is important to understand the requirements for investing in a business north of the border – and to be prepared to move forward in an efficient and well planned way, keeping in mind the following five fundamentals that are integral to successful deals.
1. Structure the Transaction for Strategic Benefits
When acquiring a privately-held Canadian business, the transaction can be completed by way of a purchase of assets or shares. Since there are very different tax, financial and legal implications for each, the way in which the transaction is structured needs to be carefully planned.
Many potential purchasers prefer to buy the assets of a company because they wish to increase the tax cost of depreciable assets or exclude from the transaction certain liabilities or components of the business.
When a non-resident acquires the assets of a Canadian company, the purchase is subject to the Investment Canada Act and if the sale involves all or substantially all of a corporation’s assets, shareholders must approve the transaction by special resolution. Competition laws may also apply. As well, consent of landlords and creditors may be necessary.
Many sellers, on the other hand, prefer to sell shares. A seller can typically reduce overall tax liability by obtaining capital gains tax treatment on the sale of shares, and in many circumstances individual sellers in Canada are potentially able to shield the first $824,177 in capital gains from any capital gains tax. As well, a share purchase is usually simpler and faster than an asset purchase because it avoids recapture of depreciation on the assets that are sold and eliminates the need to secure consent from third parties to transfer certain assets.
Given the differences between U.S. and Canadian regulations, it’s important to secure knowledgeable local advice about the structure of a transaction to ensure this fully addresses tax and liability consequences and ultimately achieves the goals for the transaction.
2. Strategize Business Ownership Structure for Optimal Tax Impact and Repatriation of Capital
While Limited Liability Companies (LLCs), Limited Liability Partnerships (LLPs), and Limited Liability Limited Partnerships (LLLPs) are common U.S. business entities, a number of Canadian tax issues arise when a U.S. resident earns income from these while carrying on
business in Canada.
LLCs, LLPs, and LLLPs generally do not qualify for full benefits under the Canada-U.S. Income Tax Convention (Treaty). Partner Mark Pearlman, who is the lead of MNP’s Inbound Tax practice, cautions that “improper structuring of a business in Canada by a U.S. resident can create problems with repatriation of funds.”
As well, because many U.S. private equity groups operate through an LLC or similar vehicle, often they are not covered by the Treaty. This creates adverse issues when structuring a business in this country. Failure to qualify for Treaty protection can raise the rate of withholding to 25%, compared with Treaty rates of 0% to 15%, depending on the type of payment.
When setting up a cross-border structure, it’s important to be aware that what works in the U.S. doesn’t always work in Canada – and may in fact create double taxation. Two of the more common ways to operate in Canada are a branch of a U.S. entity or a Canadian subsidiary. Determining the appropriate ownership structure can be key to return on investment.
3. Conduct Quality of Earnings Review
Overpaying for a business can have serious ramifications, affecting financing and future revenue. By conducting a quality of earnings review during the early due diligence phase, a purchaser can determine whether the amount of earnings the vendor claims for the business is in fact sustainable. Typically, an independent third party experienced in transaction advisory services assists with this review, which involves acquiring a thorough, objective understanding of the target business. Sitting down with the management team, this professional will explore how the business operates so that subsequent financial, customer and vendor analyses can be conducted with an understanding of where key risks lie.
While a review varies according to the type of business and the circumstances, the investigation is tailored to the areas representing the highest risk for the buyer. Discussions can range from how the target company acquires customers, how sales are made, what kind of capitalization policy is used, how inventory is handled, to what keeps management up at night.
When a quality of earnings investigation reveals information impacting the value of the business, vendor and buyer are usually able to renegotiate the deal. Equipped with a thorough understanding of the quality of earnings, purchasers and investors have the confidence to make informed decisions about a transaction and to complete a successful deal.
4. Address Tax Consequences of Bringing U.S Residents to Work In Canada – Before They Arrive
Often, investors bring employees from the U.S. to Canada to work here either temporarily, occasionally or permanently. When doing so, Mark Pearlman suggests investors should be aware of two significant issues.
The first relates to payments made by a Canadian resident taxpayer to the non-resident for services they provide in Canada. Anyone carrying on business in Canada is required to file an income tax return here. If this entity has protection under the Treaty, it may not have an income tax liability but may still be required to file a return. “Canada has a very low threshold regarding the definition of ‘carrying on business’,” says Mark, MNP International Tax specialist ” and therefore many activities will result in the requirement to file. Failure to do so will result in late filing penalties.” As well, Canada’s Income Tax Act imposes withholding requirements on payments for services rendered in Canada by non-residents. The only exception is if the non-resident corporation has received a withholding tax waiver from the Canada Revenue Agency (CRA) prior to the payment being made.
The second issue relates to wages earned by employees of the non-resident who come to Canada to provide services, even if just for a few days a year. Canadian law requires the employer to make payroll withholdings on the salary earned in Canada by the non-resident employee and to file a T-4 information return. In many situations the CRA will issue waivers to eliminate the requirement to withhold but these are only issued prior to the salary being paid for the services performed in Canada.
5. Prioritize Cyber Security on the Due Diligence Checklist
Instances of corporate network breaches have been increasing dramatically in recent years. Yet despite alarming stories of vulnerabilities leading to major damage for companies, cyber security due diligence is not at the top of many M&A checklists. But it should be.
Without cyber due diligence, a purchaser can assume massive risk from a target company. Integrating a weak or compromised network of a newly acquired entity into another can introduce damaging new cyber problems into a previously protected enterprise. Consider the potential impact if assets such as confidential customer, employee or product information, intra-company communication, proprietary research or processes, customer confidence or brand reputation were compromised. Potential liability from an unforeseen breach and a subsequent decline in business value could be devastating.
Since many companies don’t reveal the full extent of data breaches, there are only rough estimates of numbers affected rather than confirmed statistics. According to global security solution provider Symantec, a conservative estimate of unreported cyber breaches in 2015 was 500 million lost or stolen personal records.
“We remind our clients that every record a company loses costs about $210 to replace,” says MNP’s National Cyber Security leader Danny Timmins. “A major cyber breach could put the entire value of an enterprise at risk.”
“This is why it is so important for business investors and purchasers to understand what you are buying, from a cyber security perspective. You don’t want to inherit security problems from another organization simply because of insufficient due diligence.”
In today’s M&A environment, it is critical to fully understand the potential impact and risks of another network and its security architecture. Danny recommends a Cyber Security Health Check as part of the due diligence for any potential acquisition or investment. “This assessment identifies key risks and provides a picture of an organization’s areas of vulnerability and preparedness against cyber threats. It also identifies priority areas for remediation and outlines resources and budget that would be required to address these,” he says.
Ultimately, the digital resilience of a business can be a major liability or a valuable asset to an investor. When it comes to doing business in Canada, there are many growth and expansion opportunities for U.S. companies that wish to benefit from this country’s proximity and receptive business environment. By addressing these five fundamentals, U.S. investors will be well positioned to capitalize on this profitable potential.
Contact John Caggianiello, CPA, CA, Senior Vice President and Director with MNP’s Corporate Finance team in Toronto at 416.513.4177 or [email protected]
Related Topics:Business Structures
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