There are numerous tax consequences that occur as a result of the acquisition of control of a corporation. (We use the term “acquisition of control” and “change of control” synonymously.)
Deemed taxation year-end
First, there is a deemed taxation year-end of the corporation immediately before the acquisition of control. Then there is a deemed beginning of a new taxation year at the time of the acquisition of the control. The deemed year-end will typically result in a short taxation year. The corporation will have to file a tax return for that short year within the normal time frame (6 months after the yearend). It will have to pay the balance of its tax owing for the year within 2 months after the year-end (or 3 months, for certain Canadian-controlled private corporations).
The short taxation year will require a pro-rating of certain deductions. For example, the corporation’s deduction of capital cost allowance (tax deprecation) will have to be pro-rated to account for the short year. As well, one more year is used up for rules that “count” taxation years.
Perhaps more significantly, the change of control will trigger income tax consequences that do not apply to a “regular” year end. Most of the rules limit the extent to which certain tax losses and other attributes can be carried over or back beyond the change of control. The significant rules are summarized below.
Restriction for net capital loss and non-capital loss carryovers
There is a blanket restriction for the carryover of net capital losses (unused allowable capital losses – generally half of capital losses) beyond the change of control. In other words, net capital losses from years before the change of control cannot be used to offset capital gains after the change of control. Similarly, net capital losses from years after the change of control cannot be carried back to offset capital gains from before the change of control.
For non-capital losses (generally, business and property losses), the same restriction applies, but not in all cases.
Non-capital losses from a business before the change of control may be carried forward to years after the change of control, but only if the same business is carried on after the change of control with a reasonable expectation of profit, and only to offset income from that business or a similar business. Similarly, non-capital losses after the change of control from a business can be carried back to years before the change of control only if the same business is carried on with a reasonable expectation of profit, and only to offset income from that business or a similar business.
Otherwise, non-capital losses cannot be carried forward or back beyond the change of control.
Write-down of accrued capital losses
Immediately before the change of control of the corporation, all of the accrued capital losses of the corporation are triggered and the cost of each property with an accrued loss is reduced to its fair market value. The accrued capital losses are recognized in the taxation year that ends upon the change of control. This rule, in conjunction with the carryover restrictions, ensures that capital losses cannot be carried over to taxation years beyond the change of control.
However, the corporation can elect to trigger accrued capital gains in respect of other property owned at the change of control. The triggered capital gains can then be offset by any accrued losses recognized as noted above. More specifically, the corporation can elect that a capital property with an accrued capital gain is deemed to be disposed of for any amount between its cost and its fair market value. The corporation will have a deemed re-acquisition cost of the property at the same elected amount.
Example
A corporation undergoes a change in control. Immediately before the change of control, it owns a capital property A with a cost (adjusted cost base) of $100,000 and a fair market value of $60,000.
Under the write-down rules, the corporation will have a deemed capital loss of $40,000 and allowable capital loss of half of that amount or $20,000.
The corporation also owned a capital property with a cost of $50,000 and fair market value of $80,000. The corporation can elect that property B is disposed of for $80,000, resulting in a capital gain of $30,000 and taxable capital gain of $15,000.
The allowable capital loss from property A will completely offset the taxable capital gain from property B. The corporation’s cost of property B will be bumped up to $80,000.
The corporation will be left with a net capital loss of $5,000 ($20,000 allowable capital loss from property A less the $15,000 amount that offset the taxable capital gain from property B). This $5,000 amount cannot be carried forward beyond the change of control, but can be carried back for up to 3 years to offset taxable capital gains, if any, in those years.
Restriction for carryover of investment tax credits
A corporation can earn an investment tax credit(ITC) in various ways. Perhaps the most common credit relates to a business that incurs scientific research and development expenses (SR&ED); these expenses generate a tax credit of 15% of the expenses and up to 35% in the case of certain Canadian controlled-private corporations. The credits can normally be carried forward 20 years or back 3 years.
However, upon the change of control of a corporation, the carryover of ITCs is restricted. Basically, ITCs earned before the change of control from a business can be carried forward to offset taxes after the change of control resulting from income from the same or similar business. Similarly, ITCs earned after the change of control can be carried back to offset taxes resulting from income from the same or similar business. Otherwise, the ITCs cannot be carried over beyond the change of control.
What is an acquisition of control?
As noted, the above rules apply to an acquisition or change in control of corporation. So when does this occur?
First, a change in control will normally occur when a transaction (such as the purchase and sale of shares) results in a new person or group of persons owning shares in the corporation carrying more than 50% of the votes required to elect the board of directors. This type of control is often called “de jure” (legal) control. This rule does not normally apply if another person related to the person or group of persons controlled the corporation before the transaction. For example, if you transfer your controlling shares in a corporation to your spouse, there will not be a change of control.
Another rule deems a change of control when a person or group of persons acquires shares in the corporation having a fair market value of more than 75% of the fair market value of all of the shares in the corporation (even if the shares are not voting shares). The rule does not apply if the person or group already had de jure control as discussed in the preceding paragraph.