Addressing Corporate Income Tax Issues in the
Due Diligence Process
By Guthrie Hurd, CPA, CA
“Diligence is the mother of good luck…”
Guthrie Hurd is a manager in
the transaction tax services
group of Ernst & Young LLP in
Toronto, where he specializes
in providing Canadian
corporate income tax advisory
services to clients pursuing the
acquisition or sale of a
business, and other corporate
restructuring transactions.
– Benjamin Franklin, The Way to Wealth (1758)
P
erforming appropriate due diligence
procedures prior to the acquisition of
a business contributes significantly
to informed decision-making and investment
success. Navigating the corporate income tax
implications of an acquisition can complicate
the process, however. A considerable amount
of tax due diligence may be required in a
share purchase transaction, for example,
since a purchaser would be acquiring not
only a target company’s shares, but also its
tax history.
What follows is a review of some Canadian
corporate income tax issues that commonly
arise during the course of a due diligence
investigation.
Reasonableness of intercompany
management fees
In the context of owner-managed businesses,
the payment and deduction of intercompany
management fees is a relatively common
practice. However, problems can arise on the
acquisition of a business that has paid such
fees, if the fees are considered unreasonable
in the circumstances.
34 CPABC in Focus • May/June 2016
For example, where a parent corporation has paid management
services fees to a subsidiary (perhaps to use up non-capital losses of
the subsidiary and shelter income from tax) but no management
services have, in fact, been performed, the Canada Revenue Agency
(CRA) has, in some cases, disallowed the deduction of such fees as
unreasonable pursuant to Section 67 of the Income Tax Act (the Act),
resulting in additional taxes payable to the parent corporation. Where
management fees are disallowed, the CRA will generally allow the
recipient of the fees an offsetting deduction to prevent double taxation.
Note, however, that this is an administrative position only. In the
event of a CRA reassessment, abusive intercompany management fee
schemes could trigger a punitive assessment of income in both companies, with the CRA disallowing the original deduction and choosing
not to apply the offsetting deduction to the recipient, resulting in
double taxation.
Care should be taken, therefore, when assessing a target company’s
intercompany management fee arrangements and any supporting
legal documentation to determine whether the substance of these
arrangements reflects the underlying economic activity of the companies
involved. Depending on the nature and amount of intercompany
management fees paid, the CRA may determine that a target company
has a significant unrecorded tax liability in this regard.
Family trust ownership structures – multiplication of
the small business deduction
When looking at a family-owned corporate group of companies, it is
not uncommon to see ownership structures that involve the control
of each operating company within the group being held (directly or
indirectly) by a separate trust—each for one member of the family as
a single beneficiary. Structures are set up this way, in part, to maximize
the small business deduction (SBD) that’s available to each operating
company within the family-operated corporate group; if they were
held under common control, these operating companies would be associated for the purposes of the Act and would be required to share
the SBD.