Buying a Company with Real Estate? Bump your Land or be Prepared to Pay
The markets continue to see real estate properties change ownership even as prices continue to climb and it is not uncommon for purchasers to acquire a target company that holds real property rather than the property itself.
When this occurs, the purchaser will have the liability of the taxable gain on the difference between the original cost of the property purchased at some past date (historical cost base) and the actual sale price of the property at some future date.
In other words, the purchaser has paid for the property at current market rates through the acquisition price, but the property itself is recognized by the CRA at its historical cost base, creating a taxable capital gains liability for the purchaser that should not be theirs to bear.
- Company A purchases 100% of Target Company B for $10m, whose only assets are made up of real property valued at market for $10m.
- Target Company B purchased the property 15 years ago for $1m.
- When Company B goes to sell the property in 2 years time for $15m, Company B will be liable for the gains on $14m ($15m sale – $1m historical cost base)
To adjust for this imbalanced situation, current tax rules allow a taxable Canadian purchaser to elect to “bump” the cost base of non-depreciable capital property (i.e., land) held within a target company when control of that target is acquired by the Canadian purchaser. There are criteria that govern whether that land is considered capital property or inventory and should be established prior to acquisition of the target company.
Whether land is considered capital property or inventory is established as ‘a question of fact’ and is not always straight forward:
Capital property generally includes long term held assets, with a primary intention to generate income (i.e., property developed or purchased for rental), the ultimate sales of which are taxed as a capital gain/loss.
Non-capital property or inventory (i.e., property developed for sale) generally includes short term held assets with a primary intention to generate profits from sales which are taxed as business income/loss.
The intentions (primary and secondary) as well as the facts and actions of the owners are important to determine whether property is capital property or not.
The amount of the bump available is determined by a prescribed formula: the maximum amount being the fair market value the purchaser paid for the shares of the target company. The minimum amount depends on the tax costs of target’s assets and other adjustments.
Further rules, called the bump denial rules, may deny the bump entirely in cases where certain transactions involve the target company’s previous shareholders or substitutions of the property. These rules, although complex, generally do not apply in most commercial circumstances, but should not be overlooked by the purchaser.
In cases where a purchaser is looking to acquire land directly, but the target company’s preference is to sell shares of the company, the bump rules are a means to negotiate a fair deal.
The following steps should be reviewed with an advisor before acquiring a target company with real property:
- The purchaser confirms whether the land is held as capital property by the target.
- The purchaser determines (1) the bump will be available and (2) the amount of the bump as it is limited to a specific formula. Consideration should be given to the allocation of the fair market value to the land and building (or other assets). Land is not depreciated for tax purposes and therefore does not create a tax deduction to lower taxable income. Buildings, however, may be amortized to provide a tax deduction.
- The advisor should confirm if the bump denial rules apply.
- The purchaser considers how the bump planning may impact the acquisition structure and the purchase price (comparing directly acquiring the land versus the acquisition of target’s shares). It must consider other factors such as GST, property transfer tax, due diligence on the target company, etc. Further tax planning may be available if the target has other assets. Assuming the bump planning is beneficial, the purchaser acquires control of the target.
- Further tax planning may be available if the target has other assets.
- Assuming the bump planning is beneficial, the purchaser acquires control of the target.
- The target would then be wound up into or amalgamated with the purchaser.
- Upon the wind up or amalgamation, the tax cost of the land may be bumped.
Implementing the bump plan can be beneficial for the purchaser as it allows the resulting amalgamated company to reduce the taxable gain realized on the future sale of land, since it recognizes the price paid initially for the target company’s shares.
It is critical to contact your advisor well before acquiring any property to assess whether the bump plan is available and optimal in the acquisition. If you have any questions, please visit the Smythe Real Estate & Construction webpage to contact one of our Smythe advisors.