In the recent past we have witnessed a notable increase in the number of acquisitions of Canadian companies due to the opportunity created by the weakness of the Canadian dollar. Many of these acquisitions concern corporations that carry Scientific Research and Experimental Development (SR&ED) tax credits on their balance sheets. These credits are attributed in the form of a receivable, such as a claim that is filed with the Canadian tax authorities but not yet processed, or a past claim that has been processed and integrated into the company’s balance sheet as cash or future tax credits.
In either scenario, the SR&ED tax credits get reflected in the purchase price from a historical as well as prospective value. However, these credits can represent a risk for the purchaser if they do not materialize due to a tax authority review that challenges the claim and results in downward adjustments. Prospective value of SR&ED tax credit claims are also impaired whenever the claim of a given year is substantially challenged and denied by the tax authorities post acquisition.
Other consequences of an acquisition or merger are the reversion to the base tax credit recovery rates when the target company is acquired by a non-CCPC (Canadian Controlled Private Corporation) and thus the target company ceases to be a CCPC. The enhanced SR&ED rates that are available to CCPCs are 35 percent and 30 percent respectively for the federal and Québec, whereas the base rates are 15 percent and 14 percent.
In the case of a CCPC acquirer, the same reversion to the base rates may occur due to amalgamation of the assets and consolidation of the income. Furthermore, the ceiling of $3 million on eligible expenditures that entitles the company to the enhanced rates would apply to the combined entities and result in gradual reduction of the overall tax recovery rates.
Tax treatment of the SR&ED tax credits is another dimension to consider in an acquisition, because the credits are taxed in the following fiscal year. Given that an acquisition may create a substantially shortened fiscal period, the small business deduction that entitles the company to pay a lower corporate tax on the credits will be pro-rated on the shortened period, thus potentially exposing the SR&ED tax credits to the higher corporate tax rate.
Other consequences to the tax credit recovery rates could arise from innocuous conditions in the letter of intent which, depending on the terms outlined in the letter, could have immediate effect on the loss of CCPC status of the target company. De facto loss of control due to a clause in the LOI could forfeit the right of the target CCPC from being entitled to the enhanced SR&ED tax recovery rates from date of acceptance of the LOI.
Another technology-related tax incentive in Québec, the Crédit D'impôt pour le Développement Des Affaires Électroniques(CDAE) or the “E-business tax credit” may see the target company’s eligibility be adversely impacted through an acquisition as the eligibility evaluation may employ different methods.
Due diligence is part of the buyer beware precept and no merger or acquisition process is complete without a proper due diligence exercise. This should also extend to the SR&ED tax credits, especially where the tax credits are material to the balance sheet of the target company. This can involve the review of past or in-process claims for evaluation from a technical eligibility and financial compliance perspective.
While the acquirer conducts its own due process, the seller should also seek appropriate advice where the manner and terms of acquisition may have a material impact on the tax treatment and recovery rates of their tax credits.
For more information contact Kegham Redjebian, Senior Manager, SR&ED, at 514.861.9724 or firstname.lastname@example.org