By now you might have heard that Budget 2016 proposes to repeal the existing eligible capital property (“ECP”) regime in favour of a new class of depreciable capital property in respect of which capital cost allowance (“CCA”) may be claimed. The new rules will become effective as of January 1, 2017. This places a relatively narrow window of time in which to take advantage of a deferral opportunity presented by the existing ECP regime, which will be lost once the new rules come into effect.
The rules generally concern eligible capital expenditures, which are incurred to acquire intangible rights or benefits, such as goodwill, for the purpose of earning income from a business. The current regime allows 75% of eligible capital expenditures to be added to a notional pool from which an annual deduction can be claimed at a rate of 7% on a declining-balance basis. The new regime will instead allow 100% of such expenditures to be added to a new class of depreciable property in respect of which CCA may be claimed at an annual rate of 5% on a declining-balance basis. Compare 75% of an expense deductible at 7% vs. 100% of the same expense depreciable at 5%; “tomato / tomato” right? Maybe not…
The more interesting change presented by the proposed regime is the tax treatment on a disposition of ECP. Perhaps the most common example is found in the sale by a corporation of its business, including its ECP (goodwill).
Assume a Canadian-controlled private corporation resident in BC (“BCco”), has internally-generated goodwill with a fair market value of $1,000,000 and nil tax cost. Under the current regime, if BCco were to sell its goodwill asset before the end of 2016, it would realize an ECP gain of $1,000,000. One half of the gain, being $500,000, would be taxable to BCco as active business income at a rate of 26%. The remaining half of the gain would be added to BCco’s capital dividend account (“CDA”) after the end of its tax year in which the sale took place. Once added to BCco’s CDA, it will be available for distribution to its shareholder tax-free.
The result is $130,000 of corporate-level tax owing in the year of disposition, leaving $870,000 of after-tax proceeds available to BCco, $500,000 of which is distributable in the following taxation year as a tax-free capital dividend. The remaining $370,000 can be paid to BCco’s shareholder as a dividend, taxable at 31.3% (assuming top rate in BC on eligible dividends), resulting in shareholder-level tax of $115,810. The combined tax is $245,810, or a little under 25% of the total ECP gain.
If BCco instead sells its goodwill after 2016, the gain would be treated as an ordinary gain from the disposition of depreciable capital property resulting in a capital gain in the amount of $1,000,000. One half of the gain would be added to BCco’s CDA, available to distribute to its shareholder tax-free. The remaining $500,000 would be subject to corporate level tax at 49.7%, resulting in immediate taxation of $248,500 in the year of disposition, a portion of which would be refundable on payment of a dividend to its shareholder. Fully distributed, net of the refund, the total tax would approximate $259,500, or just under 26% of the total goodwill gain (assuming top rate in BC on ineligible dividends).
Under the current ECP regime, there is immediate corporate level taxation in the amount of $130,000, or 13% of the total goodwill gain, leaving BCco with $870,000 in after-tax proceeds to reinvest or distribute. The proposed CCA regime would impart immediate corporate level taxation in the amount of $248,500, or 24.85% of the total goodwill gain. Comparatively, the current ECP regime presents BCco with a tax deferral advantage of $118,500, or 11.85% of the total goodwill gain.
An arm’s length purchaser of BCco’s goodwill obtains a shiny new depreciable capital asset, which will give rise to annual CCA claims under the new regime (subject to transitional rules). A goodwill sale can also be structured between non-arm’s length parties, giving business owners a chance to take advantage of the current ECP regime without selling the business to an arm’s length party. However, in the non-arm’s length context, the depreciable asset obtained is a little less shiny (exactly one half as shiny), as only one half the total asset value will be available for depreciation.
So what to do if you have significantly valued corporately held goodwill? If you’re planning an asset sale in the near future, consider accelerating your timeline so as to close before the end of 2016. If not, consider opportunities to internally reorganize your holdings so as to cause a fair market value disposition of corporately held goodwill under the current ECP regime. Although this would trigger immediate corporate level tax at a rate of 26% on one half of the goodwill gain, the tax-free one half of the gain can be distributed as a capital dividend free from shareholder level tax. If planning a distribution of corporate retained earnings anyways, this may present an efficient way to structure the distribution.
The transactions described in this blogpost, particularly in the non-arm’s length context, are described in general terms only and are not without risk. Such risk might arise in respect of valuation efforts, potential shareholder benefits and of course, the general anti-avoidance rule (GAAR). As such, before embarking on a reorganization or sale of one’s business, careful attention must be paid to the potential traps and technical provisions of the Income Tax Act together with the particulars of a given organizational structure.