Canada's 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 leaves a relatively narrow window in which to take advantage of deferral opportunities under 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.
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 that a Canadian-controlled private corporation resident in British Columbia had internally generated goodwill with a fair market value of C$1 million and nil tax cost. Under the current regime, if the company sold its goodwill asset before the end of 2016, it would realise an ECP gain of C$1 million. One half of the gain (C$500,000) would be taxable to the company as active business income at a rate of 26%. The remaining half of the gain would be added to the company's capital dividend account (CDA) after the end of its tax year in which the sale took place. Once added to the company's CDA, it would be available for distribution to its shareholder tax-free.
The result would be C$130,000 of corporate-level tax owing in the year of disposition, leaving C$870,000 of after-tax proceeds available to the company, C$500,000 of which would be distributable in the following taxation year as a tax-free capital dividend. The remaining C$370,000 could be paid to the company's shareholder as a dividend, taxable at 31.3% (assuming top rate in British Columbia on eligible dividends), resulting in shareholder-level tax of C$115,810. The combined tax would be C$245,810, or a little under 25% of the total ECP gain.
If the company instead sold 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 C$1 million. One half of the gain would be added to the company's CDA, available to distribute to its shareholder tax-free. The remaining C$500,000 would be subject to corporate level tax at 49.7%, resulting in immediate taxation of C$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 C$259,500, or just under 26% of the total goodwill gain (assuming top rate in British Columbia on ineligible dividends).
Under the current ECP regime, there would be immediate corporate level taxation of C$130,000, or 13% of the total goodwill gain, leaving the company with C$870,000 in after-tax proceeds to reinvest or distribute. The proposed CCA regime would impart immediate corporate-level taxation of C$248,500, or 24.85% of the total goodwill gain. Comparatively, the current ECP regime presents the company with a tax deferral advantage of C$118,500, or 11.85% of the total goodwill gain.
An arm's-length purchaser of the company's goodwill obtains a 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 half as shiny), as only one-half of the total asset value will be available for depreciation (subject to the transitional rules).
So what should a company with significantly valued corporately held goodwill do? If the company is planning an asset sale in the near future, it should consider accelerating its timeline so as to close before the end of 2016. If not, it should consider opportunities to internally reorganise its 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 half of the gain could be distributed as a capital dividend free from shareholder-level tax. If a company is already planning a distribution of corporate retained earnings, this may present an efficient way to structure the distribution.
The transactions described in this update, 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. As such, before embarking on a reorganisation 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 organisational structure.
Further, the transitional rules pertaining to the repeal of the ECP regime have recently been revised to address certain gaps in the initially proposed provisions. The particulars of the transitional rules are outside the scope of this update; however, before carrying out any goodwill sale planning under the current ECP regime, careful attention must be paid to the revised transitional rules to ensure that the above-noted objectives can be achieved.
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