Canada: Changes to the Eligible Capital Property Tax Rules

Last Updated: December 5 2016

Introduction to new Goodwill Taxation Rules

New tax changes are set to come into force on January 1, 2017 with respect to the income tax treatment of Goodwill. The new tax rules will result in higher taxes on the sale of Goodwill and the inability to defer income from the sale of a business using a corporation.

SME owner-managers who are considering a sale of their business in the short to medium term or who need to extract cash from their corporations (e.g. to fund personal lifestyle requirements) should contact our Canadian tax lawyers immediately so that we can help to devise a tailor-made plan for restructuring that will allow entrepreneurs to take advantage of the current favourable tax treatment of goodwill. This article explains how our experienced Canadian tax lawyers can move immediately to help you take advantage of the tax savings offered by the old rules before the end of the year.

Eligible Capital Property (Goodwill) Taxation

Eligible Capital Property is the tax term for an intangible asset held by a taxpayer. Goodwill and the valuable pre-existing relationships built up through years of doing business with suppliers and customers are the most common examples (and the most important for tax planning purposes) of Eligible Capital Property.

Canadian Income Tax Treatment of Eligible Capital Property (Goodwill)

Historically, Canadian income tax law has by design allowed for preferential tax treatment of gains on the sale of Eligible Capital Property. Under the rules currently in force (only continuing until the end of 2016), when Eligible Capital Property (goodwill) is sold for a gain as a part of a discrete transaction, or a complete sale of a business as a going concern, fifty percent (50%) of the gain is taxable as active business income, while the balance is treated akin to the non-taxable portion of a capital gain, meaning it is tax free. The non-taxable proceeds from a sale of Eligible Capital Property or goodwill are tracked in a corporation’s Capital Dividend Account and become available for distribution to the shareholders on a tax-free basis by way of capital dividends.

The previous income tax treatment of the taxable 50% portion of ECP allowed business owners to continue to defer taxes upon the sale of Goodwill through the use of a holding corporation, in some cases indefinitely. As mentioned above, the taxable portion was considered Active Business Income, allowing for the income to be taxed in the hands of the corporation at only 26% compared to the top personal rate of 54%.

As a result, the easiest and most tax effective manner of selling a business was by way of a sale of the assets of a corporation, including its goodwill. Doing so would result in half of the proceeds attributable to the sale of the goodwill being non-taxable in the corporation, and then distributed to the shareholder on a tax-free basis through a capital dividend election. The remaining taxable portion, after taxes were paid, could be retained and invested in the corporation without immediate tax consequences.

Active vs. Passive Income

Under Canadian tax law, preferential treatment is given to income that flows from an active business vs. income earned from a passive source as we discussed above.

A full explanation of the subtle nuances of income characterization is beyond the scope of this article, however, succinctly put, passive income can be understood as income earned from a passive source, such as real property rentals or investments.

When the Canadian Income Tax Act was reformed in 1971, one of the issues that the government wished to address was the incorporation of investment portfolios. Without special characterization rules, those who would incorporate could hold their investments in a corporation to defer taxes by taking advantage of the far lower corporate tax rate versus the personal income tax rate.

To address this problem, the Income Tax Act introduced Part IV tax which creates an additional tax on passive income earned in a corporation thereby bringing the corporate rate up to an amount in excess of the highest marginal personal rate. The difference is refunded to the corporation when a taxable dividend is paid, incentivizing the flow through of passive income to be taxed in the individual’s hands at the personal income tax rate.

On the other hand, active business income is given far more preferential tax treatment. When a corporation earns active business income, the income is taxed in the corporation at lower corporate rate of approximately 27% and any available small-business deduction can be allocated to reduce that rate even further. There is no additional tax on the income in the corporation, meaning the corporation is free to reinvest the income without paying additional taxes until the funds are distributed to the shareholders. At that time the individuals will pay income taxes at their marginal tax rate, subject to a tax credit being applied to recognize the tax already paid on that income by the corporation.

Thus it is basic income tax planning that a business owner will always prefer to have their income classified as from an active source, rather than as passive. As set out above, the changes to take place on January 1, 2017 will eliminate Eligible Capital Property as a separate tax class and fold it into the existing Capital Cost Allowance regime. The result will be that the taxable portion of a sale of goodwill will be deemed to be from a passive source and thus subject to Part IV tax.

The New Eligible Capital Property Regime

On March 22, 2016, the new Liberal Minister of Finance, the Honourable Bill Morneau, tabled that government’s first budget. Included among the proposed changes was a plan to repeal the existing Eligible Capital Property regime and to fold ECP deductions into the existing Capital-Cost Allowance framework under the newly proposed class 14.1.

At the same time under the proposed rules the sale of ECP after January 1, 2017 will still be characterized akin to a capital gain. As such, 50% of the gain will be non-taxable and eligible for capital dividend treatment, while the remaining 50% will be characterized as income from investment, or passive income. The characterization of the 50% of the ECP sale as passive income means that any such income will be subject to Part IV tax and taxed at the high corporate rate of 50.67% in any holding corporation. Thus, the deferral advantage will be eliminated – previously the Canadian Income Tax Act would deem the taxable portion of the sale of Goodwill to be from active business and as such taxed at either the Small-Business Deduction rate of 13.5% or the general corporate tax rate of 27%. The net after tax proceeds could then be reinvested without additional tax consequence until distribution to the shareholder.

The Tax Advantages to Crystallizing ECP Prior to January 1, 2017

Individual taxpayers who operate a business should speak to our professional Canadian tax lawyers for advice as to how to protect their lifelong investment in their business and arrange to benefit from the old ECP regime. As explained above, the tax treatment of various types of income, particularly active vs. passive can have a significant impact on how much of your hard-earned dollars you’ll be able to keep when you finally sell your business.

At the same time, business owners who are not yet contemplating a sale and would like to take advantage of the business income characterization should move quickly to ensure that a proper tax law specific reorganization is possible before the end of this coming calendar year.

There is an immediate ability to withdraw funds tax free from a corporation on the sale of goodwill due to the tax free capital dividend being paid to the owner. So, prior to January 1, 2017, assuming a goodwill value of $1 million, the tax effects of a properly structured tax-driven reorganization would be:

  • A $500,000 capital dividend may be declared, allowing the operating corporation to pay out an amount of $500,000 on a tax-free basis to the shareholder(s); and
  • Active business income of $500,000 earned by the operating corporation. This amount will be subject to the lower corporate tax rate of 27% - meaning a total tax payable by the corporation of $135,000. The remaining proceeds may be reinvested by the operating corporation; OR
  • Active business income of $500,000 earned by the operating corporation. Assuming as an example that the entire small-business deduction allocation is available, this amount will be subject to a tax rate of 13.5% - meaning a total tax payable by the corporation of $67,500. The remaining proceeds may then be reinvested by the operating corporation.

Thus, the proceeds of disposition for the business will then effectively be “crystallized” as active business income for deferral without further tax consequence upon reinvestment. It should also be noted that the payment of the $500,000 tax free capital dividend serves to offset the taxes payable on the sale of a business, as the tax free dividend can replace salary or a dividend and will allow a corporate distribution with no additional tax in the shareholder’s hands.

SME owner-managers should be advised that our experienced Canadian tax lawyers can create a custom-made restructuring plan that will in most cases have an immediate and positive cash-flow effect, despite the fact that taxes may become payable.

Conversely, if we assume a goodwill value of $1 million after January 1, 2017, the tax effects are:

  • A $500,000 capital dividend may be declared, allowing the operating corporation to pay out an amount of $500,000 on a tax-free basis to the shareholder(s); and
  • Passive income of $500,000 earned by the operating corporation. This amount will be subject to Part IV tax at a rate of 50.67% - a total tax payable by the corporation of $253,350. Thus, the difference of almost 20% of the value of goodwill is not available for reinvestment by the operating corporation.

Those who do not take advantage of the old rules BEFORE the end of 2016 will see their immediate income tax obligations rise and will be unable to take advantage of the valuable income deferral available through the corporation.

We must emphasize that there is no single “catch-all” solution to this problem as appropriate tax planning must be undertaken to ensure that no unforeseen income tax consequences are triggered based on facts specific to any corporation. Depending on the circumstances, the plan for overall restructuring will often be different from one business to another.

Any business owner considering a sale of their business in the short to medium term or who needs to extract cash from their corporations (e.g. to fund personal lifestyle requirements) should contact our Canadian tax lawyers immediately so that we can help to devise a tailor-made plan for restructuring that will allow any business owners to take advantage of the soon to disappear ECP- goodwill regime.

Similarly, those business owners who are not considering a sale can nevertheless take advantage of the preferential tax treatment using a similarly tailor-made strategy devised by our knowledgeable Canadian tax lawyers. As the changes take effect on January 1, 2017, time is of the essence.

The information is thought to be current to date of posting. Income tax law changes frequently and content may no longer reflect the current state of the law. This document is not intended to create an attorney-client relationship. You should not act or rely on any information in this document without first seeking legal advice. This material is intended for general information purposes only and does not constitute legal advice. If you have any specific questions on any legal matter, you should consult a professional legal services provider.

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