This is article is part of a series dealing with draft legislation released for comment by the Department of Finance on July 29th. Read the complete series:
- The evolving taxation of derivatives
- Sales of linked notes
- Taxation of switch fund shares
- Changes coming to country-by-country transfer pricing documentation requirements
- Alternative arguments in support of tax assessments
Budget 2016 proposed rules to replace the existing eligible capital property ("ECP") regime with a new class of depreciable capital property effective as of Jan. 1, 2017. Property that was ECP will be treated as depreciable capital property and will generally be subject to the depreciable capital property regime of the ITA. Draft legislation to implement the new rules was included in the Notice of Ways and Means Motion that formed part of Budget 2016. On July 29, 2016, revised draft provisions were released for comment (the "2016 Legislative Proposals") which are substantively similar to the Budget 2016 proposals save for certain consequential amendments to provisions in the ITA and amendments that are intended to eliminate certain technical glitches.
Currently, capital expenditures may qualify as ECP where they are incurred in respect of intangible property for the purpose of earning income from a business and are not deductible as a current expense or are incurred to acquire an intangible property. Under the ECP regime, 75 per cent of an eligible capital expenditure is added to the taxpayer's cumulative eligible capital ("CEC") pool in respect of the business and is deductible at a rate of seven per cent per year on a declining-balance basis. Similarly, 75 per cent of an eligible capital receipt (generally, a capital receipt for rights or benefits of an intangible nature that is received in respect of a business, other than a receipt that is included in income or is proceeds of disposition of a capital property) is deducted from the relevant CEC pool. If the balance of the CEC pool becomes negative as a result of such deduction, the amount of the negative balance must be included in the taxpayer's income as recaptured CEC. Once all of the previously deducted CEC has been recaptured, any excess receipt (an "ECP gain") is generally included in income from the business at a 50 per cent inclusion rate, akin to the inclusion rate for a capital gain. The remaining 50 per cent is added to the capital dividend account ("CDA") and can be distributed to shareholders on a tax-free basis.
By contrast, the depreciable capital property regime permits discretionary deductions in respect of the cost of depreciable capital property of a taxpayer. The amount of capital cost allowance ("CCA") that may be deducted by a taxpayer is based on prescribed rates applied on a declining-balance basis to the undepreciated capital cost ("UCC") of the property. Different types of depreciable property are assigned to various classes in the Regulations and have their own prescribed maximum rates of depreciation. The disposition of depreciable capital property could give rise to income in the form of recaptured depreciation (or a loss on income account) and/or a capital gain (or capital loss).
Under the proposed rules, a new class of depreciable capital property is created (Class 14.1) for CCA purposes effective as of Jan. 1, 2017, which will include goodwill associated with a taxpayer's business, property that was ECP before 2017 and property acquired on or after Jan. 1, 2017, the cost of which would have been treated as an eligible capital expenditure under the ECP regime. As with the ECP regime, a separate Class 14.1 will be maintained in respect of each business of the taxpayer.
It is proposed that expenditures that are currently added to the CEC pool will be fully added to Class 14.1 as of Jan. 1, 2017 as compared to the 75 per cent inclusion rate under the ECP regime. The annual prescribed rate of depreciation for new Class 14.1 will be five per cent to be applied on a declining-balance basis, as compared to the current rate of seven per cent that applies in respect of amounts in a taxpayer's CEC pool. For taxation years that end before 2027, the proposed rules effectively allow the seven per cent rate of depreciation to apply to the portion of the UCC of new Class 14.1 that relates to expenditures incurred before Jan. 1, 2017.
Special rules are proposed with respect to the acquisition and disposition of goodwill. The rules provide that every business of a taxpayer is considered to have a single goodwill property associated with it, even if no expenditures were made to acquire goodwill. Expenditures and receipts that do not relate to the acquisition or disposition of an identifiable property will adjust the capital cost of the goodwill of the business and consequently the UCC of new Class 14.1 (i.e., expenditures are added to the capital cost and will increases the UCC and receipts reduce the capital cost and therefore the UCC by the lesser of the cost of the goodwill in respect of the particular business and the amount of the receipt). These rules are intended to ensure that capital expenditures and receipts previously captured by the ECP regime are accounted for in new Class 14.1. If the receipt exceeds the original cost of the goodwill, the excess will be treated as a capital gain.
The proposed rules also apply to adjust the balance of Class 14.1 where the taxpayer acquires goodwill as part of a property that is combined with the taxpayer's existing business or where the taxpayer disposes of a portion of the goodwill but continues to carry on the existing business.
There are complex transitional rules to transition tax balances of businesses with ECP to the new Class 14.1 regime. Generally, the proposed transitional rules provide for, inter alia, the computation of the UCC and the capital cost of new Class 14.1 and special straddle period rules where a taxpayer has a taxation year that straddles Jan. 1, 2017 but ends after Jan. 1, 2017.
(i) Capital Cost and UCC
It is proposed that the UCC of new Class 14.1 is generally equal to the amount that would have been the CEC balance in respect of the business at the beginning of Jan. 1, 2017.
The deemed total capital cost of the property in Class 14.1 at the beginning of Jan. 1, 2017 is generally the total of 4/3 of what would have been the CEC balance on that day and 4/3 of depreciation claimed but not recaptured before that day. This computation is important in determining the amount of gains and recapture that may be realized by the taxpayer in the future.
The transitional rules provide that the capital cost of each property (other than goodwill) is deemed to be the lesser of the eligible capital expenditures of the taxpayer in respect of the particular property and the amount by which the total capital cost of the class exceeds the total amounts each of which is the capital cost of the property. The residual capital cost, if any, is then attributed to goodwill in respect of a business. The taxpayer will be required to designate the order in which the capital cost of each property (other than goodwill) is determined. If such a designation is not made, the Minister may designate the order.
(ii) Straddle Year – Capital Cost
Notwithstanding the foregoing, there are special proposed rules that apply to adjust the capital cost of property in new Class 14.1 where a taxpayer has a taxation year that straddles Jan. 1, 2017 ("Straddle Year") and the taxpayer receives an eligible capital receipt in the Straddle Year but prior to Jan. 1, 2017.
Where a taxpayer disposes of ECP in a Straddle Year (but prior to Jan. 1, 2017), the amount by which the CEC balance of the taxpayer would be negative (i.e., if the taxpayer's taxation year had ended at the end of 2016) exceeds the deductions previously claimed in respect of ECP will be deemed to be a capital gain instead of an income inclusion, unless the taxpayer elects with the Minister before the taxpayer's filing due-date for the relevant taxation year for the amount to instead be included in computing the income of the taxpayer from a business or property.
A couple of issues were highlighted in response to the Budget 2016 proposals with respect to the foregoing election, which seem to have been addressed by the 2016 Legislative Proposals. Firstly, it was unclear in the Budget 2016 proposals whether there would be a CDA addition where the election was made (with respect to Canadian-controlled private corporations ("CCPCs")). The 2016 Legislative Proposals clarify that a CDA addition will be made with respect to 50 per cent of the gain. Secondly, the election was not available if the taxpayer ceased to carry on the business on Jan. 1, 2017 (i.e., proceeds received on a 2016 sale in a straddling year). The 2016 Legislative Proposals propose to eliminate this requirement.
The proposed transitional rules, like the ECP rules, allow taxpayers to defer income inclusions and capital gains where new Class 14.1 property is acquired prior to the end of the particular taxation year.
(iii) Gross-Up of UCC and Anti-Avoidance Rules
The proposed transitional rules contain a relieving measure that is intended to ensure that a receipt from the disposition of property, the cost of which was included in CEC at a 75 per cent rate does not reduce the UCC at a 100 per cent rate. This is done by increasing the UCC of new Class 14.1 to the extent necessary to prevent excess recapture when a taxpayer disposes of certain property. This gross-up does not apply where certain rollover provisions were used. Moreover, the capital cost is generally ground-down where the taxpayer holds the property as a result of engaging in non-arms' length transactions. This rule is intended to prevent taxpayers from increasing the depreciable base of a property through the use of a non-arm's length transfer of depreciable property that was ECP.
Impact of the Proposed Rules
There is a significant tax deferral advantage for CCPCs that dispose of ECP under the current regime because half of the amount of the capital receipts in respect of the disposition of ECP is added to the CDA and the other half is taxed as active business income and generally subject to the small business deduction. It has been a common planning strategy for sellers of ECP to distribute a portion of the cash proceeds to the shareholders on a tax-free basis as a capital dividend and maintain the balance in the corporation thereby deferring the payment of personal tax on such amounts.
Under the proposed rules, one half of the amount is added to the CDA but the other half will be taxed as investment income which is taxed at a higher rate for CCPCs (and subject to additional refundable tax when the corporation pays taxable dividends to its shareholders). Accordingly, the proposed rules will result in the loss of a tax-deferral strategy for CCPCs that dispose of ECP. CCPCs with accrued gains on ECP may wish to consider crystallizing the ECP gains prior to the effective date of the proposed rules on Jan. 1, 2017 to take advantage of the current rules.
The crystallization of the ECP gains would generally entail the transfer of the ECP to a new subsidiary ("Subsidiary") to trigger the gain. One technical issue that has been highlighted by practitioners is whether the Subsidiary would obtain full tax cost in the transferred ECP such that it would not realize a gain on the ultimate disposition to a third party. Variable A.1 in the definition of CEC provides for a grind in Subsidiary's CEC balance as a result of the non-arm's length transfer. This would cause the Subsidiary to realize a gain on the disposition to the third party buyer (thereby triggering double tax on the same gain). However, the 2016 Legislative Proposals provide the required upward adjustment in capital cost to address this problem.
In conclusion, the proposed rules eliminate the historical tax-deferral opportunity for CCPCs and introduce certain computational requirements for all other taxpayers in connection with the transition into the new regime. While the determination of the total capital cost of new Class 14.1 is not relevant until the time of disposition of the relevant property, taxpayers may wish to assemble the necessary information and documents to enable them to make the computations pursuant to the proposed transitional rules so that all information is readily available at the time of any future transaction.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.