August 13, 2020: Please note this blog has been updated since its original publication date of July 28, 2020.
One of the criticisms of the Canada Emergency Wage Subsidy (CEWS), as originally implemented, was that employers which acquired revenue-generating assets between the qualifying period and the historical comparison period often found it difficult to meet the qualification requirements for the CEWS due to the increased revenue earned on the new assets. Where business assets were acquired after the relevant prior reference period, the comparison of qualifying revenues for a current reference period might not reflect the true economic impact of the COVID-19 pandemic on the eligible entity's revenues. On July 27, 2020, Bill C-20, An Act respecting further COVID-19 measures received Royal Assent. Part I of the legislation extended the CEWS to December 19, 2020, and redesigned certain key features of the program, including providing a revenue continuity rule in the case of certain asset acquisitions. The continuity rule is also the subject of revised guidance from the Canada Revenue Agency (CRA) in the form of its frequently asked questions.
The redesign also includes a scaled base subsidy available to all employers who experience any decline in monthly revenues (eliminating the existing all-or-nothing 30% revenue decline test) and a scaled top-up subsidy available to employers who experience a three-month average revenue drop of more than 50 percent, the details of which are described in our previous blog, Canada Emergency Wage Subsidy: Proposed Extension until December 19, 2020 and Redesign.
While the new CEWS provisions for asset acquisitions are a welcome addition to the CEWS, they raise their own series of issues and questions. This blog outlines the new asset revenue continuity test and some of those issues and questions.
Asset Acquisition Continuity Rule
The asset acquisition continuity rule is contained in new subsections 125.7(4.1) and (4.2) of the Income Tax Act (ITA). Where the specified requirements are satisfied, the provisions provide for continuity in calculating qualifying revenue in prior and current reference periods, thereby effectively enabling a purchaser of a business to establish a revenue reduction and thus potentially qualify for the CEWS. The rules are effective retroactive from April 11, 2020, and apply for all qualifying periods.
Basic Requirements and Conditions
For the rule to apply and provide the necessary relief (as described in more detail below), five key requirements must be satisfied:
- an eligible entity (i.e., an employer that is eligible to qualify for the CEWS) must acquire "assets" in the qualifying period in question or at any time before that period;
- the fair market value (FMV) of the acquired assets must constitute "all or substantially all" of the FMV of the property of the seller used in the course of carrying on business (calculated at the time that is immediately prior to the acquisition of the assets) and the acquired assets must have been used by the seller in the course of a business carried on in Canada by the seller;
- it is reasonable to conclude that none of the main purposes of the asset acquisition was to increase the amount of the CEWS to which the acquiring eligible entity would have otherwise been entitled; and
- finally, if the seller continues to exist during the particular qualifying period, the eligible entity and the seller must jointly elect to have the regime apply in respect of that period and file with the Minister accordingly. If the seller no longer exists, the eligible entity must elect in respect of the particular qualifying period and file an election in prescribed form and manner with the Minister. As with other CEWS elections, the CRA's FAQs indicate that the election must be retained with the eligible employer's records.
Application and Consequences
If the above conditions are satisfied, the provisions operate to deem the qualifying revenue of the seller for the prior reference period or the current reference period, for the qualifying period that is reasonably attributable to the acquired assets (the assigned revenue), to be included in determining the qualifying revenue of the recipient eligible entity (for its prior reference period or current reference period, as the case may be, for the particular qualifying period). Conversely, this assigned revenue will be subtracted from the seller's prior reference period or the current reference period, as the case may be. The inclusion of the assigned revenue in the purchaser's revenue, and exclusion of the same, from the seller's revenue, the seller and purchaser from both claiming the CEWS in respect of the same revenue.
To use an example, suppose a seller carried on a manufacturing business throughout 2019 with monthly qualifying revenues of $100,000, and sold the assets of said business to a newly formed eligible entity on June 30, 2020, which continues to carry on the business as is but recognizes qualifying revenues of only $60,000 in July 2020. Under the pre-amendment version of the rules, the purchaser entity would determine its eligibility for the CEWS by comparing its July revenues with its average January/February revenues and, since it was not in business in January/February, it would not qualify. Under the revised regime, the purchaser would be deemed to have qualifying revenue of $100,000 in the prior reference period and hence would qualify for the CEWS (assuming all other conditions are met). The seller will be deemed to no longer have experienced this revenue drop and would not qualify for the CEWS in respect of that particular business in that same qualifying period.
Additionally, under the new rules, the portion of assigned revenue, if any, received by the seller from non-arm's length parties will be deemed not to be derived from non-arm's length parties by the eligible entity recipient, if the third party deals at arm's length with the eligible entity recipient throughout the current reference period. Finally, if the seller meets certain conditions to be a "qualifying entity", namely being registered to, or using a payroll administrator to, make payroll remittances as of March 15, 2020, the eligible entity recipient will be deemed to meet those conditions as well. This permits an eligible entity that did not have employees as of March 15, 2020, to still qualify for the CEWS in respect of any qualifying period after the qualifying asset acquisition.
While the proposed new rule fills an important gap previously left open by the CEWS legislation, it is not without its own set of concerns and certain issues may lead to unintended and adverse tax results. Some of the issues identified to date are as follows.
All or Substantially All—Part of a Business
The new asset acquisition continuity rule mandates that the FMV of the acquired assets constitute all or substantially all of the FMV of the property of the seller used by the seller in the course of carrying on business. The CRA generally interprets the words "all or substantially all", including for purposes of the CEWS regime, to mean 90 percent or more, although there is a case law supporting a slightly lower threshold in appropriate circumstances.
The wording of the provision suggests that there can be only one seller and that the substantial entirety of the seller's business be transferred. In contrast, certain other tax provisions using similar tests expressly permit the acquisition of substantially all of the assets of "part" of a business. On first blush, it does not appear the CEWS asset continuity test applies where only a part of a business is acquired or where an entire business is acquired from multiple (rather than only one) sellers (for example, co-venturers), effectively constraining numerous commercially viable asset acquisition arrangements. The CRA also appears to take the view that the sale of a division (even if stand-alone) of a taxpayer's business will not qualify if the FMV of the particular assets of that division does not constitute all or substantially all of the FMV of the property of the taxpayer used in the course of carrying on the business (see the updated CRA FAQ, Example 6-3). It thus appears that a purchaser of assets may not qualify for the CEWS due to circumstances outside of the purchaser's control.
There is, however, some case law, in respect of other provisions of the ITA using similar language, which supports the position that the sale of a separate and distinct part of a multi-faceted business (that was found not to be interdependent on the other factions) qualified as a sale of all or substantially all of the property used in the carrying on of a business. On that basis, it is arguable that the new CEWS asset acquisition continuity rule should be interpreted to apply where there is a purchase and sale of "part" of a business, if such "part" can effectively constitute a separate business on its own. Accordingly, the CRA's view with respect to the sale of a division of a business, discussed above, may not be correct in law if the division can constitute a separate business on its own. Even in that case though, the issue of multiple sellers of one business, such as co-venturers, is still of concern.
Main Purposes Test
As above, one of the requirements that must be satisfied for the asset continuity rule to apply is that it must be reasonable to conclude that none of the main purposes of the acquisition was to increase the amount of CEWS to which the eligible entity would otherwise have been entitled. The use of the phrase "reasonable to conclude" indicates that the purpose test for the asset continuity rule is intended to refer to an objective test that looks beyond the subjective intentions of the parties. One difficulty with the test is that an asset acquisition is likely to have several purposes, as acknowledged in the legislation's reference to "main purposes".
In the context of other tax provisions, Canadian courts have rejected the argument that a taxpayer can have only one "main" purpose, holding that any significant purpose is a main purpose. Some courts have held that, where a transaction is entered into for a "genuine commercial purpose" and is not deliberately structured in such a way as to obtain a tax advantage, the tax advantage should not be regarded as a main purpose of the transaction. Such an interpretation would appear to be reasonable within the context of the CEWS, such that the anti-avoidance rule should not apply where the eligible entity can show that the asset acquisition had a genuine commercial purpose. Other cases have, however, held that, where a transaction results in a tax benefit (here, an increase in the CEWS), the tax authority may reasonably infer that a purpose of the transaction was to obtain that benefit and that, to rebut that inference, the taxpayer must offer a persuasive explanation that establishes that none of the purposes was to effect the tax benefit.
The issue can arise in numerous situations. For example, prior to the amendments to CEWS, asset deals may have been put on hold due, in part, to CEWS and related uncertainties. If such a deal were now to proceed in light of the amendments, such transaction may be perceived as having a main purpose of receiving the CEWS benefits and, accordingly, this anti-avoidance rule could conceivably be triggered.
As the question of purpose is one of fact, it will be difficult to achieve certainty on the application of this test and, where an asset acquisition results in an increased claim for the CEWS, taxpayers and their advisors will need to be in a position to evidence that the CEWS claim was not a main purpose of the acquisition.
"Asset" vs. "Property"
The new rules use the term "assets", a term otherwise undefined (and only sparingly used) in the ITA. Principles of statutory interpretation indicate that, given that this term is used in conjunction with the word "property", the meaning of the two terms must also be distinct.
The term "assets" is well-defined for accounting and balance sheet purposes, but these meanings are not generally determinative for purposes of the ITA. A peculiar interplay between the term "asset" and "property" may also take place, whereby certain things or rights may be "assets" but may not always be "property".
This is not the first time that the CEWS legislation has used accounting concepts otherwise undefined in the ITA—the term "extraordinary items" in the definition of "qualifying revenue" being another example. Accordingly, just as was done with the term "extraordinary items", we would invite the CRA to provide additional guidance and clarification on the meaning of the term "assets" so that taxpayers may have certainty in considering whether they may qualify for the proposed new asset acquisition continuity rule.
The asset acquisition continuity rule mandates that the seller use the assets in the course of carrying on a business in Canada. This effectively prevents "flip" transactions whereby a broker or middleman acquires a business for immediate resale for a profit or where creditors seize business assets and then seek to sell such assets. By disallowing continuity in "flip" transactions, the new asset acquisition continuity rules may impede important commercial elements of asset purchases.
Necessity of Election
The new asset acquisition continuity rule requires an election, whether by the purchaser acting alone or the purchaser and seller jointly (as discussed above). This raises certain complexities. For example, in asset acquisition agreements entered into after the introduction of these rules, the particular agreement should contain a provision whereby both parties agree to the election as well as the parameters and respective obligations of the parties in ensuring that the election is appropriately made and filed with the CRA. Appropriate indemnity provisions should also be drafted.
For asset acquisitions that have already been completed, however, the purchaser will need to seek out the seller's consent to the election after the fact. This may be difficult given that the seller has no incentive to agree to making the election, particularly where the vendor has already made a CEWS application for the relevant qualifying period and wishes to avoid amending it.
The introduction of the asset acquisition continuity rule fills an important gap within the CEWS regime. That said, certain elements raise practical difficulties and may provide uncertainty for taxpayers in numerous respects.
Given the significant penalties which can arise in the case of an incorrect CEWS claim, eligible entities should carefully prepare their application materials and entities currently negotiating asset purchases, or those which have acquired assets during a particular qualifying period, are urged to consult with any member of the Bennett Jones Tax group for assistance in applying these provisions in their particular circumstances. Should the CRA question any of your filings, we would be pleased to assist you in any dispute.
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.