Budget 2015 delivered lower tax rates for business owners, but it leaves a troubling issue unresolved.
This year’s budget proposes to reduce the small business tax rate, currently 11%, to 9% over four years. The reduction generally applies to the first $500,000 of business income. Effective January 1, 2016, the rate will be reduced to 10.5%; and it falls 0.5% each year until 2019.
The dividend tax credit is changing accordingly. As a percentage of the grossed-up amount of a non-eligible dividend, the effective DTC rate will be 10.5% in 2016, 10% in 2017, 9.5% in 2018 and 9% after 2018.*
Despite this good news, industry experts were hoping Budget 2015 would address an issue the government raised last year: changes to the eligible property regime. Specifically, the potential changes would put eligible capital property (ECP) – which includes intangible assets like goodwill and client lists — into its own Capital Cost Allowance class. ECP currently has its own special rules.
But all this year’s document said was that the government was still thinking about the issue, and would release draft legislation for comment.
The 2014 information concerned many practitioners, because they argue the new regime could create disadvantages and confusion for small business owners.
Here’s what you need to know.
What is Capital Cost Allowance?
When businesses buy buildings, equipment, computer hardware, vehicles and other tangible assets, they go on the balance sheet as capital. Businesses cannot deduct those purchase costs from revenue.
But, CRA recognizes that over time, things wear out or become obsolete. So, it allows businesses to deduct an amortization expense, or Capital Cost Allowance (CCA), each year. The type of asset determines the annual amortization: each asset belongs to one of a few dozen CCA classes. Class 1, for instance, applies to buildings and amortizes at 4%. Class 38 includes power-operated equipment “used for excavating, moving, placing or compacting earth, rock, concrete or asphalt,” and amortizes at 30%.
In the first year a business acquires an asset, it can only claim amortization on half the asset’s value (known in accounting circles as the “half-year rule”).
What happens when you sell an amortized asset?
Let’s say you bought a truck for $100, and it’s been amortized down to $20. If you sell it for $20, there is no capital gain or loss (so, no tax effect). But, if you sell it for more than the original cost – say, $125 – then the $25 difference is considered a capital gain, and taxed as such.
What is the Eligible Capital Property regime?
Intangible assets, such as goodwill and client lists, do not have their own CCA classes. Instead, they’re considered Eligible Capital Property (ECP). But, intangibles like goodwill (i.e., a company’s reputation) can still become obsolete. So, CRA lets businesses put 75% of an ECP’s value into a cumulative eligible capital (CEC) pool, and that value amortizes at 7%.
What happens when you sell ECP?
Let’s say you bought a client list for $100. At time of purchase, 75% ($75) would have gone into the CEC pool. Now, let’s say there’s nothing else in the pool, and over time the client list amortizes down to $20 in the CEC pool ($26.67 including the non-amortized part outside the pool). If you sell the list for $26.67, 75% of that ($20) is subtracted from the CEC pool.
But, if you sell the list for between $26.67 and the original cost of $100 – say, $35 – then the CEC pool becomes negative. In this case, 75% of $35 ($26.25) would be subtracted from the CEC pool, and the pool would be negative by $6.25. Since CRA doesn’t allow a CEC pool to have a negative balance, the business has to recapture the $6.25 by including it in its income.
If the list is sold for more than its original cost of $100 – say, $120 – the CEC pool becomes negative. In this case, 75% of $120 ($90) would be subtracted from the CEC pool, and the pool would be negative by $70. The business would have to capture the $70 by including it in its income. The business would also have to account for the $20 gain on the ECP sale.
The good news: CRA only requires you to include half the gain. The other half goes to the business’ Capital Dividend Account, which the company can pay out as a tax-free dividend after the first day of the following tax year. That’s unique to ECP – by contrast with “genuine” capital gains, you can pay the dividend the day after. Kim Moody, director at Moodys Gartner Tax Law, says many business owners forget about that difference and pay out dividends before the next tax year, incurring penalties.
An ECP gain’s treatment is capital gain-like (since only half of capital gains are taxed), but there’s a key difference: generally, the ECP gain is still considered income, not a capital gain. That means a business can’t offset the ECP gain with a capital loss; it can only offset it with a business loss.
These rules are complicated, and similar ones don’t exist in most other countries, says Moody. That’s prompted some folks to ask the government to simplify things, which is why the Department of Finance has proposed giving intangible property its own CCA class.
How would the new regime work?
The info released in Budget 2014 says ECP would have its own CCA class, and would be included in the class at 100%. The amount in the CEC pool (which, as we recall, only represents 75% of the intangible asset’s value) would be transferred to a new CCA class. That new class would amortize at a rate of 5%.
(In reality, 5% on 100% of an asset is actually less advantageous for business owners than 7% on 75% of the same asset. The government would pick up 25 basis points from this amortization change.)
Former ECP would then be subject to the CCA regime: new purchases would be subject to the half-year rule. And, when the property’s sold for more (or less) than its depreciated amount, that action would create a capital gain (or loss).
To give businesses time to transition, the amortization rate for the new CCA class would be 7% for 10 years after implementation. And, any property sales would reduce the CCA pool by 75% instead of 100%.
Potential issues with the new regime
“I do think the government’s primary motivation is simplifying the system,” rather than capturing more tax revenue, says Michael Friedman, co-chair of the tax group at McMillan.
But, the new system may not actually be simpler. He points out businesses would have 10 years of dealing with a hybrid regime for old property (75% of the property amortized at 7%) and the new regime for new property (100% of the property amortized at 5%).
The half-year rule
Since intangible assets would be subject to the half-year rule, the depreciation amount deductible in the year of purchase would be reduced by half.
Capital gain/loss versus income
Under CCA, sale of an intangible asset would create a capital gain or loss, not an income gain or loss. That would let businesses offset capital gains with capital losses. But some businesses prefer ECP gains to be treated as income.
Disadvantages for CCPCs
Moody says some tax practitioners actually like the ECP regime, particularly if their clients own Canadian-Controlled Private Corporations (CCPCs).
CCPCs pay an additional 26.67% tax on investment income, above the small business tax. So, on $100 of investment income, it’s another $26.67. That $26.67 goes into a notional pool called the Refundable Dividend Tax on Hand (RDTOH) pool.
The CCPC can get that $26.67 refunded if it issues a taxable dividend equivalent to 3x the tax, or $80. So, “you’re going to pay roughly 20% corporate tax on $100 of investment income,” says Moody. The person who receives the dividend then pays personal tax on it.
Under the current regime, an ECP gain is considered regular income (not investment income), so there’s no additional tax on it. The ECP gain would be eligible for the lower small business rate.
Under the potential new regime, a gain from the proceeds of an ECP sale would become a capital gain, and is considered investment income. That would make the ECP gain subject to the additional 26.67% tax. And the only way to recover that 26.67% is to push out a dividend equivalent to 3x the tax.
“It never makes sense not to try to recover that 26.67%,” says Moody. “But you do that at the expense of deferral.”
In other words, since the corporate tax bill is lower under the current regime, more cash remains inside the corporation. The business owner can hold off on distributing the cash to herself as a dividend, deferring the personal tax. This may be helpful if she knows she’ll be in a lower personal tax bracket in future.
Under the new regime, the business owner would be forced to push out a dividend to recover the 26.67%. That’s because it would cost more to keep the ECP proceeds in the CPCC than it would to pay the dividend, and the business owner would lose out on the deferral.
What should clients do?
Moody says some tax firms have advised CPCC clients to consider selling ECP now to get ahead of the new regime. But, since the government hasn’t released draft legislation, any changes would be premature.
Friedman is also cautious. “If you’re a CCPC, and its principal asset is goodwill, there are advantages to selling under the old regime,” he says. “But, are you going to sell your business before you’re ready, just to capture the tax advantage? Many would say no, but for those who are nearing retirement, this may become relevant.”
Advisors should watch for these proposals and ensure they update clients who would be affected by them. And, they could comment on the proposals, or encourage their tax-savvy clients to do so.
*The original version of this article included a passage stating non-eligible dividend tax rates were falling. That is incorrect. Return to the corrected sentence.