The federal government cites taxpayer and advisor input as the reason for the public consultation on the Department of Finance’s proposal to reshape the tax rules associated with eligible capital property. This is important, as it could simplify a complicated set of rules. The new approach, as outlined in the 2014 budget, will significantly impact people selling their businesses using an asset sale strategy.
Examples of eligible capital property include:
- incorporation costs;
- customer lists;
- franchise rights; and
- goodwill resulting from a purchase of another company’s assets.
These are all capital expenditures for intangible assets used in the business to earn income. Assets that are deductible as a current year expense, or that fall within the capital cost allowance (CCA) rules, are not considered eligible capital property.
For tax purposes, eligible capital property is grouped into a single pool called the cumulative eligible capital (CEC) account. When a taxpayer acquires a CEC property from an arm’s length person, three-quarters of the purchase price is added to the CEC pool. Similarly, when a taxpayer disposes of a CEC property, three-quarters of the proceeds of disposition is deducted from the pool.
At year-end, the taxpayer is permitted to deduct a current year charge of up to 7% of the positive balance. This deductible amount is permitted as a reflection of the depreciation or amortization of the assets within the pool. The deduction is discretionary at the taxpayer’s option, but cannot exceed a maximum of 7% of the pool’s balance. The annual CEC amount claimed is subtracted from the CEC pool balance at the end of the year.
If the CEC pool has a negative balance at the taxpayer’s year-end, the corporation faces a tax hit. The portion of the negative balance equal to the cumulative claims made over the years is reported as a recaptured amount, and is treated as active business income. Two-thirds of any excess negative value is brought into income as active income.
There are two proposed changes.
- Eligible capital property would no longer be treated as outlined above. Instead, it would become a new class within the capital cost allowance regime. This means 100% of expenditures for eligible capital property would be added to a new capital cost allowance pool with a maximum annual prescribed rate of depreciation of 5%. The CCA rules relating to recapture, capital gains, the half-year rule and other CCA rules would generally apply.
- A capital gain realized upon the disposition of eligible capital property will be taxed as passive investment income, not as active income.
- What’s this mean to an asset sale? If a buyer is willing to pay more than fair market value for all of the business assets, the excess is considered a payment for goodwill. If the gain were taxed as active income, the corporate tax rate would be between 25% and 31%, depending on the province (those percentages are 2014 corporate tax rates, assuming the active business rate on income is in excess of the small business income limit).
If, instead, the gain is taxed as passive income, the corporate tax rate would be between 44.67% and 50.67%, depending on the province. Some of the corporate tax paid on passive income is refundable when the corporation pays a taxable dividend to the shareholder (generally 26.67%).
Let’s look at the outcome using a simplified example. George is operating an incorporated consulting company in Manitoba and has no assets owned by the firm. He sells his entire business operations for $2 million. The buyer does not want to buy the shares. Since the only asset sold is goodwill, the following chart summarizes the corporate and personal income tax liabilities under each regime.
Corporate Level Current Regime Dept of Finance 2014 Proposal Difference Proceeds of disposition $2,000,000 $2,000,000 – Credit to CEC pool $1,500,000 $2,000,000 – Negative balance in CEC pool $1,500,000 $2,000,000 – Income inclusion $1,000,000 $1,000,000 – Corporate tax rate 27.00% 45.67% 18.67% Corporate tax liability $270,000 $456,700 $186,700 After-tax cash position $1,730,000 $1,543,300 $186,700 Refundable taxes* zero $266,700 $266,700 Credit to capital dividend account $1,000,000 $1,000,000 –
* Addition to the RDTOH Account
Under the current and proposed scenarios, the sale of goodwill will result in a $1 million credit to the corporation’s capital dividend account. Following the sale, the company could reinvest the after-tax cash proceeds in an investment portfolio that the shareholder could access in the future as needed.
But the proposed change to the tax rules means George would have to pay an extra $186,700 in income taxes at the corporate level.
Eventually, the shareholder will take the net proceeds out of the corporation in order to subsidize his lifestyle. A distribution to the shareholder creates a personal tax liability on the taxable dividends received.
Shareholder/Personal Level Current Regime Dept of Finance 2014 Proposal Difference Capital dividend received $1,000,000 $1,000,000 – Taxable dividend received $730,000 $810,000 $80,000 Tax rate 32.27%** 40.77%*** 8.5% Personal tax liability $235,571 $330,237 – After-tax cash position $1,494,429 $1,479,763 $14,666
** Top marginal effective rate on eligible dividends
*** Top marginal effective rate on ineligible dividends
If the shareholder were to wind up the corporation immediately after the sale of the goodwill, his personal net after-tax cash position wouldn’t be much different under either option.
But if funds are not needed immediately, leaving the funds inside the company defers the personal tax bill. Because the corporate tax bill is lower under the current approach, more cash remains inside the corporation. The value of deferring the tax consequence can be a significant advantage especially if the shareholder is in a lower tax bracket in the future.
Change is inevitable. While it’s not wise to hurry the sale of a business to fit within a changing tax world, understanding proposed changes and the impact on planning strategies helps minimize surprises.By James W. Kraft, CPA, CA, MTax, CFP, TEP and Deborah Kraft, MTax, TEP, CFP.
James is vice-president, head of Business Advisory & Succession, BMO Nesbitt Burns and Deborah is director, Master of Taxation Program, University of Waterloo.
Originally published in Advisor's Edge Report
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