It took them two years, but the government has finally addressed eligible capital property.
The 2016 Budget proposes to put eligible capital property (ECP) – which includes intangible assets like goodwill and client lists — into its own Capital Cost Allowance class as of January 1, 2017. ECP currently has its own special rules.
Over the past few years, tax practitioners had argued against the new regime, saying it would create disadvantages and confusion for small business owners. Others had encouraged the change, calling the special rules too complex.
Here’s what you need to know about the old and new regimes.
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. And, $80 ($100 minus $20) is recaptured CCA and included in income.
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%. This regime is in place until December 31, 2016.
Right now, 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 recapture the $55 of deductions in respect of ECP previously claimed ($75 minus $20) 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, told us in 2015 that 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. That had prompted folks to ask the government to simplify things, which is why the Department of Finance is now giving intangible property its own CCA class.
How will the new regime work?
Budget 2016 confirms that ECP will have its own CCA class, and 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) will be transferred to a new CCA class. To give businesses time to transition, former ECP will amortize at 7% from January 1, 2017 to December 31, 2026, and at 5% thereafter. Any new eligible property purchased after January 1, 2017 will amortize at 5%.
(In reality, 5% on 100% of an asset is initially less advantageous for business owners than 7% on 75% of the same asset. The government picks up 25 basis points — indeed, the regime change is projected to net the government $220 million from 2016 to 2018.)
Former ECP will then be subject to the CCA regime: new purchases after January 1, 2017 are 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).
Selling former ECP will reduce the CCA pool by 75% instead of 100% until all the former ECP is sold.
Issues with the new regime
Michael Friedman, co-chair of the tax group at McMillan, says as suspected, the new regime will create accounting headaches. “The complications we envisioned are here,” he says. “The transitional rules are quite dense and detailed.”
Companies 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%). “There are fairly detailed rules that will dictate how you track capital costs and assets,” he says.
The transitional rules are “designed so you should be indifferent from a tax perspective” between the new and old rules. And Finance does not want business owners taking advantage of the new rules to save tax. “They’re disallowing games people might play to artificially increase the undepreciated capital cost of eligible capital property held prior to January 1, 2017,” says Friedman.
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
The old ECP regime was advantageous for clients who 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,” Moody told us. 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. An ECP gain is eligible for the lower small business rate.
“We may see a lot of people undertaking transactions prior to the end of the year to crystallize that advantage,” says Friedman.
That’s because under the new regime, a gain from the proceeds of an ECP sale will become a capital gain, and be considered investment income. That will 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%,” said 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 will 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 CCPC than it would to pay the dividend, and the business owner would lose out on the deferral.
What should clients do?
Clients will have to look carefully at the transition rules and be careful when disposing of property that was purchased prior to January 1, 2017. And, corporations with non-calendar fiscal years that sell property prior to 2017 will have complicated elective rules to follow.
But aside from the compliance headache, people who own regular corporations have no tax reason to panic, says Friedman. “The intention was for this to be neutral — [but] CCPCs will be the exception,” he adds.
CCPC clients could sell ECP prior to 2017 to get ahead of the new regime. “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,” says Friedman. “For people who were already contemplating a transaction, there might be an added incentive to carry out that transaction this year. That comes at a cost, though. You have to pay the tax. It’ll only be a certain class of taxpayers thinking actively about that.”