The 2016 federal budget proposes to change how goodwill and other intangible capital property are treated for income tax purposes, beginning January 1, 2017.
This property is also known as eligible capital property (ECP) owned by a business, which is pooled in an account known as the cumulative eligible capital (CEC) account. The CEC account is used to track the acquisition, amortization and disposition of eligible capital property.
The Department of Finance first mentioned it wanted to revamp the ECP rules in the 2014 federal budget, which proposed to conduct public consultation on the subject. The general theme of the 2016 proposals is to treat ECP similar to depreciable capital property, which is subject to recapture and capital gains.
Effective January 1, 2017, a new capital cost allowance (CCA) class will be created specifically for ECP: Class 14.1, with 100% of post-2016 ECP expenditures classified as 14.1. The treatment of a disposition of ECP will differ based on the date the property was originally acquired.
- Post-2016: Class 14.1 is reduced by the lesser of 100% of the proceeds realized on the disposition and the capital cost of the property.
- Pre-2017: Class 14.1 is increased by 25% of the capital cost of the property and decreased by the lesser of 100% of the proceeds realized on the disposition and capital cost of the property.
If Class 14.1 becomes negative because of a disposition, the negative amount in the account will be treated as CCA recapture. When the proceeds of disposition are greater than the cost of the ECP, a capital gain will arise. This creates a taxable capital gain, which is treated as passive income to the corporation.
In the year of purchase, the half-year rule applies, where only half the expenditure is added to Class 14.1 for the purposes of determining that year’s CCA claim. The annual capital cost allowance on Class 14.1 is set at 5%, except as noted in the transitional rules discussed below.
Another note: the first $3,000 of incorporation expenses will be deductible, rather than added to Class 14.1.
Transitional rules will be used to manage this significant shift for existing situations, as follows:
- The balance in the CEC on January 1, 2017 will become the balance of new CCA Class 14.1 on that date, regardless of the year-end of the company.
- For taxation years ending before 2027, a 7% CCA rate will apply to ECP expenditures made prior to 2017. For this same 10-year period, taxpayers will be permitted to claim the greater of $500 or the amount otherwise determined for pre-2017 expenditures. However, it’s limited to the opening balance on January 1, 2017. The purpose of the $500 minimum is to provide businesses the opportunity to eliminate small ECP balances.
Here’s an example. Consider the situation where Widgetco purchases goodwill valued at $100,000 when it acquires another business in spring 2017. Later that year, Widgetco pays $200,000
for goodwill from a different transaction.
Widgetco had not purchased any goodwill prior to these transactions. The balance of Class 14.1 will be $300,000 at the end of Widgetco’s taxation year.
The subsequent year, Widgetco sells a portion of its business, receiving $75,000 for goodwill. The impact on Class 14.1 is a reduction equal to the lesser of cost ($300,000) and proceeds ($75,000), leaving a balance of $225,000, assuming no prior claims for CCA.
If the proceeds from the sale were $500,000 instead of $75,000, the outcome is a $200,000 capital gain (see Table 1, this page). Class 14.1 is reduced by the lesser of cost ($300,000) and proceeds ($500,000), leaving a balance of zero and a $200,000 capital gain (assumes no claim for CCA).
Meanwhile, Table 2, this page, shows the impact of the new rules. Exampleco pays $100,000 for goodwill in year one, and sells it for $1 million three years later.
The tax impact of the sale is significantly different for the corporation, resulting in total tax payable under the old rules of $73,621, compared to $226,180 under the new rules. If Exampleco’s objective is to retain the net proceeds rather than pay a dividend to the shareholder, the low-tax impact of the old rules provides a substantial deferral of total income taxes payable.
While the new rules triple the immediate income tax liability, 30.66% of the passive income (based on a taxable capital gain of $450,000) is refundable ($138,000) when Exampleco pays a taxable dividend to its shareholder (provided ExampleCo is a Canadian-controlled private corporation).
The bottom line impact on the shareholder is less significant, with a slight tax savings when comparing net after-tax proceeds of $712,008 under the old rules, versus $704,001 for the new rules.
In simple terms, the new rules eliminate the opportunity for the deferral of income tax which, depending on amount and timing, could be significant.
Table 1: Widgetco outcome ($500,000 sale of goodwill)
|Opening balance Jan 1, 2017||$0|
|Purchase #1 of goodwill||$100,000||$100,000|
|Purchase #2 of goodwill||$200,000||$300,000|
|Sale of goodwill $500,000||$(300,000)||$0|
|= Proceeds of disposition $500,000 less cost $300,000
Table 2: Comparison of old and new
|Expenditure for ECP||Old rules||New rules|
|Credit to ECE pool||$75,000||$100,000|
|Amortization, year 1||$5,250||$2,500|
|Amortization, year 2||$4,883||$4,875|
|Proceeds of disposition||$1,000,000|
|Active income tax rate||16%|
|Passive income tax rate||50%|
|Refundable portion of taxes||$138,000|
|Potential taxable dividend||$926,379||$911,820|
|Shareholder effective tax rate||45%|
|After tax to shareholder||$712,008||$704,001|
Property (with indefinite duration) that will typically be under new Class 14.1 for CCA purposes include goodwill, customer lists, licences, franchise rights and farm quotas.
by James W. Kraft, CPA, CA, MTax, CFP, TEP, and Deborah Kraft, MTax, LLM, TEP, CFP. Deborah is faculty and director, Master of Taxation Program, School of Accounting & Finance, University of Waterloo. James is vice-president, Head of Business Advisory & Succession, BMO Nesbitt Burns.