If you own a business and you’re planning an exit strategy or asset sale, you may want to complete it by December 31.
Starting January 1, 2017, changes to the Income Tax Act brought about by the Liberal’s Budget 2016 will modify the way the government taxes asset sales. The change is meant to simplify the rules; it creates a new capital cost allowance (CCA) category (class 14.1) and essentially merges eligible capital property (ECP) into the depreciable property category.
As a result, your incorporated business will pay an additional refundable tax when it disposes of goodwill or other ECP. That tax isn’t refunded until taxable dividends are paid to shareholders.
ECP includes goodwill, customer lists, franchise rights, farm quotas and other intangibles. The costs of incorporation, reorganization or amalgamation also qualify.
If you own, say, a small Canadian-controlled private corporation, goodwill may be the single largest asset you’ll have to sell and it could be hit with a big tax liability. If you’re a dairy farmer who wants to sell quota held in a corporation, you’ll pay an extra tax on the gain in value.
Because of changes in the treatment of ECP, owners considering the sale of their corporations (or any ECP) might want to consider the advantages of:
Some capital expenditures are neither deductible from taxes as a business expense nor treated as a capital property subject to depreciation under the CCA rules. These expenditures are those a company pays out to acquire certain ECP in order to earn business income.
Currently, the taxation of ECP works this way:
1. 75% is included in a cumulative eligible capital (CEC) pool,
2. An annual deduction of 7% of the CEC pool on a declining balance basis may be deducted from active business income related to the ECP,
3. 50% of any gain from the disposition of ECP is taxed at the lower tax rate applicable to active business income, and
4. The remaining 50% is captured in a corporation’s capital dividend account and can be paid out to shareholders tax free (creating a significant tax deferral).
Income from most businesses qualifies as active business income, except when the money comes from a specified investment business, a personal services business or it’s investment income. The latter includes taxable capital gains less allowable capital losses, property income less property losses and foreign business income.
Starting January 1, ECP taxation of ECP will change so that:
1. 100% acquired on or after that date will be considered depreciable property,
2. An annual deduction of 5% will apply to ECP on a declining basis, and
3. Gains from the disposition of ECP will be taxed as investment income in the form of capital gains resulting in a higher tax liability.
So, under the new rules, you’ll no longer be able to take advantage of the tax deferral on captured gains and the effective tax rate on gains on goodwill or other ECPs could double, depending on your province. (If you sell your corporation for shares, the new ECP rules will have no effect on the tax cost of the sale.)
There are two ways to structure a business sale transaction: an asset sale or a share sale.
Buyers generally prefer asset transactions as they carry less risk and the buyer can cherry-pick which assets it will purchase and which liabilities it will assume. Also, the buyer needn’t take on non-union employees, unless the seller requires it, and there’s more complex paperwork.
Sellers, on the other hand, often prefer share sales, because all assets and liabilities are transferred, employees generally continue working and the paperwork is less cumbersome. Stock transactions also offer a lower tax rate on capital gains and the potential to shelter a portion of the proceeds from tax through the shareholders’ lifetime capital gains exemption.
With the new rule in place, sellers may be even more motivated toward share sales. Purchasers who wish to proceed with an asset sale may have to compensate the seller for the additional tax costs associated with the deal. Likewise, sellers may become more selective when considering competing offers.
The remainder of 2016 is the last window of opportunity to sell your business in an asset sale (or a hybrid transaction that involves the sale of assets and shares) where the lifetime capital gains exemption is available to shareholders. This would allow your corporation to benefit from the deferral opportunities provided by the current ECP regime.
If you’re considering a full or partial sale of your business after the rules change, take into account these three issues:
1. Determine how much of your business value is goodwill and other eligible intangibles, and thus subject to the higher tax rates. If they don’t amount to much, no immediate action may be necessary.
2. Review your corporate structure. Changes to your business structure may allow you to shelter some of your capital gains from tax if you decide to sell after January 1.
3. Consider taking steps to crystallize your gains related to ECP. You may be able to have some of the gains taxed at the current rates, which will reduce the impact of potential taxes on a sale that takes place after January 1.
A sale is complex and requires careful planning — particularly with the changes coming down the road. Consult with your tax advisor for detailed information on the changes, how they’ll affect your corporation and the best steps to take moving forward.