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Tax Notes
Eligible Capital - Some Big Changes
Part I
By: David Louis, J.D.,
C.A., Tax Partner.
Minden Gross LLP
Special thanks to Joan
Jung, also of Minden Gross LLP, for her comments and
giving me the idea for the article.
(*This release is based
on an article published in Tax Notes, February
2005, Number 505, CCH Canadian Limited)
As you can see, this
article is about eligible capital. Don’t stop
reading. I know what you’re thinking – you have
probably been privy to complex dissertations
about this subject. (Let’s see now, it’s 3/4 of
this and 3/2 of that. Or is it 3/4 of that
and 3/2 of this?)
But seriously, folks, some
of the most exciting recent developments in
taxation have centered around eligible capital.[i]
In this article, I will try to hit the
highlights. I promise – no 3/4 of this, 3/2 of that.[ii]
Lower corporate tax
So what’s so exciting about
eligible capital? The difference between
eligible capital and capital gains treatment at
the corporate level is fairly dramatic. In
Ontario, for example, a corporate-level capital
gain attracts a tax rate of 24.9%,[iii]
whereas, for a gain in respect of eligible
capital, the tax rate will be only 18.06%.[iv]
This is nearly a 7% swing, or to put it another
way, a tax reduction of nearly 30%. The reason
for this reduction is that the taxable portion
of eligible capital does not attract the
6-2/3rds refundable surtax,[v]
while qualifying for the 7% rate deduction
available for “business income”.[vi]
In fact, theoretically at least, when contrasted
to a share sale, there may be little effective
tax from a “bilateral standpoint”: the tax rate
on the eligible capital may, depending on the
discount rate, be quite similar to the present
value of the tax shield generated by the
eligible capital.[vii]
Whether the purchaser will gross up the purchase
price is another matter!
But at a cost
For both eligible capital
and capital gains, 50% of the gain will qualify
for capital dividend treatment. But in the case
of eligible capital, there’s a price to pay:
while the taxable portion of a capital gain will
qualify for refundable tax treatment, this is
not the case with the taxable portion of
eligible capital.
But how big a price
is this? For a large-scale sale of a business,
my contention is – usually not very. Yes, there
may be an element of double-taxation when the
taxable portion of eligible capital is
distributed from the corporation. In Ontario,
for example, a distribution of the taxable
portion of an eligible capital gain as a
dividend will attract a tax rate in excess of
56.1%. (This, of course, is double the
effective tax rate on the entire gain.)
But this may be many years
in the future. As I said earlier, 50% of the
gain can qualify as a capital dividend and
therefore be eligible for timely removal (at
least fairly timely – see below). In a large
business sale, the owner-manager will often
desire to retain what’s left of the taxable
portion of eligible capital for his or her
family, especially if the income generated from
the business itself is no longer available. For
this reason, the retention of the capital in the
corporation until death - or even later - is a
distinct possibility. And if the corporate
surplus is realized as a capital gain - e.g., on
death - the Ontario tax rate will drop to just
under 51% - only about three points more than a
distributed taxable capital gain.[viii]
Furthermore, an estate freeze can effectively
reduce the death tax exposure.[ix]
Subsection 14(1.01)
If, however, capital gains
treatment is desired, it may well be possible to
obtain this through an election under subsection
14(1.01) of the Act. This potentially allows
eligible capital (other than “goodwill”) to be
treated as a capital gain.[x]
For the reasons above, the
consequences of this election can be far
reaching. In fact, there are other effects of a
subsection 14(1.01) election.[xi]
For example, if the vendor has capital loss
balances, they can be used where a subsection
14(1.01) election is filed. However,
pre-existing capital losses would also offset
the CDA addition. If, on the other hand, a CDA
addition is by virtue of eligible capital –
i.e., without a subsection 14(1.01) election -
there would be no netting effect on either
ground: capital losses cannot be applied against
gains from eligible capital, and the excess of
capital losses over capital gains will not
reduce the capital dividend account attributable
to eligible capital. The timing of the addition
to CDA may also be relevant in terms of being
able to take out the funds. The addition to CDA
without a subsection 14(1.01) election arises
only at year-end (because eligible capital is a
year-end calculation).[xii]
In the case of a subsection 14(1.01) election,
while certainly open to question, it has been
the CRA’s view that the CDA addition does not
occur until filing.[xiii]
Subsection 14(1.01) proposals now provide for
the election to be filed either in the
taxpayer’s return of income for the year or in
the capital dividends election[xiv];
the latter may allow the taxpayer to accelerate
the capital dividend (if the CRA’s policy is of
concern). Finally, it appears that a subsection
14(1.01) election permits a reserve[xv]
whereas a disposition of eligible capital does
not.[xvi]
There continues to be uncertainty in respect of
whether “internally developed” eligible capital
qualifies for the election. The original
wording of the subsection 14(1.01) election
required that “the cost of the property
to the taxpayer can be determined”. Apparently,
there were concerns on the part of the CRA that
internally developed eligible capital may not
have a “cost”. The current wording, which
allows for an election “in respect of the
acquisition of the property”, requires that
the “eligible capital expenditure can be
determined.” It has been observed that the
wording continues to suggest that the election
may be restricted to property acquired from a
third party.[xvii]
[i] For the most
part, I will dispense with the precise
terminology relating to section 14,
referring to an eligible capital
“expenditure”, “amount”, “property” etc. as
“eligible capital”. To be frank, after more
than 25 years of practice, I think I’m
entitled (and, yes, references herein to
“tax brackets” mean “marginal tax rates”).
For the record, though, here is a summary of
the rules/terminology, which I have brazenly
lifted from “Eligible Capital Property
Update”, by Bradley Severin, 2003 PPC, p.
4:2/3:
-
Qualifying eligible capital expenditures
made in the taxpayer's year are added to
the pool, known as the "cumulative
eligible capital" property pool, at a
specified inclusion rate [currently 75%];
-
The pool is decreased in a particular year
by each "eligible capital amount" for
the year or any required adjustments
necessary under the application of
subsection 80(7). An eligible capital
amount results from a disposition of
eligible capital property and the
eligible capital amount is generally
determined as a specified rate multiplied by
the "base for the eligible capital amount";
-
Where a positive balance exists in the
cumulative eligible capital account pool at
the end of the taxpayer's taxation year, the
taxpayer may elect to take a deduction under
paragraph 20(1)(b) in computing the
taxpayer's income for the year. The amount
that may be deducted cannot exceed 7% of the
pool balance at the end of the year. The
pool is decreased appropriately for the
amount of the deduction; and,
-
In the event that there is a negative
balance in the pool at the end of the year,
subsection 14(1) requires that an amount be
included in the income of the taxpayer, in a
manner that emulates the recapture of
previously recognized capital cost allowance
deductions.
[ii] I will do
this by assuming (for the most part) that,
in respect of the disposition of eligible
capital, there is no pre-existing cumulative
eligible capital pool. Alas, those who
present full-scale papers on the subject do
not have this luxury. For those who want a
more detailed review of eligible capital, in
addition to Mr. Severin’s paper, see also
“Non-Taxable Payments & Eligible Capital
Property”, L. Branham, 2003 BCC 14.
Where there are
pre-existing pools, the taxable amounts of
eligible capital and amounts in the capital
dividend account may differ from equivalent
capital gains (see also notes to the
discussion of proposed subsection 14(1.01),
below). One remark I will make about
pre-existing pools is that a principal
difference between the taxation of
dispositions of depreciable and eligible
capital property is that, in the former
case, the pool absorbs proceeds up to the
original cost of the particular asset,
whereas the entire pool balance is available
to absorb a disposition of eligible capital.
[iii] The
effective rate can be reduced to about 24.1%
by a distribution to a top-bracket
individual shareholder, ignoring RDTOH
“blockage”; however there is still an
element of under-integration, since the
personal rate on capital gains is about
23.2%.
[iv] All tax
calculations ignore the small business
deduction and assume a top-bracket
Ontario-resident individual, where
applicable.
[vii] 75% of the
expenditure is added to eligible capital and
is subject to an amortization rate of 7%.
While 75% of 7% is 5.25%, amortizing the
entire expenditure on a 5.25% declining
balance basis (e.g., running a CCA tax
shield calculation on this basis) will, of
course, overstate the value of the tax
shield. The Ontario corporate tax payable
on a $10M “gain” in respect of eligible
capital property is about $1.8M, whereas the
present value of the tax shield generated is
about 100K lower, assuming a 4% discount
rate.
[viii] See note
3, above. Of course, this assumes that the
surplus retained at the corporate level will
be taxable at death on a dollar-for-dollar
basis, which may not be the case.
[ix]
This can be the case even if the freeze
occurs after the sale. If the taxable
proceeds from a sale of a business are
reinvested, the income may generate
refundable tax. If so, this can be used to
“redeem out” the freeze shares, so that,
effectively, the double-tax exposure will be
passed on to the next generation. Of
course, this effect can be enhanced by the
re-injection/retention of proceeds reflected
in the capital dividend account to the
corporate level, to generate increased
amounts of refundable tax.
[x] Subsection
14(1.01) cannot be used to trigger a capital
loss. In addition, an individual’s exempt
gains balance must be nil.
[xi] This
article has assumed that there are no
pre-existing eligible capital pools.
However, if there are, the taxable amount as
well as the capital dividend account may
differ, depending on whether a subsection
14(1.01) election is made. Conceptually,
eligible capital taxation, like the rules
relating to depreciable capital property, is
based on a “pool” (in this case for all
eligible capital in respect of a business)
and “recapture” concept, as well as “gains”,
with the latter included in the capital
dividend account. A subsection 14(1.01)
election credits the pool to the extent of
the cost of the item, then determines the
capital gain and potential inclusion in the
capital dividend account based on the same
cost. Some sample calculations I did showed
that, while the taxable amount by virtue of
a subsection 14(1.01) election could be
greater or less than eligible capital
treatment, the CDA resulting from the
election would normally exceed the eligible
capital CDA, presumably because the other
assets in the pool convert the would-be CDA
to recapture or shelter within the pool.
[xii] See
paragraph (c.2) of the “capital dividend
account” definition in subsection 89(1) and
paragraph 14(1)(b). Administrative relief
is available for elections filed prior to
February 1, 2002 on the basis that CDA was
enlarged at the time of disposition. The
CRA’s rationale for the deadline is that the
tax community became aware of the provisions
by virtue of an article by Karen Yull (“CDA
on Sale of ECP”), published in the January
2002 issue of Canadian Tax Highlights.
It has been observed that the CDA cannot be
paid out until the first moment of the
following taxation year. Subsection
83(2) allows CDA to be paid out that is on
hand immediately before the time the
dividend becomes payable. Since the
addition to the CDA only occurs at the end
of the year, the dividend cannot be made
payable until the first moment of the
following year. See Doc. No. 2002-0142127,
dated June 19, 2002. This may be
significant where a capital dividend is to
be paid in connection with a share sale,
since there is a deemed year-end by virtue
of the acquisition of control. For further
discussion, see “Non-Taxable Payments &
Eligible Capital Property”, L. Branham, 2003
BCC 14.
[xiii] Doc. No.
2003-0030245, September 16, 2003. However,
per Doc. No. 2002-0163825, October 22, 2002,
the date of the deemed disposition per the
subsection is the date of the actual
disposition.
[xiv] Subsection
14(1.01) of the Act does not include a
provision that would entitle a taxpayer to
late-file such an election. Furthermore, for
the purposes of subsection 220(3.2) of the
Act, a late-filed election under subsection
14(1.01) of the Act may not be made since it
is not prescribed in section 600 of the
Regulations. See Doc. No. 2003-0183625,
January 28, 2003. Per Doc. No.
2002-0123107, April 8, 2002, a subsection
14(1.01) election cannot be amended or
revoked.
[xv] See Doc.
No. 2002-0133797, April 18th
2002, which overrides an earlier technical
interpretation.
[xvi] See
subsection 14(2).
[xvii] See “ECP
Election and Equity” by Doug Frost and
Sheryl Mapa, Canadian Tax Highlights,
March 2003. The authors also indicate that
the wording of subsection 14(1.01) still
suggests that the election applies only if
there is some original positive cost. Alas,
the prospect of curing this apparent
deficiency by flipping the property in
question into another taxpayer pursuant to
subsections 85(1) or (2) - i.e., on a
rollover basis - is foreclosed by proposed
paragraph 14(1.03)(b).
The “acquisition issue” was also raised in
the CBA/CICA Joint Committee submission in
respect of the December 20th,
2002 Technical Amendments; however, the
wording was not changed in the February 27th,
2004 draft legislation.
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