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Tax Notes
Eligible Capital - Some Big Changes
Part II

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, March 2005, Number 506, CCH Canadian Limited)

In last month’s article, I talked about the taxation of eligible capital, and the significant reduction in corporate-level tax when contrasted even with capital gains status - once the preferred way to go for the vendor of a business.  Where capital gains status is desired (e.g., to generate refundable tax), an election is potentially available pursuant to subsection 14(1.01) of the Act, for eligible capital other than goodwill (see, however, “Addendum” at the end of this article). 

 Little has been written as to the distinction between goodwill and other eligible capital - there is no definition of “goodwill” in the Act.  However, a few years ago, the CICA Handbook distinguishes between goodwill and other intangible assets.  Accordingly, section 1581 provides guidance on the distinction under GAAP[i].  The latter must arise either from a legal right, or be separable (capable of being sold): 

.48       An intangible asset should be recognized apart from goodwill when:

(a)        the asset results from contractual or other legal rights (regardless of whether those rights are transferable or separable from the acquired enterprise or from other rights and obligations); or

(b)        the asset is capable of being separated or divided from the acquired enterprise and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so).

            Otherwise it should be included in the amount recognized as goodwill. [JULY 2001]

 .49       An intangible asset that cannot be sold, transferred, licensed, rented or exchanged individually meets criterion (b) when it can be sold, transferred, licensed, rented or exchanged in combination with a related contract, asset or liability. An assembled workforce is not recognized as an intangible asset apart from goodwill. Appendix A provides additional guidance relating to the recognition of acquired intangible assets apart from goodwill, including examples of intangible assets that meet the recognition criteria in paragraph 1581.48.[ii]

 

Note:  The reason for the distinction is that the old “40 year amortization” rule for goodwill was dropped. In the case of intangible assets other than goodwill, Handbook section 3062.10 requires that a recognized intangible asset (other than goodwill) should be amortized over its useful life to an enterprise, unless the life is determined to be indefinite[iii] (note the word “indefinite” – not “infinite”).  In all cases, the carrying value must be written down if the value is impaired.  While the purchaser may therefore have definite views about allocations to goodwill and other intangibles, the subsection 14(1.01) election provides the vendor with considerable leeway; however, if intangibles constitute Class 14 property, there will be a mandatory allocation to capital property (rather than eligible capital), thus forcing recapture/capital gains.  Happily, Class 14 property - which must be a patent, franchise or concession for a limited period - may not be a preferred item for a purchaser.  However, the concepts of “limited period” per Class 14, and indefinite life are not necessarily mutually exclusive.[iv] 

Bonuses restricted

 As I mentioned in last month’s article, because the sale of goodwill does not generate refundable tax, the distribution of the taxable portion of goodwill as a dividend will result in a material degree of under-integration.  Of course, this advantage can be remedied if the taxable portion can be bonused out.  Needless to say, however, absent the CRA’s usual policy in respect of owner-manager bonuses,[v] an issue arises as to whether the bonus is reasonable. 

 In the 90’s, the CRA had been increasingly reassuring that its bonus policy would extend to the taxable portion of eligible capital.  Unhappily, in the new millennium, this trend came to an abrupt halt.  At the 2003 annual Canadian Tax Foundation conference (subsequently documented in Technical News No. 30), the CRA indicated that the policy would not apply to remuneration paid out of the proceeds generated from a major sale of business assets, including the sale of the entire business or those of a large division.[vi]  The CRA has suggested that such bonuses are not necessarily unreasonable; however, it reserves the right to review the issue.  The CRA has indicated that it will issue advance rulings in these situations, and several of these have been published.

So what else is new?

Here are some other recent developments in the taxation of eligible capital:

• Non-arm’s length “grinds”.  For non-arm’s length transfers of depreciable property of a prescribed class, paragraph 13(7)(e) “grinds” the depreciation base to the extent of the non-taxable portion of the capital gain of the vendor.  Similar provisions in respect of eligible capital are contained in the December 20^th 2002 technical amendments.[vii] 
  
  Even with these amendments, it may often make sense to purposely trigger a taxable disposition of eligible capital.  Consider, for example, a professional who wishes to incorporate, but needs distributions on an ongoing basis to defray personal needs.  Suppose that goodwill of, say, $100,000 is to be transferred into his or her corporation.  If this is done on a rollover basis, funds subsequently distributed in the form of dividends would attract top-bracket Ontario tax of about 31.4%.  Suppose a rollover is not claimed.  The disposition of goodwill on a taxable basis would attract a rate of 23.2% (i.e., the same as a capital gain)[viii] but would provide a credit balance of $100,000, thus saving $31,400.  In addition, there would be eligible capital of $50,000, 75% of which would be added to cumulative eligible capital, subject to a 7% “amortization”.  This generates a tax shield with a present value of about $8,500 at a 4% discount rate.  All told, this strategy generates considerable tax savings:

Tax on dividend of $100,000	$31,400
Less - tax on disposition of goodwill	-23,200
Add - present value of tax shield (approx.)	8,500
Tax saving from taxable disposition of goodwill	$16,700

• Non-competes.[ix]  As most readers are aware, payments in respect of non-competition and other restrictive covenants are now potentially fully taxable (exceptions may apply for the dispositions of a partnership interest or shares).  However, where the amount is required to be included in “cumulative eligible capital”[x], the taxpayer may escape full taxation if the taxpayer and purchaser elect in prescribed form to apply the exception.  In keeping with the draconian nature of the restrictive covenant proposals, proposed paragraph 56.4(3)(e) requires both the vendor and purchaser to include a copy of the form in the income tax return for the year in which the covenant was agreed to, and both must file the return on or before the filing due date for that year.[xi]  If this is desired, it is important to ensure that the purchaser agrees to these terms.[xii] 
  
  As I mentioned earlier, recent changes to the CICA Handbook eliminate the amortization for true goodwill and other intangible assets with an indefinite life.  As a result, a purchaser, especially if a listed corporation, may want to minimize the allocation to non-competes, assuming that amortization is required.

Addendum – Subsection 14(1.01)

Based on a discussion I had with a Department of Finance official after Part I of this article was published, subsection 14(1.01) was not intended to apply to internally developed eligible capital.[xiii]  Further, there is no intention to change the wording of the provision in this respect (i.e., to clarify that it does not apply to internally developed eligible capital)[xiv].