What Small Business Owners Need to Know - Eligible Capital Property Changes on the Horizon

In the 2014 Federal budget, the government announced it would begin public consultations (consultation is a code word for: we are making changes, but we will consider your thoughts on the matter) into repealing the rules that governed eligible capital property (ECP). They also proposed, subject to these consultations, that the ECP regime would be replaced by a new capital cost allowance (CCA) class.

Two years later, the 2016 Federal budget was released and not surprisingly, the legislation proposes the removal of the ECP regime and the introduction of a new CCA Class 14.1 effective January 1, 2017.

Many of you are probably saying to yourself, what the heck is ECP and why do I even care. Today, I will explain what ECP is and why you as a business owner should care about these changes.

What is ECP?

ECP is essentially “intangible assets” that do not qualify for the CCA rules (CCA is the tax word for depreciation). ECP also includes internally generated assets, such as goodwill, which are not reported on the balance sheet or tax return until there is a disposition of such. In addition to goodwill, some other common examples of ECP are:

• Incorporation expenses

• Customer lists

• Trademarks

• Farm Quotas

• Patents and Licenses with indefinite life

What are the main changes?

The most impactful change will be to Canadian-Controlled Private Corporation’s (CCPC) and how the disposition of ECP is treated subsequent to December 31, 2016, which I will address separately in a bit more detail below.

The way the ECP regime works now is; 75% of any expense for ECP is added to a pool, and each year 7% of the remaining pool can be deducted on a declining balance in the company’s return against income. When ECP is sold, there may be recaptured depreciation which is fully taxable, plus effectively 50% of any resulting gain which is taxable as active business income. The other 50% of the gain goes into the Capital Dividend Account ("CDA"), which can be distributed to the shareholders tax free. See my blog post on the CDA if you are not familiar with this account.

The new rules will allow 100% of any expense for ECP to be included in a new CCA class (14.1), and each year 5% of the remaining pool can be deducted. Rules that currently govern CCA such as the half year rule and recapture will apply to the new 14.1 CCA class. When ECP is sold after December 31, 2016 in excess of capital cost, the resulting gain will be treated as a capital gain (unlike the active business income treatment noted above), such that 50% of the gain is taxable and taxed at the high investment income tax rates. This change will have the largest impact of these new rules.

I know this discussion is technical and complicated, but I need to set forth the new rules. I have an example below that will hopefully bring everything together and clarify the issue.

There are a number of other transitional rules (e.g. pre 2017 dispositions for non-calendar year ends straddling January 1, capital cost determinations) which this blog will not cover due to the complexities involved.

The new rules will allow you to deduct immediately the first $3,000 of incorporation expenses, with anything above the $3,000 going into class 14.1. In prior years only 75% of the expense was allowed and it took years and years to get the tax benefit.

What happens to my current ECP pool after December 31, 2016?

In general terms, whatever your ending ECP pool balance (Schedule 10 of the corporate tax return) is on December 31, 2016 will become the opening balance of Class 14.1 on January 1, 2017. As noted above, there are separate transitional rules for companies that have year ends that straddle January 1, 2017 but in general terms the ending ECP balance will equal the opening Class 14.1.

For any ECP incurred before 2017, the company will be able to use a 7% CCA rate for 10 years, consistent with the deduction rate of ECP that is currently in place. After 10 years the CCA rate will revert back to the 5% rate applicable for Class 14.1. In addition, in order to allow any small balances of pre 2017 ECP to be written off quickly, the Class 14.1 CCA deduction for 10 years will be the greater of $500 and the amount otherwise deductible (i.e. 7% of the pool).

Dispositions of ECP After 2016

As mentioned above, the biggest change going forward for CCPC’s is that for a sale prior to January 1, 2017, the gain is taxed as active business income, and for a sale subsequent to this date, the gain will be taxed as a capital gain. This is best reflected by using an example. So, let’s assume an Ontario CCPC sells goodwill that results in a $200,000 gain.

If the sale takes place on December 31, 2016, $100,000 (50% of the gain) will be taxable to the company as active business income, resulting in taxes owing of $15,000 if the small business deduction can be applied against the income, or $26,500 if the company’s income for the year is already over $500,000.

If the sale takes place on January 1, 2017, $100,000 (50% of the gain) will taxable to the company as a capital gain, resulting in taxes owing of $50,170, a portion of which would be refundable only after a taxable dividend is paid to the shareholder. The immediate taxes owing on this sale are $23,000 - $35,000 higher than if the sale had occurred one day earlier. It is important to note this is essentially a loss of a tax deferral, not an absolute tax cost; as the deferral of tax by retaining funds from the sale in the company is essentially lost under the new rules.

In both of the above scenarios, the other half of the 50% gain is still added to the Capital Dividend account of the company, and available for distribution to shareholders tax free, so no change in that regard. One small advantage to the new rules will be be the date you can make the tax free payment out of the capital dividend account. For sales of ECP before January 1, 2017 you would have to wait until the first day of the following tax year to pay out the capital dividend, whereas the new rules will allow the payment of the capital dividend as early as the day after the sale. 

Asset sales that include ECP will likely prove to be more difficult to negotiate after 2016 due to the higher tax cost, as the seller will be looking for a higher purchase price to cover the additional tax.

It may be prudent, in situations where your current accountant would not have this information, to begin compiling the following information:

• Original cost and date of purchase of any ECP purchased in the past

• Any ECP pool deductions taken from the time of purchase on any assets identified above

This information will assist your accountant in determining the gain on a disposition of ECP that occurs after January 1, 2017.

What planning can be done?

If your CCPC is planning on selling its business in the future via an asset sale or hybrid sale (versus a sale of shares), or selling any ECP of the company, serious thought should be given to completing this sale before January 1, 2017.

If your CCPC has a significant amount of internally generated goodwill, and no external method of sale is available before January 1, 2017, it may be possible to complete an internal reorganization to take advantage of the current ECP rules. This is extremely complicated and before you consider undertaking this type of transaction, you must speak with your accountant/tax advisor to determine if this is a viable option.

With less than 3 months until the transition date, if you think your company may be adversely affected by the new rules, now is the time to speak to your advisors.

I would like to thank Colin Sirr, Manager, Tax, for BDO Canada LLP for his extensive assistance in writing this post. If you wish to engage Colin for ECP tax planning, he can be reached at csirr@bdo.ca

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Should You Transfer Your Sole Proprietorship into a Corporation?

To minimize costs and test the economic waters, many Canadians start their own business as a sole proprietorship. If your business proves successful, you are then faced with the decision of whether

or not to incorporate. Today’s post discusses the income tax and business issues you must consider before deciding to move from a sole proprietorship to a corporate structure.

Legal Liability

As a business grows, sales tend to become larger and the consulting engagements more complex. Consequently, the risk of a product flaw or error becomes greater. As a proprietor, any legal action taken against your business places all your personal assets at risk, including your home (if it is in your name and not your spouses). Therefore, the decision to incorporate often makes sense just to ensure your personal assets are protected.

Until you incorporate, it is vital to ensure you maintain adequate business insurance and minimize the assets held in your own name.

Profitability and Tax Rates

As a proprietor, you must report your business income on your personal income tax return. As such, your profits are taxed at your marginal income tax rate. If you require all your business profits to fund your lifestyle; it does not make sense to incorporate your business (subject to other issues I will discuss below). However, if your business has become profitable enough that you do not need all the income generated, incorporation begins to make some sense as a tax deferral mechanism.

For example: In Ontario, the first $500,000 of active business income is taxed at only 15.5%. If you need $80,000 to live on and can leave the rest of the money in the corporation, you would defer at minimum 20% in income tax by utilizing a corporation (The marginal rate of income tax in the $80k range is approximately 35.5% vs. 15.5% corporate rate). If you are in the highest Ontario personal marginal rate you could be deferring upwards of 34%. By the way, active business income means what it sounds like: running a real business - manufacturing, wholesale, consulting, etc. A passive business earns income from stocks, rental properties, etc.

Capital Gains Exemption

One of the main advantages of incorporating is potentially being able to access the capital gains exemption for qualified small business corporation shares. The exemption is currently $750,000 per shareholder, but is scheduled to rise to $800,000 beginning January 1, 2014. Based on the 2014 exemption, a husband and wife who are 50/50 shareholders could sell their business for $1,600,000 and not pay any income tax, subject to the criteria discussed below. If you think your company may be worth millions in the future, you may even want to consider utilizing a family trust that would provide an exemption of $800,000 for every family member you include in the trust.

The criteria to determine whether shares qualify for the capital gains exemption are very complicated. The rules look back at the last twenty-four months prior to a sale and at the company on the date of the sale. In addition, the more successful you are, the harder it is to qualify. If you have excess cash and investments in the company you may fall offside the rules. I will discuss these confusing and complicated rules in a separate blog post in the future; but keep in mind, tax planning is imperative to ensure you qualify for the capital gains exemption.

Income Splitting

Income splitting opportunities for a corporation are often over-estimated. However, if you include your spouse as an owner, there may be significant income splitting benefits through the use of dividends. Dividends may be based on pure ownership (i.e.: Mr. A and Mrs. A each own 50%, so they each get 50% of any dividend paid) or you may be able to structure the corporation with discretionary shares that allow the dividends to be paid in any proportion to either Mr. A or Mrs. A (i.e.: 100% of the dividends are paid to Mrs. A and none to Mr. A). This type of structuring is complex and again you need to ensure you get proper tax and legal advice before utilizing a discretionary share structure.

How Do I Go from a Sole Proprietorship to a Corporation?

There are specific rollover provisions contained in Section 85 of the Income Tax Act that allow for you to transfer your sole proprietorship to a corporation on a tax-free basis. Shares of the corporation must be received on the transfer. The rollover is undertaken by filing Form T2057. Although this is a standard transfer provision, it is fraught with landmines.

The combined legal and accounting fees to undertake this transaction can range from $5,000 to $10,000 depending upon the complexity of the transfer. As such, many people decide to forgo this step, especially when they consider their main proprietorship asset to be personal goodwill (you are  the business and without you, it is worthless) as opposed to business goodwill (the portion of the business value that cannot be attributed to business assets such as inventory and equipment. i.e. The value of your business name, customer list, intellectual property etc). However, if you ignore filing Form T2057, you do so at your own risk.

This is because when you transfer your assets and goodwill from your proprietorship to a corporation, you are deemed to have sold or disposed of these assets at their fair market value. In order to avoid this deemed sale and to ensure you do not create any income or capital gains upon the transfer of these assets, I always suggest filing the tax-free rollover under Section 85.

As noted above, I have had clients argue they have no business goodwill and that all their goodwill is personal in nature. While in some cases there may be some validity to this argument, I think it is penny wise and pound foolish to take the risk that the CRA will deem a large gain on the transfer of your proprietorship goodwill when you can just make the election and eliminate that concern.

Once you have decided to rollover your goodwill to the corporation, it needs to be valued for purposes of the T2057 form, which can be a costly exercise. While not recommended, if you will be issued all the shares of the corporation, accountants may accept a client’s estimate of their goodwill for purposes of the election if it is reasonable and supportable. However, where other family members will become shareholders, a professional valuation is required. For example, if John transfers his proprietorship to a corporation and a valuator determines his shares are worth $500,000, John must be issued special shares worth $500,000 to ensure he has not conferred a benefit on his spouse or children. Once the special shares are issued to John, his spouse, family and/or trust subscribe for new common shares at $1.

It is important to note that I am glossing over several complex attribution rules here and you should not consider including any family member in the new corporation until you obtain proper income tax and legal advice. It is crucial to understand the ramifications of either decision and whether dividends must be paid to you in order to avoid the attribution rules.

Cost and administrative considerations

The cost of maintaining an incorporated company is far more expensive than operating a proprietorship. You must file financial statements with the CRA and the corporate income tax returns are complicated. You require annual legal resolutions and the administration is far more costly. Thus, I would not recommend the use of a corporation (subject to the other factors such as creditor proofing and the capital gains exemption discussed above) unless you could leave approximately $50,000 at minimum, but more like $75,000 of taxable income in the corporation after any salary you require.

Proprietors sometimes have difficulty separating their corporate funds from their personal funds as they are used to taking draws and simply paying tax on their business income. The corporate structure is more formal and personal drawings must be paid in the form of salary with income tax withheld and/or dividends. Both require filing of government forms (T4/T5).

The income tax benefits of a corporation can be significant. However, the transfer of a proprietorship to a corporation is very complex, especially when introducing family members as shareholders. It is thus vital that you engage an accountant and a lawyer to explain all the income tax issues to you before undertaking the transfer.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.