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If you’re a business owner thinking of selling in the next 18 months, you need to know about the recent proposed changes to the Eligible Capital Property (ECP) regime. Scheduled to take effect on January 1, 2017, these changes could significantly impact the amount of money a business owner pockets after selling, making it more critical than ever to plan today to minimize taxes tomorrow.
The 2014 Federal Budget announced a public consultation on a proposal to repeal the Eligible Capital Property (ECP) regime and replace it with a new capital cost allowance (CCA) class. Detailed legislative proposals were recently provided in the 2016 Federal Budget.
These changes will impact the structuring of a sale of a business. Some business owners may want to go to market now so they have an opportunity to defer more tax. For others, creating an internal gain on the disposition in 2016 may be advantageous if the business is not expected to be sold in the foreseeable future.
The changes are most impactful to CCPCs selling their business. One of the most important differences under the proposed rules is that property that was previously ECP will now be considered capital property. This has various implications when selling a business that includes goodwill. As things stand now, goodwill is considered ECP.
First, the gain on a disposition would be considered a capital gain, and thus taxed as investment income by the corporation, whereas it’s currently taxed as business income. This diminishes the ability to defer tax by retaining income within the corporation.
Secondly, the capital dividend account would be impacted at the time of disposition. A vendor could distribute a capital dividend during the year of sale and not have to wait until the subsequent taxation year, as is the case today. Third, a vendor may be able to claim a reserve on a disposition whereas this was not possible under the current ECP rules.
Essentially, selling today as opposed to next year will result in higher total after-tax proceeds and a higher available tax deferral. Deferral as a percentage of proceeds could be up to 13.79% if the sale took place in 2016 and just 2.94% in 2017.
There are some advantages to the changes, such as earlier access to the capital dividend account and the ability to potentially claim a capital gains reserve. But the reduced deferral opportunity and the expected higher tax cost on the sale of property would likely make a seller less inclined to agree to an asset sale without a compensatory increase in the sale price.
Buyers generally prefer an asset purchase over a share purchase to access the tax basis of the assets for future amortization. The value of the future tax deductions available to the buyer have to be weighed against the increased compensation demands from the seller in determining a fair purchase price.
If you’re not planning to sell your business in the foreseeable future, you may be able to take advantage of the current ECP regime in the remainder of 2016. This can be done by transferring the goodwill to a newly incorporated entity at fair market value, creating a gain of the same amount. This results in positive cash flows with respect to the goodwill in the future, although a portion of the benefit will be offset by recapture of the goodwill when the business is sold.
If enacted, the proposed changes will impact how the purchase and sale of businesses are structured. Business owners may need to rely on the safe income exception when making distributions prior to selling the business. Tax practitioners will have to face the challenges of structuring transactions to ensure the safe-income determination time is not triggered prematurely.
Owners of businesses with a significant goodwill component will have to decide over the next several months whether it is more beneficial for goodwill to be taxed under the current eligible capital property regime or as a depreciable capital property later. Talking to your tax practitioner early will help you minimize unintended tax consequences down the road.
For more information please contact Patrick Khouzam at [email protected].
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