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On February 11, 2014, the Minister of Finance, Jim Flaherty, tabled his 2014 federal budget. The Budget included a proposal by the Department of Finance to hold consultations on modifications to the tax system applicable to “eligible capital property” (such as goodwill, customer lists and licenses, franchise rights and farm quotas of indefinite duration). No draft legislation was released.

This proposal, if it carried out, would bring major changes to the taxation of eligible capital property. In general terms, currently tax legislation is set up around a tax pool referred to as “cumulative eligible capital”. 75% of an eligible capital expenditure goes into this pool and “depreciation” can be taken at a rate of 7% on a declining balance basis. The sale of an eligible capital property generally gives rise to a 50% income inclusion.

The 2014 Budget proposes to eliminate this pool and to consider an eligible capital property as a new class of depreciable asset entitled to a 5% capital cost allowance. In addition, the sale of an eligible capital expenditure (including goodwill) will be treated as a capital gain and no longer as business income.

These measures, if adopted, will change the way sales of a business are structured, particularly with regard to the choice between a sale of assets and a sale of shares. Assume the following: goodwill (with no tax cost) is sold for an amount of $500,000 by a Canadian-controlled private corporation (“CCPC”). Under the current rules, this sale will give rise to an income inclusion of $250,000 for the corporation, taxable at a combined rate (Québec and federal) of 19% if eligible for the small business deduction (“SBD”). Accordingly, the effective corporate tax rate is 9.5% (half of 19%). For income which is not eligible for the SBD, the effective corporate rate is 13.45% (half of 26.9% - active business tax rate not eligible for the SBD). In addition, the sale of goodwill will give rise, at the year end of the CCPC, to an addition to the capital dividend account of $250,000. Thereafter this amount can be distributed tax-free to a shareholder by way of a capital dividend.

If the 2014 Budget proposals are eventually adopted, the sale of goodwill will give rise to a capital gain of $500,000 and a taxable capital gain of $250,000, taxable at the rate of 46.57% (the tax rate for passive income). The effective corporate tax rate will be 23.285% (half of 46.57%). Furthermore, the sale of goodwill will not give rise to an addition to the GRIP account (as opposed to the current legislation with respect to income that is not eligible for the SBD). Obviously, a portion of this tax is recoverable by the CCPC (that is approximately 13.33% or half of 26.67% - corresponding to the amount of refundable dividend tax on hand) which will bring down the effective corporate rate to approximately 10%. However, the RDTOH can be only recouped when a taxable dividend is paid by a corporation to a shareholder. This means, given that the taxable dividend will not be “eligible”, that the shareholder will be taxed at the rate of approximately 39.78% (being the combined highest marginal rate federal and Québec for 2014). This translates into an immediate increase in the corporate rate of approximately 13.8%. For income which is not eligible for the SBD, this corresponds to an increase of 9.8%. In a nutshell, these new rules will put an end to the current tax deferral on a sale of goodwill.

Another example. In the event of the sale of goodwill (with no tax cost) for an amount of $2,000,000, the estimated corporate taxes (federal and Québec) would be $465,700 (that is, 46.57% x $1,000,000), rather than $229,500 ($95,000 for the portion which will be eligible for the SBD and $134,500 for the portion which is not eligible for the SBD). This means that the corporation will pay an additional tax of $236,200. Subsequent to its year-end, the company could pay out an amount of $1,000,000 to its shareholder by way of a tax-free capital dividend. The balance of the corporate after-tax proceeds ($770,500) would be paid out to the shareholder by way of a taxable dividend ($500,000 would be eligible and $270,500 would not). To recap, the tax consequences will be as follows:

-          Estimated corporate taxes:  $229,500

-         Estimated individual taxes:  $283,705 (35.22% x $500,000 plus 39.78% x $270,500)

-          Estimated after-tax proceeds to the individual shareholder:  $1,486,795

Based on the proposals, $1,000,000 could also be paid out tax‑free by way of a capital dividend. The after-tax balance can be paid out to the shareholder by way of taxable dividend. For each $3.00 of taxable dividend paid, the company will be refunded $1.00 (to the extent of its RDTOH). Assuming that the company is being repaid its full RDTOH (26.67% x $1,000,000, or $266,700), the total taxable dividends received by the shareholder will be equal to an amount of $801,000. In summary, the tax consequences will be as follows:

-          Estimated corporate tax (once the RDTOH is recouped):  $199,000

-          Estimated individual taxes:  $318,317 (39.78% x $801,000)

-          Estimated after-tax proceeds to the individual shareholder:  $1,482,683

The following table outlines the integration of corporate and personal taxes on the sale of goodwill:

The proposals (if they become law) will put an end to a significant tax deferral available on a sale of goodwill with the result that “mixed sales of shares and assets” will likely be a thing of the past.

Pierre-Paul Persico is a tax lawyer at Spiegel Sohmer with extensive experience in corporate reorganization and estate planning