Part II: Introduction to Changes to the Eligible Capital Property (Goodwill) Tax Rules
Having explored the concept of Eligible Capital Property along with its existing tax treatment under Canada's Income Tax Act, we will analyze the changes taking place on January 1, 2017.
Business owners are reminded that our expert Canadian tax lawyers can help them to take advantage of the existing soon to change tax rules by carefully planning a corporate tax reorganization before the year's end.
Active vs. Passive Income
Under Canadian tax law, preferential treatment is given to income that flows from an active business vs. income earned from a passive source as we discussed in Part I of this article.
A full explanation of the subtle nuances of income characterization is beyond the scope of this article, however, succinctly put, passive income can be understood as income earned from a passive source, such as real property rentals or investments.
When the Canadian Income Tax Act was reformed in 1971, one of the issues that the government wished to address was the incorporation of investment portfolios. Without special characterization rules, those who would incorporate could hold their investments in a corporation to defer taxes by taking advantage of the far lower corporate tax rate versus the personal income tax rate.
To address this problem, the Income Tax Act introduced Part IV tax which creates an additional tax on passive income earned in a corporation thereby bringing the corporate rate up to an amount in excess of the highest marginal personal rate. The difference is refunded to the corporation when a taxable dividend is paid, incentivizing the flow through of passive income to be taxed in the individual's hands at the personal income tax rate.
On the other hand, active business income is given far more preferential tax treatment. When a corporation earns active business income, the income is taxed in the corporation at lower corporate rate of approximately 27% and any available small-business deduction can be allocated to reduce that rate even further. There is no additional tax on the income in the corporation, meaning the corporation is free to reinvest the income without paying additional taxes until the funds are distributed to the shareholders. At that time the individuals will pay income taxes at their marginal tax rate, subject to a tax credit being applied to recognize the tax already paid on that income by the corporation.
Thus it is basic income tax planning that a business owner will always prefer to have their income classified as from an active source, rather than as passive. As set out above, the changes to take place on January 1, 2017 will eliminate Eligible Capital Property as a separate tax class and fold it into the existing Capital Cost Allowance regime. The result will be that the taxable portion of a sale of goodwill will be deemed to be from a passive source and thus subject to Part IV tax.
The New Eligible Capital Property Regime
On March 22, 2016, the new Liberal Minister of Finance, the Honourable Bill Morneau, tabled that government's first budget. Included among the proposed changes was a plan to repeal the existing Eligible Capital Property regime and to fold ECP deductions into the existing Capital-Cost Allowance framework under the newly proposed class 14.1.
At the same time under the proposed rules the sale of ECP after January 1, 2017 will still be characterized akin to a capital gain. As such, 50% of the gain will be non-taxable and eligible for capital dividend treatment, while the remaining 50% will be characterized as income from investment, or passive income. The characterization of the 50% of the ECP sale as passive income means that any such income will be subject to Part IV tax and taxed at the high corporate rate of 50.67% in any holding corporation. Thus, the deferral advantage will be eliminated – previously the Canadian Income Tax Act would deem the taxable portion of the sale of Goodwill to be from active business and as such taxed at either the Small-Business Deduction rate of 13.5% or the general corporate tax rate of 27%. The net after tax proceeds could then be reinvested without additional tax consequence until distribution to the shareholder.
In Part III of this article we will explain how these changes
could affect your small business and provide an example of the old
vs. new tax treatment of Eligible Capital Property. We will further
explain how our experienced Canadian tax lawyers can help business
owners move quickly to maximize tax savings.
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Goodwill Taxation Part 1 Or Goodwill Taxation Part 3 to be
published on 14th November 2016. Check back Soon. To read the
summarized version click on
Goodwill Taxation.
The information is thought to be current to date of posting. Income tax law changes frequently and content may no longer reflect the current state of the law. This document is not intended to create an attorney-client relationship. You should not act or rely on any information in this document without first seeking legal advice. This material is intended for general information purposes only and does not constitute legal advice. If you have any specific questions on any legal matter, you should consult a professional legal services provider.
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