Pre-2017 ECP Crystallizations for CCPCs

For CCPCs, one negative aspect of the replacement of the present eligible capital property (ECP) regime with a new CCA class is that dispositions of this property after 2016 may generate investment income rather than active business income (ABI). As a result, taxpayers who are considering selling a business relatively soon after the new rules begin to apply may consider entering into a crystallization transaction before 2017 that locks in ABI treatment. A technical glitch that might have halted such planning has been fixed by revised draft legislation released on July 29, 2016.

Under the existing rules, a sale of ECP for which proceeds exceed cost (the associated eligible capital expenditure) effectively causes 50 percent of the difference to be taxed as ABI. However, under new rules that bring ECP into the CCA system and that generally take effect on January 1, 2017, this amount is a taxable capital gain (that is, investment income). Because CCPCs pay a higher effective corporate tax rate on investment income than on ABI (and only part of the excess is refundable on the payment of dividends), taxpayers may consider crystallization transactions.

Assume, for example, that Ms. A is the sole shareholder of Opco. She is approached by a buyer willing to purchase Opco’s assets for $20 million, almost all of which is attributable to internally generated goodwill. Because the buyer is investigating other potential target companies, it is expected that the deal cannot be finalized before January 1, 2017. Therefore, Ms. A can have Opco transfer all of its assets, including goodwill, to a newly incorporated subsidiary, Subco. The transfer will be under section 85, with an elected amount of $20 million. The proceeds of disposition are thus $20 million and the ACB is zero; therefore, a gain of $10 million (12 × ($20 million − 0)) is recognized by Opco, and this gain is ABI (which is the goal of the transaction).

The technical issue with this transaction is to make sure that there is no capital gain to Subco in 2017 when the goodwill is sold to an outside buyer. Because Opco and Subco are related parties, variable A.1 in the definition of “cumulative eligible capital” (CEC) in subsection 14(5) provides for a grind to Subco’s CEC balance. Thus, Subco’s CEC balance at the end of 2016 will be $10 million ((34 × $20 million elected amount) less a grind of (12 × $10 million gain realized by Opco)). In the absence of special rules, this ground-down CEC balance will be used to determine future capital gains: the capital cost of the property included in new CCA class 14.1 on January 1, 2017 is essentially four-thirds of the CEC balance on December 31, 2016 (subsection 13(37)). Fortunately, the revised draft legislation provides the required upward adjustment in capital cost in proposed paragraph 13(41)(a) of the Act. (The earlier draft legislation released on March 22, 2016 did not include this provision: CRA document 2016-0641851E5, June 7, 2016.)

The paragraph prtovides that if the amount determined for A in the CEC definition in subsection 14(5) would have been increased immediately before 2017 if the property had been disposed of immediately before that time, the capital cost of the property is deemed to be increased by four-thirds of the amount of that increase. A $5 million increase in A (through a reversal of the grind) would have occurred if there had been a disposition of the ECP by Subco before 2017. Thus, the capital cost of the property included in new class 14.1 is $20 million ((43 × $10 million CEC balance on December 31, 2016) + (43 × $5 million grind)). Therefore, when the class 14.1 asset is sold for $20 million, there is no capital gain.

Jin Wen
Grant Thornton LLP, Toronto
jin.wen@ca.gt.com

Canadian Tax Focus
Volume 6, Number 3, August 2016
©2016, Canadian Tax Foundation