ECP Planning: Some Practical Considerations

The changes to the eligible capital property (ECP) regime, set to take effect on January 1, 2017, have prompted many taxpayers to undertake planning prior to year-end in order to crystallize any accrued gains on ECP held by a CCPC. The typical planning involves a taxable transfer of ECP to a related entity. A gain on ECP will give rise to a business income inclusion pursuant to subsection 14(1) to the extent that a taxpayer has received certain amounts on account of capital in respect of the underlying business to which the ECP relates. The gain in excess of the ECP income inclusion is added to the capital dividend account (CDA).

The most common types of assets that constitute ECP are goodwill, knowhow, key long-term contracts, quotas, unlimited life licences, brand names, and trademarks. Because of the nature of these assets, taxpayers should keep some practical issues in mind when implementing these tax-planning strategies.

One such issue is whether goodwill can be transferred without also transferring the business. The view of the courts (Herb Payne Transport Ltd. v. MNR, 1963 CTC 116 (Ex. Ct.)) is that goodwill is inseparable from the business to which it adds value. Accordingly, the accrued gain on goodwill cannot be realized apart from a disposition of the business.

A similar issue arises with respect to the transferability of knowhow. Knowhow is usually the knowledge, experience, and ideas of a corporation’s employees. Courts have reached conflicting decisions about whether knowhow constitutes property that can be disposed of (see, for example, Roth v. The Queen, 2005 TCC 484, and 289018 Ontario Limited v. MNR, 87 DTC 38 (TCC)). The general rule is that knowhow will be considered to have been disposed of only if the transferor can no longer avail itself of the knowledge in question—for example, when it sells the business to which the knowledge relates. An exception may exist if the knowhow is of a type that can be clearly documented and separated from the employees who developed it. Such a situation may account for the CRA’s statement that “proceeds from the outright sale of knowledge are considered to be from the disposition of EC property” (Interpretation Bulletin IT-386R, “Eligible Capital Amounts,” paragraph 2(d); archived). This statement appears to contemplate the feasibility of transferring knowledge.

When an entire business must be transferred in order to crystallize any accrued gains in respect of goodwill or knowhow, the implications of disposing of other types of business assets must also be considered. For example, a disposition of real estate may give rise to land transfer tax, and a transfer of employment or supplier contracts may require the renegotiation of terms or the seeking of third-party approvals. Other issues include changing the CRA payroll number for employees, dealing with CCA limitations following transfer to a related company, informing customers and suppliers that they are dealing with another entity, and providing notice as required by certain contracts and banking arrangements.

However, if these non-tax issues prove too difficult to address, it may still be possible to realize the gain on goodwill and knowhow. Instead of transferring the entire business, the seller could transfer only the beneficial ownership of the business’s assets to a related entity. The seller would continue to hold legal title, retain the employees, and act as agent for the purchaser. The two entities could also enter into the necessary services and rental agreements.

A series of tests has been developed by the courts and the CRA for assessing whether an agency relationship exists (see General Motors Acceptance Corp. of Canada Ltd. v. The Queen, 2000 CanLII 223 (TCC); Merchant Law Group v. The Queen, 2008 TCC 337; and GST/HST Policy Statement P-182R, “Agency”). The three principal requirements are (1) evidence of the consent of both the principal and the agent, (2) authority of the agent to affect the principal’s legal position, and (3) the principal’s control of the agent’s actions.

Another challenge that arises in respect of the disposition of ECP is the determination of its FMV—a step that is essential in order to avoid adverse implications pursuant to section 69. And consideration in respect of goodwill, for example, must be reasonably allocated pursuant to section 68. Owing to their inherently intangible nature, assets such as goodwill, trademarks, and knowhow should be valued by an independent professional business valuator in order to substantiate tax positions in the event of a future CRA audit.

When documented knowhow or trademarks are transferred on a standalone basis to a related party, an intercompany licence will likely have to be established to substantiate the continuing value of the transferred asset for the transferee, as well as to preserve the transferor’s ability to carry on its business uninterrupted. The licensee must also consider whether the licence constitutes the acquisition of ECP.

Finally, when it comes to ECP planning, a key motivation is to increase the taxpayer’s CDA; therefore, it is important to remember that the addition to the corporation’s CDA arising as a result of the disposition of ECP is not made until year-end. Corporations should avoid paying out capital dividends until the taxation year following the year in which the ECP in question is transferred.

Alison Spiers
Deloitte LLP, Ottawa
aspiers@deloitte.ca

Canadian Tax Focus
Volume 6, Number 4, November 2016
©2016, Canadian Tax Foundation