Asset Sale – Price Allocation
- Jack Bernstein, Aird & Berlis LLP
In this article, the tax consequences to the vendor and the purchaser on the sale of different assets will be reviewed. The purchaser will prefer to allocate the purchase price to inventory and to depreciable property. On the other hand, the vendor may prefer to sell goodwill or capital property and allocate less to depreciable property. The allocation of the price may also have an impact on the harmonized sales tax and land transfer tax. If the vendor is compensated for prepaid expenses such as rent, interest, taxes, and services, the vendor will be taxable if the amounts had been previously deducted. The purchaser will be entitled to deduct the amount paid over the period to which the expenses relate.Note1
On the sale of inventory, the three-year reserve for unpaid amounts in paragraph 20(1)(n) may be available. The purchaser will treat the amount paid as the cost of inventory.
In the case of depreciable property, the vendor will be taxable on recapture, and no reserve is available. Recaptured depreciation is considered to be active business income for the purposes of the small business deduction. If a capital gain arises, the five-year capital gains reserve may be available if there is a balance of sale.Note2 A terminal loss may arise on depreciable property when the purchase price is less than the undepreciated capital cost of the property.
The purchaser will be entitled to claim capital cost allowance on depreciable property, depending on the class. Generally, the purchaser will be subject to the half-year rule(that is, only one-half of the capital cost allowance ordinarily available may be claimed in the year of purchase) unless the available-for-use rule applies. If the fiscal year of the purchaser is less than 365 days (for example, when a shelf company is used), it will be necessary to prorate the amount of capital cost allowance available in the first year based on the number of days that the purchaser was in existence. Note that the assets that are acquired may not fall into the same class in which they were held by the vendor. The rate of capital cost allowance may have been changed over the years and assets acquired by the vendor before a specific date may have continued to be in a separate class.
On the disposition of non-depreciable capital property, a capital gain or capital loss maybe realized or incurred. For the purchaser, the amount paid will represent the capital cost of the property.
If accounts receivable are sold, the taxpayer should consider filing an election under section 22. The election is only available if at least 90% of the assets of the vendor used in a business carried on in Canada are sold.Note3 If the accounts receivable are sold at a discount (which is common), the vendor will be entitled to deduct the shortfall. By making the election, the purchaser preserves the right to claim a deduction for a bad debt in connection with the receivables that are acquired. In the absence of such election, any uncollected amount would be treated as a capital loss.
The sale of a leasehold interest is treated as a capital gain (assuming that the vendor did not claim capital cost allowance on the leasehold interest). The purchaser may deduct the amount paid for the leasehold interest over the remaining term of the lease plus the first renewal period (over a minimum of six years, including the half-year rule). Often, the business will have goodwill of location, and it is possible to allocate an amount to the purchase of the lease. This may be preferable, from the standpoint of the purchaser, to making a greater allocation to goodwill.
If goodwill is sold, the vendor will effectively be taxed on half the gain. No reserve is available if payments for goodwill are made over time. The portion that is taxable is treated as active business income for purposes of the small business deduction. If a loss is realized and the business is not to be carried on, the remaining cumulative eligible capital may be written off by the vendor.
There is a limited election under subsection 14(1.01) available to a vendor of eligible capital property to treat an eligible capital amount as a capital gain. In order to make the election, the actual proceeds of disposition must exceed the taxpayer’s eligible capital expenditure in respect of the acquisition of the property. The election is not available on the disposition of goodwill Note4 or other eligible capital property for which the original expenditure cannot be determined. For example, it will not apply on a sale of goodwill which the vendor did not previously purchase.
The amount paid for goodwill is regarded as an eligible capital expenditure. The purchaser may write off three-quarters of the amount paid for goodwill at the rate of 7% per annum on a declining balance basis.Note5
A vendor may pay a purchaser to assume future undertakings of the vendor in respect of which the vendor has received payment, which was included in the vendor’s income under paragraph 12(1)(a). In such circumstances, the vendor will be entitled to claim a deduction for the payment, and the purchaser may be able to claim a reserve in respect of the payment if the vendor and purchaser have so elected. Note6
If there is an unreasonable allocation of the purchase price, section 68 of the Act provides the CRA with the authority to reallocate the purchase price between the assets. Unless the parties do not deal at arm’s length or one side is not taxable (for example, if any of the parties is a non-resident, a pension, or has a loss carry forward), the CRA will usually accept the allocation, provided both parties make the same allocation. As long as the parties have competing interests, the allocation should be considered reasonable. Evidence of negotiations and hard bargaining will reduce the risk of section 68 applying.
In the recent case of Transalta Corporation v. The Queen,Note7 the parties, who acted at arm’s length, agreed to allocate $190 million to goodwill out of a total asset purchase price of over $800 million. The Tax Court of Canada determined that while the parties had relatively equal bargaining positions with respect to the overall negotiation, TransAlta (the purchaser) had a stronger hand on the goodwill allocation. AltaLink (the purchaser) was indifferent to the allocation to goodwill as long as the allocation to tangible assets was at least equal to net regulated book value. The Court applied section 68 and concluded that $140 million was a reasonable allocation to goodwill. Section 68 will apply to an allocation where there is sham or subterfuge.8 Ideally, the parties will include the allocation of the purchase price in the agreement.
- This article first appeared in the CCH newsletter Tax Profile No. 7 (July 2012).
1 See subsection 18(9) of the federal Income Tax Act (the “Act”).