Published: March 18, 2020
Last Updated: April 13, 2020
Canadian Tax Lawyer Strategy for Addressing Changes to the Eligible Capital Property (Goodwill) Tax Rules
Part III: Introduction
In this final part of the article, we explain how SME business owners who move quickly can secure preferential tax treatment for their Eligible Capital Property (goodwill), and offer a discrete example of the significant savings that can be achieved for those who move quickly to reorganize before the changes take effect on January 1, 2017.
Readers should also be advised that our experienced Canadian tax lawyers can create a custom-made restructuring plan that will in most cases have an immediate and positive cash flow effect, despite the fact that taxes may become payable.
The Tax Advantages to Crystallizing ECP Prior to January 1, 2017
Individual taxpayers who operate a business should speak to our professional Canadian tax lawyers for advice as to how to protect their lifelong investment in their business and arrange to benefit from the old ECP regime. As explained in Part II of this article, the tax treatment of various types of income, particularly active vs. passive can have a significant impact on how much of your hard-earned dollars you’ll be able to keep when you finally sell your business.
At the same time, business owners who are not yet contemplating a sale and would like to take advantage of the business income characterization should move quickly to ensure that a proper tax law specific reorganization is possible before the end of this coming calendar year.
There is an immediate ability to withdraw funds tax free from a corporation on the sale of goodwill due to the tax free capital dividend being paid to the owner. So, prior to January 1, 2017, assuming a goodwill value of $1 million, the tax effects of a properly structured tax-driven reorganization would be:
- 1. A $500,000 capital dividend may be declared, allowing the operating corporation to pay out an amount of $500,000 on a tax-free basis to the shareholder(s); and
- Active business income of $500,000 earned by the operating corporation. This amount will be subject to the lower corporate tax rate of 27% – meaning a total tax payable by the corporation of $135,000. The remaining proceeds may be reinvested by the operating corporation; OR
- Active business income of $500,000 earned by the operating corporation. Assuming as an example that the entire small-business deduction allocation is available, this amount will be subject to a tax rate of 13.5% – meaning a total tax payable by the corporation of $67,500. The remaining proceeds may then be reinvested by the operating corporation.
Thus, the proceeds of disposition for the business will then effectively be “crystallized” as active business income for deferral without further tax consequence upon reinvestment. It should also be noted that the payment of the $500,000 tax free capital dividend serves to offset the taxes payable on the sale of a business, as the tax free dividend can replace salary or a dividend and will allow a corporate distribution with no additional tax in the shareholder’s hands.
Conversely, if we assume a goodwill value of $1 million after January 1, 2017, the tax effects are:
- A $500,000 capital dividend may be declared, allowing the operating corporation to pay out an amount of $500,000 on a tax-free basis to the shareholder(s); and
- Passive income of $500,000 earned by the operating corporation. This amount will be subject to Part IV tax at a rate of 50.67% – a total tax payable by the corporation of $253,350. Thus, the difference of almost 20% of the value of goodwill is not available for reinvestment by the operating corporation.
We must emphasize that there is no single “catch-all” solution to this problem as appropriate tax planning must be undertaken to ensure that no unforeseen income tax consequences are triggered based on facts specific to any corporation. Depending on the circumstances, the plan for overall restructuring will often be different from one business to another.
Those who are considering a sale of their business in the short to medium term or who need to extract cash from their corporations (e.g. to fund personal lifestyle requirements) should contact our Canadian tax lawyers immediately so that we can help to devise a tailor-made plan for restructuring that will allow our business owners to take advantage of the soon to disappear ECP regime.
Similarly, those business owners who are not considering a sale can nevertheless take advantage of the preferential tax treatment using a similarly tailor-made strategy devised by our knowledgeable Canadian tax lawyers. As the changes take effect on January 1, 2017, time is of the essence.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."