Tax Factor 2016-06

June 16, 2016


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The 2016-06 issue of the Tax Factor is available for download. In this issue, we cover:

Replacement of the eligible capital property regime

You may have heard that the federal government is proceeding to implement proposals to replace the current eligible capital property (ECP) regime with a new property class under the capital cost allowance (CCA) system. The proposed change was first announced in 2014, and the 2016 federal budget has moved this significant change forward.

So, what do the proposals mean for you and your business? First of all, most businesses have a cumulative eligible capital (CEC) account, which is a depreciable tax account for goodwill, certain licences, and intangible expenses. All businesses with a CEC account at December 31, 2016 will be impacted by the change. Although all such businesses will need to transfer their CEC account to the CCA system on January 1, 2017, the greatest impact of the proposed changes will be higher income taxes payable by private companies when a business or ECP assets are sold at a gain. The good news is that the new rules don’t take effect until January 1, 2017. This gives you time to assess the implications of the proposals and determine whether any planning may be beneficial. In this article, we answer some of the initial questions you may have on the upcoming changes.

What assets are affected?

ECP generally includes goodwill and other intangibles without a fixed lifespan which have been purchased for the purpose of earning income from a business. This does not include expenditures that are deductible as a current expense or depreciable under current CCA rules. In addition to goodwill, common examples of ECP include incorporation expenses, customer lists, farm quotas, and franchise rights and licences with an indefinite life.

What are the current rules?

Under the current ECP regime, 75% of an eligible capital expenditure (ECE) is added to the CEC account and is deductible at 7% per year on a declining-balance basis.

When a business or ECP assets are sold, 75% of the proceeds of disposition attributable to ECP reduce the CEC account. This may result in recapture (i.e. previously claimed CEC deductions) and an additional income inclusion related to the gain over original cost (i.e. the ECP gain). Generally, any ECP gain is currently taxed as active business income at a 50% inclusion rate. For Canadian-controlled private corporations (CCPCs), the federal tax rate on such income is 15%, or 10.5% if it is eligible for the small business deduction. In addition, 50% of the ECP gain is added to the company’s capital dividend account (CDA) at year-end and is available for tax-free distribution after year-end. The portion of the gain taxed at the general corporate rate  of 15% forms part of the company’s General Rate Income Pool and can be paid out as an eligible dividend.

What are the proposed rules?

Under the proposed rules, expenditures that are currently added to the CEC account will be included in new CCA Class 14.1. The expenditures will be included at a 100% inclusion rate and deductible at 5% per year on a declining-balance basis. Existing CCA rules will generally apply, including rules for recapture, capital gains, and depreciation, as well as the “half-year rule” for acquisitions. There will be a separate new Class 14.1 in respect of each business that the taxpayer carries on.

Dispositions

When property is disposed of under these new rules, proceeds up to original cost reduce the undepreciated capital cost (UCC) of the class, and any excess over original cost will be included in income as a capital gain. The taxable portion, or 50%, of the capital gain is taxed at a much higher federal investment income tax rate of 38.67%, where a portion is refundable only after a taxable dividend is paid by the company. Following the current rules for capital property, 50% of the gain will be added to the company’s CDA. The taxed portion of the gain can be distributed to shareholders as an ineligible dividend.

Goodwill

Under the new rules, every business will be considered to have a goodwill property even if no expenditures were made to acquire goodwill. This doesn’t mean that businesses can recognize internally-generated goodwill and start claiming tax deductions. It simply means that a goodwill account exists for each business though the balance may be nil. In addition, special rules will apply in respect of expenditures and receipts that do not relate to a specific property. Such expenditures will affect the capital cost of goodwill of a business as defined under these new rules.

Importantly and consistent with the current rules, the new rules recognize that goodwill is not a separately identifiable property, and can only be disposed of as part of the sale of a business as a going concern.

Fast write-off of small pre-2017 balances

For small expenditures incurred before 2017, the new rules will allow businesses to deduct the greater of $500 per year and the amount that would otherwise be deductible as CCA for the year. This will help to eliminate small carry-forward balances and will be available for taxation years that end before 2027.

Incorporation expenses

A separate business deduction for incorporation expenses incurred after December 31, 2016 will be available. This change will allow a current deduction on the first $3,000 of these expenditures. Expenses over $3,000 will be included in Class 14.1 as goodwill.

What happens at the transition time of January 1, 2017?

Numerous transitional rules have been proposed and while this article will not cover every rule, we will discuss the general transitional rules. As well, we will use a simple example to illustrate what happens at transition time for a company with a December 31, 2016 year-end and an existing CEC account balance.

Determining the opening UCC balance and capital cost

As of January 1, 2017, each existing CEC account balance related to a particular business will be converted to one new CCA Class 14.1 asset. Therefore, the opening UCC of the new class in respect of a business will be equal to the amount that would have been the CEC balance for that business on January 1, 2017.

For purposes of future dispositions, the total capital cost of all property in Class 14.1 at transition time is deemed to be, generally, 4/3 of the total of:

  1. the CEC balance at December 31, 2016, plus
  2. past CEC deductions claimed that have not been recaptured before January 1, 2017.

This total capital cost will need to be allocated between goodwill and each identifiable property that formed part of the CEC balance at December 31, 2016. This is required in order to be able to properly determine recapture and capital gains in the event of a future disposition. It is not necessary to determine these amounts for purposes of claiming CCA, since each CEC account that existed prior to the change will be converted to one new Class 14.1 asset rather than multiple CCA assets. However, it will be important to keep detailed records to track the total capital cost and its allocation to each property at transition time. This will help ensure that the information is readily available in the event of a future disposition.

Simple scenario on transition

Facts

Let’s consider Corporation X which has a December 31 year-end. In 2013, the company acquired a milk quota for $100,000 and incurred $2,000 of incorporation expenses. Both expenditures are considered to be ECEs and 75% of each amount was added to the company’s CEC account. From 2013 to 2016, assume Corporation X has taken a total of $19,274 in CEC deductions which results in a CEC balance of $57,226 at December 31, 2016.

Capital cost of property

Under the proposed new rules, the total capital cost equals $102,000. This is determined as 4/3 of the total of the December 31, 2016 CEC balance of $57,226 and the CEC deductions claimed of $19,274. The capital cost allocated to the milk quota is $100,000. This is the lesser of the total capital cost and the original cost of the milk quota. The remainder of the capital cost of $2,000 (i.e. $102,000 – $100,000) is allocated to goodwill of the business. Under the new rules, this step is taken after identifying the capital cost of any specific properties included in the CEC account at December 31, 2016.

Note that prior to the new rules coming into effect, this business did not have a goodwill balance. However, with a move to the new rules, the business will have a goodwill property capital cost balance as it has incurred expenditures that do not specifically relate to a particular property – in this case, the incorporation expenses. If there were no such expenditures, Corporation X would still have a goodwill property, but its capital cost would be nil.

UCC of new Class 14.1

As discussed, every business will be considered to have goodwill property that forms part of Class 14.1. As such, the milk quota and goodwill will both be property included in new Class 14.1. As noted above, the incorporation expenses will form part of the cost of goodwill included in the new class. The UCC of the new class as of January 1, 2017 is $57,226, which is equal to the amount that would have been the CEC balance at that time.

The UCC and capital cost amounts are summarized as follows:

Opening UCC at January 1, 2017 $57,226
Capital cost of milk quota ​ ​$100,000
​Capital cost of goodwill $2,000


Additional depreciation

For the first ten years under the CCA system, the depreciation rate for the new CCA class will be 7% for expenditures incurred before January 1, 2017. Note that the proposed rules do not suggest the creation of a separate CCA class specifically for expenditures incurred before January 1, 2017. As such, there could be additions to the same CCA pool after the implementation date. To allow for two CCA rates (i.e. 7% for expenditures incurred before January 1, 2017 for the first ten years and 5% for new expenditures), we suggest that you track additions after 2016 separately in your working papers. This will help to ensure you apply the appropriate CCA rate for purposes of your tax provisions and returns, as notionally there will be two pools within the same class.

Other transitional rules

Keep in mind that many other transitional rules have been proposed, including (but not limited to) rules governing:

  • Future sales of former ECP so that excess recapture will not result;
  • Dispositions of ECP before 2017 during a taxation year that straddles January 1, 2017; and
  • Non-arms’ length dispositions of former ECP which will prevent the use of such transfers to increase the UCC of the new class.

If you have questions pertaining to these transitional rules, your BDO advisor can assist.

What are the implications?

If ECP such as goodwill (including internally-generated goodwill that is not currently recognized), trademarks, and farm quotas make up a substantial part of the value of your CCPC’s assets, the proposed changes may have a significant impact in the event of a sale of the assets of your business (as opposed to a share sale). As mentioned, under current rules, 50% of the gain on the sale of ECP of a CCPC is taxed as active business income at a federal rate of 15% (or 10.5% if it is eligible for the small business tax rate). While under the proposed changes, the gain on the sale of ECP will be a taxable capital gain subject to tax at the federal investment income rate of 38.67% where a portion is refunded only after a taxable dividend is paid to the shareholder. This means that the deferral of tax that is available under the current rules when funds are retained in the corporation will be lost. The result is an immediate increase in federal income tax payable in the year of disposition of approximately 11.84% compared to the gain being taxed under the current ECP regime as active business income above the small business deduction threshold. The increase is 14.09% for income subject to the small business tax rate. If the small business tax rate is applicable, then there will also be a provincial tax rate differential.

What planning opportunities should I be aware of?

Half-year rule to apply to additions to new Class 14.1

You should keep in mind that additions to the new Class 14.1 will be subject to the half-year rule, whereas additions to the current CEC pool are not. As such, if your business is planning to acquire ECP with a substantial value, consideration should be given to making the acquisition before the end of 2016 to take advantage of the full 7% CEC deduction in the year of acquisition.

CCPCs — Completing sales or transactions involving corporate ECP by December 31, 2016

Imagine the scenario where an owner-manager of a CCPC plans to sell the assets of their successful business in the near future, and the business has a significant value of internally-generated goodwill that is not currently recognized. The treatment of the gain upon sale will have a considerable impact on them. Based on the proposed changes, if the business assets are sold after the proposed changes take effect, the CCPC will be paying an additional 11.84% of federal tax upfront on the gain attributable to goodwill, assuming the small business deduction limit is otherwise used up.

As it is common for owner-managers to defer taxes, possibly for many years, on the portion of the gain in excess of the amount that can be distributed on a tax-free basis from the CDA, the loss of the deferral available under the current rules may have a significant impact on the owner-manager’s finances. Assume the proceeds of disposition attributable to goodwill is $5,000,000 and that the small business deduction is not available. The additional upfront federal tax will be over $590,000, which the company won’t get back until sufficient proceeds of the sale are distributed as a taxable dividend.

As such, if you are considering the sale of your business by asset sale or contemplating a sale or transactions involving ECP, we recommend that you consider doing so before January 1, 2017 to take advantage of the current rules.

CCPCs — Corporate reorganization or non-arm’s length sale to crystalize goodwill value under current ECP regime

If you are in a situation where no external sale is currently contemplated, your business has large accrued gains on internally-generated goodwill (or other ECP), and you have or foresee personal cash needs in the near future, you may want to consider whether it makes sense to undertake a corporate reorganization or a non-arm’s length transaction to crystallize the gains before the end of the year. Your BDO advisor can assist you in assessing the costs and benefits of undertaking any tax planning that may be beneficial in your particular situation.

As the proposed changes to eliminate the current ECP tax regime take effect January 1, 2017, now is a good time to prepare for the transition to the CCA system and consider any tax planning that may be beneficial for your business. Your BDO advisor is ready to help.

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Tax changes impacting life insurance planning

Life insurance is often part of planning for the future, whether it be on an individual basis or as part of key business decisions. Life insurance can provide a source of funds needed in various circumstances, such as to cover certain tax liabilities on death, to maintain business stability following the loss of a key employee, or to provide a needed source of funds for family members after the insured person’s passing.

Insurance may also be purchased with a goal of wealth creation. Certain types of life insurance policies that qualify as “exempt” policies allow for the tax-deferred growth of the cash value of the policy, as investment earnings on accumulations in the policy are not taxed on an annual basis. As well, these policies will provide a tax-free receipt of the death benefit proceeds upon the passing of the person insured. In the right circumstances, this can be a sound alternative to investing on a taxable basis.

Most life insurance policies in Canada are structured as exempt policies. The rules governing the exempt status of a life insurance policy are very complex. Fortunately, it is generally the insurance companies that manage policies for the policyholders, helping to ensure that policies maintain their exempt status.

The current rules related to the exempt test for life insurance policies have been in place for over 30 years. With that much time passing comes change, and in 2012, the federal government announced its intention to modernize and improve the rules. Key stakeholder consultations followed the announcement, and in 2014, updated rules were passed into law. These rules will come into effect January 1, 2017.

In addition to modernizing certain rules, the government announced in its 2016 federal budget that it is closing loopholes that have allowed private corporations to distribute amounts tax-free, that would otherwise have been taxable, through the use of life insurance. You should note that the related changes will need to be taken into account when planning around life insurance.

In this article, we will first discuss the planning that has been eliminated due to the recent federal budget proposals, which have already come into effect. We will then provide a general overview of some of the key changes that relate to life insurance policies coming into effect in 2017.

Closing insurance loopholes

Corporate distribution of life insurance proceeds

When dealing with corporate-owned life insurance, the capital dividend account (CDA) mechanism will essentially allow a corporation to distribute the tax-free amounts it receives to its shareholders. Where a private corporation receives a death benefit from a life insurance policy, there will be a credit to its CDA of proceeds over the corporation’s adjusted cost basis (ACB) of the policy immediately before the death of the insured individual.

Based on current rules, if the life insurance holdings are structured with the corporation as the beneficiary, but not the owner of the policy, the ACB of the policy for the corporation is nil. This can lead to a higher CDA addition when the death benefit is paid. Take note that there is a similar result when partnerships are involved.

There have been concerns that the general anti-avoidance rule (GAAR) could apply to related planning. The Canada Revenue Agency has indicated in the past that they would consider GAAR where they believe there is an artificial increase in the CDA. Consequently, in the recent federal budget, the government has effectively shut down this type of planning. This is an indication that the government believes that planning designed to increase the CDA has become widespread and a specific anti-avoidance rule was needed to curtail it.

Effective for deaths after March 21, 2016, the ACB of the policy will be used to calculate the CDA (or adjusted cost base of a partnership interest) regardless of whether the corporation (or partnership) that receives the policy benefit is a policyholder of the policy. Along with this change, the government will introduce information-reporting requirements that will apply where a corporation or partnership is not a policyholder but is entitled to receive a policy benefit.

Life insurance policy transfers

For income tax purposes, a transfer of an interest in a life insurance policy is considered to be a disposition. A policy gain will result on the disposition where the fair market value (FMV) proceeds of disposition are greater than the ACB of the interest in the policy. However, if the life insurance policy is transferred on a non-arm’s length basis, there is a special policy transfer rule that applies. This will generally apply where the policy is gifted, distributed by a corporation, or transferred to a related person including a corporation. This rule deems the proceeds to the transferor and the ACB to the transferee to be equal to the surrender value of the policy.

The effect of this rule can be particularly beneficial on the transfer of a life insurance policy from an individual to their private corporation. If the FMV of the consideration received by the transferor on the transfer is higher than the surrender value, the difference would not be subject to tax due to the deeming rule. When the insured dies, the corporation will get an addition to its CDA and the CDA can be distributed tax-free as a capital dividend to the corporation’s shareholder(s). The total amount that can be received tax-free on the transfer and on the capital dividend distribution could easily be higher than the amount that would be paid on death if the corporation was the original holder of the policy.

To eliminate this benefit, it is proposed that the special policy transfer rule for non-arm’s length transfers be modified for dispositions after March 21, 2016. Under the proposed rule, if the FMV consideration exceeds the surrender value of the policy, the transferor’s proceeds of disposition will equal the FMV consideration. As a result, the excess of the FMV consideration over the surrender value will now be taxable on the transfer. Note as well that the acquiring person’s ACB will be equal to the FMV consideration in this case.

A change has also been proposed for certain non-arm’s length policy transfers that took place before March 22, 2016. The change will generally apply where the FMV consideration on such transfers was in excess of the surrender value at the time of transfer. Where policy benefits are received on such policies as a result of deaths that occur after March 21, 2016, the CDA addition will be reduced by the excess of the FMV proceeds received over the surrender value of the policy. This will effectively eliminate the additional tax-free distribution of proceeds on a retroactive basis.

Similar concerns to those discussed above for transfers also arise in the partnership context and where an interest in a policy is contributed to a corporation or partnership as capital. Therefore, amendments have also been proposed to deal with these circumstances as well.

Changes coming in 2017

Exempt policy test and related rules

Effective for policies issued or deemed to be issued after 2016, changes will be made to the calculations that determine how much can be invested in an exempt life insurance policy, as well as to certain policyholder rules. These changes reflect that individuals are living longer today which can result in later policy payouts. As well, the changes will ensure that a policy does not qualify for favourable tax treatment if the policy is mainly used as an investment vehicle where the insurance purpose is a lesser component. Some of the key changes are as follows:

  • The accumulation room of an exempt policy will generally be reduced over the longer term. Overall, the changes are likely to have a larger impact on Universal Life Level Cost of Insurance policies.
  • It will take longer to prepay a permanent life insurance policy. Under the new rules, the minimum premium payment period will be around eight years.
  • Limitations will be made to the tax-free payment of the fund value on death for a multi-life policy, along with adjustments to the ACB of such policies.
  • Due to the required use of more recent mortality tables and other assumption changes, the Net Cost of Pure Insurance (NCPI) will change. The NCPI generally reflects the mortality cost of an insurance policy and its value impacts the results under certain tax rules as outlined below.

The impact of the NCPI changes for tax purposes

Under the new rules, the NCPI for standard mortality polices will generally be lower in earlier years when compared to the current pre-2017 rules. This change may have a significant impact on certain corporate-owned life insurance policies, as the NCPI reduces the ACB of the policy. With a smaller ACB reduction in earlier years of the policy, the addition to the CDA for death benefits paid out during this period will be reduced, meaning less will be available to distribute tax-free to shareholders. However, with a lower ACB reduction, any policy gains on dispositions in earlier years would be similarly smaller, and would result in less tax to be paid on these gains.

The NCPI changes will also impact loan arrangements where the cash value of the policy is required as collateral on loans for investment or business purposes. Life insurance premiums are generally not deductible, unless they meet the required conditions in the tax rules related to collateral insurance. Where the requisite conditions are met, the deduction will be the lesser of NCPI and the premiums paid on the policy. This means that with a potentially lower NCPI under the new rules, the premium deduction for collateral insurance may also be lower.

One last point of interest is that under the new rules, substandard ratings based on health will now impact NCPI. These ratings could have the opposite effect and increase NCPI. But, keep in mind that there may be extra premium charges for a substandard life policy which would also impact the ACB of the policy.

Application of the new rules

The new rules will not apply to policies issued before 2017, as they will be “grandfathered”. However, there are certain circumstances that may cause a pre-2017 policy to lose its grandfathered status and be subject to the new rules. For example, a term life insurance policy that is issued before 2017 and is converted to permanent insurance after 2016 will no longer be grandfathered. As well, a policy issued before 2017 that has additional coverage added after 2016, that is a result of medical underwriting completed after 2016, will not be grandfathered. In either case, policy changes should be made before the end of the year if it is determined that it is beneficial for the current pre-2017 rules to continue to apply to your policy. Note that there are other situations that will result in a loss of grandfathering.

Considerations before 2017

Rest assured that there is still time before the life insurance changes come into effect in 2017. If you haven’t already considered a review of your life insurance policy in light of the changes, now is the time. If it is important to ensure your policy is subject to the current rules and you want to change your policy, remember that certain policy changes will need to be made before the end of this year. Or, if you are contemplating the purchase of life insurance, you should consider whether you are better off under the old rules or the new rules and time your purchase accordingly.

There are various reasons to hold life insurance, and if you are a business owner, you will need to consider whether life insurance should be held personally or in a corporation. And, in any case involving life insurance, it will be important to answer key questions when making decisions regarding a policy, such as what is the purpose of the funds to be paid out in the future and where (or to whom) will those funds need to be paid.

Keep in mind that it can take time to make the appropriate decisions for your future, or that of your business, as well as to make changes to a current policy or to issue a new one. Therefore, take action now to understand how the 2017 changes, along with the 2016 federal budget proposals, will directly impact you. Work with your BDO advisor and your insurance advisor to ensure your life insurance planning will meet your needs in the future and in a tax-efficient manner.

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The information in this publication is current as of June 1, 2016.

This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.

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