Here’s the scenario: you’re selling assets and your accountant advises you that it’s best to have a written agreement with the buyer concerning the allocation of the purchase price among the different assets you are selling. You know, you’ve got goodwill (i.e. patient records), supplies, furniture, leaseholds, administrative equipment and fixtures, computer hardware and software, and clinical equipment and fixtures. Your accountant goes on to even suggest that the best tax treatment for you (as the seller) would be to have the HIGHEST AMOUNT of the purchase price allocated to clinical equipment and fixtures and then allocate the LEAST AMOUNT of the purchase price to leaseholds, since they’ll be HST that typically needs to be paid (read more about that HERE).
So for example, on a $1-million purchase price, your accountant may suggest having $500k for clinical equipment and leaseholds and $10,000 for leaseholds. Is that OK?
You see, section 68 of the Income Tax Act allows the CRA to determine what ought to be a reasonable amount for the sale of a particular property. The CRA can make that determination “irrespective of the form or legal effect of the contract or agreement” – meaning that a Court can disregard what a purchase and sale agreement says! In other words: the purchaser and the vendor must make a reasonable allocation of the proceeds of the purchase price among the different asset classes.
In TransAlta Corporation v. The Queen, 2012 FCA 20, the Federal Court of Appeal provided some guidance on how section 68 is to be applied. In that case, TransAlta Corporation sold its electricity transmission business to an arm’s length party. They negotiated the purchase price, which was over and above the book value of the assets. That difference was allocated to “goodwill” (an asset class on its own). Make sense so far right? If you’re familiar with basic accounting principles, it would make perfect sense. This was a standard allocation for regulated industries, which was supported by valuation theory, audited financial statements and long-standing industry practice.
But the CRA took the view that THERE IS NO GOODWILL in a regulated industry and allocated the premium to other assets, which resulted in recapture (and a big tax bill) to TransAlta Corporation.
The Federal Court of Appeal decided in favour of TransAlta, allowed it’s appeal, allowed it to recover costs and dismissed the CRA’s case.
Here’s how the Federal Court of Appeal got there:
- Goodwill has three characteristics: (a) it must be an intangible; (b) it must arise from the expectation of future earnings, returns or other benefits in excess of what would be expected in a comparable business; (c) it must be inseparable from the business to which it belongs and cannot normally be sold apart from the sale of the business as a going concern. If these three characteristics are present, it can reasonably be assumed that goodwill has been found.
- To determine if an amount can reasonably be regarded as the consideration for the disposition of a particular property, section 68 of the Act requires considering whether a reasonable business person, with business considerations in mind, would have allocated that amount to that particular property. Consequently, long-standing regulatory and industry practices, as well as auditing and valuation standards and practices, ARE relevant to such a determination.
- The industry standard allows for the allocation to goodwill of any premium paid above the net regulated book value of those assets. Such a premium can reasonably be understood as the value of the special advantages of the transmission business which allow it to potentially achieve returns in excess of what is deemed by its regulator to be a normal market return. The reasonableness of this long-standing industry practice is supported in this case by the regulatory process itself and by valuation and accounting theory and practice. The allocation of such a premium to goodwill can thus be regarded as reasonable for the purposes of section 68 of the Act.
So, to sum it up, a Court would need to ask whether a reasonable person, with business considerations in mind, would have allocated that amount to that particular property. Here, the court held that the “agreed allocation was reasonable precisely because of its compliance with industry and regulatory norms and its consistency with standard valuation theory for regulated businesses and standard accounting principles applied in such industries.”
What about the purchase and sale agreement? And the fact that the parties were arms-length when they negotiated the price and allocation? Doesn’t that count for anything? Remember what section 68 says… “irrespective” of the legal agreement. BUT the Federal Court of Appeal made a comment here (borrowing from the case of Petersen v. Minister of National Revenue)- namely, that how the allocation was determined “is an important factor to consider for the purpose of section 68 of the Act. However, the weight to be given to such an agreement will vary according to the circumstances”: an agreement where the parties have strong divergent interests concerning the allocation will be given considerable weight, while an agreement where one of the parties is indifferent, or where both parties’ interests are aligned as regards the allocation, will be given less weight.
So there you have it… it’s not a free-for-all when it comes to dividing up the asset allocation in a sale. You must give consideration to what a reasonable business person, with business considerations in mind, would have allocated to a particular asset class.