Principal Issues: [TaxInterpretations translation] Tax treatment to be accorded to a lump sum received by an investment advisor following the sale of its business assets such as receivables, client lists, goodwill and the right to receive commissions if insurance policies are renewed.
Position: None.
Reasons: General comments
XXXXXXXXXX Danielle Bouffard 2006-016849 March 22, 2006
Dear Sir,
Subject: Request for technical interpretation:
Business income versus capital gain
This is in response to your letter of November 28, 2005, to the Jonquière Tax Centre, which was forwarded to us by the XXXXXXXXXX Tax Services Office on January 25, 2006, for reply. We have also taken into account the additional information you sent us on March 2, 2006. We apologize for the delay in responding to this request.
Facts
You are a financial securities advisor. You are self-employed. On XXXXXXXXXX, you sold, to a third party dealing at arm's length with you (the "Purchaser"), your business assets, namely: your client base and contracts (in life insurance and/or disability insurance and/or segregated funds and/or annuities and group insurance), goodwill, and the right to a commission when your clients renew their policies after XXXXXXXXXX). You received, in XXXXXXXXXX, the sum of $XXXXXXXXXX in consideration for the sale of those assets. You did not give any guarantee to the purchaser, the latter having acknowledged "that this purchase is made at his own risk". You also undertook to assist the purchaser and introduce him to your principal clients, and to provide him with the necessary information about your clients' files for a period of 12 months from XXXXXXXXXX. After the expiry of this period, you will be fully released from this obligation.
Question
What tax treatment should be given to the $XXXXXXXXXX?
Our Comments
As stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, it is the practice of the Canada Revenue Agency (the "CRA") not to issue written opinions on proposed transactions otherwise than by way of advance rulings. Furthermore, when it comes to determining whether a completed transaction has received appropriate tax treatment, that determination is made first by our Tax Services Offices as a result of their review of all facts and documents, which is usually performed as part of an audit engagement. However, we can offer the following general comments that we hope may be helpful to you. These comments may, however, under certain circumstances, not apply to your particular situation.
The Income Tax Act (the "Act") provides certain rules where a taxpayer disposes of, inter alia, accounts receivable and eligible capital property in connection with the cessation of a business. As stated in paragraph 2 of Interpretation Bulletin IT-313R2, the facts of a case determine whether or not a taxpayer has ceased carrying on a business. This generally occurs when the taxpayer has ceased the normal activities of the business with little likelihood of starting them up again in the near future. IT-313R2 or any of the other Bulletins referred to in this letter are available on the CRA's website at http://www.cra-arc.gc.ca/menu/ITSC-e.html.
Where a taxpayer sells a business, the sale price must be allocated in a reasonable manner to the assets sold, such as, for example, accounts receivable, capital property (depreciable and other assets), goodwill, the list of customer accounts, etc. The consequences of such an allocation are briefly described below:
Receivables
Where the vendor disposes of all or substantially all of the assets of a business it carried on in Canada to a purchaser who proposes to continue carrying on that business, an election under subsection 22(1) may be made. If the vendor and the purchaser jointly elect under subsection 22(1):
- the vendor can deduct the difference between the face value of the receivables sold and the consideration the vendor receives from the purchaser in computing the vendor’s income,
- The purchaser must include this difference in its income and will be able to treat the receivables as if they had arisen while the purchaser owned the business. In this way, the purchaser will be able to deduct amounts in respect of bad and doubtful debts.
If an election under subsection 22(1) is not filed, the sale of the receivables will be recognized as a sale of capital property, so that the vendor's losses, and subsequently the purchaser's, will be capital losses.
Goodwill
For tax purposes, goodwill is part of an account called "cumulative eligible capital" (CEC). The sale of goodwill results in a reduction in CEC. That account must be reduced by 75% of the proceeds of disposition. Where the CEC is negative, a portion of that negative balance must be included in the vendor's business income for the taxation year. Alternatively, if a vendor has disposed of all the eligible capital property of a business, any final positive CEC balance is deducted from income in the taxation year in which the business ceases. For more information on eligible capital expenditures and the tax consequences of selling those assets, we refer you to Chapter 5 of Guide T4002(E) Rev. 05 "Business and Professional Income" under the sub-title "Sole Proprietorships" for examples of how to calculate regarding the sale of eligible capital property. That document is available on the CRA website at http://www.cra-arc.gc.ca/E/pub/tg/t4002/READ-ME.html
List of customer accounts
As stated in paragraph 3 of Interpretation Bulletin IT-386R, in the same way that a particular expenditure may be characterized as being either an eligible capital expenditure or a current expense depending on the circumstances of the case, a particular amount of consideration to a taxpayer may be either proceeds from the disposition of eligible capital property or an income receipt. Element E of the applicable formula in the definition of ECP contains the "mirror image" test. Under that test, the costs qualify as eligible capital expenditures for the same business if a taxpayer who disposed of a property related to the business were to look in a mirror and ask whether, instead of disposing of the property, the taxpayer was acquiring it. As noted in paragraph 4 of IT-386R, this test is particularly significant in determining whether, inter alia, dispositions of customer lists and ledger accounts will be considered to be dispositions of eligible capital property. Paragraph 8 of Interpretation Bulletin IT-143R3 states that where a taxpayer acquires lists or ledger accounts of clients, customers or subscribers, it is necessary to determine whether the cost of acquisition is a capital expenditure or an expense of the year. The current version of Interpretation Bulletin IT-187 provides guidelines for this determination. Generally, the cost of a list bringing an enduring benefit to the business of the purchaser is a capital outlay and is an eligible capital expenditure. For the vendor, the payment received is considered to be a return on a capital investment that was its business.
If the customer list is eligible capital property to the vendor and the vendor has not made an election under subsection 14(1.01) (discussed below), 75% of the proceeds of disposition, otherwise calculated, must reduce the CEC. The comments regarding the calculation of CEC in the section dealing with goodwill also apply on the disposition of a customer account list.
In certain circumstances, the election under subsection 14(1.01) may be made by a taxpayer who disposes of eligible capital property that is not goodwill. If certain conditions are satisfied, namely:
- The cost of the eligible capital property can be determined
- The proceeds of disposition exceed that cost
- The taxpayer’s exempt gains balance is nil
the gain on the disposition of that eligible capital property will be treated as a capital gain. For more information on that election, please refer to Chapter 5 of Guide T4002 and Chapter 3 of Guide T4037 (E) Rev. 05 Capital Gains in the "Other transactions" section.
Right to receive amounts if policies are renewed
A right to income from a business transaction or contract is property for the purposes of the Act. Where a taxpayer sells the taxpayer’s right to income to a third party, and it is possible to determine the value of that right at the time of the sale, a gain may result. In your particular situation, the right to the income is conditional on a client renewing a policy. The determination of the value of that right is in our opinion a matter of valuation which can only be determined after a review of all the facts and documents surrounding the transaction which is not within the purview of our Directorate. We suggest that you address that question to the valuation section of the XXXXXXXXXX Tax Services Office for further details on the subject.
In conclusion, the $XXXXXXXXXX you received in XXXXXXXXXX from the sale of your business assets must be allocated, in a reasonable manner, to the various assets sold. Based solely on the information provided, it appears to us that a large portion of the $XXXXXXXXXX received from the purchaser may be attributable to the customer list and goodwill. If the customer list is eligible capital property and you do not make the election under subsection 14(1.1), 75% of the proceeds of disposition of that property and the goodwill would reduce the CEC, which could result in income from the business in the XXXXXXXXXX taxation year if the CEC balance were negative.
These comments are not advance income tax rulings and do not bind the CRA with respect to any particular factual situation.
Best regards,
Alain Godin
For the Director
International Operations and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch