Be aware of the potential tax consequences
If you’re an advisor selling your business, a recent Tax Court decision involving an insurance broker who sold his client list but received payments based on future commissions will serve as a reminder of the severe tax consequences of such a sale.
General tax treatment
For advisors who are “self-employed,” the sale of a financial planning practice would largely constitute the sale of the client list, or what is known as “goodwill.” The disposition of goodwill, or eligible capital property (ECP), typically results in a credit to the cumulative eligible capital (CEC) pool equal to 75 per cent of the proceeds received. Assuming that the goodwill being sold was not originally purchased from another advisor, the CEC pool would have a zero balance before the disposition of the business, and therefore the disposal of goodwill creates a negative CEC pool balance. This negative balance is multiplied by 2⁄3 and taken into income, resulting in a net 50 per cent (3⁄4 X 2⁄3 = 1⁄2) inclusion rate. This provides the vendor with capital gains-like treatment on the sale of her unincorporated practice.
Purchase price dependent on future commissions
As I discussed in my 2005 column (“Selling your Practice,” FORUM, March 2005), a problem arises when the amount allocated to goodwill is sold for a price determined by future commissions. A 2005 Canada Revenue Agency (CRA) technical interpretation (2004-00984121E5) dealing with the sale of goodwill stated that if the consideration received for the disposition of ECP is dependent upon the use of or production from that property, and no amount can be quantified at the time of sale, such consideration is not proceeds from the disposition of ECP and is, instead, taxable as income when received. This position is consistent with the CRA’s positions in interpretation bulletin IT386R — Eligible Capital Amounts.
CRA’s interpretation bulletin IT462 — Payments Based on Production or Use sets out CRA’s positions on the tax treatment of any amount received that is dependent on the production from or use of property, whether or not the amount is an instalment of the sale price of the property.
If all payments for the goodwill associated with the sale of a practice are based on future commissions, all amounts received by the vendor will be taxable in the year received as regular income. If, on the other hand, the agreement for sale provides for a fixed lump sum payment plus a percentage of future commissions, the lump sum payment is proceeds of the disposition of ECP, giving rise to capital gains-like treatment as discussed above, and the future commissions are fully taxable as income when received.
Smith versus The Queen, 2011 TCC 461
In 2002, Quebec insurance broker George Smith sold his client list to B.F. Lorenzetti & Associates Inc. Based on annual commissions generated of $156,000 times an acquisition factor of 2.25, BFL agreed to purchase Smith’s client list for a total purchase price of $351,000, with payments adjusted each year based on actual commission revenue for the prior year.
The agreement specified that the purchase price, subject to adjustment, would be paid 40 per cent in 2002 ($143,000) with 20 per cent ($69,500) payable in each of 2003, 2004 and 2005. The payments due beyond 2002 were subject to an interest rate calculated at prime. If the annualized commission revenue at any anniversary payment date was greater or less than the amount warranted, the annual payments contemplated above would be adjusted upwards or downwards accordingly.
As it turns out, the payments were $142,500 in 2002, $74,000 in 2003, $93,000 in 2004 and $86,000 in 2005, along with interest payments of $9,383 for 2003, $3,125 for 2004 and $4,429 for 2005.
Smith included in his income for the 2002 to 2005 taxation years the total consideration received for the sale of the clientele — including the interest — as the disposition of ECP, and thus claimed the capital gains-type treatment.
The CRA reassessed Smith, including the subsequent adjusted payments received in 2003, 2004 and 2005 as income from the sale of the business whose payments were based on production and thus 100 per cent taxable. The CRA also taxed the interest received annually in full.
The judge agreed with the CRA, upholding the reassessment. As he wrote, “it cannot be said that the purchase price was fixed and determined in advance since the annual payments to the appellant were calculated each year based on commissions received for the previous year. The initial price of $351,000 was only an estimate and the purchase price was not fixed… [It] could fluctuate depending upon the annualized commissions received on any anniversary payment date.”
Based on the above case, an advisor looking for favourable tax treatment would be best off fixing the purchase price in advance. If the purchaser cannot pay all at once, at least the price should be fixed in advance so as to ensure capital gains-type treatment, even if taxation occurs before the full proceeds are received. Note that no capital gains reserve is available for the sale of goodwill.