The mechanics of the sale determine its tax treatment
by Jamie Golombek
It has been one year since the Supreme Court of Canada (SCC) handed down its now-infamous decision in Gifford v. the Queen (2004 SCC 15). Advisors will recall that the SCC found that both the payment to buy a "client list" and the interest paid on money borrowed to finance the purchase of the client list were not tax deductible.
The Gifford decision has had a huge impact on advisors who are considered employees, the result being that any amounts paid to purchase a client list are simply not deductible. For advisors who are "self-employed", however, the purchase of a book of business from another self-employed advisor would most likely be considered to be a purchase of goodwill or, in tax parlance, "eligible capital property" (ECP). As a result, three quarters of the purchase price would be added to the cumulative eligible capital (CEC) pool and amortized at seven per cent per year. To date, little attention has been given to the tax treatment of the proceeds received by the advisor who is selling his or her book.
Sale by employee
If the vendor is an employee, what is actually being sold? Some insight may be gleaned from the analysis in Gifford. According to the SCC's decision, what was being sold was a combination of goodwill, developed over years of the vendor's dealing with his clients, and an agreement not to compete with the purchaser. In fact, in Gifford, the purchase and sale agreement required the vendor to provide written endorsements of Mr. Gifford to select clients and not to compete for them for 30 months.
Assuming that the facts in Gifford do not significantly differ from a typical sale by an employee, the proceeds received by the vendor who is an employee would likely be fully taxable, either as employment income or as payment received in respect of an agreement not to compete. Note that this need not be a separate, stand-alone agreement but rather could take the form of a provision or covenant in the sales agreement.
If the advisor is self-employed, the tax treatment will depend on whether the advisor is selling shares or is selling an unincorporated practice.
Sale of shares
Setting aside the much larger issue of whether or not an advisor is permitted to incorporate a non-insurance (i.e., securities) financial planning practice, the tax treatment of proceeds received on the sale of a practice depends on what the proceeds are for. Where the advisor enters into a non-compete agreement as part of the sale, the proceeds must be allocated between the actual shares being sold and the non-compete agreement.
The allocation is significant: proceeds allocated to the shares would be used, in conjunction with the adjusted cost base of the shares, to calculate the vendor's capital gain, taxable at 50 per cent and potentially eligible for tax-free treatment if the gain can be sheltered by any remaining lifetime capital gains exemption on the sale of qualified small business corporation shares (assuming the shares qualify for such treatment).
On the other hand, an allocation of proceeds to the granting of a non-compete covenant, which is governed by new legislation still in draft form but generally retroactive to October 7, 2003, will result in full income treatment to the vendor, unless a special election is completed by both the vendor and the purchaser and a copy is filed by both parties with their income tax returns for the year of the sale.
Sale of an unincorporated practice
The unincorporated advisor who is selling his or her financial planning practice must similarly allocate the proceeds received between the non-compete agreement, if any, and the sale of goodwill (and any other assets that form part of the sale). The amount allocated to the non-compete agreement will be fully taxable as income unless the election described above is made between the purchaser and the vendor.
The disposition of goodwill typically results in a credit to the 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.
Proceeds payable over several years
A problem arises when the amount allocated to goodwill is determined in advance but is payable over a number of years. The Canada Revenue Agency (CRA) has stated in IT-123R6 - Transactions Involving Eligible Capital Property that no reserve in respect of goodwill may be taken since the sale of ECP is not considered to be a sale of property "in the course of the business" as is required by the Income Tax Act provision dealing with reserves.
Purchase price of an unincorporated practice dependent on future commissions
The biggest problem that gives rise to the most tax uncertainty arises when an unincorporated financial planning practice is sold for a price determined by future commissions. A recent 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 or production from that property and no amount can be quantified at the time of sale, such consideration is not proceeds of disposition of ECP and is instead taxable as income when received. This position is consistent with the CRA's positions in Interpretation Bulletin IT-386R - Eligible Capital Amounts.
As support for this seemingly harsh result, the CRA refers to the Tax Court of Canada's decision in 289018 Ontario Limited v. M.N.R (87 DTC 38). The court held that the sale of the business, where payment was received as a percentage of sales, falls within the Act's rule governing payments based on production or use of property. The taxpayer had argued that since what was being sold was simply "know-how", the proceeds should be taxable as a disposition of ECP.
Curiously, the CRA seems to have ignored another tax case a few years later with the opposite result. In the Estate of Jean-Paul Rouleau v. M.N.R. (91 DTC 120), the judge found that payments on the sale by an accountant of his goodwill, paid over five years based on gross billings, were not subject to the payments-based-on-production rule and were, in fact, to be treated as proceeds of disposition of ECP.
John Durnford, a law professor at McGill University, argues in his 1991 Canadian Tax Journal article entitled "The Distinction Between Income from Business and Income from Property, and the Concept of Carrying on Business", that the payments-based-on-production rule should be limited to sales of property and should exclude sales of businesses.
As Professor Durnford wrote: " ... the objective in introducing [the payments-based-on-production rule] was ... to prevent the tax-free receipt of what was considered to be, in reality, income. The sale of a business is a capital transaction. The mere scheme of the payment of the price should not have the effect of converting payments on account of capital into income. The fact that the purchaser seeks the protection of an earnout clause in order to ensure that the business is worth the price being paid should not have the effect of prejudicing the vendor's tax position".
Notwithstanding Professor Durnford's comments, the CRA obviously disagrees and we may have to wait for a higher court decision on this matter before it may be willing to reconsider its position.
CRA's Interpretation Bulletin IT-462 - Payments Based on Production or Use sets out the 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 the payments for the goodwill associated with the sale of a practice are all 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 disposition of ECP, giving rise to capital gains-like treatment as discussed above, and the future commissions are fully taxable as income when received.
Based on the above analysis, careful tax planning is needed to ensure the optimal tax treatment. Expert valuation advice may also be needed to determine the appropriate allocation of proceeds received to the non-compete agreement. Finally, the purchase price should be fixed in advance and payable at once. If the purchaser cannot pay all at once, at least the price should be fixed in advance to ensure capital gains-type treatment, even if taxation occurs before the full proceeds are received.
The author would like to thank William R. Holmes of Thorsteinssons tax lawyers for his comments during the writing of this article.