Category: Domestic Tax

Earnings in a TFSA are typically not taxable. However, earnings in a TFSA become taxable when they are earned from carrying on a securities trading business.

In a February 6, 2023, Tax Court of Canada case, CRA had assessed the TFSA on the basis that it was carrying on a business and was therefore taxable on its income for the 2009 through 2012 taxation years. The TFSA holder was a professional investment advisor who had engaged in aggressive trading in non-dividend-paying speculative penny stocks, all of which were qualified investments. The total income assessed was $569,481, earned from annual contributions of $5,000 in each of 2009, 2010, and 2011.

The taxpayer argued that the TFSA should be treated in the same manner as an RRSP and not taxed on income from a business of trading in qualified investments. The taxpayer further argued that the traditional tests used to determine whether a business of trading in securities was being carried on were inappropriate for application to TFSAs. The taxpayer referred to an earlier Court case that had suggested registered accounts trading in qualified investments are not carrying on a business.

Taxpayer loses

The Court noted that TFSAs are one of several statutory schemes, each with its own detailed provisions. Their components are not interchangeable. In comparing TFSAs to RRSPs specifically, the Court cited ten significant differences between the two schemes other than the treatment of business income. The Court further noted that the judicial test for carrying on a business of securities trading was well established when TFSAs were introduced in 2008 and would have been known to Parliament when they legislated taxation of income from carrying on a business in a TFSA. This indicated thatthe existing test was considered appropriate for this purpose.

Parliament provided that income earned from carrying on a business within a TFSA would be taxable to the TFSA. If Parliament intended to exclude a business of trading qualified investments, it would have included the same exception provided for RRSPs.

The TFSA, directed by its holder, traded frequently, had an extensive history of buying and selling shares that were speculative in nature and held the shares for short periods. The holder was a knowledgeable and experienced investment professional and spent considerable time researching securities markets. There was no doubt that the TFSA carried on a business of trading qualified investments throughout the period at issue.

ACTION ITEM: Carrying on a business of trading securities in a TFSA leads to full taxable income inclusion rather than tax-free amounts. Caution should be afforded when considering such activities.

The Canadian Federation of Independent Businesses (CFIB) released a report on January 10, 2023, focused on succession expectations for small businesses. It included the following survey responses:

• 76% of small business owners (constituting $2 trillion in business value) are planning to exit their business in the next 10 years;
• 9% have a formal business succession plan in place;
• obstacles to succession planning include:
  • finding a suitable buyer (54%),
  • business valuation (43%), and
  • over-reliance of owner in day-to-day activities (39%);
• considerations that owners selling their businesses found to be very or somewhat important were:
  • ensuring current employees are protected (90%),
  • getting the highest price (84%), and
  • finding a buyer who will carry forward their way of doing business (84%)
• business owners reach out to the following individuals to develop a succession plan:
  • accountants (43%),
  • lawyers (24%), and
  • only themselves (39%);
• business owners plan to sell to the following persons:
  • unrelated buyers (49%),
  • family members (24%), and
  • employees (23%).

There are many hurdles and opportunities in selling a business. Many can be addressed in advance, leading to significant improvements in the sale process and an increase in sale price. Often, several years are needed to position the business for sale or transition sufficiently, so planning should start as early as possible, even if the owner has not definitively determined if and when the sale will occur. In many cases, simply preparing for a sale can lead to increased profitability, efficient processes and reduced stress for the owner, such that they are in a better position even if they eventually decide not to sell.

ACTION: If you are considering selling or transitioning your business in the near to medium term, start planning now to ensure a smooth transition.

Buyers and sellers often concern themselves greatly with the “price” in a sale of a business. However, an equally important factor that has a large impact on the actual “value” exchanged between the two parties in a sale is the form or type of “consideration” exchanged for the business, and the timing of when the consideration is settled or paid out in cash. In this article, we will discuss various forms of “consideration” that are often seen in a business sale transaction, and how they impact the value exchanged.

When a notional business valuation is prepared it is usually under the concept of a “fair market value”, which is usually defined as the highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, each acting at arm’s-length in an open and unrestricted market, when neither is under compulsion to buy or to sell and when both have reasonable knowledge of relevant facts. However, in open market transactions many of the factors are not always so simple and the purchase price may be paid in a number non-cash forms. As a result, the economic value of the purchase price may be different from the face value of those items and should therefore be assessed on an equivalent cash basis.

Cash

The simplest type of consideration seen in business transactions is cash, paid immediately at the time of closing. When a business is sold and the seller receives the entire purchase price upfront in the form of cash from the buyer, the value to the buyer and seller is equal to the amount of cash exchanged. All-cash transactions offer the lowest risk to the seller, as the cash is received immediately and the purchase price is certain. However, all-cash transactions are generally risker for the buyer. If the business does not perform as expected after the sale, the buyer may not realize the full value of the purchase price paid. Additionally, it is often difficult for a buyer and seller to come to an agreement on the price that should be paid for a business.

As a result, business sales are often structured to include multiple types of consideration. Often, a partial upfront cash payment is made, and the remainder of the purchase price is paid in other ways, such as:

• Holdbacks • Promissory notes or vendor takebacks • Earn-outs • Share exchanges, either publicly traded or privately held companies Holdbacks Holdbacks are common in transactions for privately held businesses and normally protect the buyer against deficiencies in working capital, debts that were not paid off prior to closing, and undisclosed or unknown liabilities and contingencies such as legal or environmental.

Holdbacks are an effective way to manage risk in a transaction and usually represent only a small portion of the purchase price. Holdbacks tend to be released over an agreed upon time period ranging from six months to two years.

Promissory notes or vendor takebacks (VTB) are forms of debt issued by the seller to the buyer. The promissory note or VTB may or may not bear interest, and the interest may be fixed or variable, and may be higher or lower than comparable commercial rates. VTBs arise when a portion of the negotiated purchase price is withheld by the buyer and is paid to the seller over a period of time, or entirely at a later date.

Buyers often favour VTBs as they lower the up-front investment (i.e., cash) required, while still satisfying the purchase price negotiated between the parties. VTBs are also favourable to buyers, as they tend to motivate sellers to ensure a smooth transition after the sale, as the seller retains a portion of the risk related to the business. Further, when using bank debt to finance the purchase of a business, the lender will typically require at least a portion of the purchase price paid through a VTB in order to ensure the interests of the buyer and seller are aligned. VTBs can also be beneficial to sellers in a number of ways. By agreeing to accept a VTB, sellers are able to lower the up-front capital needed by potential buyers, creating a more competitive sale process and attracting multiple potential buyers. Additionally, in a VTB, the negotiated interest rate may lead to higher returns for the seller than if the entire amount was received in cash up-front.

The economic value of a VTB may be different from the dollar amount, or face amount, that is financed. In order to determine the fair market value (i.e., cash equivalent) of a VTB, the payments of future principal and interest should be discounted using a market interest rate. The sum of the present value of these payments is equal to the total fair market value of the VTB loan.

Earn-outs

An earn-out is when a portion of the purchase price is paid over time based on the prospective revenues, earnings, or some other measure related to the post-acquisition results of the acquired business. Earn-outs are commonly used in a business sale to bridge a pricing gap between the buyer and seller, where the parties may disagree on the future prospects of the business. An earn-out effectively shifts the risk from the buyer to the seller because if prospective results are not realized, the purchase price is reduced. Similar to a VTB, in order to determine the fair market value (i.e., cash equivalent) of an earn-out arrangement, the expected earnout payments should be discounted using a discount rate that considers the risk that payment will not be satisfied, as well as the general risk of the business.

Share Exchanges

When a business is sold to another corporation, the corporation may offer its own shares as currency to finance a transaction leaving the seller with an interest in the combined company after the transaction has taken place. Where the seller is a privately held company, and the buyer is a public company, the seller is typically able to assess the value received if the shares received in exchange are freely tradable. However, the valuation exercise becomes more complex where the seller is restricted from selling the shares for a period of time and/or the public company buyer has a relatively small market capitalization, thereby causing the block of shares held by the seller following the transaction to be somewhat illiquid. In these cases, the value of the publicly traded shares that carry restrictions on trading or are illiquid is generally lower than their face value.

Determining the fair market value (i.e., cash-equivalent) of shares received in a share exchange is particularly complicated where the buyer is also a private corporation (i.e., not publicly traded). In effect, it becomes a relative valuation exercise between the buyer and seller. These situations are further complicated when a controlling interest in a privately held company is sold in exchange for a minority interest position in a privately held, and generally larger company. In these situations, a shareholders agreement becomes extremely important as they typically provide a means for the seller, who ultimately holds minority interest of the combined company, to sell their shares to the remaining shareholders for their prorata value (i.e., without a minority or liquidity discount). In the absence of a shareholders agreement where shares of two private companies are exchanged, the minority position that the seller receives may be worth less than pro-rata value of their shares in the combined company.

Conclusion

Buyers and sellers typically employ a wide range of transaction structures involving different types of consideration such as contingent and non-cash. When assessing a potential transaction as either a buyer or seller, it is important to consider the types of consideration being offered and the associated risks with each consideration to properly evaluate the merits of the transaction and the economic value being exchanged. Additionally, the tax consequences of a transaction varies depending on the transaction structure, and should be discussed with a designated tax professional.

To receive more information on the topics discussed in this article or assistance in determining the most appropriate structure for your business purchase or sale, please contact our valuation and tax specialists.

UHT is a 1% federal tax intended to apply to the value of vacant or underused residential real property owned by non-resident non-Canadians. However, many Canadian individuals and other entities are also required to file UHT returns and may even be liable for the tax. Numerous exemptions from the tax itself exist, but significant penalties can apply where the required return is not filed, even if no tax is payable.
UHT was first applicable to the 2022 year, with the first filing deadline being April 30, 2023. However, CRA recently announced (March 27, 2023) that penalties and interest for the 2022 calendar year will be waived for any late-filed UHT return and any late-paid UHT payable, provided the return is filed or the UHT is paid by October 31, 2023. The late filing penalties start at $5,000 for individuals and $10,000 for corporations.

In general, UHT returns must be filed by all persons (which include both individuals and corporations) that are on title of a residential property on December 31 of each year, unless that person is an excluded owner. No tax is applicable if there is no filing obligation.

From an individual perspective, the only excluded owners are Canadian citizens and permanent residents. However, individuals that are on the title of a property in their capacity as a trustee of a trust, or a partner of a partnership, cannot be excluded owners, even if they are Canadian citizens or permanent residents.
From a for-profit corporate perspective, the only excluded owners are public corporations (i.e. listed on a Canadian stock exchange). That is, a private Canadian corporation is not an excluded owner.

Even if a filing obligation exists, an owner may still benefit from one of fifteen exemptions from the tax liability. The exemptions broadly fit into four categories: type of owner; availability of the property; occupant of the property; and location and use of the property. Even though the exemption eliminates the tax, the person still has a filing obligation. The exemptions are listed in Parts 4 through 6 of the UHT Return and Election Form (UHT-2900).

Some of the more common questions and concerns related to the UHT are noted below.

Is my property a “residential property”?

In general, a “residential property” is a property that contains a building with one to three dwelling units under a single land registry title. A unit is considered a dwelling unit if it contains private kitchen facilities, a private bath and a private living area. CRA provides various examples of properties that they view as residential properties in Notice UHTN1, such as: detached houses, duplexes, laneway houses, condominium units and cabins. Apartment buildings, commercial condominiums, hotels and motor homes would not be residential properties. Properties provided through accommodation platforms are likely residential properties (see Notice UHTN15).

How would an income-earning property (such as an Airbnb property or long-term condo rental) that is held by two or more individuals, such as a married couple, be treated?

Although both individuals may be Canadian citizens or permanent residents, there is a possibility that the property is being held in their capacities as partners of a partnership. In that case, the individuals are not excluded owners. The analysis generally starts with determining whether the operating relationship for the income-earning activity constitutes a partnership, which can be complicated. In general, a partnership is a relationship between two or more people carrying on a business, with or without a written agreement, to make a profit. See Notice UHTN15 for guidance.

A parent or child is on title of a property for probate or mortgage purposes.

Where a person is on title but is not a beneficial owner (such as where a relative is on title only for probate or mortgage purposes), they may be holding an interest in the property in their capacity as a trustee of a trust, even if no formal trust agreement is in place. As such, filing may be required even if the individual is a Canadian citizen or permanent resident. Professional advice may be required.

Properties sold before year-end.

UHT may apply in respect of a property sold prior to December 31 if the applicable land title registry has not been updated by the year’s end.

Multiple returns to file.

One return must be filed for each of the properties owned by the person, potentially resulting in multiple filings by a person. Likewise, if multiple persons are on title for a single property, each has their own filing obligation.

Private corporations that own residential property.

Most private corporations that are on title of a residential property will have filing obligations, even if they are holding the property in trust and even if they are exempt from the tax liability.

Owner of residential property passes away.

Usually, some time is needed to transfer title of a property from a deceased person to a beneficiary or executor/trustee of an estate. In cases where an individual has died but is still on title of the property, a filing obligation may still exist. However, if the owner was an excluded owner before their death, CRA has indicated that they will continue to consider them excluded after death. Where the property title has been transferred to a personal representative of the deceased (such as an executor), a special provision applies which allows the new holder to be an excluded owner for a limited period even though they are holding the property in their capacity as a trustee.

ACTION: Consider whether you or your corporation may have UHT filing or tax obligations.

A January 11, 2023, BC Civil Resolution Tribunal case addressed a claim for wrongful dismissal. The employer filed a counterclaim in respect of a 50-hour discrepancy between the employee’s timesheets and tracking software data over a period of about a month during which the employee was working remotely.

The employee argued that significant hours were spent working from hard copies; however, this was rebutted by records of printer usage and a lack of evidence of such work being uploaded to the employer’s electronic system. The Tribunal accepted the software evidence of time theft, and indicated that this was a “very serious form of misconduct” which justified the employee’s dismissal. The Tribunal further awarded the employer damages of over $2,600, plus interest, for the unaccounted-for time and an unrepaid advance.

ACTION: As employment work models shift, new employment-related challenges may arise.

Budget 2023 (A Made-in-Canada Plan: Strong Middle Class, Affordable Economy, Healthy Future) was introduced in the House of Commons on March 28, 2023. The top five changes that may impact individuals and owner-managed businesses are as follows:

1. Dental plan – The Canadian Dental Care Plan would be introduced to provide coverage for all uninsured Canadians with an annual family income of less than $90,000 (the previous Canada Dental Benefit only provided benefits for children under 12) by the end of 2023. Benefits would be reduced for families with income between $70,000 and $90,000.
2. Green investments – New and expanded green investment tax credits for businesses, including for clean electricity at 15%; clean hydrogen ranging from 15% to 40%; clean technology manufacturing at 30%; and expansion of the clean technology investment. Labour requirements, including wage levels and apprenticeship training opportunities, would need to be met to receive the full amount for most business credits.
3. Intergenerational business transfers – In the summer of 2021, rules were introduced that allowed individuals to benefit from the sale of their corporation to a child’s corporation in the same way as a sale to a third party. Previously, such transfers to a child’s corporation would result in a capital gain being converted into a more highly taxed dividend and also prevent the usage of the capital gains exemption. Budget 2023 proposed amendments to limit the 2021 rules by adding specific eligibility requirements focused on the transfer of ownership, management, and control of the business. The proposals would take effect in 2024.
4. Employee ownership trusts (EOTs) – Rules were proposed to better facilitate employees buying their employer through a trust. Proposed to be effective in 2024, these rules would provide business owners with an additional exit strategy, where for example, a third-party buyer or transition to a family member is not feasible or desired.
5. Alternative minimum tax (AMT) – The AMT is an alternative method of calculating taxes that ensures that an individual pays a minimum amount of tax even if they would not have a tax balance under the normal system due to using one or more tax advantages. Budget 2023 proposed to modify the AMT rules to better target wealthier individuals. The standard exemption from this tax would be increased from $40,000 to approximately $173,000; however, the tax rate would be increased from 15% to 20.5%. In addition, many of the deductions and credits currently allowed to reduce AMT would be eliminated or restricted. These changes would be effective for the 2024 tax year.

ACTION ITEM: If you are significantly affected by, or could benefit from, any of these changes, reach out for more information and assistance.

Are you a business owner that is developing interactive digital media products at a permanent establishment in Ontario using employees that reside in the province of Ontario? If so, the Ontario Interactive Digital Media Tax Credit (“OIDMTC”) program may apply to you.

Read the program highlights and full eligibility details in this short synopsis prepared by RSM Canada.