<b>Principal Issues</b>: 1.What is the tax treatment of POD of CRCE and goodwill? 2. Are there any reserves in regards to the sale proceeds payable in future?
<b>Position</b>: 1. See the response. 2. No.
<b>Reasons</b>: Facts and law.
XXXXXXXXXX
2014-055507
Lata Agarwal, CPA, CMA
MBA
January 12, 2015
Dear XXXXXXXXXX:
<b>Re: Sale price subject to earn-out </b>
This letter is in response to your email dated November 10, 2014, in which you requested our views on the tax consequences in a situation where a corporation (the "Vendor") disposes of certain property (the "Property") in respect of which the applicable expenditures were incurred during the development phase of a proposed wind turbine system. You have advised that the Property includes land options agreements, permits, maps, environmental assessments reports, engineering data and the technical report which is associated with a wind turbine farm. You have also advised that the site has not been developed and does not have any tangible property at this point. In your view, the expenditures incurred by the Vendor in respect of the Property were eligible as Canadian renewable and conservation expense ("CRCE") as that term is defined under subsection 66.1(2) of the Income Tax Act ("Act") and section 1219 of the Income Tax Regulations ("Regulations").
In brief, the Vendor is planning to sell the Property to an arm's length corporation. It is your view that the part of the proceeds of disposition ("POD") allocated to the disposition of the Property will be deducted from the Vendor's cumulative Canadian exploration expense ("cumulative CEE") pool. Any remaining proceeds will be considered to relate to the disposition of goodwill. Further to our telephone conversation (Agarwal/XXXXXXXXXX) on November 25, 2014, it is our understanding that the portion of the selling price allocated to goodwill is structured as a reverse earn-out as the initial sale price will be fixed to a maximum amount that may be reduced depending on the electricity generation capacity of the wind turbine system. Finally, you enquire as to whether the Vendor will be entitled to claim a reserve in respect of the POD that will be received in future.
<h3><b>OUR COMMENTS</b></h3>
This technical interpretation provides general comments about the provisions of the Act and related legislation. It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R6, Advance Income Tax Rulings and Technical Interpretations.
<h4><b>I. CRCE</b></h4>
CRCE is defined under section 1219 of the Regulations and is only applicable to a project where it is reasonable to expect that at least 50% of the capital cost of depreciable property to be used in the project would be property that is described in Class 43.1 or 43.2 of Schedule II of the Regulations. Paragraph (v) of Class 43.1 includes a fixed location device that is a wind energy conversion system that is used by the taxpayer primarily for the purpose of generating electricity and refers to specific eligible equipment. In addition, CRCE includes the specific expenses that are set out in paragraphs 1219(1)(a) to (g) of the Regulations.
Provided that the Vendor's project qualifies under section 1219 of the Regulations, certain start-up expenses incurred during the initial phases of development of the project will be eligible as CRCE. For example, CRCE may include the costs of certain pre-feasibility studies, feasibility studies, environmental assessment expenses and the expenses for negotiating power purchase agreements. In particular, paragraph 1219(1)(c) includes the costs of negotiating a site access agreement with landowners, obtaining approval to use the site from various regulatory authorities and obtaining permits (e.g., environmental, building and drilling permits) for the project from various regulatory authorities. However, we note that CRCE excludes, under paragraph 1219(2)(b), the costs associated with the purchase or lease of land for the project, other than the costs that relate to temporary access to the project site.
Paragraph (g.1) of the definition "Canadian exploration expense" in subsection 66.1(6) of the Act includes CRCE. Since the Vendor will dispose of the Property, the cost of which was originally eligible as CEE, the amount that becomes receivable to the Vendor will be subject to the provisions of paragraph 66(12.1)(a) and will reduce the Vendor's cumulative CEE balance under element "G" of the definition under subsection 66.1(6). The negative pool balance will be included in income under subsection 59(3.2).
Although the Act does not contain any provision for reserves in respect of the amount receivable under paragraph 66(12.1)(a), the Vendor will be entitled to add the portion of the receivable that is established to be a bad debt into its cumulative CEE pool under element "D" of the definition. Any recovery of such debts reduces the cumulative CEE balance under element "I" of the definition.
<h4><b>II. GOODWILL</b></h4>
It is not apparent from your email whether the Vendor is disposing of an entire business (which would include its associated goodwill), or solely the Property. As stated in paragraph 6 of Interpretation Bulletin, (Archived) IT-143R3, Meaning of Eligible Capital Expenditure, available on Canada Revenue Agency (CRA) website at http://www.cra-arc.gc.ca/E/pub/tp/it143r3/it143r3-e.html:
<blockquote>¶ 6. Goodwill cannot be divorced from the business itself. It follows the business and may be sold with the business, but it cannot be sold separately. Generally, goodwill arises as a recognizable asset only when a business is acquired at a price in excess of the value, as a going concern, of its net assets.</blockquote>
In this regard, although the Act does not provide a definition of goodwill, paragraph 5 of IT-143R3 refers to some pertinent definitions from jurisprudence while Interpretation Bulletin, (Archived) IT-386R, Eligible Capital Amounts, available on CRA website at http://www.cra-arc.gc.ca/E/pub/tp/it386r/it386r-e.html, provides some instances of goodwill. For example, subparagraphs 2(b) and (c) of IT-386R state as follows:
<blockquote>
<p style="padding-left: 30px;">(b) A person carries on a business for a period of time and then sells the business together with its associated goodwill. The sale of the goodwill is a disposition of EC property. "Goodwill" may include one or more of the following:</p>
<p style="padding-left: 60px;">(i) reputation,</p>
<p style="padding-left: 60px;">(ii) services of employees,</p>
<p style="padding-left: 60px;">(iii) favourable commercial contracts,</p>
<p style="padding-left: 60px;">(iv) trademarks or trade names,</p>
<p style="padding-left: 60px;">(v) favourable financial relationships,</p>
<p style="padding-left: 60px;">(vi) management performance record, and</p>
<p style="padding-left: 60px;">(vii) non-competition provisions.</p>
<p style="margin-left: 40px;">(c) Ms. A owns a business which she sells together with its associated goodwill to a corporation she owns or controls. The portion of the sale price attributed to the goodwill is generally considered to be the proceeds from the disposition of EC property provided that the sale is a bona fide business transaction.</p>
</blockquote>
In your particular case, while allocation of a part of the POD to goodwill would involve a factual determination, for the purposes of our comments below, we have presumed that the Vendor would be disposing of the business along with its goodwill.
In general, the POD of goodwill in connection with a business may be considered as an eligible capital ("EC") amount under subsection 14(1) and may apply to reduce the "cumulative eligible capital" ("CEC") pool pursuant to element E of the CEC definition in subsection 14(5) of the Act. CEC must be recalculated each year. In general, this pool is increased in a particular year by ¾ (the inclusion rate) of each EC expenditure made or incurred in the year and decreased by ¾ of the POD of an EC property. Any negative pool balance is included in income pursuant to subsection 14(1) provisions.
In your situation, the taxpayer is entitled to receive a maximum amount in respect of goodwill that may be reduced where the electricity generation capacity of the wind turbine system is below a certain stated capacity. Our comments with respect to Payments based on production or use are contained in Interpretation Bulletin (Archived) IT- 462 available on CRA website at http://www.cra-arc.gc.ca/E/pub/tp/it462/it462-e.html. As stated in paragraph 9 of IT-462, paragraph 12(1)(g) will not apply to your situation where the maximum amount is equivalent to the fair market value of the goodwill at the time of the sale. It is our position that provided that the maximum amount represents the fair market value of goodwill at the time of the disposition and provided that there is a reasonable expectation that the electricity generation capacity of the wind turbine system will be met, the maximum amount will be considered to be POD pursuant to element E of the CEC definition. If the electricity generation capacity is not met and the amount of the proceeds is later determined to be less than originally determined, the amount calculated in element E would be reduced accordingly. If this results in a positive CEC balance and the taxpayer's business has ceased, a deduction in accordance with the provisions of paragraph 24(1)(a) might be possible. Also, as noted under paragraph 7 of IT-143R3, if the portion of the total consideration for the business that is allocated to the goodwill is unreasonable, the CRA can apply the provisions of section 68 to deem what may reasonably be regarded as the amount for the goodwill. Where the terms of the agreement for sale include a restrictive covenant, any amounts received or receivable in respect of the restrictive covenant should also be included in income under section 56.4 unless any of the exceptions in that section apply.
As stated in paragraph 37 of Interpretation Bulletin (Archived) IT-123R6, Transactions Involving Eligible Capital Property, available on CRA website at http://www.cra-arc.gc.ca/E/pub/tp/it123r6/it123r6-e.html, where sale of an EC property results in an income inclusion in the year of disposition under subsection 14(1) as described above, but some part of the sale price is not due until a later year, a reserve under paragraph 20(1)(n) is not permitted. This is because the sale of an EC property is not considered to be a sale of property "in the course of the business" as required by paragraph 20(1)(n). However, subsection 20(4.2) of the Act provides for a deduction for a bad debt arising on a disposition of EC property as stated in paragraph 36 of this IT. Finally, we note that the cost recovery method, as described in Interpretation Bulletin (Archived) IT-426R, Shares Sold Subject to an Earn out Agreement, applies only to the sale of shares and not to the sale of goodwill.
We trust that these comments will be of assistance.
Yours truly,
Fiona Harrison, CPA, CA
Manager
Resources Section
Reorganizations Division<b> </b>
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
