2014-0549761I7 Internally generated goodwill & excluded property

Principal Issues: Whether internally generated goodwill should be considered in the determination of the excluded property status of shares of a foreign affiliate held by another foreign affiliate?

Position: Yes.

Reasons: Based on a textual, contextual and purposive analysis of the Act.

Author: Gravel, Hugo
Section: 95(1), 149(10), 110.6(1)

Minh-Thi Truong
International Tax Division
International and Large Business Directorate                                                                                    2014-054976
Canada Revenue Agency                                                                                                                   Hugo Gravel, LL.B., D. Fisc.
344 Slater St.
Ottawa, ON K1A 0L5

March 6, 2015

Ms. Truong:

Internally Generated Goodwill & Excluded Property Status 

We are writing in response to your e-mail dated June 25, 2014 wherein you asked whether internally generated goodwill should be considered in determining whether shares of a foreign affiliate (“FA2”) of a corporation resident in Canada qualify as “excluded property”, as that term is defined in subsection 95(1) of the Income Tax Act (the “Act”), of another foreign affiliate (“FA1”) of the corporation.  Unless otherwise noted, all statutory references herein are references to the Act.

Our comments

The relevant part of the definition “excluded property” in subsection 95(1) reads as follows:

"excluded property", at a particular time, of a foreign affiliate of a taxpayer means any property of the foreign affiliate that is

(a) used or held by the foreign affiliate principally for the purpose of gaining or producing income from an active business carried on by it,

(b) shares of the capital stock of another foreign affiliate of the taxpayer where all or substantially all of the fair market value of the property of the other foreign affiliate is attributable to property, of that other foreign affiliate, that is excluded property,

[…]

Pursuant to paragraph (b) of that definition, the shares of FA2 will qualify as excluded property of FA1 if all or substantially all of the fair market value of FA2’s property is attributable to property that is excluded property. For the purposes of this analysis, we are assuming that FA2 has no property that is contemplated by paragraphs (b) to (c.1) of that definition such that, pursuant to paragraph (a) of that definition, it is necessary to determine whether all or substantially all of FA2’s properties are “used or held” by FA2 “principally for the purpose of gaining or producing income from an active business carried on by it”. You question, in particular, whether internally generated goodwill, as opposed to purchased goodwill, can be considered property for these purposes. In considering this question, we find it relevant to look to prior positions taken by this Directorate in the context of subsection 149(10) and section 110.6, which are discussed below.

Paragraph 149(10)(b) deals with property deemed to be disposed of on the transition from exempt to non-exempt status (and vice versa) of a corporation or trust. In a technical interpretation dated December 21, 1993 (document number 9319777) and a ruling issued in 2002 (document number 2002-0126653) this Directorate took the position that internally generated goodwill was property of the taxpayer immediately prior to the transition time such that it was deemed to be disposed of, and reacquired, by the taxpayer for an amount equal to its fair market value.

The definition “small business corporation” in subsection 248(1) is one of the factors that determines eligibility for the capital gains deduction under subsection 110.6(2.1) in respect of gains from the disposition of shares of certain corporations. One of the requirements of that definition is to establish that all or substantially all of the fair market value of the assets of the corporation is attributable to certain assets of the corporation, including assets that are used principally in an active business carried on primarily in Canada by the corporation. At the 1988 annual conference of the Canadian Tax Foundation, officials of Revenue Canada (now the Canada Revenue Agency) said the following in this regard:

In [our] view the “all or substantially all” test will normally be satisfied if assets representing at least 90 percent of the fair market value of the assets of the corporation are used in an active business carried on by it. The assets of the corporation include goodwill, whether or not such goodwill has been purchased.

We see no basis to apply different reasoning in the context of the “excluded property” test. Thus, we are of the view that internally generated goodwill is property used by FA2 that should be taken into account in determining whether the shares of FA2 are “excluded property” of FA1. However, it must also be determined whether such goodwill is used by FA2 principally for the purpose of gaining or producing income from an active business carried on by FA2. This may, depending on the circumstances, require an apportionment of such use as between the active business of FA2 and the other activities of FA2.

We trust these comments are of assistance and thank you for your enquiry.

Dave Beaulne, CPA, CA
Manager
for Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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