2017-0719531I7 Section 22 election and carrying on a business

Principal Issues: Where a predecessor corporation uses assets in a business that it carries on and the assets are sold shortly after by an entity resulting from a corporate amalgamation, will the seller and purchaser benefit from the application of section 22 where an election was filed?

Position: Although some conditions of application of section 22 are not technically met, we recommend accepting the election that was filed by the seller and purchaser.

Reasons: The facts (particularly the fact that there was no disruption or change in the business) and the context and purpose of section 22 when read in conjunction with section 87 support extending the benefit of section 22 to the seller and purchasers.

Author: Moreno, Yves
Section: 22, 87

                                                                                                             October 24, 2017

Kristy Nguyen                                                                                       HEADQUARTERS
Large Business Audit Division                                                              Income Tax Rulings Directorate
Legislation Application Section                                                             Yves Moreno

                                                                                                              2017-071953

Application of section 22 of the Income Tax Act in the context of an amalgamation

All statutory references in this document are to the Income Tax Act, R.S.C. 1985, (5th Suppl.) c.1, as amended.

Dear Ms. Nguyen:

As requested, we are writing in response to your letter dated July 19, 2017.

Facts

Our understanding of the key facts related to the section 22 issue is as follows:

*     During the years XXXXXXXXXX, XXXXXXXXXX (“Predecessor 1”) carried on several businesses including XXXXXXXXXX (the “Businesses”).

*     Predecessor 1 was a wholly-owned subsidiary of XXXXXXXXXX (“Predecessor 2”).

*     Both corporations were taxable Canadian corporations.

*     On XXXXXXXXXX, Predecessor 1 vertically amalgamated with Predecessor 2 pursuant to subsection XXXXXXXXXX of the XXXXXXXXXX. The “new” amalgamated corporation formed as a result of the vertical amalgamation continued as XXXXXXXXXX (“Amalco”).

*     On XXXXXXXXXX, Amalco transferred all of the assets used in the Businesses to XXXXXXXXXX separate partnerships: XXXXXXXXXX. (the “Partnerships”).

*     The parties jointly elected pursuant to subsection 97(2) of the Act in respect of the assets used in the Businesses, with the exception of the accounts receivable that related to the Businesses.

*     The Partnerships each continue to carry on the respective businesses transferred to it from Amalco.

*     On XXXXXXXXXX, Amalco, jointly with each of the Partnerships, filed a T2022 election form in accordance with the requirements of section 22 relating to the XXXXXXXXXX sale of the respective accounts receivable that related to the Businesses.

You question whether the conditions of application of section 22 are met in respect of the transfer of the accounts receivable from Amalco to the Partnerships.

Purposes of section 22

Because the sale of the business is considered a capital transaction, the sale of accounts receivables of that business at a loss results in a capital loss to the vendor, and a capital asset to a purchaser, which cannot be written down.

We believe that section 22 serves to fulfill two main objectives:

*     Preserve the treatment of the accounts receivable as assets of a current nature, therefore allowing the purchaser to deduct bad debts and a reserve for doubtful debts from its income from carrying on a business.  The vendor would also be allowed to deduct from its income from carrying on a business the difference between the face value of the debt and the consideration received on the debt.  This would make the tax treatment in line with commercial and accounting treatment.

*     Preserve a continuity of treatment between the vendor and the purchaser.  Without an election under section 22, the vendor would have to include in its income under paragraph 12(1)(d) a paragraph 20(1)(l) reserve deducted in a previous taxation year and the difference between the consideration received for the debt and its face value may not be deductible as a current expense.  On the purchaser side, since the debt has not been included in the purchaser’s income in a previous taxation year, it would not be able to avail itself of a deduction for a reserve for doubtful debts under paragraph 20(1)(l) or bad debts under paragraph 20(1)(p).

Conditions of application of section 22

Section 22 reads:

Where a person who has been carrying on a business has, in a taxation year, sold all or substantially all the property used in carrying on the business, including the debts that have been or will be included in computing the person's income for that year or a previous year and that are still outstanding, and including the debts arising from loans made in the ordinary course of the person's business if part of the person's ordinary business was the lending of money and that are still outstanding, to a purchaser who proposes to continue the business which the vendor has been carrying on, if the vendor and the purchaser have executed jointly an election in prescribed form to have this section apply, the following rules are applicable:

(a) there may be deducted in computing the vendor’s income for the taxation year an amount equal to the difference between the face value of the debts so sold (other than debts in respect of which the vendor has made deductions under paragraph 20(1)(p)), and the consideration paid by the purchaser to the vendor for the debts so sold;

(b) an amount equal to the difference described in paragraph (a) shall be included in computing the purchaser’s income for the taxation year;

(c) the debts so sold shall be deemed, for the purposes of paragraphs 20(1)(l) and (p), to have been included in computing the purchaser’s income for the taxation year or a previous year but no deduction may be made by the purchaser under paragraph 20(1)(p) in respect of a debt in respect of which the vendor has previously made a deduction; and

(d) each amount deducted by the vendor in computing income for a previous year under paragraph 20(1)(p) in respect of any of the debts so sold shall be deemed, for the purpose of paragraph 12(1)(i), to have been so deducted by the purchaser.

The following conditions have to be met for an election made under section 22 to be valid:

1)    The existence of a business that is carried on;

2)    The existence of accounts receivable that are required to be included in income in respect of that business (referred to as “debts” in section 22, there is no indication that the Businesses included the lending of money);

3)    A sale by a person of all or substantially all the property used in carrying on the business, including the accounts receivable;

4)    The contemplated continuation of the business by the purchaser of all or substantially all the property used in carrying on the business.

Based on the information that we received and described above, it appears that the third and fourth conditions of application of section 22 are met.  Amalco sold all or substantially all of the assets used in the Businesses, including the accounts receivable and we understand that the facts support that the purchaser proposed to continue the Businesses.

However, it appears that the second condition is not met.

As part of the amalgamation of Predecessor 1 and Predecessor 2, Amalco acquired the accounts receivable along with the assets used in the Businesses.  It appears that paragraphs 12(1)(d), 20(1)(l), 87(2)(g) and 87(2)(h) are well integrated and coordinated to achieve a proper consolidated result in the context of an amalgamation.  However, none of it results in the existence of “debts that have been or will be included in computing [Amalco’s] income”, as required pursuant to the conditions in the preamble of section 22.  Despite the absence of requirement to include the receivables acquired from Predecessor 1 in its income (this deals with the receivables on which no reserve was claimed by Predecessor 1), Amalco can claim a reserve under paragraph 20(1)(l) in respect of such receivables that are doubtful debts by virtue of paragraph 87(2)(h).  That is the case whether Predecessor 1 has claimed a previous reserve or not on that account receivable and in either case, there would be a matching income inclusion on a consolidated basis (in Predecessor 1 if no reserve was claimed on in Amalco if a reserve was claimed).

The only inclusion in income that Amalco does in respect of accounts receivable of Predecessor 1 is under 12(1)(d) and it includes in its income a reserve (there is no presumption that the underlying receivable was included by Amalco in its income).  The presumption that Amalco is deemed to have included in its income a receivable that it acquired from Predecessor 1 is in paragraph 87(2)(h) and that presumption is only there to enable Amalco to claim a reserve under paragraph 20(1)(l) (which it won’t as it transferred the business assets to a partnership before the end of that year, that future reserve has nothing to do with the scheme of section 22).  To the extent that Predecessor 1 had claimed a reserve in respect of its accounts receivable in the taxation year ending on the amalgamation, Amalco is required to include that reserve in its income (paragraphs 12(1)(d) and 87(2)(g)).

As far as the first condition, you express the view that because Amalco sold the assets used in the Businesses, including the accounts receivable, XXXXXXXXXX minutes after the amalgamation, it did not “carry on the business” of Predecessor 1, hence the election under section 22 was not valid.  In support of that view, you refer to the position expressed in paragraph 1 of interpretation bulletin IT-188R, which describes the conditions of application of section 22.

That view might arguably be consistent with the conclusion of the Tax Court of Canada in the case of Gillen v. The Queen, 2017 TCC 163.  In that case, the Court had to determine whether for purposes of subparagraph 110.6(14)(f)(ii), a limited partnership that acquired and disposed of property on the same day disposed of “all or substantially all of the assets that it used in an active business carried on by it”.  The Court concluded that was not the case.  On that basis, the exception to the deeming rule in paragraph 110.6(14)(f) did not apply and the shares did not qualify as small business corporation shares on which a capital gain could be deducted under subsection 110.6(2.1).

Administrative Position

Provided there is no disruption in the continued operation of the business and the third and fourth conditions of application of section 22 are met, we are of the view that the context and purpose of section 22 are satisfied where a corporation resulting from an amalgamation that is governed by section 87 or its predecessor have included receivables from that business in their income and have used property in carrying on that business.

On the one hand, having different taxpayers that carry on the business is the premise of section 22.  Had the subsidiary predecessor corporation transferred its businesses to the purchasers and then amalgamated with its parent (i.e., reversed the ordering of the steps), the end result would be the same and there would be no basis to suggest that would be against the scheme of section 22, as long as that business is not interrupted.

On the other hand, we are of the view that the purpose of section 22 to extend the integration of the tax treatment of the accounts receivable on the transfer of the property used in a business is a corollary of the purpose of paragraphs 87(2)(g) and (h).  Paragraphs 87(2)(g) and (h) provide a continuity in the history of the accounts receivable of the subsidiary predecessor corporation and ensures a seamless transition of the reserves mechanism by providing the same income inclusions and deductions on a consolidated basis as if Predecessor 1 had continued its existence in Amalco.  In our view, refusing a section 22 election from being made at any time after an amalgamation runs against the legislative scheme of section 87.

On that basis, we recommend that the election filed by Amalco and the Partnerships under section 22 be accepted as valid and that the application of section 22 be extended to Amalco and the Partnerships.

We informed the Department of Finance of our view.

We would like to emphasize that had the facts been different and the businesses actually ceased operating after the amalgamation based on a lack of the continuity, frequency and regularity of the commercial activities associated with those businesses, our conclusion would be different.

The comments in Income Tax Folio S4-F7-C1 (“Amalgamations of Canadian Corporations”) will reflect the position expressed in this letter and the History section of that Folio will describe discrepancies with paragraph 1 of Interpretation Bulletin IT-188R (archived - “Sale of Accounts Receivable”).

For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the CRA’s electronic library.  A severed copy will also be distributed to the commercial tax publishers, following a 90-day waiting period (unless advised otherwise to extend this waiting period), for inclusion in their databases.  The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer.  Should the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity.  Requests for this latter version should be e-mailed to: ITRACCESSG@cra-arc.gc.ca.  In such cases, a copy will be sent to you for delivery to the taxpayer.

Yours truly,

Yves Moreno
for Division Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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