2019-0817641I7 Acquisition of rights to pension surplus

Principal Issues: Is an amount paid by the purchaser of a business in respect of actuarial surplus in the seller's RPP an eligible capital expenditure?

Position: No, it is a non-deductible capital amount.

Reasons: Consistency with past positions. The amount is excluded under paragraph (a) of the ECE definition in subsection 14(5) as an outlay in respect of which an amount would not be deductible by virtue of one or more provisions of the Act (such as paragraph 18(1)(e) or subsection 78(4)), or because it represents part of the cost of an equitable interest in a trust for purposes of the exclusion in paragraph (f).

Author: Ferrigan, Helen
Section: 14(5), 20(1)(b),13(34), 13(35), 13(36), 20(1)(a), 20(1)(b), 248(25), 20(1)(q), 147.2(1), 18(1)(e), 13(34), 13(35), 13(36), 18(1), 108(1), 78(4), “property” definition in subsection 248(1), Class 14.1

                                                                                                             January 21, 2021

XXXXXXXXXX Tax Services Office                                                     Income Tax Rulings Directorate
Audit Division                                                                                       H. Ferrigan
XXXXXXXXXX                 

                                                                                                           2019-081764

Attention: XXXXXXXXXX      

CONTAINS TAXPAYER INFORMATION - PROTECTED B

XXXXXXXXXX (the “Purchaser”)

We are writing in response to your email dated XXXXXXXXXX, requesting our views regarding the income tax treatment of approximately $XXXXXXXXXX paid by the Purchaser in respect of actuarial surplus on its purchase of a business and its assumption of the seller’s obligations under a registered pension plan. We also acknowledge the additional information provided by email and telephone, including submissions from the representatives of the Purchaser dated XXXXXXXXXX. We regret the delay in our reply.

All statutory references in this memo are to the provisions of the Income Tax Act (Canada) (the “Act”) and the Income Tax Regulations (the “ITR”) as they read during the relevant taxation year, which ended on XXXXXXXXXX (the “Taxation Year”).

I. SUMMARY OF POSITION

It is our view that the $XXXXXXXXXX paid by the Purchaser to the Seller in respect of the actuarial surplus is a non-deductible capital amount.  Specifically, the payment is not deductible by reason of paragraph 18(1)(b) of the Act, nor is it an “eligible capital expenditure” for the purposes of section 14 and paragraph 20(1)(b) of the Act, as those provisions read during the Taxation Year.

II. FACTS AND ASSUMPTIONS

Based on the documents you have provided to us, our understanding of the relevant facts is as follows:

*    In XXXXXXXXXX, the Purchaser acquired an XXXXXXXXXX business under an asset transfer agreement (the “ATA”) from an arm’s length seller (the “Seller”).

*    Under the ATA, the Purchaser was assigned the Seller’s obligations under a registered pension plan with only a defined benefit provision (the “Plan”), the terms of which are set out in an agreement between the Seller and certain of its employees dated XXXXXXXXXX (the “Plan Agreement”). XXXXXXXXXX.

*    At the time of the assignment, the Plan had an actuarial surplus of $XXXXXXXXXX, arising as a result of revised actuarial assumptions and higher than expected investment returns. XXXXXXXXXX (the “Surplus Amount”).

*    A payment of approximately $XXXXXXXXXX was made to the Seller by the Purchaser in respect of the Surplus Amount on XXXXXXXXXX. 

The Plan is governed by (i) a Plan Agreement with between the Seller as employer and certain of the Seller’s employees and (ii) a trust agreement between the Seller and a commercial trust company (the “Trustee”). The relevant provisions of these documents are as follows:

*    The Plan Agreement states that the primary purpose of the Plan is to provide retirement income for the employer’s employees as a registered pension plan under the Act and applicable pension laws.

*    The Plan is non-contributory, requiring only the employer to make contributions based on actuarial estimates and subject to the limits in the Act and pension law.

*    Neither the Plan Agreement nor the trust agreement contain any language or provision making employer contributions to the Plan irrevocable or requiring that all of the Plan trust’s funds are used for the exclusive benefit of Plan members.

*    The Plan permits the employer to use actuarial surplus to determine or reduce the contributions it would otherwise be required to make under the Plan. Actuarial surplus may also be returned to the employer to the extent allowed by the Act and pension law, subject to any conditions and approval procedures imposed by law.

*    Overpayments of contributions that could make the Plan’s registration revocable under the Act may also be returned to the employer. Any surplus assets will be returned to the employer on termination or wind-up of the plan.

*    The trust agreement appoints the Trustee to hold, administer and invest trust property and to pay Plan benefits as the employer directs.

*    The trust agreement may be amended at any time without limitation by written agreement of the parties.

*    The trust agreement limits the Trustee’s powers to be only in respect of the employer’s defined benefit plan and permits the employer, its designate or its replacement to direct the Trustee with respect to the distribution of plan assets on termination or wind-up of the Plan, subject to the approval requirements of applicable pension legislation. It also expressly permits the employer to authorize the Trustee to transfer Plan funds to a defined contribution plan, again to the extent permitted by and the conditions and approval procedures imposed by pension law.

The Purchaser took the position that the Surplus Amount was an “eligible capital expenditure” (“ECE”). In its tax return for the Taxation Year, the Purchaser reported the Surplus Amount as a “cost of eligible capital property acquired during the year” on T2 Schedule 10 and claimed a deduction for the year in respect of the Surplus Amount to the extent permitted under the Schedule. (footnote 1) 

You are proposing to disallow the characterization of the Surplus Amount as an ECE on the basis that it is a capital property for which no deduction is permitted under the Act. You have requested our views about this proposed reassessment.

III. POSITIONS OF THE PARTIES

Taxpayer’s Position

Based on material you have provided and the submissions of the Purchaser’s representative, we understand that the Purchaser’s position is as follows:

*    Due to the onerous approval requirements under the Pension Benefits Act (Ontario) (the “PBA”) XXXXXXXXXX, it is virtually impossible for the Purchaser to withdraw or use the Surplus Amount directly and it can only be used for contribution holidays.

*    The Surplus Amount has all of the characteristics of goodwill as described by the Federal Court of Appeal in TransAlta Corporation v. R., 2012 FCA 20, in that (i) it is an unidentified intangible asset; (ii) it arises from an expectation of future benefits, providing an enduring benefit in the form of increased cash flows and harmonious labour relations; and (iii) it is inseparable from the Purchaser’s business XXXXXXXXXX.

*    The tax community views acquired surplus as goodwill (citing a 1996 CTF article (footnote 2) ).

*    The Surplus Amount meets the requirements of an ECE as defined in subsection 14(5), in that it was incurred in respect of the business XXXXXXXXXX and is a capital expenditure resulting in an enduring benefit (in the form of future contribution holidays).

*    Treating the Surplus Amount as an ECE is relatively conservative as it results in gradual amortization over time, not in a straight deduction.

*    Disallowing the deduction of the Surplus Amount is inconsistent with the spirit of subsection 147.2(1), which essentially permits a deduction when cash is expended to satisfy pension obligations.

*    Disallowing the deduction of the Surplus Amount results in asymmetrical tax treatment (and potential future double taxation) because pension surplus received by a vendor (or by the Purchaser on a future surplus distribution such as on windup) is included in the recipient’s income under paragraph 56(1)(a).

Audit’s Position

Based on your position paper and our subsequent discussions, we understand that Audit’s proposed reassessing position is as follows:

*    Paragraphs 20(1)(q) and subsection 147.2(1) do not apply to permit a deduction because the payment in this case was made to the Seller, not to a registered pension plan.

*    The Surplus Amount can be used to take contribution holidays and can be directly withdrawn with the consent of the Ontario pension regulator. Actual surplus can also be returned to the employer on wind-up after all obligations to fund Plan benefits are satisfied.

*    The Surplus Amount is not goodwill as it is not an “unidentified intangible” but rather an identifiable asset; it can be converted to cash or improved cash flow so does not provide additional funds or benefits; it is separable from the business because it could have been returned to the Seller before the Plan was assigned to the Purchaser.

*    The Surplus Amount is not an ECE because it was an amount excluded under subparagraph (f)(i) of the ECE definition in subsection 14(5) as an amount that was the cost of an interest in a trust.

For these reasons, you conclude that the Surplus Amount is not an eligible employer contribution deductible under paragraph 20(1)(q) and subsection 147.2(1), nor an ECE deductible under section 14 and paragraph 20(1)(b), nor a prepaid expense deductible under paragraph 18(9)(b). It is essentially a non-deductible capital nothing.

IV. ISSUES

Characterizing the Surplus Amount to the Purchaser for income tax purposes raises the following issues:

1.    Is the Surplus Amount an ECE of the Purchaser? This requires determining:

(a)   if the Surplus Amount was incurred on account of capital for the purpose of gaining or producing income from its business;

(b)   if any portion of the Surplus Amount is deductible by virtue of any other provision of the Act;

(c)   if any portion of the Surplus Amount is not deductible by virtue of any provision of the Act other than paragraph 18(1)(b);

(d)   if the Surplus Amount is the cost of all or part of an interest in a trust or a right to acquire an interest in a trust such that the exclusion in subparagraph 14(5)(f)(i) applies; and

(e)   if the Surplus Amount can be characterized as goodwill and therefore an ECE on this basis alone.

2.    Would the Surplus Amount be considered Class 14.1 property if paid after the repeal of the ECP rules?

V. ANALYSIS

Relevant legislation

Pension Benefits Act (Ontario)

Very generally, the PBA and the policies of the Financial Services Regulatory Authority of Ontario (formerly the Financial Services Commission) permit an employer to withdraw pension surplus with the Authority’s consent in specific situations in accordance with sections 77.11 to 79 of the PBA. Generally, the plan documents must expressly permit the withdrawal or the employer must either enter into an agreement with plan members that meets specific conditions. To give its consent to the withdrawal of surplus from an ongoing plan, the Authority will require either an agreement with members or a court order. The Authority must also be satisfied that the plan has a surplus and retains a specific amount of surplus to cover current service costs.

When a business is sold, section 80 of the PBA provides that the original and successor employers may agree to transfer pension assets and responsibility for providing pension benefits to transferred employees. Section 80 and the PBA Regulations also set out rules for a series of notices that must be provided to current and retired plan members, trade unions and other potential beneficiaries before actuarial surplus can be transferred.

In contrast, if the parties to the sale of a business agree that the buyer will assume the seller’s role as sponsor under a pension plan, there is no transfer of plan assets, only a transfer of rights and obligations so section 80 does not apply. In these circumstances, the parties may negotiate a purchase price adjustment that reflects the funded status of the plan to take into consideration the overall financial effect of transferring the pension obligations. From a commercial perspective, the price adjustment is not a purchase of surplus although the consideration for the purchaser’s assumption of pension responsibilities may be computed based on the net value of surplus at the time of sale.

ECP Regime

In this case, the Purchaser reported the Surplus Amount as an ECE. Neither the Act nor the ITR expressly provide for the characterization of an amount paid by a non-sponsor in respect of surplus in an RPP. Prior to their repeal, the ECP rules in section 14 governed the tax treatment of ECEs not otherwise accounted for as business revenues or expenses or under the rules relating to capital property. The cost of ECPs was recognized for tax purposes in a pool system similar to the capital cost allowance system for depreciable property. (footnote 3)  In simplified terms, if the Surplus Amount is an ECE of the Purchaser, it would result in favorable tax treatment by increasing the Purchaser’s eligible capital pool balance and permitting either a partial deduction under paragraph 20(1)(b) or a reduction of the income inclusion that would otherwise arise under subsection 14(1) if the Purchaser’s pool balance was negative.

Essentially an ECE is a capital expenditure of an intangible nature that a taxpayer incurs to earn income from a business and which is not deductible under any other provision of the Act. (footnote 4)  More particularly, as defined in subsection 14(5), an ECE is as an outlay or expense made: (a) in respect of a business; (b) as a result of a transaction occurring after 1971; (c) on account of capital; (d) for the purposes of gaining or producing income from the business. (footnote 5) 

The ECE definition is subject to a number of exclusions. In particular and in relevant part, an ECE cannot be any of the following:

(a)   an amount that is not deductible solely because of a quantum restriction (such as exploration and development expenses limited to available income in a year under section 66);

(b)   an amount that is not deductible by virtue of a specific provision of the Act other than paragraph 18(1)(b); (footnote 6) 

(c)   an amount that is specifically deductible by virtue of any provision of the Act, such as interest expense deductible under paragraph 20(1)(c); or

(d)   an amount that is the cost of all or part of a share or an interest in a trust or similar property, or a right to acquire an interest in such property.

Relevant jurisprudence

Although there are no reported cases on the tax characterization of an amount paid in respect of pension surplus, a number of Canadian cases have considered the competing interests of employers and employees in actuarial and actual surplus in a pension plan. These cases establish that:

*    legal and equitable entitlement to pension surplus is determined according to the words of the relevant documents, using ordinary trust law principles when the pension fund is impressed with a trust or using principles of contract interpretation if there is no express or implied declaration of trust; (footnote 7) 

*    an employer cannot claim an entitlement to trust funds (including actuarial surplus) unless the terms of the trust expressly provide for it; (footnote 8)

*    if the trust documents provide that the plan is for the exclusive benefit of employees, the employees will be considered to have an equitable interest in the pension trust funds, including in any surplus remaining on wind-up; (footnote 9)  and

*    if plan funds are held in an express trust without an exclusive benefit clause, the trustee will hold legal ownership of the defined benefits, leaving employees with an equitable interest in the funds needed to cover their benefits but with no right to surplus when the plan is wound up. (footnote 10)

These cases suggest that if one party to a pension agreement (i.e., either the employer or the employees) is entitled to receive a return of surplus or a distribution of surplus when the plan is wound up, that party will be considered to have an equitable interest in the ongoing plan trust. The cases also suggest that an employer (such as the Purchaser in this case) should be considered to have an equitable interest in the plan trust if the plan documents entitle it to withdraw actuarial surplus in an ongoing plan, to apply surplus to its current contribution obligations or to claim a refund of surplus remaining in the plan on termination.

Previous CRA positions

We have considered the characterization of an amount paid or received for pension surplus in a purchase and sale situation on several previous occasions.

We generally take the position that an amount received in respect of actuarial surplus by the seller of a business or part of a business should be included in the seller’s business income, either under section 9 or under subparagraph 56(1)(a)(i) as a superannuation or pension benefit. (footnote 11)  We consider an amount paid for actuarial surplus to be a capital outlay for which no deduction is available because (i) the payment gives the buyer the right to apply surplus to current contribution obligations which is an enduring benefit to the buyer’s business and therefore incurred on account of capital; (ii) the payment is made to acquire rights to the pension surplus which represents an interest in the pension trust for purposes of the exclusion in paragraph (f) of the ECE definition; and (iii) the deduction of the payment is specifically prohibited by virtue of paragraph 18(1)(e) and subsection 78(4) for purposes of the exclusion in paragraph (a) of the ECE definition. (footnote 12) 

In light of recent jurisprudence and legislative developments in this area, we decided to review our previous positions in detail to ensure that they remain current.

Discussion

Under the regulatory regime for pensions in Ontario, plan surplus must be transferred when a business is sold and pension assets are transferred to another person. Because the parties to the ATA in this case chose to assign sponsor responsibilities to the Purchaser, there was no requirement under the PBA that consideration be paid for the Surplus Amount by the Purchaser to the Seller. More generally, the PBA and Financial Services Regulatory Authority permit a plan sponsor with a right to surplus under the plan’s document to apply surplus to contribution holidays, or to withdraw it. In both cases, however, such use of surplus is subject to a number of rigorous limits and approval processes in order to safeguard employees’ interests.

Under the case law, a pension plan sponsor is only entitled to trust funds if named as a beneficiary of the trust or if a power of revocation is reserved. In this case, the amended trust agreement permits the sponsor (now the Purchaser) to direct the trustee with respect to the distribution of plan assets, including to the Sponsor and to other plans of the Sponsor, and gives the Sponsor the ability to receive plan assets on termination or wind-up of the Plan, provided the approval and notice requirements under applicable pension legislation are met.

As a result, to the extent permitted under the PBA, the Purchaser can apply the Surplus Amount to its current service obligations, i.e., to take contribution holidays. It can also direct the trustee to pay Plan surplus to fund deficits in other plans or to return contributions on wind-up or termination of the Plan. The plan documents therefore give the Purchaser an entitlement to trust funds under certain circumstances. This is relevant because the deductibility of the Surplus Amount depends in part on whether it represents consideration paid for this equitable interest for purposes of the exclusion in paragraph (f) of the ECE definition.

Our conclusions with respect to the issues arising from your request are as follows:

Issue 1: Is the Surplus Amount an ECE of the Purchaser?

The ECE definition is complex and subject to a number of exceptions. Set out below are the elements of the ECE definition as they apply to the Surplus Amount:

(a)   Was the Surplus Amount incurred by the Purchaser on account of capital for the purpose of gaining or producing income from its business?

It is not disputed that paragraph 18(1)(b) would apply to preclude the deduction of the Surplus Amount as a current expense of the Purchaser. The Surplus Amount was paid to obtain an asset of enduring benefit to the Purchaser’s acquired business. Acquired pension surplus offsets the buyer’s contribution obligations for a number of months or years so is analogous to a capital asset. Like the surrender payments in Devon Canada Corporation v. R., 2018 TCC 170, the Surplus Amount was paid for a business income-earning purpose related to employee compensation. These requirements of the ECE definition are therefore met.

(b)   Is any portion of the Surplus Amount deductible by virtue of any other provision of the Act?

The Surplus Amount will not be an ECE if it is deductible under another provision of the Act. Paragraph 20(1)(q) and subsection 147.2(1) permit an employer to deduct contributions to an RPP subject to a number of limits and conditions. These provisions do not apply to the Surplus Amount because it was paid to the Seller, not to the Plan. There does not appear to be any other provision that clearly applies to permit the deduction of the Surplus Amount. This requirement of the ECE definition is therefore met.

(c)   Is any portion of the Surplus Amount non-deductible by virtue of any provision of the Act?

The Surplus Amount will not be an ECE if its deduction would be prohibited by another provision of the Act (other than paragraph 18(1)(b)). While there is no provision of the Act that expressly applies to prevent the deduction of an amount paid to the former sponsor of an RPP in respect of plan surplus, two provisions apply by analogy or extension.

Paragraph 18(1)(e) would apply to prohibit a deduction if the Surplus Amount is characterized as a reserve. The word “reserve” is not defined in the Act but has been described by the courts as something set aside that can be relied upon for future use. (footnote 13)  As any actuarial surplus in this case can be applied as a contribution holiday to relieve the Purchaser from its future contribution obligations for a number of months or years, the Surplus Amount may be viewed as a reserve in that it is an amount set aside that can be relied upon for future use.

The deduction of a reserve under paragraph 18(1)(e) was considered in Industries Perron Inc. v. R., 2013 FCA 176. The taxpayer purchased term deposits and hypothecated them to a bank as security against US softwood lumber duties, recording them as assets on its balance sheet. The Court said that although the taxpayer might have a future liability for duties subject to the US government’s review, the extent of its liability was unknown at the time the amounts were paid. The liability was therefore contingent, making the payments non-deductible under paragraph 18(1)(e).  Like the term deposits in Perron, the Surplus Amount was not paid once and for all. This is because actuarial surplus in the Plan may be applied against the Purchaser’s future contribution obligations and would ultimately be refundable to the Purchaser if the surplus withdrawal procedures imposed by provincial law are followed or if the Plan is terminated or wound-up.

Subsection 78(4) applies where an amount in respect of a taxpayer’s expense that is a superannuation or pension benefit, salary or other remuneration is unpaid six months after the end of the taxation year in which the expenses was incurred. In those circumstances, the amount is deemed not to have been incurred as an expense until the taxation year in which it is actually paid. Subsection 78(4) could apply generally to an employer who sponsors a defined benefit plan in that the employer would incur expenses in a taxation year for the current service benefits that accrue to employees in that year but that would not be paid until the employees retire. When surplus is used to cover the employer's current service costs, with the result that no amount is paid to the plan, subsection 78(4) of the Act would operate to prohibit the employer from claiming a deduction in respect of those expenses.

Therefore, as both paragraph 18(1)(e) and subsection 78(4) would apply to preclude the deduction of the Surplus Amount, this requirement of the ECE definition would not be satisfied.

We also note that the scheme of the Act as a whole prohibits the deduction of any amount in respect of surplus under a registered pension plan. The Act provides a strict deductibility regime for the funding of registered pension plans that effectively limits employer deductions to those amounts actually contributed to the plan in accordance with paragraph 20(1)(q) and subsection 147.2(1). Other rules in the Act and Regulations apply to limit the amount that can be contributed to a registered pension plan. Notably, paragraph 147.2(2)(d) limits the deduction for employer contributions by permitting an actuary to disregard surplus in determining employer contributions to the extent it does not exceed 25% of the employer’s actuarial liabilities. As a result, an employer will not be able to make any contributions if the plan is overfunded, which effectively compels a contribution holiday. In our view, therefore, the scheme of the Act with respect to registered pension plan contributions supports our conclusion that the Surplus Amount is non-deductible by virtue of one or more provisions of the Act.

(d)   Is the Surplus Amount part of the cost of an interest in a trust or a right to acquire an interest in a trust?

The Surplus Amount will not be an ECE if it is an amount that is the cost or any part of the cost of an interest in a trust or a right to acquire an interest in a trust for purposes of the exclusion in paragraph (f) of the ECE definition.

Pensions law jurisprudence establishes that entitlement to pension surplus must be expressly reserved when the trust is settled (as was done in this case) and suggests that an employer with an entitlement to surplus has an equitable interest in the plan trust. Paragraph (f) of the ECE definition excludes any part of the cost of an interest in a trust without any qualifications or limitations. As there is no exclusive benefit clause in the Plan documents in this case, it appears that the Seller as employer retained an equitable interest in the Plan trust fund which was transferred to the Purchaser under the APA.

In Devon, payments made to employees to surrender their stock options after a take-over bid were held to be ECEs, in part because they did not represent part of the cost of an asset for purposes of paragraph (f) of the ECE definition. As the employers who made the surrender payments did not obtain any assets or any rights to acquire future assets in return for the payments, paragraph (f) of the ECE definition did not apply to disqualify the payments as ECEs. The Court reasoned that paragraph (f) prevents a taxpayer from making or incurring an ECE when the cost of the property, such as a share or trust interest, will have tax recognition on a subsequent disposition. Where the outlay is not for a specific property that could be disposed of in the future, such as a stock option surrender payment, it would be appropriate to allow ECE treatment and inappropriate to apply paragraph (f) to deny any tax recognition of the amount paid.

Characterizing the Surplus Amount as part of the cost of a trust interest is consistent with the Devon Court’s purposive interpretation of paragraph (f) of the ECE definition. The Surplus Amount in this case could be considered a “cost” or part of the cost of an asset, i.e., an equitable or a specific interest in the Plan Trust which was acquired by the Purchaser, or a right to acquire a specific trust interest on the assignment of employer rights and obligations. It is possible that the Purchaser might dispose of the purchased business in the future, including its rights and obligations as sponsor of the Plan. In those circumstances, the Purchaser might receive additional consideration for the value of any actuarial surplus then existing in the Plan from, which it would presumably be able to subtract the Surplus Amount as the adjusted cost base of its interest. It is therefore more appropriate to apply the paragraph (f) exclusion in this case than it was in Devon where there was no possibility of a future disposition of the acquired “property.”

Notwithstanding the unusual facts in this case, we view a payment in respect of actuarial surplus in a registered pension plan without an exclusive benefit clause as the cost of or part of the cost of an equitable interest in the plan trust. On this basis, the Surplus Amount would be excluded and the final requirement of the ECE definition would also be unsatisfied.

(e)   Can the Surplus Amount can be characterized as goodwill and therefore an ECE on this basis alone?

In support of its argument that the Surplus Amount is an ECE, the Purchaser’s representative states that the Surplus Amount is similar or analogous to the goodwill of a business as described by the Federal Court of Appeal in TransAlta. In that case the Court considered whether it was reasonable for the parties to the sale of a business to have allocated an amount arising from a “tax allowance benefit” to goodwill. The energy regulator’s rate regime provided an allowance for income taxes paid by the supplier so the participation of a tax-exempt pension fund in the purchaser’s partnership structure resulted in beneficial tax-savings. The Court concluded that the recipient’s allocation of this tax allowance benefit to goodwill rather than to the purchased depreciable property was reasonable under the circumstances because it was neither a part of the seller’s goodwill nor a tangible asset. The Court did not consider, however, the tax treatment of this goodwill amount to the purchaser.

Although the Act does not expressly define goodwill, it is generally considered to be ECP to the seller of a business. (footnote 14)  The Surplus Amount in this case is somewhat similar to goodwill in that it is a residual amount XXXXXXXXXX that provides an expectation of future earnings (or at least reduced pension plan expenditures) and enduring benefits in the form of good employee relations and retention.

The fundamental characteristic of goodwill described by the Court in TransAlta, however, is that it is an unidentified intangible asset. In this case the Surplus Amount was supported by actuarial estimates and was objectively quantifiable, so was not an unidentified intangible. As noted above, pension surplus is similar to a reserve in that it represents real value that can be applied to offset the employer’s contribution obligations for a number of years. Like other identifiable assets, it fluctuates in value based on external factors such as interest rates and member life expectancy. Unlike goodwill, pension surplus can be separated from the employer’s business if, as in this case, the plan terms permit surplus to be returned to the employer when the appropriate regulatory procedures are followed.

Finally, there is no provision of the Act and no general principle that makes an amount paid in respect of goodwill deductible by the payor, unless it is an outlay or expense that fits all of the requirements of the ECE definition. Therefore even if the Surplus Amount is considered analogous to goodwill, it will not be deductible by the Purchaser because it fails to meet all of the necessary requirements of the ECE definition.

Conclusion for Issue 1

The Surplus Amount does not meet two of the requirements of the ECE definition so it cannot be deducted by the Purchaser even if it is somewhat similar to goodwill. 

As there is no other provision in the Act that could provide a deduction for the Surplus Amount, denying ECE treatment in this case results in no current tax recognition for a considerable expenditure. This somewhat harsh result is unavoidable in light of the narrow ECE definition in the Act and the purposive interpretation of paragraph (f) expressed in Devon. Practically, however, the Purchaser will be relieved from the obligation to make employer contributions to the Plan for some time, likely several years, and may also be able receive additional consideration in respect of any actuarial surplus existing in the plan in the event of a future disposition of the acquired business or a termination of the Plan.

Issue 2: Would the Surplus Amount be considered Class 14.1 property if paid after the repeal of the ECP rules?

For completeness we also considered if the new Class 14.1 rules would apply to permit a capital cost allowance (“CCA”) deduction in respect of a hypothetical amount such as the Surplus Amount if it were to be paid on or after January 1, 2017.

For taxation years beginning after 2016, the ECP regime was repealed and replaced with new rules for a new class of depreciable property, described in Class 14.1 of Schedule II to the ITR, that is generally subject to the same CCA rules as other depreciable property. The full cost of Class 14.1 property is now added to the undepreciated capital cost (the “UCC”) of the class and a deduction for CCA may be taken on a declining balance basis under paragraph 20(1)(a) at the rate of 5% (plus, until the end of 2026, an additional allowance of 2% for Class 14.1 property acquired before January 1, 2017). The stated rationale for the repeal of the ECP regime was reducing the complexity of the ECP rules and eliminating the deferral opportunity arising from the treatment of gains on the sale of ECP as active business income. 

Generally, the new rules make all ECP under the former regime depreciable property. In particular, Class 14.1 describes property held by a taxpayer in respect of a business that is (a) goodwill; (b) property that was ECP of the taxpayer immediately before January 1, 2017 or (c) property acquired after 2016 that does not fall into specific exclusions. These exclusions, which are described using language that is nearly identical to that used to describe the ECE exclusions, are tangible property; property not acquired for an income-producing purpose; property in respect of which any amount is otherwise deductible or non-deductible; interests in a trust or partnership; shares and other choses in action,; and rights to acquire such property. Class 14.1 property is therefore a residual class of business property that (like ECP) excludes expressly deductible and non-deductible property as well as securities and similar properties the cost of which would be recognized for tax purposes on a future disposition.

The new rules do not provide an express definition of “goodwill” so earlier judicial and CRA interpretations of the term presumably continue to apply, and certain additional amounts are now deemed to be goodwill under the new rules. In particular, under subsection 13(35), a taxpayer is deemed to acquire goodwill when incurring an outlay or expense on account of capital for an income-producing purpose if no portion of the amount is (a) the cost of a property; (b) otherwise deductible; (c) otherwise non-deductible (other than by virtue of paragraph 18(1)(b)); or (d) and (e) are paid to a creditor or a shareholder, partner or beneficiary of the corporation. If these conditions are met, the cost of that acquired goodwill, which is Class 14.1 property, is deemed to be equal to the amount of the outlay.

Applying these new rules we concluded that the hypothetical Surplus Amount would not be Class 14.1 property as it would not meet any of the three alternate definitions. In particular, it would not be goodwill under the common law for purposes of paragraph (a) of Class 14.1 because, as outlined above, it is not an unidentified intangible asset. As it would be acquired after January 1, 2017 if would not meet the paragraph (b) definition. Finally, it would fail subparagraph (iv) of paragraph (c) of Class 14.1 because it would be an amount not otherwise deductible under either paragraph 18(1)(e) or subsection 78(4) for the reasons set out above.

The hypothetical Surplus Amount would also not be deemed goodwill because it would fail two of the conditions subsection 13(35). First, it would fail the condition in paragraph 13(35)(a) because it would represent the cost of a property. The word “property” is broadly defined in subsection 248(1) and includes a right of any kind whatever. The right to apply actuarial surplus to contribution obligations under a defined benefit pension plan would be considered property under this definition. It would also fail the condition in paragraph 13(35)(c) in that, as outlined above, it is not otherwise deductible because of paragraph 18(1)(e) or subsection 78(4).
Consequently, it is our view that even if the Purchaser’s transaction had occurred after 2016, the Surplus Amount would be considered neither Class 14.1 property nor deemed goodwill under subsection 13(35).

VI. CONCLUSION

Based on our review of the facts and of the relevant legislation and case law outlined above, we agree with your view that the Surplus Amount is not an ECE of the Purchaser. We are also of the view that the new Class 14.1 rules would not apply if the Purchaser’s transaction had occurred after 2016. 

Unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. After a 90-day waiting period, a severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. You may request an extension of this 90-day period. The severing process removes all content that is not subject to disclosure, including information that could reveal the identity of the taxpayer. The taxpayer may ask for a version that has been severed using the Privacy Act criteria, which does not remove taxpayer identity. You can request this by e-mailing us at: ITRACCESSG@cra-arc.gc.ca. A copy will be sent to you for delivery to the taxpayer.

We trust these comments will be of assistance.

Yours truly,

Dave Wurtele
Section Manager
For Division Director
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1   XXXXXXXXXX.
2   Rodney Bergen, “Purchase and Sale of Assets: An Update”, 1996 Corporate Management Tax Conference, 3:1-23. Mr. Bergen notes that an amount paid by the purchaser for surplus in the seller’s pension plan is in the nature of a prepaid expense but since such expenses are non-deductible and since subsection 147.2(1) and 20(1)(q) only permit deductions for amounts actually contributed to the plan, the amount could be considered to form part of the business’ goodwill and be added to the purchaser’s cumulative eligible capital.
3  October 2016 Department of Finance Technical Note to Bill C-29 which repealed section 14 as of January 1, 2017.
4  Krishna, The Fundamentals of Income Tax Law (Thomson Reuters, 2009) at 9:3.
5  See paragraph 2 of IT-143R3, “Meaning of Eligible Capital Expenditure”.
6  Paragraphs 18(1)(h), prohibiting the deduction of personal expenses, and 18(1)(l), prohibiting the deduction of club memberships, are two commonly cited examples of provisions that would cause an outlay not to be an ECE if incurred on capital account.
7  Professional Institute of the Public Service of Canada v. Canada (Attorney General), 2012 SCC 71 at paras. 57-8 citing Burke v. Hudson’s Bay Co., 2010 SCC 34.
8  See Nolan v. Kerry, 2009 SCC 39 at para. 58 citing Schmidt v. Air Products Canada, [1994] 2 SCR 611 for the principle that a transfer of property to a trustee is absolute unless made subject to a power to revoke or control the trust.
9  Burke at para. 72; Schmidt at pp. 655-6.
10  Burke at para. 57.
11  2008-029492 and 2007-0256401I7.
12  2008-029651 and 2002-0118835.
13  Crane Ltd. v. M.N.R.,  [1961] Ex. C.R. 147.
14  As outlined in IT-143R2, “Meaning of eligible capital expenditure” and IT-386R, “Eligible Capital Amounts”, the CRA’s long-standing position that a seller’s goodwill is ECP, the disposition of which results in the receipt of an ECA. During the Taxation Year, “goodwill amount” was defined in section 56.4 to refer to the ECE definition in subsection 14(5).

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