2020-0841791I7 Application of paragraph 111(4)(e)

Principal Issues: 1) Whether the designation under paragraph 111(4)(e) could be made with respect to internally generated goodwill? 2) Whether a capital loss would be realized with respect to a loan receivable from a controlled foreign affiliate? 3) Whether the designation under paragraph 111(4)(e) could be made with respect to class 12 property?

Position: 1), 2) and 3): Yes.

Reasons: According the law and previous positions.

Author: Ouattara, Sidi
Section: 111(4)(e)

                                                                               May 19, 2020

Small and Medium Enterprises                              Income Tax Rulings Directorate
  Directorate                                                           S. Ouattara    
                                                                               (450) 926-7687
Attention:  Minguy Choi
Senior Technical Specialist

                                                                               2020-084179

Technical interpretation of paragraph 111(4)(e) with respect to goodwill

This is further to your request for assistance concerning the designation under paragraph 111(4)(e) of the Income Tax Act (the “Act”) with respect to internally generated goodwill.

Unless otherwise stated, all statutory references are to the Act.

BACKGROUND

Our understanding of the facts is as follows:

XXXXXXXXXX (the “Taxpayer”) is a taxable Canadian corporation controlled by XXXXXXXXXX, a publicly traded corporation listed on the XXXXXXXXXX.

XXXXXXXXXX

XXXXXXXXXX

In computing the adjusted cost base (“ACB”), to the Taxpayer, of the loan receivable from one of its controlled foreign affiliate (the “Loan”), the Taxpayer deducted the amount by which the ACB, to the Taxpayer, of the loan (i.e. XXXXXXXXXX) exceeded its fair market value (“FMV”) (i.e. XXXXXXXXXX) pursuant to paragraph 111(4)(c).  The amount of XXXXXXXXXX was deemed to be a capital loss of Taxpayer pursuant to paragraph 111(4)(d).

The Taxpayer designated – in its return of income for the taxation year that ended on XXXXXXXXXX – the following capital property pursuant to paragraph 111(4)(e):

*    Class 12: intellectual property;

XXXXXXXXXX

*    Class 14.1: customer relationship;

XXXXXXXXXX

*    Class 14.1: goodwill.

XXXXXXXXXX

YOUR QUESTIONS

1)    Whether customer relationship and/or goodwill arises as a recognizable asset only when a business is acquired or can be internally generated with no cost immediately before the acquisition of control occurred?  Can a capital property be created with no cost before the acquisition of control?  If so, is it consistent with the view stated in paragraph 6 of IT-143R3?

2)    If so, then, customer relationship or/and goodwill would be classified as CCA class 14.1 (cost is nil and FMV to be determined per valuation); if so, there is a capital property to file the election under 111(4)(e).  In this case, the determination of FMV would be an issue (per valuation section).

3)    If not, there would be no capital property to file the election under 111(4)(e); in order to file an 111(4)(e) election, a capital property should exist.

4)    When the FMV of the Loan would be XXXXXXXXXX (the Loan would have become uncollectible), would it trigger a capital loss when the change in control occurred?

5)    Class 12 - intellectual property: Could the UCC of class 12 be increased, based on the valuation only, if it was not acquired or added with no cost immediately before the change in control occurred?

OUR COMMENTS

General Comments

A taxpayer that is a corporation is subject to a loss restriction event where control of the corporation is acquired by a person or a group of persons as per paragraph 251.2(2)(a).

Under paragraph 249(4)(a), where at any time a taxpayer is subject to a loss restriction event, the taxation year of the taxpayer is deemed to end immediately before that time and a new taxation year of the taxpayer is deemed to begin at that time.

Where control of a corporation is acquired by a person or group of persons, the net capital losses of the corporation for taxation years ending before control was acquired cannot, by virtue of paragraph 111(4)(a), be carried forward to any taxation year ending after control was acquired.  Similarly, the net capital losses of the corporation incurred in a taxation year ending after control was acquired, cannot by virtue of paragraph 111(4)(b) be carried back to a taxation year ending before control was acquired.

Where the ACB of non-depreciable capital property of a corporation exceeds its FMV immediately before the time that control of the corporation is acquired, such excess is required to be deducted from the ACB of that property by virtue of paragraph 111(4)(c).  The excess is deemed to be a capital loss of the corporation by virtue of paragraph 111(4)(d) for its taxation year deemed to end immediately before the acquisition of control.

Paragraph 111(4)(e) allows a taxpayer under certain conditions to recognize, unrealized capital gains on depreciable and non-depreciable capital property.  The taxpayer may designate any amount between the ACB and FMV of the property as the proceeds of disposition, and the property is deemed to be reacquired at a cost equal to the elected proceeds.  This election may help to offset net capital losses carried forward that would have become non-deductible after the change in control event and any unrealized losses that were deemed to be realized.

Comments with respect to questions 1, 2 and 3

Subsection 248(1) defines the term “property” for the purposes of the Act as property of any kind whatever whether real or personal, immovable or movable, tangible or intangible, or corporeal or incorporeal and includes in paragraph (e) of that definition the goodwill of a business, as referred to in subsection 13(34).

Subsection 13(34) contains rules that apply to a property that constitutes goodwill. Particularly, paragraph 13(34)(a) states, among other things, that where a taxpayer carries on a particular business, there is deemed to be a single goodwill in respect of the particular business.

Finance explanatory notes which provide guidance on the new rules stated the following:

“Consequential on the repeal of the ECP rules and the creation of new Class 14.1 of depreciable property, new subsection 13(34) provides rules for determining the cost of goodwill acquired and disposed of.  It is necessary to determine the cost of the goodwill of a business in order to calculate capital gains, the undepreciated capital cost balance of the new class, and the recapture of depreciation previously claimed”.

Furthermore, Finance explanatory notes mention that subsection 13(34) is intended to recognize that goodwill is not a separately identifiable property and can only be disposed of as part of the sale of a business as a going concern.  This is consistent with paragraph 6 of Interpretation Bulletin IT-143R3 “Meaning of Eligible Capital Expenditure”, August 29, 2002 (“IT-143R3”):

“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”.

Consequently, since January 1, 2017, even if goodwill in respect of a business of a taxpayer cannot be divorced from the business itself, it is nevertheless a depreciable property of class 14.1 and is therefore a capital property to the taxpayer.  Paragraph 111(4)(e) allows a taxpayer to designate an amount in respect of any capital property of the taxpayer, including its goodwill.

However goodwill is not defined in the Act.  Paragraph 5 of IT-143R3, explains that goodwill has often been defined by the Courts as the whole advantage of the reputation and connection of the firm which may have been built up by years of honest work or gained by lavish expenditures of money or the privilege, granted by the seller of a business to the purchaser.

In defining the notion of goodwill, the Federal Court of Appeal in Transalta Corporation v. Canada (footnote 1) stated the following: 

“As noted at the outset of these reasons, three characteristics must be present in order for goodwill to be found: (a) goodwill must be an unidentified intangible as opposed to a tangible asset or an identified intangible such as a brand name, a patent or a franchise; (b) it must arise from the expectation of future earnings, returns or other benefits in excess of what would be expected in a comparable business; (c) it must be inseparable from the business to which it belongs and cannot normally be sold apart from the sale of the business as a going concern. If these three characteristics are present, it can be reasonably assumed that goodwill has been found

An established reputation, customer satisfaction, a unique product or process leading to a monopolistic position, good or astute management, favourable location, manufacturing efficiency, harmonious labour relations, advertising, quality of products, and financial standing have all been found to constitute goodwill insofar as they meet the three characteristics: Durnford at pp. 772-773.”

Based on the above, it is assumed that the goodwill and the customer relationship, which were subject of the designation under paragraph 111(4)(e) by the Taxpayer, constitute a single property, being the goodwill in respect of the Taxpayer’s business.

In document 2017-0709141C6, our Directorate has confirmed that a designation pursuant to paragraph 111(4)(e) can be made with respect to internally generated goodwill.  That document still reflects our position in that respect.

Comments with respect to Question 4

Where the ACB of non-depreciable capital property of a corporation exceeds its FMV immediately before the time that control of the corporation is acquired, such excess is required to be deducted from the ACB of that property by virtue of paragraph 111(4)(c).  The excess is deemed to be a capital loss of the corporation by virtue of paragraph 111(4)(d) for its taxation year deemed to end immediately before the acquisition of control.

Paragraphs 111(4)(c) and 111(4)(d) would be applicable to a Loan if it were held as capital property by the Taxpayer.  Whether or not a property is held as capital property is a question of fact to be determined after a complete review of the facts and circumstances surrounding a particular situation.

Comments with respect to Question 5

A taxpayer may designate under paragraph 111(4)(e) any amount between the ACB and the FMV of property, including intellectual property included in class 12, as proceeds of disposition, and this property is deemed to be reacquired at a cost equal to the elected proceeds.

If the capital cost of the property exceeds the elected proceeds, for the purposes of sections 13 and 20 and any regulations made under paragraph 20(1)(a), the capital cost of the property will be deemed to be the capital cost immediately before the deemed disposition, and the excess will be considered to have been allowed to the corporation as capital cost allowance.

We trust our comments will be of assistance to you.

Yours truly,

Jean Lafrenière, LL. B, LL. M. Fisc.
Manager
for the Director
Reorganizations and Resources 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  2012 CAF 20, paragraphs 54 and 55.

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