commercial real estate transactions capital gains-income tax considerations 11 june 2009

Commercial Real Estate Transactions

Capital Gains-Income tax considerations

11 June 2009

22 May, 2008 Presentation title Commercial Real Estate TransactionPage 2

Agenda

► Capital gain or business income► What is a capital gain?

► Reducing Current Cash Outflow► Capital gains reserve► Replacement property rules► Capital gains exemption

► Unexpected cash taxes► Allocating purchase price between land and building

► Questions


Presenters

Ian M. Sherman, FCA, Tax Partner, Ernst & YoungIan manages our Ottawa Office Tax Practice of over 50 professionals and is a Tax Account Leader coordinating and facilitating services to several of Ernst & Young’s local and multinational clients.

Grant Smith, CA. Tax Senior Manager, Transaction Advisory Services, Ernst and Young

Grant specializes in tax matters with respect to significant or large transactions. He advises his clients on tax considerations of mergers and acquisitions, corporate reorganization and other significant transactions such as sales of major assets.


Capital Gain or Business Income We will discuss

General overview of capital gains and tax rates

What is a capital gain?► What the Courts have said:

► Primary intent► Doctrine of secondary intention► Direction the Courts are moving► Factors used to evaluate intent

► What Canada Revenue Agency has said.

► What to do to have the best results with the Tax Authorities.


Capital Gain or Business Income Overview

► Capital gains or business income► Question of fact► Governed by common law► No guidance in the Income Tax Act

► Taxpayers bias► Capital gains are 50% tax free.► Business income fully taxed but business losses can be

deductible against other income.


Capital Gain or Business Income Tax Rates

Estimated 2009 Tax Rates- combined Federal and Ontario

Business Capital GainIndividual 46% 23%

Corporate/personal* 46% 29% (Income distributed to shareholder)

Corporate** 16.5% 31%(Income not distributed)

Corporate/personal*** 53% 29%(Income distributed to shareholder)

* Earned in a Canadian Controlled Private Corporation ( CCPC) and distributed to shareholder as dividend.** Earned in a CCPC eligible for small business deduction.*** Earned in a Corporation not eligible for small business deduction and income distributed to shareholder as a dividend


Capital Gain or Business Income Tax optimization

What do the numbers mean?

► Slightly more tax effective to earn capital gains directly as an individual.

► Approximate 6% tax leakage to earn capital gains through a corporation and distribute after tax cash as dividends.


Capital Gain or Business Income What is a Capital Gain?

What the Courts have said:

► Primary intent = The intention of the taxpayer at the time the property was purchased determines if the sale results in business income or capital gains.

► Evidence includes:► Sworn testimony► Deduced from the taxpayers entire conduct



What the Courts have said:

► Doctrine of secondary intention

► If the primary intended use does not get realized the Court will at times look to the secondary intent.

► Secondary intent could support income or capital.



► The doctrine of secondary intention has been examined by the courts on a number of occasions, and from these decisions it is clear that:

► not only must the thought of a sale at a profit be present at the time of the acquisition of the property,

► the prospect of a sale must have been evident as an operating motivation to acquire the property.



Direction the Courts are moving

► The Courts are moving away from the doctrine of secondary intent.

► Why: Everything is for sale at the right price.

► Courts place burden on CRA to prove secondary intent.



Factors used to evaluate intent

► The taxpayer's intention with respect to the real estate at the time of its purchase.

► Feasibility of the taxpayer's intention.► Geographical location and zoned use of the real estate acquired.► Extent to which intention carried out by the taxpayer.► Evidence that the taxpayer's intention changed after purchase of

the real estate.► The nature of the business, profession, calling or trade of the

taxpayer and associates.



Factors used to evaluate intent► The extent to which borrowed money was used to finance the

real estate acquisition and the terms of the financing, if any, arranged.

► The length of time throughout which the real estate was held by the taxpayer.

► The existence of persons other than the taxpayer who share interests in the real estate.

► The nature of the occupation of the other persons referred to above as well as their stated intentions and courses of conduct.

► Factors which motivated the sale of the real estate.► Evidence that the taxpayer and/or associates had dealt

extensively in real estate.



What the Canada Revenue Agency has said:

► Interpretation Bulletin 218R: Capital gains and losses from sale of real estate, including farmland and inherited land and conversion of real estate from capital property to inventory and vice versa.

► Very consistent with the Courts however….



Our experience with Canada Revenue Agency:

► The CRA’s position is that even if a taxpayer’s primary intention was to hold a property as an investment, if the taxpayer also had, at the time of acquisition, a secondary intention of selling the property for a profit, the gain should be business income and not a capital gain.

► Considerable weight is placed on:► The nature of the property.► The length of time it was held.► Other business dealings of the taxpayer.



Our Recommendation:

► Keep detailed documentation prepared at the time of purchase and at key decision points which evidences the intended use of the property.

► The better the documentation, the better chance you will be successful with the tax authorities.


Where we are and what’s to come




► Questions


Reducing current cash outflow

Capital Gains Reserve► When it applies:

► Where all or a portion of the sale proceeds are not payable until after the end of the year.

► Who qualifies:► Taxpayer can not be a non-resident.► Transaction can not be with a related party.

► How does it work?► Based on a formula the gain can be recognized in income over 5

years, i.e. lesser of 20% per year or by formula based on unpaid proceeds.


Capital Gains Reserve Example

► In Year 1, A. Co realized a capital gain of $30,000.

► Proceeds of sale were $50,000.

► 10% of proceeds, $5,000, were payable on closing.

► $20,000 due and payable in Year 2.

► The remaining $20,000 due and payable in year 3.



Year 1Capital Gain $30,000

Reserve: Lesser of A and B

► Gain/proceeds X proceeds payable after year end $30,000/$50,000 X$45,000 = $27,000 (A)

► 80% of gain = $24,000 (B)

Capital Gains ReserveLesser of A and B = $24,000

Capital gain included in income$30,000-$24,000 = $6,000



Year 2Capital Gain ( prior year reserve) $24,000


► Gain/proceeds X proceeds payable after year end $30,000/$50,000 X$22,500 = $13,500 (A)

► 60% of gain = $18,000 (B)

Capital Gains ReserveLesser of A and B = $13,500

Capital gain included in income$24,000-$13,500 = $10,500



Year 3Capital Gain ( prior year reserve) $13,500


► Gain/proceeds X proceeds payable after year end $30,000/$50,000 X $0 = $ 0 (A)

► 40% of gain = $12,000 (B)

Capital Gains ReserveLesser of A and B = $0

Capital gain included in income$13,500-$ 0 = $13,500



Replacement property rules:► Capital gain on the disposition of the former property can be

deferred if the replacement property is:► Same or similar as former property.► The replacement property is acquired:

► Voluntary disposal – within 12 months of the year end.► Involuntary disposal- with 24 months of the year end.

► Gain is deferred to the extent proceeds from the former property are used to purchase the replacement property.

► Does not apply to rental properties.

► A tax election (form) is required.



Replacement Property Rules Example► Land is sold for $100,000 resulting in a $25,000 gain► A replacement property is purchased for $80,000

► Gain is lesser of A. Gain $25,000 (A)

B. Proceeds of former property $100,000 Less cost of replacement property $ 80,000

$ 20,000 (B)Gain included in taxable income $20,000



Capital gains exemption

► What is it: $750,000 of tax free capital gains.

► How to get it: Capital gain must be realized on a qualifying small business corporation.

► The rules: Complex even for tax specialists but real estate can qualify. Professional tax advice is always recommended when considering if a transaction might qualify for the capital gains exemption.


Reducing current cash outflowCapital gains exemption: High level overview

To qualify: Shares must be sold of a Small Business Corporation

Small Business Corporation is:► Generally, a Canadian Controlled Private Corporation► 90% of the value of the assets relate to:

► Asset used primarily in an active business in Canada.


Reducing current cash outflow Capital gains exemption: High level overview

Active Business is defined to be a business carried on which is not a specified investment business or a personal services business.

Specified Investment Business is a business with less than 5 employees and which earns its income primarily from property (i.e. rents).

Therefore:► The sale of the shares of a specified investment business would not

qualify for the capital gains exemption.

► The sale of an individual piece of real estate would not qualify for the capital gains exemption.


Reducing current cash outflow Capital gains exemption: High level overview

Qualifying for the Capital Gains Exemption, an example:

► Mr A is a Canadian resident and owns 100% of the shares of A. Co.

► ACo has been operating for many years and has consistently owned the same 10 rental properties.

► ACo has no other assets on the balance sheet other than the 10 rental properties.

► The business requires 6 full time employees to manage the rental properties.

In this fact pattern, it is likely that on the sale of the shares of Aco. Mr A could qualify for the capital gains exemption.


Where we are and what’s to come




► Questions


Unexpected cash taxes

Reallocation of Proceeds of Disposition

► When does it apply: ► On the sale of land and building, a taxpayer has:

► A business loss on the building, (i.e. a terminal loss).► A capital gain on the land.

► What happens:► The tax rules reallocate the proceeds of disposition to reduce the

business loss thereby reducing the taxpayer ability to shelter other business income.


Unexpected cash taxes Reallocation of Proceeds of Disposition

Allocation by taxpayer Land Building Total

Proceeds of disposition $ 1,000,000 $ 300,000 $ 1,300,000

ACB/UCC $ 700,000 $ 400,000 $ 1,100,000

Gain/(Loss) $ 300,000 $ (100,000) $ 200,000

Income Inclusion/deduction $ 150,000 $ (100,000) $ 50,000


Unexpected cash taxes Reallocation of Proceeds of Disposition

Allocation by tax rules Land Building Total

Proceeds of disposition $ 900,000 $ 400,000 $ 1,300,000

ACB/UCC $ 700,000 $ 400,000 $ 1,100,000

Gain/(Loss) $ 200,000 $ - $ 200,000

Income Inclusion/deduction $ 100,000 $ - $ 100,000

Questions

Ian [email protected]

Grant [email protected]

Thank You

Ian [email protected]

Grant [email protected]

commercial real estate transactions capital gains-income tax considerations 11 june 2009

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