June 5, 2015
A PDF copy of this Newsletter is available HERE.
ITC Allocation Method – Back to Where We Started
Martin Goguen, CPA, CA, Tax Recovery Services, MRSB Group, DFK Affiliate Firm
The Excise Tax Act generally allows taxpayers to recover tax incurred for the purpose of making taxable supplies. As tax professionals we are often asked to review the apportionment method used to allocate input tax credits between commercial and non-commercial activities. The ETA requires that the apportionment method used be fair and reasonable and used consistently throughout the year. The Act, however, does not prescribe any particular method for allocation, leaving it up to the registrant to determine how to allocate between these two activities. Moreover, the courts have held that the registrant can choose any method that is “fair and reasonable”, even if another method might be more fair or more reasonable.
The issue of apportionment has always been contentious as a small change in the allocation can result in large reassessments or refunds. During the 2006 CICA Commodity Tax Symposium, the CRA announced it would no longer allow ITCs for past reporting periods based on a change in allocation method, much to the surprise of the attending tax professionals. The CRA’s policy was that unless an error had been made, once a fair and reasonable allocation method had been applied to a particular year, the taxpayer could not retroactively change that method for another, more favourable method and claim additional ITCs.
When the CRA disallowed the $1 million ITC claimed by CIBC World Markets (CWM) after a retroactive adjustment to an allocation method, the matter eventually found itself in front of the Tax Court of Canada. The Court agreed with the CRA’s position, stating that if the initial claim was fair and reasonable, it would be “perverse” and detrimental for “fiscal certainty” if a registrant retroactively changed its allocation method.
This decision would ultimately prove irrelevant for financial institution like CWM. In July 2010, a new section of the ETA was enacted to require financial institutions to use CRA approved apportionment methods that cannot be changed without written consent of the Minister. It is somewhat ironic that these new rules were enacted retroactively to 2007.
Nevertheless, CWM appealed the decision to the Federal Court of Appeal in 2011. The FCA reversed the lower court’s decision and allowed the retroactive ITCs. The court stated that the CRA’s policy would essentially turn the act of filing a tax return into one of making an “irrevocable election” to use a particular method, and if such a result was intended, the legislation would clearly say so. Furthermore, the FCA stated that the ETA required only consistency throughout the year and does not prevent the apportionment method from being changed from one year to the next but rather from one period to another with the same fiscal year.
We still occasionally encounter clients who, either as a result of a ruling, audit or reassessment received between 2006 and 2011, are unaware of this policy change. This strong FCA court decision however confirms that taxpayers who are in the business of making both taxable and exempt supplies, other than financial Institutions, are indeed entitled to review their ITC allocation method annually, and if an improvement can be made, claim additional ITCs retroactively provided that they are made within the normal limitation period of 4 years. In the end, we are back to where we started.
When is the Right Time to Sell Your Business?
Craig Maloney, MBA, CA, CBV, Partner, WBLI Chartered Accountants, Halifax, NS, DFK Affiliate Firm
For the past five years (or more), we have anticipated a flood of business owners exiting their businesses. According to a 2012 Canadian Federation of Independent Business (CFIB) study, close to half of small and medium sized enterprise (SME) owners planned to exit their business in the next five years; a dramatic increase from the 2006 CFIB survey when one-third of businesses were in the same position.
Another study shows similar statistics: 6 in 10 private companies in Canada will change ownership structures within the next decade. (CICA/RBC Business Monitor Survey, 2010) Despite these promising stats, there has been an underwhelming absence of actual buy and sell activities among SMEs over the past several years.
The flood is coming, as baby boomers are approaching 70…
According to Industry Canada, baby boomers, or those born between 1946 and 1966, accounted for approximately 7 out of 10 SME business owners in 2004. In 2010, more than 60% of SMEs were controlled by an owner aged 50 or older; thus, the number of business owners seeking an exit option is very likely to increase in the near future. (“The State of Entrepreneurship in Canada” Industry Canada. February, 2010.)
A few reasons for the lack of business transitions in the past few years include the following:
- the economic downturn of 2008-09 delayed the exit date of many SME owners, as their personal RRSP / investment portfolios were hit, business valuations were down, and lending was tougher to access;
- SME owners are not clear on how to begin the process of transitioning their businesses. People generally know how to sell a house; but selling a business is a much more complex process.
- Business owners are struggling to identify successors who will maintain the legacy of the business and the culture. In many cases, the business owner has operated the business for 20 plus years – transitioning such a business can give rise to protective sentiments akin to those felt when considering an appropriate spouse for your offspring.
- Understanding what the business is worth and knowing what to do after retirement / the sale of the business. Some owners will confuse ‘what they need to retire’ vs. ‘what the business is worth’. It is important to have realistic expectations of the value of a business.
While businesses are changing hands quietly and confidentially in Canada via transitions to family members, management buyouts, and private company transactions, the level of transactions has not neared the ‘flood level’ … yet. The data shows that a mass transition of businesses should be occurring in the next few years.
What are your exit options?
Business owners need to transition their business in some form, at some point. There are four real options to exit:
- Winding up the business is not an attractive alternative in most cases. Drastic events, such as health issues or death aside, proper planning should mitigate the need to windup a business.
- Transitioning to family members is occurring, but it is less common. Fewer family members are stepping up to continue the family business. Generally speaking, the children of baby boomers are less likely to take over the family business, and they face less pressure from their parents to do so. Only one-third of family businesses are successfully transferred to the next generation, and a mere 13% are passed on to the third generation. (Family Firm Institute Inc.)
- Transitioning to a management team is a good, viable option for many companies. A few factors are key to a successful MBO:
- the business has to be big enough to employ a capable management team;
- the knowledge and relationships should be shared with the management team;
- management should actually purchase as much as feasible in order to have ‘skin in the game.’
- Selling to an outside party. The greatest number of buyers exists within the ‘outside party’ group which includes entrepreneurs, other companies, and private equity groups. For owners, selling to an outside party is a very feasible and attractive alternative for quality businesses. Some owners will consider partial sale options that allow them to retain some ownership during a transition period (this can be an easier pill to swallow than simply ‘handing their child over’).
There is a potential downside to the expected course of events over the next several years: the vastly increased supply of SME businesses available might lead to a dramatic increase in companies for sale which would likely drive down valuations and give new leverage to buyers.
Succession Planning is a Process, not an Event
Business owners are generally responsible, organized and forward looking people; planning for the succession of their business should be high on their list of things to do. However, according to a 2012 CFIB survey, less than 10% of SME owners have a formalized business succession plan.
It is important to plan the transition process. An effective succession plan is put in place one to five years before the eventual transition of ownership. It is too late to capture value or appropriately plan when a significant health issue or significant business issue occurs.
Each transaction and business valuation is unique. Having good advisors can simplify the process. WBLI can help you prepare for an eventual transition and help make your business more attractive to prospective buyers. We have the knowledge and skillset to identify your business’ key value drivers and will provide you with a roadmap of how to leverage those drivers.
Perhaps no other area of the accounting profession changes as often as taxation.
At WBLI LLP, we are committed to understanding our clients’ tax needs—
both from a corporate and personal tax perspective.
THE INFORMATION PROVIDED IN THIS PUBLICATION IS INTENDED FOR GENERAL PURPOSES ONLY. CARE HAS BEEN TAKEN TO ENSURE THE INFORMATION HEREIN IS ACCURATE; HOWEVER, NO REPRESENTATION IS MADE AS TO THE ACCURACY THEREOF. THE INFORMATION SHOULD NOT BE RELIED UPON TO REPLACE SPECIFIC PROFESSIONAL ADVICE.