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March 2009 - Steven Araki, CA - David Metzger, CA
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March 2009 - Steven Araki, CA - David Metzger, CA

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Replacement Property Rules - KPMG

Replacement Property Rules - KPMG

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  • As David mentioned, the replacement property rules are a form of tax deferral Tax deferral is probably the most common objective in any tax planning. Can be done by: Deferring income With the theory of integration, the small business deduction On a sale of shares, paying a safe income dividend (within the limits to avoid S. 55(2), as David mentioned) Reserves, for when you recognize the income but not all the proceeds are received (20(1)(n) for income and (40(1)(a)(iii)) for capital) – the timing of the tax liability follows the cash flow The replacement property rules to some degree also follow the cash flows, in that you dispose of a property and then take that cash and reinvest it. By reinvesting it appropriately, you defer the tax liability Today’s presentation discusses the RPR apply towards capital assets. There’s also special RPR that apply to small business shares – S.44.1 (post Oct17/00)
  • Disaster – fire, or acts of mother nature, or basically anytime something happens that entitles you to insurance proceeds These are what are classified as involuntary dispositions Relocating your business is another scenario where RPR can be used; this is what’s classified as a voluntary disposition
  • amount has become receivable – pretty self explanatory that there was a disposition that entitled you to some sort of proceeds, whether they’re sale proceeds, insurance proceeds, etc. a replacement property is acquired in the required time – the time depends on whether it was voluntary or involuntary. As you would expect, the rules are more lenient when it’s involuntary These provisions are elective, so a taxpayer needs to make the appropriate election in their tax return. I’ll explain how and when to make the election later.
  • The requirements for a replacement property As the name implies, it is meant to replace the former property. This is a purpose test. There must be a correlation between the disposition of the former property and the acquisition of the replacement. it should have the same or similar use as the former property – David will elaborate on this point later where applicable, it has to be used in a same or similar business – David will elaborate on this point as well later
  • As previously mentioned, there’s basically two types of dispositions involuntary dispositions can be any type of capital asset (including equipment, personal use assets, etc.). David will provide some additional comments on that later. taken under statutory authority (or intention to be taken). As an example of that, when the City of Abbotsford started making plans to build the new entertainment and sports centre and they had to purchase all the land, even though I don’t believe it got to the point where they expropriated the property, my understanding was that they did make it clear that it could come to that if necessary. So those land owners could have used the RPR replacement must be acquired within 24 months following the year of disposition (in other words by the end of the 2 nd taxation year following). For voluntary dispositions, it has to involve a “former business property”, which is a capital real property used primarily for the purpose of gaining or producing income from a business (that’s the key here). It excludes rental properties which means real property used to gross revenue that is rent ...
  • So as previously mentioned, you need to make an election to use the RPR. The timing of election is dependant on when the actual replacement property is acquired. If the disposition and replacement take place in the same year, then by simply filing the tax return with the correct calculations in it, that constitutes making the election. However, since you’re not making any explicit statements about using the RPR, it may be subject to followup questions from CRA, for example, if you’re showing a disposition with no gain/loss and they don’t recognize that the RPR are being used A replacement can in fact be acquired before the disposition of the former property, and David will talk about that a bit later. In that case, the election is make by attaching a letter to the tax return in the year acquired. However, if it’s evident that the new property qualifies as a replacement, you can file it instead in the subsequent year of disposition. There’s also the option of using the Taxpayer Relief Provisions to late file the election (ie. the Fairness provisions). The point is that CRA is somewhat lenient on allowing this election to be filed late where all the conditions are otherwise met.
  • So in the example, the taxpayer receives $550K proceeds, and spends all $550K towards a replacement property. So as I discussed earlier, it would be nice if the taxpayer can defer the tax liability, since he doesn’t actually have any of the proceeds available to pay the taxes.
  • So with the capital gain on the land, the simple way of looking at it is that the taxpayer received $425K of proceeds, but then purchased a replacement for $400K, so there’s $25K that he didn’t reinvest. This $25K therefore becomes the capital gain the taxpayer realizes. The other $150K of capital gain that was deferred reduces the ACB of the replacement land, so instead of being $400K, it’s only $250K.
  • So with the building, the taxpayer received $125K as proceeds, but then bought a replacement for $150K. Because the taxpayer spend more than the proceeds he received, the $50K of recapture is being deferred. But then instead of having a UCC of $150K for the replacement, then the UCC gets reduced by the deferred recapture, so the UCC is only $100K. In fact, as long as the taxpayer spent at least $50K on the replacement, then recapture would have been avoided (but then there’s be no UCC going forward). One thing to note is that if the replacement was acquired in the same year as the disposition and both assets are part of the same pool for the UCC class, then you’d get this same result anyway.
  • So in this example, without the RPR you’d have a total income inclusion of $137,500, being 50% of the capital gain of $175K plus the $50K recapture. With the RPR, you can reduce that income inclusion to $12,500. So you’re deferring $125K of income (which is 50% of the capital gain of $150K and the $50K recapture). That deferral is built in the lower ACB on replacement land and the lower UCC for the replacement building.
  • So while that example results in a very good tax deferral, there was still a $25K capital gain being realized. If you recall, the taxpayer in the example actually reinvested 100% of the proceeds, so it would be nice if all of the taxes could be deferred. This is where 44(6) could potentially help. This section applies were there’s a former business property disposed of that was land and building. It allows you to potentially reallocate the proceeds between the land and buildings, for purposes of determining the capital gain. Basically, the amount that can be reallocated from one part is be up to the amount by which the proceeds of that part exceeds the ACB of that part (ie. the amount of the gain on the capital asset). It doesn’t apply to recapture, since recapture is only when proceeds is between ACB and UCC. It’s useful because it allows you to reallocate the proceeds to match how the replacement property costs were allocated, which maximizes the deferral opportunities (whether that’s eliminating a gain otherwise being realized, or by minimizing the grind to UCC of a replacement property by allocating less building proceeds – which is important given the subsequent CCA claims that can be made). Election is made in the year replacement property is acquired, and also can be late filed under the taxpayer relief provisions. One thing to note is that this provision is not only applicable when you use the replacement property rules. You can do this election anytime you dispose of a former business property.
  • So in looking back at our example, you’ll see that we aren’t able to reallocate any of the building proceeds, since there wasn’t a capital gain being realized. However, on the land, there was otherwise a $175K gain being realized, so we can if we want reallocate up to $175K of the proceeds to the building. In our example, we’re interested in eliminating the $25K capital gain being realized. Therefore, we intuitively would like to move $25K of proceeds from the land to the buildings. This gives us $400K proceeds for the land and $150K for the buildings. Note that this allocation is now identical to the cost allocation of the replacement property.
  • So now, you go through the same RPR calculations, and you’ve now deferred the entire capital gain. However, note that your ACB of the replacement land is still $250K (as it was without 44(6)) and not $225K as you may have intuitively expected.
  • With the buildings, the additional $25K building proceeds still doesn’t result in a capital gain since the ACB was of the original property was 150K. However, going forward the capital cost of the replacement property is $125K (which like for land, is the same as if 44(6) wasn’t used). However, the UCC is now $25K less than when 44(6) wasn’t being used. So there’s a tradeoff between avoiding a current tax liability and getting the benefit of future deductions

Transcript

  • 1. Replacement Property Rules Presented to: Fraser Valley CA Association March 5, 2009 Presented by: Steven Araki, CA David Metzger, CA
  • 2. Replacement property rules = tax deferral
    • Ways to defer taxes:
    • Defer income (e.g. accruing bonuses, different year ends, completed contract method)
    • Use of small business deduction
    • Pay safe income dividends
    • Claim reserves where not all proceeds received (income under 20(1)(n) or capital gain under 40(1)(a)(iii))
    • Replacement property rules:
      • capital assets (today’s presentation)
      • small business shares – S. 44.1 (post Oct 17/00)
  • 3. Technical references
    • Relevant sections of the Income Tax Act
    • S. 44(1) – capital property
    • S. 13(4) – depreciable property
    • S. 14(6) – eligible capital property
    • Other reference sources
    • IT-259R4 Exchanges of Property
    • IT-491 Former Business Property
  • 4. Replacement property rules – when apply?
    • Disaster
    • Relocate business
  • 5. Requirements
    • Amount has become receivable by taxpayer as proceeds of disposition
    • Taxpayer acquires a “replacement property” within the required time
    • Taxpayer elects in their tax return
  • 6. “ Replacement property” means:
    • Acquired to replace the former property (purpose test)
    • Have the same or similar use as the former property
    • Be used in the same or similar business as the former property (if applicable)
  • 7. Types of dispositions
    • Involuntary
      • compensation for property unlawfully taken
      • compensation for property destroyed
      • compensation for property taken under statutory authority (or intention to be taken)
      • replacement must be acquired within 24 months following the year of disposition
    • Voluntary
      • “ former business property” – capital property that was real property used primarily for the purpose of gaining or producing income from a business
        • excludes real property used to generate rent other than property leased to a related person and used principally for any other purpose
      • replacement must be acquired within 12 months following the year of disposition
  • 8. Making the election
    • If disposition and replacement in the same year, then filing the correct calculations constitutes the election
    • If replacement in a subsequent year, elect by attaching a letter to tax return in the year acquired
      • should include description of properties, calculations and request for adjustments
    • If replacement acquired in a year prior to disposition, attach a letter to tax return in the year acquired
      • should included description of properties
      • can late file with tax return for year of disposition if it’s evident that new property qualifies
    • Can also late file under Taxpayer Relief Provisions
  • 9. Example
    • Former property:
    • Cost UCC Proceeds
    • Land $250,000 $ - $425,000
    • Building 150,000 75,000 125,000
    • $400,000 $75,000 $550,000
    • Replacement property:
      • Land $400,000
      • Building 150,000
      • $550,000
  • 10. Example (cont)
    • S. 44(1)(e) gain on land:
      • No replace With replace
      • Proceeds $425,000 $425,000
      • Cost 250,000 400,000
      • Capital gain $175,000 $ 25,000
      • ACB of land $400,000 $250,000
  • 11. Example (cont)
    • S. 13(4) recapture on building:
    • No replace With replace
    • UCC $ 75,000 $ 75,000
    • LCP 125,000 125,000
    • Reduction ( 50,000 )
    • 75,000
    • Recapture $ 50,000 $ -
    • UCC for bldg $150,000 $100,000
    • Notes:
    • LCP = Lesser of cost ($150,000) and proceeds ($125,000)
    • Reduction = Lesser of recapture ($50,000) and replacement cost ($150,000)
  • 12. Summary of example results
    • Without replacement property rules:
    • Capital gain on land = $175,000
    • Recapture on building = $50,000
    • With replacement property rules:
    • Capital gain on land = $25,000
    • Recapture on building = $0
    • New ACB of replacement land = $250,000
    • New UCC of building = $100,000
  • 13. 44(6) Reallocate proceeds
    • Applies to capital gains, but not recapture
    • Reallocate proceeds between land and buildings
    • Match up allocation with replacement costs
    • Minimize building proceeds to minimize grind on UCC
    • Elect in year replacement property is acquired
  • 14. 44(6) Example
    • Before 44(6)
    • Cost Proceeds Excess
    • Land $250,000 $425,000 $175,000
    • Building 150,000 125,000 -
    • $400,000 $550,000 $175,000
    • After 44(6)
    • Proceeds
    • Land $400,000
    • Building 150,000
    • $550,000
  • 15. 44(6) Example (cont)
    • S. 44(1)(e) gain on land:
      • No replace With replace
      • Proceeds $425,000 $400,000
      • Cost 250,000 400,000
      • Capital gain $175,000 $ -
      • ACB of land $400,000 $250,000
  • 16. 44(6) Example (cont)
    • S. 44(1)(e) gain on building:
      • No replace With replace
      • Proceeds $125,000 $150,000
      • Cost 150,000 150,000
      • Capital gain $ - $ -
      • Capital cost $150,000 $125,000
      • UCC $150,000 $ 75,000
  • 17. To elect or not to elect
    • Generally, elect to defer recapture as 100% taxable
    • Consider not electing if have a capital gain on land and shareholder considering withdrawing cash from company:
    • Non-elig
    • Dividend Capital gain
    • Draws 1,000,000 1,000,000
    • Tax rate 33% 22%
    • Taxes 330,000 220,000
  • 18. Misc. planning points
    • If acquire more than one replacement property, grind the one that will be held the longest to defer the capital gain the longest.
    • If sell former property in year 1 and acquire replacement property in year 2, don’t pay capital dividend in year 1 as CDA disappears once make replacement property election.
    • Land acquired for resale cannot qualify as not a capital property.
    • Can acquire replacement property prior to disposition of former property.
  • 19. Misc. planning points
    • Facts:
      • Opco owns real property used in business (Prop 1)
      • Opco acquires another property to replace Prop 1 (Prop 2)
      • Intend to lease out Prop 1, but will sell it before Prop 2
    • Plan:
      • Opco sells Prop 1 to a Sub and triggers capital gain
      • Opco purchases Prop 2
      • Opco uses replacement property rules to defer capital gain on Prop 1 by using Prop 2’s replacement cost
  • 20. Acquiring shares of a company
    • Shares probably cannot qualify as replacement property - Dallas [2005] 1 C.T.C. 47 (FCA)
    • Property acquired on the winding-up of a company may qualify – IT-259R4 p. 22
    • Land transfer tax applies on winding-up, but not on amalgamation
    • Is property “acquired” on an amalgamation?
    • Work around?
  • 21. Partnerships
    • A partnership can use the replacement property rules – IT-259R4 p. 23
    • A partner’s property used by the partnership may qualify for the replacement property rules – IT-259R4 p. 23
    • Former partners who have an undivided interest in former partnership property may be able to use the rules to “swap” properties so each partner can become the sole owner of a property – IT-491 p. 12
  • 22. Property must be used, not just acquired
    • Vacant land is not “used” therefore, a capital gain from its sale cannot be deferred using the replacement property rules – TI 2004-0088421E5
    • Klanten Farms Ltd. [2007] 5 C.T.C. 2384 (FCA) – property acquired on wind-up of subsidiary not used in farming as leased out
    • Depaoli [2005] 1 C.T.C. 47 (FCA) – owner arranged for local farmers to cultivate, plant and harvest crops. The purpose of the cultivation was to keep the land clean and workable. Qualified as “used”.
  • 23. Same or similar use
    • Generally bear same physical description
    • Warehouse = manufacturing building
    • Retirement home cannot replace a motel because the use and business are different – TI 2003-0053261E5
    • An RV park can “replace” a motel if it includes similar services – TI 2006-0173181E5
    • May be able to defer capital gain on a cottage if involuntarily disposed of – use is non-income earning purpose – IT-259R4 p. 16
  • 24. Same or similar business
    • Businesses will be considered similar if they both fall within the same category
    • See IT-259R4 p.18-21 for categories:
      • Farming
      • Merchandising (retail/wholesale)
      • Manufacturing and processing
      • Etc.
    • OK to change category if produce same product
    • Service industries:
      • Depends on facts
      • CRA to interpret “similar business” reasonably broadly
  • 25. Business expansion
    • “… the fact that a property is purchased under a business expansion will not, in and by itself, mean that the property cannot be considered a replacement property.” IT Tech News No. 25
    • Must be some correlation or direct substitution, that is, a causal relationship between the disposition of a former property and the acquisition of the new properties.
    • Must review the facts of each situation
    • Minimize overlapping operations
    • 2002-0156414; 2003-0006993
  • 26. Leased property
    • A building situated on leased land can be a “former business property” since it is an interest in real property – TI 2002-0173815
    • Leasehold improvements are depreciable property; therefore may qualify – TI 2006-0156171E5
  • 27. How you can help your clients
    • Time limit
    • How much to spend on land/building
    • Modeling tax impact of electing vs. not electing
    • Preparing election
    • Revising prior year’s tax returns
    • Similar use/business issues