HST-Exempt Financial Services No Longer Exempt

This week I want to address a topic that’s very important for auto dealerships. The CRA made a significant change to HST rules that directly affects dealerships, and in turn, their cash flow. The change was made a while ago yet not everyone seems to be aware of the modification or the new developments surrounding it so I think it’s worth mentioning.

The CRA has narrowed the definition of HST-exempt financial services. What does this mean for dealerships? Most auto dealerships have a finance department that helps customers arrange a lease or loan with a financial institution. In return, the dealership receives a commission from the financial institution. This commission, or fee the dealership receives, is no longer always an exempt financial service – under these new rules the fee may now be considered taxable and subject to HST.

This means you have to be careful how you structure the agreement with your financial institution of choice and be mindful of the added tax you may have to pay. Keeping these factors in mind will ensure you’re not surprised in a tax audit.

The CRA made this change a while ago, however, the Canadian Automobile Dealers Association (CADA) is working to overturn the legislation and make dealership’s arranging financial services tax exempt. There are possible circumstances which could enable a dealership to object to an audit assessment from the CRA; I highly suggest you speak with your accountant to check if your particular circumstances apply. Meanwhile, keep in mind that if your dealership has already received an audit assessment, you have 90 days from the date of assessment to file an objection.

Have you been hit by the new HST changes? If you have I’d be interested in hearing your story in the comment section below.

- Dave 

Watch Out for the Taxman and Restrictive Covenants

What do you get when you use an elephant gun to kill a mosquito? You get the Canada Revenue Agency attempting to close what they perceive as a loophole and catching a lot of other innocent taxpayers.

Let’s bring some context to my statement. A number of years ago, 2003 to be precise, tax legislation was proposed to close the perceived abuse that might transpire as a result of the Fortino and Manrell cases.

The Fortino case involved the sale of Fortinos Supermarket Ltd. to a competing grocery store chain. The transaction involved the sale of shares and a non-competition agreement. An amount was allocated to the share sale as well as the non-competition agreement. The non-competition agreement stipulated that the vendors would not compete with the purchaser for a certain number of years.

The taxpayers reported the share sale in their respective tax returns but did not report the proceeds from the non-competition agreement. They argued the amount received represented personal goodwill, not income from a source, and constituted a windfall. The Minister of National Revenue disagreed and first reallocated the non-competition as additional proceeds on the sale of shares then later as just income. The Fortinos objected and won their case at the Federal Court of Appeal.

To close this loophole, the CRA recently drafted legislation that states the taxation of amounts received pursuant to non-competition agreements are taxed as income, not capital, and stipulates that an election must be filed to recharacterize the amounts as proceeds from the sale if certain conditions are met.

The draft legislation is extremely complex and burdensome. Needless to say, if you are contemplating selling your dealership in the near future, you should contact a tax advisor to ensure you don’t fall into any tax traps as a result of this proposed legislation.

- Jeff

Holding Company vs. Trust

I am often asked by my automobile dealer clients whether it makes sense to introduce a holding company or family trust into the corporate ownership structure for creditor proofing and/or estate planning purposes. When a person decides to start a new business and incorporates, there is often a level of uncertainty as to whether the new venture will be successful, thus cost control is often paramount.

Most people opt to keep their corporate structure simple (meaning they don’t want to spend money on lawyers and accountants to set-up holding companies and trusts), which is understandable. However, if you have the resources upon incorporation, you should consider having a family trust own the shares of the private corporation from the outset rather than directly owning the shares.

Two reasons to consider this corporate structure are as follows:

1. A holding company can provide similar benefits to a direct holding company but with less risk.
2. A family trust provides the ultimate in tax planning flexibility.

Assuming your corporation is an active company, not an investment company, there are several benefits to having a family trust as a shareholder of your private company.

Multiply the Lifetime Capital Gains Exemption

If the company is eventually sold, a family trust potentially provides for the multiplication of the $750,000 lifetime capital gains exemption on a sale of qualifying small business corporation shares. That is, it may be possible to allocate the capital gain upon sale to, your spouse, children, yourself or other beneficiaries, which means substantial income tax savings. For example: where there are four individual beneficiaries of a family trust, the family unit may be able to save as much as $700,000 in income tax if a corporation is sold for $3,000,000 or more.

Family Trust Can Receive Dividends

In addition, where your children are 18 years of age or over, the family trust can receive dividends from the family business and allocate some or all of the dividends to the children. The dividends must be reported in the tax return of the child, but in many cases, the dividends are subject to little or no tax (if a child has no other income, you can allocate almost $40,000 in dividends income tax-free).

Creditor Proof Earnings

Finally, where you have surplus earnings in a corporation and wish to creditor proof them but don’t want to allocate the funds to your spouse or your children, you may be able to allocate those funds tax-free to the holding company if it is a beneficiary of the trust. This allows for an income tax deferral of personal taxes until the holding company pays a dividend to its shareholders.

Why would I ever not choose a family trust? Some of the reasons are as follows:

1. The initial accounting and legal costs may be as high as $7,000 - $10,000.
2. You may not have children or, if you do have children, they are young and you cannot allocate them dividends without the dividends being subject to the “Kiddie Tax” (a punitive income tax applied when minors receive dividends of private companies directly or through a trust).
3. You are not comfortable with allocating to your children any capital gains from a sale of the business and/or any dividends since legally that money would belong to them.
4. If the business fails, it may be problematic to claim an Allowable Business Investment Loss (a loss that can be deducted against any source of income) that would otherwise be available if the shares of the company were held directly by an individual.
5. There are some income tax traps beyond the scope of this blog post when a holding company is a beneficiary.

As discussed in the opening paragraph, once a business is established and has become successful, a holding company can still easily be introduced as a shareholder and the transaction can take place on a tax-free basis. A holding company is also often problematic, as the level of cash the holding company holds can put it offside of the rules for claiming the $750,000 lifetime capital gains exemption if the business is sold in the future. Thus, you may wish to consider utilizing a family trust, unless you do not have children or do not anticipate being able to sell the corporation.

If one waits until the business is successful to introduce a family trust, as opposed to introducing one as an original shareholder when the business is first incorporated, the value of the business as at the date of the reorganization must first be attributed to the original owner(s) utilizing special shares (typically referred to as an estate freeze). The costs of introducing a family trust with a holding company beneficiary as part of an estate freeze could be as high as $15,000 -$20,000 as a business valuation is often required.

The Takeaways

This issue is very complex. The key takeaway should be that having a holding company as a direct shareholder of an operating company may not always be the most tax efficient decision. A family trust with a holding company beneficiary may be a more appropriate choice depending on your circumstances.

In any event, you should definitely consult a professional advisor before undertaking such planning in order to understand the issues related to your specific situation and ensure that you are not breaching any hidden income tax traps. 

-- Jeff Carbell

Capitalizing my business?

Outside of tax planning and operational issues, how to better capitalize is one of the most common discussions I have with my auto dealer clients. Clearly one of the better ways to capitalize your business is by way of retaining internal cash flow in the business, but often this is not possible and as a result the owner must entertain offers for external financing. I have found that obtaining new financing and re-financing existing credit facilities is much more challenging as a result of the recent economic downturn as banks are more risk averse, especially in the auto retail business.

It is still possible to obtain financing in today’s market, but a well-structured plan is in order. The plan should consist of a strategic message to the bank as to why the financing is required and how the funds will be used. If the financing is simply to fund current and prior year losses, it is more likely than not that the bank will decline. However, if the funds are used to purchase additional inventory, pay off previous management or acquire new equipment, the bank is more apt to provide financing.

Business owners are sometimes so surprised that the bank is willing to provide financing, and so focused on the interest rate and loan-to-value ratio of capital property, that they forget to read the fine print on their credit facility agreement. Often there are significant terms in the credit facility that are overlooked by the business owner until it is too late. Commonly overlooked terms address personal guarantees, postponements, financial covenants, audited financial statements, and significant security.

Personal guarantees come into play when a business can no longer continue to operate and the bank calls the loan. If you have an agreement with a personal guarantee and there is not enough cash to repay the bank loan, the bank can seize your personal assets (i.e. your house!) as repayment.

Postponements require that the company postpone repayment of debts in favour of repaying bank debt. This term can be detrimental if your business runs into trouble and you have personally put significant funds into the business.

Financial covenants also pose a risk in that sometimes they can be impossible to meet and 1-3 years after the facility agreement is signed, the covenants may be breached and the bank can call the loan.

The terms may indicate that you will be required to provide the bank with audited financial statements within a specific period following your company’s year end. Audits can be costly, and you may be able to negotiate to submit reviewed financial statement (lower assurance than audited statements) which can save your company some money in accounting fees.

Another problem I see is business owners who don’t explicitly ‘shop’ around to different banks and compare terms. It is important to create a chart to compare the terms offered by different banks because more often than not facility agreements, especially for auto dealers, have a significant number of terms that are not easy to compare in your head. I suggest you write out the differences and compare all the options to make a decision based on the facts. Some points of comparison may be qualitative in nature, such as the reputation of the bank or relationship with the banking representative.

This is just a taste of what I have dealt with over the last several years with regards to capitalizing your business and I plan to write further blogs on this topic.

-- David Hertzog