At some point most entrepreneurs will need to transfer personal assets into their business. The process may be more important than you think, as an improper transfer of assets could result in a large and completely unexpected tax bill.

To understand how to transfer assets to a new corporation I spoke with Joel Campagna, a tax senior manager with KPMG's Waterloo office, who explained that both tangible and intangible assets must be considered.

There are three possible ways that assets will be transferred to a new corporation:

New entrepreneur >> Starting an incorporated company
Sole proprietorship >> Changing to an incorporated company
Partnership >> Changing to an incorporated company

All three cases may involve the transfer of physical assets, but only the last two situations are likely to include the transfer of intangible or "goodwill" assets.

Converting to a corporation: understanding the impact of goodwill

When you roll an existing sole proprietorship or partnership into a corporation you could face a serious financial penalty if you do not properly account for the intangible or "goodwill" value of the original business.

Let's say that you have operated a sole proprietorship for three years and have now decided to incorporate. In addition to your "hard" assets the company also has "soft" assets such as your company's reputation, customer lists and business location. These intangible assets are known as goodwill.

According to the Canada Revenue Agency ("CRA"), the courts have defined goodwill in two ways:
(a) "Goodwill is the whole advantage, whatever it may be, 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".
(b) It is "the privilege, granted by the seller of a business to the purchaser, of trading as his recognized successor; the possession of a ready-formed 'connection' of customers, considered as an element in the saleable value of a business, additional to the value of the plant, stock-in-trade, book debts, etc.".
(See CRA Interpretation Bulletin IT-143R3 Meaning of Eligible Capital Expenditure)

Assigning goodwill at fair market value

Joel explains, when you transfer an existing business into a corporation, the transaction is considered a "non-arm's length" transaction because you as the owner of the corporation are related to the corporation. The Income Tax Act (Canada) (the "Act") considers transactions between related parties to occur at fair market value.

In otherwords, you cannot simply assign little or no value to your business, but must set the entire value of your business at its fair market value at the time of the transfer. If you do not, at a later date the federal government could determine that you not only owe the tax on the capital gain, but that you also owe interest and penalties on the unpaid taxes.

It is possible to transfer the assets of the business to a corporation on a tax-free basis, by making an election under section 85 of the Act and filing what is commonly known as a Section 85 Rollover form. The associated form is currently T2057. In exchange for the assets transferred to the corporation, you must receive consideration which is equal to the fair market value of the assets transferred. This consideration must include at least one common share and may include a promissory note from the corporation. However, care must be taken that the cash or promissory note taken back does not exceed your tax cost of the assets before the transfer. You will also need a legal purchase and sale agreement.

Transferring "hard" or physical assets

Typically, to transfer physical assets, the business owner assigns a reasonable value to assets such as computer, furniture and vehicles and elects to transfer these to the company at the owner's tax cost of the assets. The owner usually takes back a promissory note equal to the elected amount, which means that the company owes the business owner an amount equal to the tax cost of the assets that were transferred.

Joel explained that the company could then depreciate the value of these assets using the government's 'capital cost allowance' (CCA) tables, which in turn will help reduce the company's net income. However, as noted above, the owner must take back at least one common share in addition to the promissory note.

Tip: to place a reasonable value on a vehicle being transferred to the business you can check with Canadian Black Book.

Develop your share structures carefully

Joel suggests caution in the way you structure your mix of shares and cash when doing this transfer, noting that you should not take back more consideration from the business than the value of your intangible and hard assets.

Consider a business that is valued at $100,000, of which the tax cost and fair market value of the physical assets is $10,000. If you were to take back $20,000 in cash and $80,000 in shares then you would trigger a income of $10,000, which you would then need to report on your personal income tax return. To avoid the additional taxes you would need to take back no more than $10,000 in cash and $90,000 in shares in this example.

While this may seem like additional "red tape", these issues are important to address to ensure that you are not penalized for having incorporated your business. To do the actual rollover you should seek professional assistance.

About Joel Campagna, CMA Senior Manager, Canadian and International Tax
Joel Campagna, a Canadian tax senior manager in our Waterloo office, works primarily with clients in the technology sector and those with international operations. Joel has developed expertise in the areas of SR&ED tax incentives, importing and exporting of technology to and from Canada, software withholding tax issues, international tax structuring and the purchase and sale of technology businesses in the Canadian and international contexts.

Joel is a member of KPMG Canada's International Tax Practice. He is also a member of the Canadian Tax Foundation, International Fiscal Association and a tutor at the CICA In-Depth Tax Course. Over the past twelve years, Joel has worked on international tax projects including cross-border mergers, global tax minimization, offshore sales and purchasing companies, and international financing structures. He has helped our clients expand into the United States, South America, Australia, Asia, South Africa and Europe.

Joel Campagna can be reached directly at (519) 747-8822 or by e-mail at jcampagna@kpmg.ca