The Replacement Property Rules: Using The Income Tax Act To Help You Build Your Business

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The purpose of the replacement property rules in the Income Tax Act (ITA) is to allow a taxpayer to defer the recognition of a capital gain, recapture of capital cost allowance (CCA) or the gain on sale of eligible capital property (ECE) when property has been disposed of and it is replaced with the acquisition of similar property, provided that all the requirements of the ITA are met. The benefit of these rules is that there is no cash outflow needed to pay the related income taxes on these types of dispositions provided that the proceeds are being used to purchase a replacement property. The election is made by filing a letter with the tax return for the period in which the replacement property is acquired. [1]

Overview:

Generally, the Tax Act permits a taxpayer to elect to defer the recognition of income or capital gains where a property is disposed of and a "replacement property" is acquired within the prescribed time deadlines. To be considered a "replacement property", the following conditions must be met:

1. 1. It must be reasonable to conclude that the property was acquired by the taxpayer to replace the former property. This means that there must be some correlation or direct substitution between the disposition of a former property and the acquisition of the new property.
   2. In the case of ECE, it must be acquired by the taxpayer for a use that is the same or similar to the use to which the taxpayer put the former property. For depreciable and other capital property, the property can be acquired by the taxpayer or a related person.
   3. In the case of ECE, it must be acquired for the purpose of gaining or producing income from the same or a similar business as that in which the former property was used. What this means is that you cannot use the replacement property rules to defer the income or gain on the sale of land and buildings by purchasing a manufacturing plant since they are not similar businesses.
   4. In the view of the Canada Revenue Agency (CRA), the replacement property rules are not intended to apply to business expansions. It is a question of fact as to what is considered to be a business expansion.

As per the Replacement Property Rules, the types of property eligible and the deadlines that need to be met are as follows:

1. The replacement property must be acquired before the end of the first taxation year following the disposition.
2. Depreciable and other capital property - the type of property and the circumstances resulting in the disposition determines the type of property and the timing deadline.

In the case of an involuntary disposition the replacement property must be acquired before the end of the second taxation year following the disposition. The property included in this category includes all capital property (land, buildings and equipment).

In the case of a voluntary disposition, the replacement property must be acquired before the end of the first taxation year following the disposition. The property included in this category includes only "former business property" which is defined to mean capital property of the taxpayer that is real property (land and buildings only) and does not include a rental property.

In some cases where both land and building are disposed of and a capital gain remains on one even after the application of the above rules, it may be possible to reallocate proceeds of disposition between the land and building in order to reduce and even eliminate the capital gain remaining.

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According to Replacement Property Rules, all calculations are done on a property by property basis (for example, a separate calculation is done for each of land and building). Where the proceeds of disposition are all reinvested in the replacement property, the entire income and capital gains on the disposition can be deferred.

The new capital cost of the replacement property is reduced by the amount of the deferred capital gains. As a result, when the replacement property is sold, the now lower capital cost is used in determining whether or not there are any capital gains to be realized.

The amount eligible for capital cost allowance purposes is reduced by both the deferred capital gain and the deferred recapture.

An election to defer recapture automatically means you are electing to defer the capital gain as well and vice versa.

Where the replacement property is purchased in a subsequent year, a letter needs to be attached to the tax return for the year the replacement property is acquired to request the adjustment of the prior year return (to amend the income and capital gain otherwise required to be reported in the year of disposition).

If you have any questions or want to speak further about your corporation, contact Nicholas Kilpatrick at nkilpatrick@burgesskilpatrick.com

Nicholas Kilpatrick is a partner with the accounting firm of  Burgess Kilpatrick and specializes in tax structuring and business development for his small and medium business sized clients.  Please visit our website at www.burgesskilpatrick.com or on Facebook at www.facebook.com/Burgess Kilpatrick for more information on our firm. 

[1] Replacement Property Rules, Baker Tilly.