January 1, 2017, the Government of Canada made changes to how quota sales are taxed. Many farmers are not aware that these changes could now result in a significant taxes owing on routine quota sales and transfers where no tax was payable in the past.
The following article outlines some of these changes.
How the rules changed in 2017
In the past, the CRA allowed a special 7% annual deduction on 75% of the cost of quota (effectively 5.25%) under “Eligible Capital Property (ECP)” rules. In 2017, these ECP rules were eliminated and replaced with a 5% annual deduction on 100% of the cost of quota using Class 14.1 under “Capital Cost Allowance (CCA)” rules. These CCA rules are the same as what are used to depreciate other assets (such as farm equipment) for tax purposes.
On the surface, this did not appear to be too much of a change, as the annual depreciation deduction effectively just decreased from 5.25% (old ECP rules) to 5% (new class 14.1 CCA rules). However, because the switch CCA rules now treats quota the same as any other capital asset for tax purposes, there are some much more significant tax consequences for quota sales that occurred with the change.
Selling one type of quota and replacing it with another
Under the pre-2017 rules, all quota types were treated as a single tax pool. For example, let’s say a farm acquired dairy quota at a cost of $2,000,000 and broiler quota at a cost of $1,000,000 (total of $3,000,000). If this farm then sold all of the broiler quota for $1,600,000, the sale would have triggered no immediate income for tax purposes as the total proceeds would be under the $3,000,000 combined value of the two quota types.
This same set of facts with the sale of broiler quota in 2017 (instead of 2016) leads to a much different result. The farm can now only consider the original cost of the broiler quota because the broiler and dairy quotas are distinguishable properties under the new rules.
The result is that this same farm would have to realize a capital gain of $600,000 ($1,600,000 proceeds - $1,000,000 original cost), half of which is taxable at the farm’s income tax rate. For either an individual or a corporation, this rate could be over 50 per cent, leading to additional tax after 2016 of up to approximately $150,000 in this example.
Selling small amounts of quota
Supply management boards regularly provide farms meeting certain criteria with additional free quota allocations. If the farm cannot use the quota themselves, it is commonplace to sell these quota allocations to generate cash for other farm business needs. Before 2017, these sales would typically create no tax consequences.
After 2016, the rules described above will create taxable income on almost all of these small quota sales. This is because the CRA now views units of a particular farm quota, such as dairy quota, to be indistinguishable “identical properties.” Therefore, the cost of each unit of a particular farm quota is calculated by averaging the cost of all units of that quota. For example, a sale of a unit of dairy quota for $24,000 with average cost of $10,000 would lead to a capital gain of $14,000. This formerly tax-deferred transaction is now subject to immediate tax at capital gain rates.
Buying replacement quota
Before 2017, a farm could transition between supply-managed sectors tax free in certain circumstances. For example, a farm transitioning from a dairy to a broiler operation could sell its dairy quota for $2,000,000 and buy broiler quota for $2,000,000 without any immediate tax consequences. If these transactions both occurred in 2016, there would be no taxable income inclusions for this transition. After 2016, the disposition would be subject to tax under the capital gains treatment discussed above.
if the acquisition of broiler quota took place in the tax year following the disposition of dairy quota, the pre-2017 rules allowed for a tax deferral on the acquisition of replacement quota. After 2016, the only replacement property provisions available for quota transactions are involuntary dispositions (i.e. by theft, destruction, or expropriation). The CRA has confirmed that farm quota would not qualify for replacement property treatment for ordinary dispositions under these new rules effective in 2017. Therefore, farmers can no longer rely on replacement property tax deferrals for their quota.
Transferring quota to a corporation
Before 2017, farmers could receive loan consideration for the full tax cost of the quota on a transfer into a company. For example, if your quota had a tax cost of $1,000,000 prior to 2017, you could transfer debt into the company also at the full $1,000,000 amount.
After 2016, the new regime reduces by 25 per cent the debt that a farmer can transfer to a corporation as consideration for any quota acquired prior to 2017. In the example above, you would therefore only be able to transfer $750,000 of debt into the company.
Before 2017, the 50% taxable portion of quota gains within companies was treated as “active income”. What this meant is that the proceeds were taxed at 15% (2017 rate in Ontario) in companies that qualified for the Small Business Deduction.
2016, the new regime taxes these gains as “passive income” instead of “active income”. This means that the 50% taxable portion of the gain is taxed at 50.17% (2017 rate in Ontario) instead of 15%. It should be noted that 30.67% of this 50.17% can be refunded to the company at a rate of $38.33 of tax refunded for every $100 of dividends paid out. Unfortunately, the shareholders would then have to pay another layer of personal tax on the dividends received. At the end of the day, this means a much higher amount of tax is payable on each quota sale than in the past.
farms are also negatively affected. Under the old taxation rules, gains on quota sales were not subject to the Alternative Minimum Tax (AMT) calculation when the Capital Gains Exemption was used on a quota sale. Under the new rules, the gain on the quota sales is now part of the AMT calculation. What this means is that you could be subject to a significant amount of this AMT under the new rules if you are using your Capital Gains exemption on the quota sale even though there may not be any regular tax to pay. It should be noted though that AMT is refundable against taxes otherwise payable over the next seven years.
Are there any benefits to the change?
benefit of the new rules for both corporate and non-corporate owned quota is that the taxpayer is now able to apply any capital losses they have available to offset the gain on the quota sale. This was not possible under the old rules unless it qualified for a special election.
Please note that this article cannot consider all the complexities that you may encounter with this issue.