Asset Drop-Down transactions: What happens when a third-party sale falls through?

The 2024 Federal Budget, introduced on April 16, 2024, brought significant changes to Canada’s tax landscape, particularly for business owners and investors. Among the most impactful was the proposed increase in the capital gains inclusion rate, effective June 25, 2024. For corporations, the inclusion rate rose from 50% to 66.67%, and for individuals, capital gains exceeding $250,000 now face the same increase.

This change created a rush of tax planning activity, with the Asset Drop-Down transaction emerging as a preferred strategy. However, not all plans proceeded smoothly, leaving many taxpayers asking: What should we do if the anticipated sale doesn’t go through?

This article explores the practical implications of an Asset Drop-Down transaction, the reasons some taxpayers used it ahead of the capital gains changes, and the key steps to take if your third-party sale is delayed or abandoned.

Why the Asset Drop-Down Transaction Was a Popular Solution

The new inclusion rate caused concern because it significantly increased the tax burden on capital gains realized after the June 25, 2024, effective ate. Tax practitioners recommended the Asset Drop-Down strategy as a way to provide flexibility:

• What Is an Asset Drop-Down?
  This strategy involves transferring assets from one company (the “AssetCo“) to a subsidiary (the “NewCo“) under subsection 85(1) of the Income Tax Act (Canada) (the “ITA“). This transfer can occur either at cost (avoiding immediate tax) or at fair market value (triggering a taxable gain at the lower, pre-June 25 inclusion rate).
• Who Benefited Most?
  While the government’s changes incentivized triggering capital gains before June 25, most taxpayers avoided doing so unless they had an imminent third-party sale. The logic was simple: why pay tax now without realizing cash from a sale?

For those with planned sales, the Asset Drop-Down allowed them to structure their transactions to minimize tax exposure. However, in cases where the sale was delayed or fell through, taxpayers were left with questions about their next steps.

When a Third-Party Sale Falls Through: Key Considerations

If you completed an Asset Drop-Down transaction in anticipation of a third-party sale, only to have that sale fall through or be delayed, it’s essential to address the following issues:

1. Timing of the Election

The ITA specifies timelines for making an election:

• Initial Deadline: Subsection 85(6) requires the election to be filed by the earlier of NewCo’s or AssetCo’s tax return due dates.
• Late Election: Subsection 85(7) allows for a late election up to three years after the initial deadline, but this is subject to penalties.

While late penalties may seem daunting, they are often minor compared to the potential tax savings of electing at cost rather than fair market value. However, this extended timeframe may require taxpayers to internally fund any taxes triggered while continuing to seek a buyer.

2. Inter-Company Fees

If AssetCo continues to use assets owned by NewCo while searching for a buyer, AssetCo should pay fair market value fees to NewCo for using these assets. Failure to do so could result in taxable benefits under subsection 15(1) of the ITA. Proper documentation of inter-company payments is critical to avoid scrutiny from the Canada Revenue Agency (the “CRA”).

3. Sales Tax Compliance

Business owners should assess whether NewCo needs to register for GST/HST or provincial sales taxes. If inter-company fees apply, they may also be subject to sales tax unless an election or exemption is available. Careful planning in this area can help reduce administrative burdens.

4. Bare Trust Relationships

Many Asset Drop-Down transactions involve creating a bare trust relationship, where AssetCo retains legal title to the assets while holding them in trust for NewCo.

• The CRA has announced that bare trusts will not be required to file tax returns for the 2024 taxation year unless specifically requested.
• However, if this exemption is not extended to 2025, taxpayers may face additional filing requirements for any existing bare trust relationships.

5. Inter-Corporate Debt Settlement

If it becomes evident that a third-party buyer will not be found, winding up or amalgamating NewCo with AssetCo may become necessary. In such cases, filing a T2027 election ensures that any inter-corporate debt is settled at cost, avoiding unintended tax consequences.

A “Wait and See” Approach: Balancing Risks and Opportunities

For many taxpayers, the best course of action when a sale falls through is to adopt a “wait and see” approach: continue searching for a buyer while monitoring tax filing deadlines. This strategy offers flexibility but also entails risks, including potential penalties, interest on overdue taxes, and compliance requirements.

Here’s a practical example to illustrate:

Case Study: A small manufacturing business planned to sell its assets before June 25, 2024, and completed an Asset Drop-Down to transfer the assets to NewCo. However, the sale fell through due to unforeseen market conditions.

• Short-Term Plan: The business waits for a new buyer while ensuring proper inter-company fees are paid and GST/HST compliance is maintained.
• Long-Term Plan: If no buyer is found, the company will file a late election, pay the penalty, and wind up NewCo to minimize tax exposure.

Conclusion: Proactive Planning Is Essential

The 2024 Federal Budget has created a challenging environment for businesses and their advisors. While strategies like the Asset Drop-Down transaction offer much-needed flexibility, they also introduce new complexities, particularly when third-party sales fall through.

By addressing key considerations like timing, inter-company payments, and sales tax compliance, taxpayers can mitigate risks and position themselves for long-term success.

How We Can Help?

Navigating the nuances of tax planning requires expert guidance. Our team of experienced tax lawyers is here to help you manage changes to the capital gains inclusion rate, optimize your Asset Drop-Down strategy, and protect your business’s financial health. Contact us today to discuss how we can support your tax planning needs.