Anonymised, illustrative composite. An asset purchase moved $912,000 of prepaid service obligations to the buyer by cutting the price. There is a provision written for precisely this transfer — and it requires an actual payment and a joint election, neither of which the deal had.
At a glance
The target inspected and certified sprinkler systems, extinguishers and emergency lighting for property managers across southern Ontario. Its model was an annual agreement billed and collected in advance, with inspections performed on a rolling schedule through the year. At the proposed closing date it held 1,340 live agreements with $912,000 of the year still to be delivered.
The deal was an asset purchase. The buyer wanted the contracts, the technicians and the certification records, and did not want the corporation. Both sides accepted from the start that the buyer would perform the outstanding inspections — that is what it was buying — and that it should not pay the vendor for revenue it would have to earn itself. See assumed liabilities in an asset transaction for the general framework.
The draft asset purchase agreement did the obvious thing. Purchase price $4,200,000, less $912,000 for the assumed deferred revenue, payable $3,288,000 at closing. Clean, and wrong for both parties.
Take the vendor first. The $912,000 was collected in earlier periods and was brought into its income when received, under Income Tax Act s.12(1)(a), which requires the inclusion of “any amount received by the taxpayer in the year in the course of a business” “that is on account of services not rendered or goods not delivered before the end of the year”. Each year the corporation reduced that inclusion with a reserve under s.20(1)(m), available for “services that it is reasonably anticipated will have to be rendered after the end of the year”. In its final year it can no longer anticipate rendering anything: it will not exist. The reserve goes and the $912,000 stands in income, with no deduction against it, on money the vendor has effectively handed to the buyer in the form of a lower price.
Price-reduction route: closing payment $3,288,000. Vendor's final-year income includes $912,000 with no s.20(1)(m) reserve and no offsetting deduction. Buyer's aggregate tax cost in the acquired assets: $3,288,000.
Election route: price stays at $4,200,000, and the vendor pays $912,000 to the buyer at closing as consideration for assuming the inspection obligations. Net cash across the table is identical — $3,288,000. But the vendor now deducts $912,000; the buyer includes $912,000 and immediately claims its own s.20(1)(m) reserve against the inspections it has yet to perform; and the buyer's tax cost in the acquired assets is $4,200,000, not $3,288,000. The same cash, $912,000 of additional cost base, and a deduction that otherwise evaporates.
Two mechanical points decided how the money actually moved. The $912,000 had to leave the vendor's bank account and arrive in the buyer's — a set-off recorded on the funds flow statement was specifically rejected by both accountants, because the provision speaks of an amount paid. And the election had to be filed by a deadline neither adviser had diarised.
Income Tax Act s.20(24) exists for this exact transfer, and it is written with two hard conditions. It applies where the taxpayer “paid a reasonable amount in a particular taxation year to another person as consideration for the assumption by that other person of the taxpayer’s obligations in respect of the undertaking”, and then only “if the taxpayer and the other person jointly so elect”.
Both limbs are load-bearing. Without a payment there is nothing to deduct, so a price reduction cannot engage the provision however clearly the agreement labels the reduction as consideration for the assumption. Without the joint election the provision does not apply at all, even if the payment was made and both parties intended it.
The consequences are two-sided. Paragraph (a) lets the vendor deduct the payment and removes its future s.20(1)(m) reserve, which it was losing anyway. Paragraph (b) does the work on the buyer's side: “where the amount was received by the other person in the course of business, it shall be deemed to be an amount described in paragraph 12(1)(a)”. That deeming is what lets the buyer claim its own s.20(1)(m) reserve, because that reserve is available only where amounts described in paragraph 12(1)(a) have been included in the taxpayer's income.
Then the deadline. s.20(25) provides that an election under s.20(24) “shall be made by notifying the Minister in writing on or before the earlier of the days on or before which either the payer or the recipient is required to file a return of income pursuant to section 150 for the taxation year in which the payment to which the election relates was made”. A corporation's return under s.150(1)(a) is due “within six months after the end of the year”. The vendor's year ended 31 December and the buyer's on 30 June, so on a payment made in March the controlling date was the buyer's — the following 31 December, six months before the vendor's adviser would have thought about it. The party with the earlier year end sets the deadline for both.
One boundary worth stating, because it is where this file stops. s.20(24) has no application to a share purchase. There is no payment to another person and no assumption of an obligation: the corporation keeps its own liability, the deferred revenue simply stays where it is, and the commercial problem is answered in the net working capital peg instead of by election.
The agreement was restructured before signing. Price restored to $4,200,000; a separate $912,000 payment from the vendor to the buyer on the funds flow, described in the agreement as consideration for the assumption of the outstanding inspection obligations; a closing deliverable requiring both parties to execute the s.20(24) election; and a covenant, surviving closing, to file it by the s.20(25) date with each party bearing its own filing.
The vendor's exposure is the cleaner of the two: $912,000 of income in its final year with nothing set against it. The buyer's is quieter and larger over time — $912,000 of tax cost that never existed, felt as reduced capital cost allowance every year the business runs and as a larger gain whenever it is sold on. Neither loss shows up anywhere in the deal file, because the closing statement balances perfectly either way. That is what makes this a paperwork failure rather than a pricing failure: the cash is right and the tax is wrong, and nothing in the transaction documents flags it.
Any line in a draft agreement that reduces the price by the amount of an assumed obligation. It is the standard drafting move and it is the trigger to ask whether a statutory election covers the obligation being assumed. For prepaid goods and services that election is s.20(24); for accounts receivable on an asset sale the corresponding one is the section 22 election.
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