Receivables almost never transfer at face value, because some of them will not be collected. The Income Tax Act has a joint election that puts the resulting shortfall in the right place for both parties. It is one of the cheapest things in a deal to get right and one of the most commonly missed.
Key takeaways
SECTION 01 OF 11
A business sells its receivables as part of an asset deal. Everyone knows some will go bad, so they trade at less than face value. The question nobody raises until later is what that discount is, for tax purposes, in each party’s hands — and whether the seller gets relief for the shortfall or simply loses it.
The size of the issue tracks the size of the receivables ledger, which in a services business is often the largest single asset on the schedule. A professional practice, a trades contractor, a staffing firm: in each case the receivables can exceed the equipment, and a few points of discount on them is real money.
It is also one of the few items in a deal where the tax outcome is genuinely elective rather than dictated. That makes it unusual, and it is why it deserves attention out of proportion to the number of words it occupies in the agreement.
SECTION 02 OF 11
The election lives in Income Tax Act s. 22, marginal note Sale of accounts receivable. It applies where a person carrying on a business “has, in a taxation year, sold all or substantially all the property used in carrying on the business, including the debts that have been or will be included in computing the person’s income” and that are still outstanding.
Two further conditions are easy to miss and both are load-bearing. The sale must be “to a purchaser who proposes to continue the business which the vendor has been carrying on”. And “the vendor and the purchaser have executed jointly an election in prescribed form to have this section apply”.
SECTION 03 OF 11
It is a small line in a long agreement, it costs nothing, and neither party feels its absence on closing day. The cost shows up afterwards, in the tax treatment of a shortfall that could have been characterised more favourably.
Treadstone Law puts the consequence plainly in its note on the section 22 election: “Where the discount is meaningful, though, skipping the conversation can leave value on the table for one or both sides, purely because of how the shortfall ends up being characterized for tax purposes rather than because of anything about the underlying receivables themselves.”
SECTION 04 OF 11
Without the election, the receivables are simply property that changed hands, and the discount is characterised accordingly for each party. With it, the section’s rules apply instead, aligning the treatment of the shortfall with the commercial reality — that the vendor earned income it will not fully collect, and the purchaser paid for a pool it expects to collect less than fully.
The reason this is worth a paragraph in an agreement rather than a footnote is that the parties are not symmetric. One of them is being asked to accept a characterisation that is worse for them in exchange for the deal completing, and that is a negotiation, however small.
SECTION 05 OF 11
The election is made in prescribed form and filed. That is a post-closing act that depends on cooperation from a party who, by then, has no further commercial reason to cooperate.
The fix is unremarkable and routinely omitted: an express covenant in the purchase agreement obliging both parties to execute and file, with the form itself agreed and attached as a schedule. Once the money has moved, the leverage to obtain a signature is gone.
SECTION 06 OF 11
First, the buyer must be continuing the business. A buyer acquiring receivables as part of a wind-down, or stripping assets to fold into something else, is in different territory.
Second, “all or substantially all” the property used in the business must be sold. A partial sale of a division, or a deal where the seller retains significant operating assets, may not qualify — which is the same structural question the GST/HST election in Excise Tax Act s. 167 turns on, and the two are worth testing together.
SECTION 07 OF 11
Receivables are usually one line in a schedule that also carries inventory, equipment and goodwill, and the allocation across those lines is a single negotiation with several tax consequences pulling in different directions.
Inventory sold at a gain produces ordinary income for the seller. Depreciable property can trigger recapture where the price exceeds undepreciated capital cost. Goodwill is treated differently again. A seller optimising purely for one line will usually be making it worse somewhere else, which is why the allocation is best done as one exercise with both parties’ advisers looking at the whole schedule.
The receivables line is the one where a joint election is expressly available, which makes it the easiest place to reach an outcome both sides can live with.
SECTION 08 OF 11
An aged listing, at a date close to closing, reconciled to the accounts. Not a total — a listing, by customer and by age, because a receivables pool with three customers is a completely different risk from the same total across three hundred.
Then ask what the vendor has historically written off as a percentage of billings. If the discount being negotiated is well below that history, the buyer is buying an optimistic number, and the tax characterisation of the shortfall is the least of the problem.
The diligence and the election are the same conversation, approached from two directions: what are these receivables actually worth, and where does the difference land for tax.
SECTION 09 OF 11
On a smaller transaction the temptation is to skip all of it, take the receivables at a round discount and move on. That is often the right commercial judgment, and this article is not an argument for spending five thousand dollars of professional fees on a fifty-thousand-dollar receivables pool.
The point is narrower: the election is cheap, the conditions are knowable in advance, and the decision to skip it should be a decision rather than an oversight. The two are indistinguishable at closing and very distinguishable a year later.
SECTION 10 OF 11
Of the section’s conditions, this is the one most likely to be assumed rather than checked. The statute requires a purchaser “who proposes to continue the business which the vendor has been carrying on” — the vendor’s business, not merely a business.
A strategic buyer folding the operation into an existing platform, closing the premises and migrating the customers is doing something different from an owner-operator stepping into the same premises on the Monday. Both are legitimate transactions. They are not obviously the same thing for the purposes of this wording, and the parties should form a view rather than assume one.
It matters practically because the buyer’s integration plan is usually known at signing and rarely shared with whoever is drafting the tax clauses.
SECTION 11 OF 11
Because it is a joint election in prescribed form, it needs both signatures and it needs to be filed. That makes it a covenant, not an afterthought — and it is far easier to agree while both sides still want the deal to close than afterwards, when one of them has worked out who benefits.
Sources
