Legal Alert: SCC Says “Embedded Costs” Not “Proceeds of Disposition” For Tax Purposes

On May 23, 2013 the Supreme Court of Canada clarified how to determine “proceeds of disposition” in establishing the amount of a capital gain for income tax purposes.

Should a vendor add to the “proceeds of distribution” the purchaser’s cost of the vendor’s obligations respecting the transferred property that such purchaser assumed?  The SCC said no – not where the assumed obligation is an “embedded cost”. The SCC further clarified what is – and is not – an “embedded cost”:

• Subsumed in Value.  The SCC explained that “embedded costs” are those costs reflected, or subsumed, in the value of the transferred property.  The SCC provided a simple example: where a vendor sells a house needing repair, the purchaser’s assumption of responsibility for the repair costs – whether or not required by law or separately costed in the sale agreement – the sale price reflects those repair costs.  The repair cost is subsumed – or embedded – within the value and sale price of the house; they are not an additional part of the sale price   Since the value of the unrepaired house is less than the value of the repaired house, it is wrong to include the value of the purchaser’s agreement to make the repairs as a separate item of the “proceeds of disposition”.

• Not a Liability. The SCC further clarified that an “embedded cost” item is not a liability – either absolute or contingent – that must be separately accounted for.  In this context, liabilities are expenses that are not reflected in the value of the transferred property itself.   In contrast, for example, when a vendor sells a property subject to a mortgage, and the purchaser assumes that mortgage, the mortgage is a liability that is not embedded in the property’s value.  The vendor’s “proceeds of disposition” is the sale price without deducting the mortgage.

The SCC’s decision was in the context of a transfer of Crown timber licenses, and the purchaser assumed the vendor’s obligations respecting reforestation – and related costs – imposed by the applicable Alberta legislation.  However, as the SCC’s house example illustrates, this decision applies more broadly:  the “embedded costs” associated with the transfer of any property should not be added to the “proceeds of disposition” when establishing the amount of a capital gain for income tax purposes.

Click here to read the SCC’s  decision in Daishowa-Marubeni International Ltd. v. Her Majesty.

Please contact your McInnes Cooper lawyer or any member of our McInnes Cooper Tax Team to discuss this topic or any other legal issue.

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