Allocation of Purchase Price in Asset Sales: Understanding Section 68 Risks

Q: What tax rate applies to unexplained cash credits under section 68?

The effective rate is 83.25% — a base rate of 60%, plus a 25% surcharge and a 6% penalty. These amounts cannot be offset by losses or deductions, making this one of the harshest tax outcomes in the Act.

Q: How can parties protect themselves against section 68?

Document the negotiation — solicitor correspondence as a reliable record — and ensure both vendor and purchaser report the same allocation in their respective tax filings. Consistent, documented, arm's-length bargaining is the best defense against a CRA challenge. Working with a lawyer experienced in asset purchase transactions from the outset, rather than addressing the allocation as an afterthought at closing, significantly reduces the risk.

Allocations of Purchase Price on the Sale of a Business – Be Wary of Section 68

When you buy or sell business assets, the total purchase price rarely matters as much as how it gets divided up. Allocating the price across different asset categories, inventory, depreciable property, goodwill, and land directly affects how much tax each side pays, what deductions the buyer can claim going forward, and whether the CRA decides to take a closer look at the deal.

Getting this right requires careful planning. Getting it wrong, or worse, skipping real negotiations and just writing in numbers that look convenient, can expose both parties to some of the harshest tax consequences in the Income Tax Act.

Why the Allocation Matters to the Vendor

Vendors generally want to allocate as much of the purchase price as possible to non-depreciable capital property, things like land or partnership interests. The reason is straightforward: only 50% of a capital gain is included in income, which means a lower tax bill. This is one of the core considerations in corporate tax planning for any business sale.

The picture changes with inventory and depreciable capital property. Proceeds allocated to inventory are fully taxable as business income, with no preferential rate. For depreciable capital property, including goodwill under the rules that apply to transactions after 2017, any proceeds that exceed the undepreciated capital cost (UCC) are also fully included in the vendor’s income through recapture. If the proceeds are lower than the UCC, the vendor can deduct the shortfall as a loss in the year of the transaction, which is one reason some vendors don’t resist low allocations to certain asset classes.

Why the Allocation Matters to the Purchaser

Purchasers sit on the opposite side of the ledger. Allocating the purchase price to non-depreciable capital property land, for example, gives the buyer no ongoing tax deductions and may trigger additional taxes like Ontario’s Land Transfer Tax. That’s generally the last place a buyer wants to concentrate the price.

Buyers typically prefer inventory and depreciable capital property. Inventory costs are deductible when the inventory is eventually sold. Depreciable capital property allows the buyer to deduct a portion of the total cost each year on a declining-balance basis, a meaningful benefit over the long run. Understanding the full tax implications of an asset purchase before the deal is structured is critical to making those deductions work in your favor.

Because vendor and purchaser interests genuinely pull in opposite directions, a real negotiation produces allocations that neither side is entirely happy with. That tension is actually important, and the CRA knows it.

Where Section 68 of the Income Tax Act Comes In

The CRA generally accepts the allocation that parties agree to, provided there’s clear evidence of genuine arm’s-length bargaining. Hard negotiations between parties who each have something to lose signal legitimacy.

Section 68 of the Income Tax Act gives the CRA authority to override that agreement when the allocation isn’t reasonable in the circumstances and there’s no evidence of bona fide negotiations. It applies not just to asset categories but also to amounts for services rendered alongside the transaction consulting arrangements, retiring allowances, and similar payments that get bundled into a deal.

The tax consequences of triggering section 68 are severe. Unexplained cash credits deemed suspicious by the CRA can be taxed at an effective rate of 83.25%; that’s a flat 60% rate plus a 25% surcharge and a 6% penalty, and those amounts can’t be offset by deductions or losses elsewhere.

When Legitimate Transactions Still Attract Scrutiny

One scenario that catches people off guard: a vendor who appears indifferent to the allocation. That can happen when the vendor has carryover losses they expect to use up anyway, or when the cost base of an asset is high enough that no gain is triggered regardless of how the price is allocated. In those situations, the vendor may not push back at all, and a one-sided negotiation, even if it produces a reasonable outcome, can look suspicious to the CRA.

Both parties need to engage in the negotiation, document it properly (solicitor correspondence works well for this), and report consistent allocations in their respective tax filings. Inconsistent reporting between vendor and purchaser is one of the clearest signals that something is wrong, and it’s exactly the kind of discrepancy that draws a CRA audit. For business owners thinking about a sale, this is one of several reasons to begin M&A planning early, well before a buyer is at the table.

The Practical Takeaway structured

No allocation will ever perfectly serve both sides. The goal isn’t to find a number that makes everyone happy; it’s to find a number that’s defensible, documented, and consistent. Bona fide negotiations, properly recorded, are your best protection against section 68 being invoked.

If you’re heading into an asset purchase or sale, this is one of the conversations to have with your lawyer before the deal gets structured, not after.

Speak With a Lawyer at Kalfa Law Firm

Kalfa Law Firm advises buyers and sellers on purchase price allocations in asset transactions, helping structure deals that are tax-efficient and defensible in the event of CRA review.

Book a consultation to discuss your transaction.

FAQs:

What is section 68 of the Income Tax Act?

Section 68 allows the CRA to override the allocation of purchase price agreed to by the parties in an asset sale when that allocation is unreasonable and unsupported by genuine arm's-length bargaining. It applies to both asset categories and to amounts for services like consulting fees or retiring allowances paid alongside the transaction.

What asset categories must the purchase price be allocated across in an asset sale?

The purchase price must be allocated among all assets being transferred, which typically include inventory, depreciable capital property (such as equipment and vehicles), eligible capital property (including goodwill, licenses, franchises, and concessions), and non-depreciable capital property such as land or partnership interests. Each category carries different tax treatment for both sides, which is why the allocation is rarely straightforward.

Why do vendors and purchasers have opposing interests in how the price is allocated?

Vendors generally prefer allocations that produce capital gains taxed at a 50% inclusion rate rather than fully taxable income from inventory or recaptured depreciation. Purchasers prefer allocations to depreciable assets and inventory because those generate future deductions. That structural conflict is what makes arm's-length negotiation credible to the CRA and why a one-sided or agreed-upon allocation with no pushback can raise red flags.

What is recapture, and how does it affect the vendor?

Recapture occurs when the proceeds allocated to a depreciable asset exceed its undepreciated capital cost (UCC) the tax value remaining in the asset after prior depreciation claims. The difference is included in the vendor's income as fully taxable business income in the year of sale, not as a capital gain. This is why vendors are often reluctant to accept high allocations to depreciable property and prefer to push value toward capital property instead.

Does section 68 apply to services bundled into a business sale?

Yes. Section 68 extends beyond asset categories to cover amounts paid for services included in the same transaction, things like post-closing consulting agreements, non-compete payments, or retiring allowances. If the CRA considers these amounts unreasonable or unsupported by negotiation, it can reallocate them, and the tax consequences can be significant. Structuring these payments carefully, and documenting why they're commercially reasonable, is part of protecting the deal.

What evidence does the CRA accept as proof of bona fide negotiations?

The CRA looks for evidence that both parties genuinely bargained over the allocation and that each had a real economic interest in pushing it in a different direction. Solicitor correspondence exchanged during negotiations, drafts of the purchase agreement showing changes to proposed allocations, and internal communications reflecting each party's position all help establish that the process was legitimate. A signed purchase agreement alone, without any evidence of back-and-forth, is rarely sufficient.

What can trigger the CRA to invoke section 68?

The main triggers are an allocation that doesn't reflect real negotiations, suspicious or unexplained cash credits, and inconsistent reporting between vendor and purchaser. The CRA also pays attention when one party appears indifferent to how the price is allocated; that indifference suggests the negotiation wasn't real.

What tax rate applies to unexplained cash credits under section 68?

The effective rate is 83.25% a base rate of 60%, plus a 25% surcharge and a 6% penalty. These amounts cannot be offset by losses or deductions, making this one of the harshest tax outcomes in the Act.

Should the purchase price allocation be documented in the purchase agreement itself?

Yes. The allocation should be explicitly set out in the asset purchase agreement, with each category and its assigned value clearly stated. Both parties must then report those same figures in their respective tax filings. An allocation agreed to at closing but never formally documented or one that differs between the vendor's and purchaser's returns is far more vulnerable to a CRA challenge under section 68.

How can parties protect themselves against section 68?

Document the negotiation solicitor correspondence as a reliable record and ensure both vendor and purchaser report the same allocation in their respective tax filings. Consistent, documented, arm's-length bargaining is the best defense against a CRA challenge. Working with a lawyer experienced in asset purchase transactions from the outset, rather than addressing the allocation as an afterthought at closing, significantly reduces the risk.

-Shira Kalfa, BA, JD, Partner and Founder

Shira Kalfa is the founding partner of Kalfa Law Firm. Shira’s practice is focused in corporate-commercial and tax law including corporate reorganizations, corporate restructuring, mergers and acquisitions, commercial financing, secured lending and transactional law. Shira graduated from York University achieving the highest academic accolade of Summa Cum Laude in 2012. She graduated from Western Law in 2015, with a specialization in business law. Shira is licensed to practice by the Law Society of Ontario. She is also a member of the Ontario Bar Association, the Canadian Tax Foundation, Women’s Law Association of Ontario, and the Toronto Jewish Law Society.

The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.

Speak with an experienced business & tax lawyer today.