Don’t Assume When Assuming Liabilities

The assumption of a vendor’s liability by a purchaser may constitute part of the sale price and, therefore, part of the vendor’s proceeds of disposition.  The tax consequences to the vendor and the purchaser will vary depending on whether a liability is embedded or separable from the property acquired.  The types and amounts of liabilities ought to be identified at the outset of a transaction and reflected in the legal documentation.


Tax Treatment of Assumed Liabilities


In order to determine the tax treatment of liabilities assumed by a purchaser, the following analysis must be done for each liability:


  1. Identify the liabilities assumed by the purchaser and their amount;


  1. Characterize each liability as embedded within or separable from the property acquired; and


  1. If a liability is separable from the property being acquired, determine whether the liability is contingent or absolute.


The characterization of the assumed liabilities can impact the tax treatment to both the vendor and purchaser. Taxpayer’s and their advisors should be cautious not to assume that all liabilities are treated equally.


Identifying the Liabilities


The purchaser must first identify the liabilities being assumed as part of the purchase and the quantum of each liability.  Liabilities can include: mortgages and other secured loans, unpaid taxes, pension liabilities, etc.


Embedded vs. Separable


Whether a liability is embedded (or intrinsic) or separable (or extrinsic) from an asset will impact the tax treatment.


A liability embedded within the property should not be added to the proceeds of disposition of the vendor.  For example, a vendor selling a building with windows in need of repair calculates the cost of installing new windows and accepts a lower purchase price to reflect the state of repair of the building.  It would not be logical to estimate the cost of the windows and then add that amount to the vendor’s proceeds of disposition.  The cost of the repairs is a future cost embedded in the property that depresses the value of the property at the time of sale.[1]


Contrast the window example with the sale of a property encumbered with a mortgage.  The purchaser may agree to assume the mortgage as partial consideration for the sale price.  The property could be sold without the assumption of the mortgage, in which case, the purchaser would pay more cash consideration.  Whether the mortgage is assumed or not, the property has a defined agreed-upon value that the vendor will insist on receiving in one form or another.


An embedded obligation is not added to the vendor’s proceeds of disposition.  If an embedded obligation is not added to the vendor’s proceeds of disposition, then it is unlikely that it would form part of the purchaser’s cost base on acquisition.  It is more likely that that liability would be deductible as an expense in the year that expense is incurred.



Absolute vs. Contingent Liabilities


If a liability is separable from the property purchased, it is necessary to determine whether the liability is absolute or contingent.[2]


In order to determine if a liability is a contingent liability, the test is whether a legal obligation comes into existence at a point in time or whether it will not come into existence until the occurrence of an event which may never occur.[3]  An absolute liability is any liability which is not a contingent liability.


Tax Treatment of Contingent and Absolute Liabilities


Contingent liabilities cannot be deducted from a taxpayer’s income from business or property.[4]  The CRA’s position is that when a business is sold and the purchaser assumes contingent liabilities as part of the consideration for the business, the vendor’s proceeds of disposition would include the fair market value (FMV) of the contingent liability.  However, the cost of the asset acquired by the purchaser would not include the contingent liability until the contingency has been met.  When the purchaser pays the contingent liability, the payment is made on account of capital and thus would form part of the purchase price of the business assets.  The CRA has recognized that this approach may lead to inefficient results in certain circumstances.[5]


Where a purchaser assumes liabilities of a vendor in consideration for the acquisition of assets, that amount represents the cost to the purchaser.[6]


Allocating to Cost Base


If only one asset is purchased on the acquisition of a business, it is clear which asset will have its cost adjusted on the assumption of absolute or contingent liabilities.  However, if a group of assets is purchased in exchange for a bundle of consideration (which can include absolute and contingent liabilities), it is necessary to determine which assets are to be associated with which liabilities.


The CRA has offered no guidance with respect to how liabilities should be allocated to cost base, except that it should be “reasonable.”  Certain liabilities will relate to specific assets (eg, a mortgage on a property) and, in these cases, the liability should be allocated to the cost base of the obvious asset.  In other cases, however, it is less clear, such as with the assumption of pension liabilities.


The purchaser and vendor will typically negotiate the allocation of consideration to cost base in the purchase and sale agreement.  This may provide the purchaser with some cover to support that its position is “reasonable” if the CRA challenges the allocation.  The allocation of purchase price and consideration paid between arm’s length parties is usually accepted as reasonable by the CRA.


[1] This example is from Daishowa-Marubeni International Ltd. v R., 2013 SCC 29 (“Daishowa”).

[2] “Contingent liability” and “absolute liability” are not defined in the Income Tax Act, RSC 1985, c 1 (5th Supp.).

[3] McLarty v R., 2008 SCC 26.

[4] Subsection 18(1)(e), Income Tax Act.

[5] CRA Views, 2002-0164607, “Contingent liabilities – sale of business.”

[6] CRA Views, 9222345, “Assumption of contingent liability re purchase of assets.”