Tax season for entrepreneurs with their own business can look different case by case. Whether you are a sole proprietor, or have incorporated your business, you will have to file the income/losses associated with your business for tax purposes. These articles will explain how you are taxed on your income from your business, which expenses are and are not deductible for tax purposes, and go a bit in depth on more specific topics.
Depreciation vs CCA
What are the differences between depreciation and CCA? We will start off with some basic definitions of each.
Depreciation: Depreciation is the expense incurred when your item becomes less valuable after a given amount of time. For example: the fair market value of your car today is not the same as the fair market value of when it was first bought. This is because the car is used, it is subject to wear, and subject to mileage. The loss in its fair market value is the depreciation expense. For accounting/bookkeeping purposes, the depreciation can be recorded using the straight line method, declining balance method, or the units of production method.
CCA: Also known as “Capital cost allowance” for short. In simple terms, the CCA is the tax version of depreciation. Meaning the CCA is the amount that is tax deductible when computing your taxable income.
Because depreciation expenses rely heavily on estimates (since you can choose 1 of 3 methods to compute for depreciation expense), the CRA has only 1 rule when computing for CCA.
Depreciation expenses will lower your net income from business operations, which also means the net income for tax purposes. In order to compute taxable income for tax purposes, we must first add back the depreciation amount to your net income, then we subtract the CCA amount from the net income.
Here is a simple example: the net income is $100, in which depreciation expense incurred during the year is $20, and CCA is $25. To find the taxable net income it will be: $100 + $20 – $25 = $95 taxable net income.
Before we go over how we determine the CCA amounts, we will take a look at these commonly used vocabulary when it comes to CCA determination.
Undepreciated capital cost (UCC): The UCC is the tax value amount of the asset that has not been deducted by CCA yet. In simple terms, think about it as the net amount of the asset remaining after deducting the CCA. For example: the asset is initially worth $100 in 2021, the CCA amount of that amount is $20 for the 2021 year, the UCC amount at the end of 2021 would be $100 – $20 = $80
Classes and CCA rates:
Each type of depreciable capital asset is separated into different classes. Each class is also subject to a different rate at which the amount of CCA can be recorded. For example: a car has a different CCA rate compared to supplies. Most classes (with a few exceptions) will be using the declining balance method when determining CCA. Which means the CCA for a given year would be the rate of the class multiplied by the UCC amount. However note, that is not always the case with, some specific classes have specific methods for the CCA determination. To view the different types of CCA classes and for more information/specific rules, feel free to take a look here.
Note: Half year rule: When accounting for CCA of an asset in the first year, the CCA amount is subject to the half-year rule, meaning you can claim an additional 50% on top of the normal CCA amount.
Now we shall take a look at how the CCA amount is determined
Pooling CCA classes and when to separate: Generally, when you have multiple depreciable properties in the same CCA class (ex: multiple equipment, multiple supplies etc), you would pool the items together into the same CCA class. When you sell 1 of the items in that class, you would remove the amount from the entire pool, and when you buy a new depreciable property, you would add it to the associate pool. Note under some situations however, though the same asset falls under the same property, they may be required to be put into separate CCA classes. Examples of this would be buildings (class 1), Equipment that are excess $1000 (class 8). Automobiles costing over $30,000 (class 10.1), Manufacturing and processing machinery/equipment acquired between 2016 – 2025 (class 43).
Tax implication for selling depreciable properties: If a depreciable property is sold off, you will have to deduct the UCC amount by the lower of: cost (how much it was originally paid for) and proceeds (how much you sold the property for). For example: suppose the UCC of your class 8 equipment is $100, you sold 1 of the equipments in the class for $20 and you originally paid $10 for it, the remaining UCC in your class 8 would be: $100 – lower of cost ($10) and proceeds ($20) = $90 (since what you paid for is lower than how much you bought it for).
How sale of assets affects the half-year rule: During the first year of calculating CCA for an asset the asset is subject to the “half-year rule” (mentioned above). However when there is disposition of a depreciable property in the same year, we must deduct the disposition amount against the newly acquired amount. The remaining amount will be subject to the “half-year-rule” for CCA. For example: acquired $100 worth of class 8 assets, but disposed a total of $60 (assuming 60 is lower of cost and proceeds), the amount that is subject to the half-year rule would be $40 ($100 (how much is bought) – $60 (the amount disposed)). The CCA would then be: $40 * 20% * 1.50 = $12
Note: if the disposition amount is higher than the acquired amount for the year, the newly acquired amount will not be subject to the first-year rule. Example: assume acquired $100 of class 8 assets, but disposed of $120 (assuming 120 is lower of cost and proceeds), $100 – $120 = -20, you will deduct the total UCC pool by $20, and find the total CCA as normal (UCC * rate of CCA, no first-year rule applied)
Recapture and terminal loss: When you sell off every depreciable asset in a class and the remaining UCC amount is not 0, you will be subject to a recapture or terminal loss situation.
Terminal loss: If the UCC amount is higher than 0 (a positive number), you are dealing with a terminal loss situation, meaning the remaining terminal loss is tax deductible against your income for tax purposes. For example: your UCC for class 8 assets is $100, the original cost is $150 but you sold it for $80, so the remaining UCC is $100 – lower of cost ($150) and proceeds ($80) = $20. There is $20 in UCC, however there are no more assets in class 8. Therefore you have a terminal loss of $20 in this situation and you can use that $20 to deduct your business income for tax purposes.
Recapture: Recapture is the opposite of a terminal loss. A recapture would occur when the UCC is below 0 (negative number) after all the depreciable property in a class has been sold. Recapture is considered to be taxable income. You can think of recapture as being the amount that has been accounted for twice for CCA, so you will have to “put” that CCA back. Assume the same example as above but they sold the asset for $120 instead of $80. The remaining UCC would be -$20 ($100 – $120), meaning you will have to add $20 to your business income for tax purposes.
Resources
Agency, C. R. (2021, March 19). Government of Canada. Canada.ca. Retrieved February 24, 2022, from https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/sole-proprietorships-partnerships/report-business-income-expenses/claiming-capital-cost-allowance/classes-depreciable-property.html
Buckwold, William, et al. Canadian Income Taxation, 2021/2022. McGraw-Hill Education, 2021.
