Is the inventory portion of a business sale taxed as income or a capital gain?

Sellers are often surprised that the stock on the shelves is taxed differently from the rest of the business. The treatment depends on what is being sold and how the price is divided, so it is worth understanding before a purchase price allocation is agreed. This page sets out the general position for Canadian sales and the points that change it.

Why inventory is income rather than capital

A gain on capital property is generally taxed as a capital gain, which receives more favourable treatment. Inventory is the stock a business holds in order to sell it. Section 23(1) of the Income Tax Act deems inventory sold on or after disposing of or ceasing to carry on a business to have been sold in the course of carrying on the business, so proceeds allocated to it, including raw materials and work in progress, are generally treated as ordinary business income and taxed in full.

How the price allocation drives the result

In an asset sale, the agreement often sets a price for each asset, a value for the inventory and, if applicable, an amount for goodwill, as the CRA describes. Each line is then taxed under its own rules, so moving value from inventory into another category changes the seller’s result. Because an allocation also has to hold up to scrutiny, it should reflect real value, and an accountant should review it before signing. Our page on how inventory is valued in a business sale covers the counting and pricing side.

Share sales and the capital gains deduction

If the owner sells shares instead of assets, the thing sold is the shares, not the individual items the company holds, so the income-versus-capital character of the inventory is not negotiated as part of the price. The lifetime capital gains deduction the CRA describes applies to taxable capital gains on particular property, such as qualified small business corporation shares, so it does not reach ordinary income from selling inventory.

When part of the price is paid later

The reserve the CRA describes for spreading a gain over several years is built for capital property. For amounts from property sold in the course of a business, the Income Tax Act has a separate reserve provision, paragraph 20(1)(n), which covers amounts payable after the end of the year and, except for real property, requires that all or part of the amount was not due until at least two years after the sale. The two should not be confused, and how a vendor take-back is taxed shows how deferred payment is handled more generally.