In the Federal Budget of May 23rd, 1983, the then Minister of Finance introduced a lifetime Capital Gains Exemption which, when fully phased in, was intended to give each Canadian taxpayer up to Five Hundred Thousand Dollars ($500,000.00) of tax-free capital gains. The general exemption was eliminated in 1993, but an exemption still exists for “qualifying small business corporation shares”. The exemption was increased again effective January 1, 2014, to Eight Hundred Thousand Dollars ($800,000.00) indexed for years after 2014. For those who own their own companies, this can mean tens of thousands of dollars in tax savings.
The effect of the Exemption is that upon a sale of the shares of the corporation, either an arm’s length sale, or a transfer to the next generation, the first $800,000.00 (in 2021, with indexation this amount is $892,218) of capital gain per shareholder will be free of tax. This represents a tax saving of approximately $237,955 for each shareholder, which can include multiple family members.
There are many technical rules to determine whether shares of any particular corporation qualify for the Exemption.In order for the shares of a corporation to qualify for the enhanced capital gains exemption the shares must first meet the criteria for Qualified Small Business Corporation ("QSBC") shares.
The primary tests are as follows:
Holding Period Test
In order to qualify for the LCGE, during the 24 month period immediately preceding any disposition of shares, the shares must not have been owned by any person other than the current shareholders or by a person related to the current shareholder.
Active Business Assets Test
As set out above, all or substantially all (defined by Canada Revenue Agency to mean at least 90%) of the fair market value of the assets of the corporation must be assets used principally in an active business carried on in Canada. As well, at least 50% of the fair market value of the assets of the corporation must be used in the active business over the 24 month period leading up to the sale or other disposition. An accumulation of cash or other “non-active” investments can throw the mix of assets offside, and the result is that the shares might not qualify for the capital gains exemption. In such a situation, cash and other investment assets may need to be transferred to a holding company. On an ongoing basis, it may be necessary to strip excess cash and investment assets out of a corporation in order that the shares always qualify for the capital gains exemption.
Need for Ongoing “purification”
It may seem pointless to engage in a series of transactions to strip excess cash assets out of an operating company if there is not thought of selling the company. However, a number of events, the most notable of which is death, will trigger a deemed sale at fair market value. Since none of us can know when such an event will occur, it only makes sense to ensure that the shares of our companies qualify for the capital gains exemption at all times, in order to meet the tests set out above. It would be a shame for our families to be saddled with a tax bill of as much as Two Hundred Twenty-Three Thousand Six Hundred Dollars ($223,600.00) being the top marginal tax cost in Ontario in respect of an Eight Hundred Thirteen Thousand Six Hundred Dollar ($835,716) capital gain on shares that, with some advance planning, would have qualified for the exemption.
Shareholder Entitlement to LCGE
Assuming that the shares of a company qualify for the capital gains exemption using the criteria set out above, there is still a requirement that each individual shareholder is entitled to claim the capital gains exemption. The capital gains exemption is not $800,000.00 per company, but $800,000.00 in aggregate. Accordingly, if a shareholder claimed $400,000.00 on the disposition of shares of a company in the past, he or she would only have $400,000.00 available to be claimed. If there is any question as to a shareholder’s entitlement, the Canada Revenue Agency will, upon request, confirm the amount of capital gains exemption previously claimed by any individual.
In addition to determining whether a shareholder has previously claimed any amount of the capital gains exemption, it is important to determine if he or she has any accumulated investment losses (referred to as a Cumulative Net Investment Loss or CNIL account). To the extent that a shareholder has a balance in his or her CNIL account, that balance will reduce the amount of the capital gains exemption that he or she can claim. In planning for the sale of a QSBC, it is important to plan for the reduction of any CNIL account balances for any of the shareholders.
Proposed Tax Changes
Finance Minister Morneau has launched an all-out attack on small business corporations and their shareholders. In the largest overhaul of the tax system in 45 years, he has proposed dramatically increasing taxes on investment income earned in a private corporation (where it is already approximately double what a public company pays), and has proposed extending the Tax on Split Income (TOSI) rules to all non-active family shareholders.
Morneau announced that he would not be proceeding with changes to the LCGE. Initially, he proposed that a “non-active” shareholder would not be entitled to claim the LCGE in respect of the shares of a CCPS.
However, the TOSI rules will tax the non-exempt capital gain for a non-active shareholder as a dividend, taxable at top personal rates. So, if the shares of a CCPC do not qualify for the LCGE, a non-active shareholder, instead of being taxed on the basis of a capital gain (top rate in Ontario is 26.76%), he or she will be taxed on the basis of an ordinary dividend at top personal rates (45.30%), an increase of 18.54%
I cannot stress this enough – it is important to keep the company onside in terms of its non-active business assets. It is relatively easy to get onside for the 90% test at any time. It is impossible to go back 24 months in time to get onside for the 50% test.
I would be happy to work with you and your advisors to ensure that the shares of your company always qualify for the LCGE