Published: April 14, 2020
Last Updated: May 21, 2020
Proposed CRA Changes to the Lifetime Capital Gains Exemption – CanadianTax Lawyer Analysis
Introduction – Proposed Changes to the Lifetime Capital Gains Exemption
The Department of Finance Canada has released their proposed changes aiming to close perceived income tax loopholes relating to the use of private corporations. Specifically, Finance has targeted strategies designed to multiply access to the lifetime capital gains exemption.
Ordinarily, when a taxpayer disposes of capital property, the taxpayer must pay tax on any resulting capital gain. However, if the property is eligible for the lifetime capital gains exemption by virtue of being either the share of a qualified small-business-corporation (QSBC share) or qualified farm or fishing property, then the gain may not be taxable by virtue of a deduction under Division C of the Canadian Income Tax Act. As of 2017, each individual is entitled to a cumulative lifetime deduction of $835,716 for QSBC shares or $1,000,000 for qualified farm or fishing property. A deduction amount claimed for QSBC shares will be counted towards the cumulative total deduction claimed for qualified farm or fishing property and vice versa. Some taxpayers, with the assistance of tax planning by Canadian tax lawyers, are able to arrange for their spouses and children or other non-arm’s length parties to hold interests in property eligible for the lifetime capital gains exemption. Since each individualis entitled to their own lifetime cumulative deduction, splitting a capital gain between multiple individuals so that each individual can use up their cumulative deduction can significantly reduce the taxes owing on asale of an eligible small business. This is called multiplying access to the lifetime capital gains exemption and is a well known tax reduction strategy. Structures designed to enable this outcome often use trusts when some of the individuals accessing the lifetime capital gains exemption are minors or not involved in the business associated with the property.
The Department of Finance aims to limit multiplication of the lifetime capital gains exemption with three proposed changes. First, individuals will not be able to use the lifetime capital gains exemption for gains that accrued while they were less than 18 years old. Second, individuals will not be able to use the lifetime capital gains exemption for property held in trust for them or for gains that accrued while the property was held in trust for them, subject to a few exceptions where the department believes existing rules are already effective. Third, individuals will not be able claim the lifetime capital gains exemption on any income subject to the new expanded tax on split income. The primary impact of the third proposed change will be imposing a reasonableness test on the sale of some shares that would otherwise be eligible for the lifetime capital gains exemption.
Eligibility for Lifetime Capital Gains Exemption
In order to access the lifetime capital gains exemption a number of conditions must be met. First, the person seeking to access the lifetime capital gains exemption must be an individual. Corporations are not able to access the lifetime capital gains exemption. Second, the individual must be resident in Canada throughout the taxation year in which the individual claims the deduction. In some cases, subsection 110.6(5) of the Canadian Income Tax Act will deem part year residents to have been resident in Canada throughout the year in which they immigrated to or emigrated from Canada for the purposes of the life time capital gains exemption. Third, the property being sold must be qualified small business shares, qualified farm property, or qualified fishing property.
The Canadian Income Tax Act provides a complex definition of qualified small business shares. There are three main requirements for a share to be a qualified small business corporation share. First, there is an asset requirement. The share must be a share of the capital stock of a Canadian-controlled private corporation, at least 90% of the assets of which are in an active business in Canada at the time the individual claiming the lifetime capital gains exemption disposes of the share. Second, there is an ownership requirement. In the 24 months preceding the disposition of a qualified small business corporation share, the share must be owned by the individual claiming the life time capital gains exemption on the disposition of the share or a person or partnership related to that individual. Beneficiaries of a trust which disposes of the shares may also be able to claim the lifetime capital gains exemption because the Canadian Income Tax Act effectively allows the character of a capital gain realized by a trust to be flowed through to a beneficiary of the trust. Third, there is a mixed asset-and-ownership requirement which requires that throughout the 24-month period preceding the disposition of the qualified small business share, that the share be of a Canadian-controlled private corporation that was using at least 50% of its assets in an active business in Canada. The full requirements for qualified small business corporation shares are complex, so consulting an experienced Canadian tax lawyer for advice is essential if you plan to take advantage of the lifetime capital gain exemption. For more information read our article on the lifetime capital gain exemption (link to LGCE general article) or contact one of our top Toronto tax lawyers.
Eligibility for Qualified Farm or Fishing Property
The Canadian Income Tax Act sets out elaborate definitions for qualified farm or fishing property. Qualified farm or fishing property can include:
- a real property;
- a fishing vessel used in a fishing business;
- a share of the capital stock of a family-farm or family-fishing corporation;
- an interest in a family-farm or a family-fishing partnership; or
- an eligible capital property used in a farming or fishing business in Canada.
To qualify, the property must meet certain requirements in the 24 months preceding the disposition of the property. Much like the requirements for qualified small business corporation shares, there is an ownership test, an asset test, and a mixed asset and ownership test. The ownership aspects of these tests are similar to the ownership requirements for qualified small business corporation shares. The asset tests impose requirements that the property was used in a farming or fishing business in Canada. If the property is the share of a corporation, then that corporation must meet requirements that indicate it was primarily engaged in running a farming or fishing business in Canada.
Multiplying Access to the Lifetime Capital Gains Exemption
The ownership requirements for qualified small business corporation shares and qualified fishing or farming property allow for many individuals to claim the life time capital gains exemption on their share of the proceeds from the sale of a qualified property so long as they are “related” for the purposes of the Canadian Income Tax Act. Individuals related by blood or marriage are deemed to be “related” for the purposes of the Canadian Income Tax Act. This means that if ownership of a qualified property is split between several family members, each of the family members can claim their life time capital gains exemption when the property is sold. For example, suppose an individual sells qualified small business shares and realizes a gain of five million dollars. That individual will use up their entire $835,716 lifetime capital gains exemption and pay tax on the remaining $4,164,284 gain. Now suppose the shares are distributed among the individual, his or her spouse, and their two children. Since all of those individuals are related, each individual can claim their life time capital gain exemption. As a result, the combined life time capital gains exemption claimed is $3,342,864, with the individuals collectively needing to pay tax on a much smaller $1,657,136 gain. The tax savings from structuring the disposition of property so that more individuals can claim the lifetime capital gains exemption on the disposition of the property can be very large. With proper tax advice from an experienced Canadian tax lawyer, a family trust can be used to multiply access to the lifetime capital gains exemption. Family trust structures are useful in circumstances where you would like to multiply access to the lifetime capital gains exemption without giving up full control over the business or assets giving rise to the exemption.
Proposed Measures to Restrict Access to the Lifetime Capital Gains Exemption
The Department of Finance has proposed three new constraints on eligibility aimed at limiting the ability of Canadian taxpayers to multiply access to the lifetime capital gains exemption. The first proposed constraint is to impose an age limit on access to the lifetime capital gains exemption. Under the proposed changes, individuals who realize a capital gain in a taxation year prior to the taxation year in which they attain the age of eighteen are never eligible to claim the lifetime capital gains exemption. Additionally, when an individual realizes a capital gain during any taxation year where they have attained at least the age of eighteen, the portion of the gain, if any, which accrued before the taxation year in which the individual attained the age of eighteen is not eligible for the life time capital gains exemption.
The second proposed constraint is to impose a reasonableness test in determining whether the lifetime capital gains exemption applies in respect of a capital gain. This proposal appears to be focused on instances where the property that may be eligible for the lifetime capital gains exemption is shares of a corporation.The proposed reasonableness test is the same as for the proposed changes to the tax on split income. This reasonableness test would only be applied when the individual seeking to claim the lifetime capital gains exemption is related to another individual who exercises considerable influence over the corporation. The Canadian Income Tax Act considers individuals related by blood to be related. The reasonableness test itself weighs the labour and capital contributions to the corporation made by the individual against all previous amounts received from the corporation by the individual including both dividends and wages. The greater the extent to which an individual has made contributions to the corporation for which the individual has not yet received compensation, the more likely the reasonableness test will be met. This proposed reasonableness test uses a higher standard for what constitutes a labour or capital contribution to the corporation for individuals aged between 18 and 24.The new tax on split income rules are very complex. For more details see this article or consult one of our top Canadian tax lawyers.
The third proposed constraint is to prevent individuals from claiming the lifetime capital gains exemption for capital gains that have accrued during a period in which a trust held the property. Several types of trusts to which restrictive rules already apply would be exempt from this constraint including spousal trusts, alter ego trusts, and certain employee share ownership trusts where the individual is an arm’s length employee of the employer sponsor of the arrangement. The Department of Finance believes the restrictions already in place on these types of trusts is sufficient to prevent them from being used to multiply access to the lifetime capital gains exemption.
Tax Tips – the Lifetime Capital Gains Exemption
The proposed changes significantly restrict the scope of who can qualify for the lifetime capital gains exemption and will disrupt many existing tax planning structures. Any individuals who currently qualify for the lifetime capital gains exemption who will no longer qualify once the proposed changes are in acted should consider realizing the eligible capital gain. With advice from an expert Canadian tax lawyer, transactions which realize the relevant capital gain to the extent necessary to make use of the lifetime capital gains exemption without losing control of the underlying assets can be arranged. These transactions are known as lifetime capital gains exemption crystallization transactions . The proposed transitional rules will likely include an election to ease the process of crystallizing existing exemptions prior to when the new rules come fully into effect.
In addition, many taxpayers who where anticipating being able to use the lifetime capital gains exemption in the future will have to rework their existing tax plans. In particular, plans involving family trusts or property held by individuals below the age of eighteen or who are unlikely to be able to pass the reasonableness test will need to be revisited. Due to the complexity of the lifetime capital gains exemption and the new proposed changes, consulting a knowledgeable Canadian tax lawyer will be essential when revising your tax plan.
Disclaimer:
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."
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