$800,000 Lifetime Capital Gains Exemption
Capital gains are advantageous compared to regular business income (including interest income) or dividend income in many ways. For example, only 50% of capital gains are taxable, while business income is fully taxable and dividend income is "grossed up" and taxed. Another benefit is the capital gains exemption. This exemption is applicable to individuals who dispose of shares of a Qualified Small Business Corporation ("QSBC"), and allows you to claim a lifetime exemption on $800,000 as of 2015 of gross capital gains ($400,000 of taxable capital gains) as tax-free income. This $800,000 amount is indexed as of 2015, so will be increasing on an annual basis.
Qualified Small Business Corporation ("QSBC")
The obvious follow-up question is to ask what qualifies as a QSBC. A 3-part test is given in the Income Tax Act. A QSBC must be:
- A Small Business Corporation (SBC) at the time of determination
- Pass the Holding Period Test
- Pass the Holding Period Asset Test.
SBC at the time of determination: To qualify as an SBC, a corporation must be a Canadian Controlled Private Corporation ("CCPC"), where all or substantially all (meaning more than 90%) of the fair market value of the assets can be attributable to assets that are:
- Used principally in an active business and carried on primarily (meaning more than 50%) in Canada by the corporation or a related corporation
- Shares of the capital stock or indebtedness of one or more small business corporations that are connected corporations
- A combination of the above.
The Canadian income tax act has special definitions for what qualifies as a CCPC, "active business", "related" corporation, and a "connected" corporation, but those are all beyond the scope of this article. Also, because the ‘time of determination’ will usually be taken as the moment that you dispose of the shares of the corporation, steps can be taken beforehand to ensure that the shares disposed of meet this requirement.
Holding Period Test for Capital Gains Exemption
In a nutshell, this test requires that for the 24 months preceding the determination time, the shares were not owned by anyone other than the individual or a person/partnership related to them; additionally, throughout this period the corporation must have qualified as a CCPC. This requirement prevents individuals from receiving a share from an SBC one day, selling it the next, and claiming the exemption. Additionally, the tax act states that newly issued shares are deemed to have been owned immediately before their issuance by an unrelated persons, outside of a few enumerated circumstances, meaning that a newly issued share will also not qualify as being owned by a person/partnership related to them. so that newly issued shares have to be held for two years.
Holding Period Asset Test for Lifetime Capital Gains Exemption
This test is linked to the previous test, and it requires that for the 24 months of the Holding Period Test, the share was of a CCPC that had over 50% of the fair market value of its assets used in an active business. Assets considered to be used in an active business consist of: (a) Assets used principally in an active business carried on primarily in Canada by the corporation or a related corporation, and (b) Shares or debt of connected corporations that qualify as a CCPC and that meet certain conditions.
Purification Transactions to Meet Lifetime Capital Gains Exemption Tests
As over 50% of the assets must be used principally by the active business in Canada, but connected subsidiary corporations can help out with qualifying under this 50% test, there’s some potential for income tax planning between parent and subsidiary corporations and in general to make sure that the tests are met. This tax planning and reorganization is usually referred to as purification. For example, if A Co has non-qualifying (‘bad’) assets of 70 and qualifying (‘good’) assets of 30, it would not meet the requirements of the holding period asset test. However, if A Co set up a subsidiary and transferred its 30 good assets and 21 of its bad assets to it, the subsidiary would pass the 50% test, meaning that A Co would now have 49 bad assets and 51 good assets (because the subsidiary counts as 51% of A Co and it has passed the test). Because of this possibility, an Anti-Stacking Rule exists that basically requires that if the 50% test is only met by having a subsidiary, the corporations must also meet a 90% test at either the parent or subsidiary level (in other words, all of the good assets must add up to constitute 90% of the active business). As these rules are very complex you should consult with one of our experienced Canadian income tax planning lawyers if you have any questions about meeting the tests or if you need assistance in structuring a purfication.
Family Farms and the Capital Gains Exemption
A note about family farms and the capital gains exemption: a sale of farm assets (including partnership interests and shares of corporations) will qualify if it meets the criteria for ‘qualified farm property’. Since farms are often worth more than $800,000 there are a number of ways to ‘multiply’ the capital gains exemption ‘ partnerships, incorporation, and family trusts are all commonly used to split up the value of the farm to various people who can then utilize their capital gains exemption amount upon sale. In fact, the same planning techniques used to multiple the capital gains exemption for farms can be used effectively with QSBC shares. The people who are typically helping to ‘multiply’ the exemption are family members such as a spouse or kids. As you can probably tell by now, taking advantage of the capital gains exemption can be very complex. If you are curious about whether your shares in a corporation qualify for the capital gains exemption, or would like to plan ahead to make use of the lifetime capital gains exemption and require an experienced Toronto income tax lawyer to advise you on this or any other income tax planning matters, please contact our income tax law firm.
"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."