The Canadian Income Tax Act (ITA) provides a special deduction in computing the taxable income of an individual relating to a capital gain resulting from the disposition of a “qualified small business corporation share” or interests in qualifying farming and fishing properties.
This deduction can result in a maximum of $750,000 in capital gains being exempted from tax under the ITA (capital gains exemption). In the case of an individual resident in Alberta, the income tax savings resulting from the use of the capital gains exemption can be as high as $146,250.
In my last article, I discussed using the capital gains exemption to reduce capital gains resulting upon dispositions of qualifying farm properties. In this article, I will discuss using the capital gains exemption in respect of dispositions of a “qualified small business corporation share” (share).
Technical qualifications to use the capital gains exemption
In order to qualify under the capital gains exemption for a share, there are a number of technical requirements that must be satisfied. Those requirements include:
l the shareholder must be an individual who is resident in Canada for purposes of the ITA;
l the share must be capital property to the shareholder and not held by a person not related to the shareholder in the last 24 months;
l the share must be in respect of a “Canadian controlled private corporation” as defined in the ITA; and
l throughout the 24 months immediately preceding the disposition of the share, more than 50 per cent of the fair market value of the assets of the corporation were attributable to assets used in an active business carried on primarily in Canada, and at the time of the disposition of the share more than 90 per cent of the fair market value of the assets of the corporation was attributable to assets used in an active business carried on primarily in Canada.
There are a number of technical provisions affecting the ability to claim capital gains exemption for a share, some of which are relieving, others of which are limiting. Further, the availability of the capital gains exemption will be reduced or eliminated by:
l prior uses of the capital gains exemption (including the $100,000 historical deduction that has been phased out);
l a balance in the shareholder’s “cumulative net investment loss” (CNIL) account (this relates to certain net investment losses claimed for tax purposes); and
l an “allowable business investment loss” since 1984 (this relates to a special class of investment losses claimed for tax purposes).
Multiplying use of the capital gains exemption
Successful owner-managers often will plan to multiply access to the capital gains exemption by their family members. For example, if shares of a corporation were to be sold for $3 million and the owner-manager was the sole shareholder of the corporation, the owner-manager would only be able to shelter a maximum capital gain of $750,000, and incur a tax liability as high as $438,750 on the remainder ($2.25 million of unsheltered capital gain).
On the other hand, the $438,750 of tax may have been avoided if other family members were also shareholders of the corporation able to use their own capital gains exemptions. Owner-managers may undertake an estate freeze coupled with, in the appropriate circumstances, the use of a family trust, to structure shareholdings so that a future sale of shares avails greater opportunities to multiply use of the capital gains exemption, as well as for income-splitting and wealth-preservation purposes. The use of family trusts will be discussed in my next article.
Planning for use of the capital gains exemption
As a result of several technical requirements that can impede use of the capital gains exemption, structuring prior to the sale of shares is often required. Such structuring may include a “purification” of the corporation so that a share satisfies statutory requirements, payment of dividend income to shareholders to reduce CNIL balances, utilization of a corporation’s capital dividend account or safe income on hand balances, among others.
It should be noted that there are limited opportunities to use the capital gains exemption in the case of “internal” sales of the shares due to an anti-corporate surplus stripping provision in the ITA. In appropriate cases, it may be possible to combine a sale by a corporation of its assets with a sale of shares by a shareholder to use the capital gains exemption.
This may avail the best of both worlds, as a purchaser may often prefer an asset purchase. Proper structuring and legal documentation is essential with this type of tax planning.
Proper due diligence, advice and documentation is essential
The capital gains exemption can avail significant tax savings for individuals disposing of shares. However, if not properly considered and addressed, there are several provisions in the ITA that can prevent or defeat the intended use of the capital gains exemption.
In order for individuals to properly avail themselves of the benefits of this exemption, appropriate due diligence, tax advice, and legal documentation should accompany the sale of the shares.
Tax Talk appears on the first and third Tuesday of every month in the Business section of the Advocate. It is written by Jason Stephan, a chartered accountant and a tax lawyer who is tax counsel with Red Deer law firm Warren Sinclair LLP. Readers with specific tax issues are encouraged to consult a qualified tax professional for advice appropriate for their circumstances. Stephan can be contacted by email at firstname.lastname@example.org and by telephone at 403-343-3320.