Canada: Lifetime Capital Gains Exemption

Last Updated: September 23 2015
Article by Howard J. Alpert

This issue of the Legal Business Report provides current information to the clients of Alpert Law Firm on estate planning techniques for small businesses and their shareholders. Alpert Law Firm is experienced in providing legal services to its clients relating to estate planning, including the preparation of wills, deeds of gift, trust documents and all documentation required in connection with estate freezes. Howard Alpert, C.S. is certified by the Law Society as a specialist in Corporate and Commercial Law and as a specialist in Estates and Trusts Law.

Capital gains arising on dispositions of qualifying shares of small business corporations, as well as dispositions of qualified farm property are eligible for a lifetime capital gain exemption of $800,000. An individual taxpayer was formerly entitled to a lifetime capital gains exemption for up to $750,000 of capital gains realized on the disposition of qualified property. The 2013 Federal Budget increased the limit to $800,000, effective for the 2014 taxation year. If a portion of the former general lifetime capital gains exemption of $750,000 has already been used, then the balance of the small business capital gain exemption will still be available in the future for shares of a small business corporation and qualified farm property. In addition, the exemption will be indexed to inflation for taxation years after 2014. The 2015 Federal Budget proposed to further increase the limit for the disposition of qualified farm or fishing property on or after April 21, 2015 to $1,000,000.

The use of these exemptions achieves actual tax savings since the cost base of the shares to the transferee is increased to their current fair market value for future dispositions. It may be possible to double up on the use of this exemption if both spouses acquired capital assets with their own funds.

The term "small business corporation" is defined in section 248(1) of the Income Tax Act (the "Act") as a Canadian-controlled private corporation of which all or substantially all of the fair market value of the assets were at the particular time: (a) used in an active business carried on primarily in Canada by the corporation or a related corporation; or (b) shares or debt of one or more other small business corporations that were at that time connected with the corporation; or (c) a combination of the assets described in (a) and (b) above.

According to the Canada Revenue Agency (the "CRA"), the term "all or substantially all" is interpreted to mean 90% or more. This definition was clarified so that "all or substantially all" refers to the fair market value of the assets in question. Prior to this legislative change, there was some uncertainty as to whether this phrase referred to the cost of assets or to their fair market value.

The CRA has generally interpreted the term "primarily", as used in "an active business carried on primarily in Canada", to mean more than 50%. The facts of each particular case must be considered for this test, with relevant factors including gross assets, employees and sales.

A corporation that meets the above-mentioned criteria is a small business corporation pursuant to the Act. However, not all shares held by an individual in a small business corporation qualify for the $800,000 capital gains exemption. Only "qualified small business corporation shares" are eligible for this exemption.

Generally, in order to be a qualified small business corporation share, such share: (a) must be a share of the capital stock of a small business corporation at the time of disposition; (b) must not have been owned by anyone other than the individual or persons related to the individual throughout the 24 months immediately preceding the time of disposition; and (c) throughout the 24-month holding period, must be a share of the capital stock of a Canadian-controlled private corporation that used more than 50% of the fair market value of the assets of such corporation in an active business carried on primarily in Canada by the corporation or a related corporation.

The 24-month holding period referred to above specifies that no unrelated person may hold the shares in question during that period. However, the individual is not required to own the shares for the entire 24-month period. Shares held by an individual for less than the 24-month holding period, including newly issued shares acquired by an individual as part of a tax-free rollover of a sole proprietorship business to a new corporation pursuant to subsection 85(1) of the Act, may still be qualified small business corporation shares assuming all other requirements are met.

The transfer of shares in a small business corporation to a spouse or spousal trust on the death of an individual now has more significance as a result of the $800,000 capital gains exemption. Shares of an individual who died prior to the end of the 24-month holding period do not qualify for this exemption when a deemed capital gain occurs automatically on the death of the individual. A transfer of such shares on the death of the individual to the individual's spouse or a spousal trust has the advantage of tax savings as a result of the use of the $800,000 capital gains exemption, as well as the advantage of further tax deferral.

The conditions to be met in order to be a qualified small business corporation share are similar where shares of a small business corporation are held indirectly through the use of a holding company. Where a holding company is used, all or substantially all of the fair market value of the assets of the holding company must, throughout the 24-month holding period, be attributable to: (a) shares or debt of connected corporations that meet the 50% test during the holding period; (b) assets used directly in an active business carried on primarily in Canada; or (c) any combination of such shares, debt and assets.

In the event that the holding company does not meet the "all or substantially all" test throughout the 24-month period, its shares will be qualified small business corporation shares only if the connected corporation in which it holds shares meets the "all or substantially all" test throughout the 24-month period rather than the 50% test as otherwise provided. This substitution of a 90% test for the 50% test is intended to prevent the stacking of corporations.

In order to be a connected corporation under the Act, the holding corporation must control the other corporation or own shares having at least 10% of the voting rights of such corporation and having a fair market value of more than 10% of the fair market value of all the issued shares of the corporation.

Proceeds of disposition arising from shares in a corporation that is considered a "specified investment business" are not eligible for the lifetime capital gains exemption. A specified investment business is defined in subsection 125(7) of the Act as a corporation whose principal purpose is to derive income from property, unless: (i) the business employs more than five full-time employees; or (ii) in the course of carrying on the active business, any other corporation associated with it provides managerial, administrative, financial, maintenance or other similar services to the corporation and the corporation could reasonably be expected to require more than five full-time employees if those services had not been provided.

The provisions of the Act dealing with the $800,000 capital gains exemption are extremely complicated. For this reason, individuals should not wait until they wish to dispose of their shares in a small business corporation to do their tax planning. Consideration must be given to purification of the assets of the corporation by removing tainted assets in excess of the prescribed percentages prior to realization of the capital gains exemptions. In addition, individuals who own qualified small business corporation shares should consider transferring such shares to a holding company or a related party in order to trigger a $800,000 capital gain and take advantage of the present exemption.

The various estate planning methods referred to in this issue of the Legal Business Report may be used in combination in order to maximize tax deferral and savings. Therefore, in certain cases it may be possible to utilize the benefits of both an estate freeze and the $800,000 lifetime capital gains exemption.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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