The Lifetime Capital Gains Exemption and Going Public – Mistakes and Fixes – A Canadian Tax Lawyer Analysis
Entrepreneurs who spend years building a successful business are, under the Tax Act, entitled to a special exemption when they finally decide to dispose of their business.
Those who choose to sell their business by way of share sale can benefit from the Lifetime Capital Gains Exemption which allows the business owner to claim an exemption from paying income taxes on the first $813,000 (as of 2017, indexed to increase annually) of gain on the shares.
However, Taxpayers should be aware that the ability to claim the Lifetime Capital Gains Exemption is subject to very strict rules in the Income Tax Act; there are a number of tax planning traps that can result in the loss of the ability to claim the exemption if proper tax planning is not undertaken.
The Lifetime Capital Gains Exemption Explained
Section 110.6(2.1) of the Canadian Tax Act creates the Lifetime Capital Gains Exemption, and also lists a number of conditions that must be met in order for the sale of the shares to qualify for the tax exemption.
First, it must be a share of the capital stock of a “qualifying small business corporation”. Secondly, throughout the 24 months prior to the sale, the share must have been in a Canadian-controlled private corporation, which utilized more than 50% of its assets in carrying on an active business. Thirdly, more than 90% of the assets must be used in an active business at the time of sale.
Provided that the basic requirements are met, taxpayers are entitled to elect to use the LCGE when they sell the shares of their small business. There are additional tax traps that taxpayers can run into when the claim the Lifetime Capital Gains Exemption, one of which we deal with below.
Going Public and Lifetime Capital Gains Exemption
When a business has been very successful for a number of years, one of the options that the owner or ownership group has is to put shares of the Corporation up for sale on a stock exchange through an Initial Public Offering. This is normally done by the main ownership group, but can lead to issues for others who hold shares because the definition of qualifying small business corporation requires that the shares cannot be traded on a public stock exchange.
Holders of shares who may have purchased, or been granted employee options may in some circumstances be precluded from selling their shares during the Initial Public Offering period. As such, when they sell they will have lost the ability to use the Lifetime Capital Gains Exemption election.
Special Election - Solution to the Problem of Going Public and Lifetime Capital Gains Exemption
Canada Revenue has a number of tax audit projects to enforce particular sections of the Act, one of them being a review of taxpayers who claim the Lifetime Capital Gains Exemption. In the example given above, employees and others who have exercised stock options may be under the impression that they can still take advantage of the Lifetime Capital Gains Exemption, despite the obvious problem of disposing of their shares on a public exchange. Taxpayers in these scenarios are not entitled to the exemption in these circumstances and the Canada Revenue Agency is actively auditing the returns of taxpayers who claim the Lifetime Capital Gains Exemption.
However, there is relief available to those who miss the opportunity to sell their shares if they act in a timely manner.
The Tax Act contains a special and little known election that allows the taxpayer to elect to have disposed of and reacquired their shares in a qualifying small business corporation in contemplation of the company going public. Taxpayers can thus “crystallize” the sale of the qualifying small business corporation shares and continue to hold the shares and sell them publicly at their convenience.
Crystallizing in this manner will in most cases not lead to the imposition of any additional tax as the taxpayer will claim the Lifetime Capital Gains Exemption on the deemed disposition. Additionally, the adjusted cost base of the shares is recalculated to the amount at which the value of the shares was elected. This serves to allow for either a decreased capital gain down the road or can in some circumstances lead to a capital loss if the share value drops prior to sale.
In addition, those who are denied the Lifetime Capital Gains Exemption can also file an election late with the Canada Revenue Agency that will allow them to retroactively crystallize the gain on their former qualifying small business corporation shares – even after the company has gone public.
In order to do so, the taxpayer must pay an estimated penalty with the election – the penalty is calculated as $100 per month that the election is late-filed up to a maximum of $2,400. Taxpayers should also be aware that the deadline to late-file the election is 2 years from the day that the taxpayer’s T1 return was due in the year that they actually disposed of the shares.
Tax Tip – Proper Advice, Planning and Information and Filing Going Public Election
Although the rules for claiming the Lifetime Capital Gains Exemption can be complex, it is much easier to ensure that you are adhering to them when you seek proper legal and tax planning advice. You should always speak to experienced tax advisors, such as our top Canadian tax lawyers to ensure that you are always onside of the rules, as proper information gathering and structure planning can solve most problems before they arise. If you have run afoul of the rules and have subsequently sold the shares, you should seek professional assistance with our lawyers to ensure that you can retroactively claim the very valuable Lifetime Capital Gains Exemption. As indicated above the window to fix issues is set at a relatively short timeframe – 2 years. Acting quickly is imperative in these circumstances.