Small businesses are the cornerstone of Canada's economy, and thus there are many specific tax advantages available in Canada's Tax Act that benefit small business owners. The most well known example is the Lifetime Capital Gains Exemption (“LCGE”). The LCGE allows taxpayers to claim an exemption from tax on the first $850,000 (approximately) of capital gain received on the sale of certain small business shares.
Qualifying for the Lifetime Capital Gains Exemption
However, the LCGE is one of the more misunderstood tax benefits offered by the Income Tax Act. Many small business owner taxpayers fall into the pitfall of claiming the LCGE on the sale of shares that may not actually qualify. The Income Tax Act requires that in order for an individual to benefit from the LCGE, the underlying sale of shares must meet the technical definition of a Qualified Small Business Corporation (“QSBC”). In order to avoid CRA tax audit and reassessment, and to properly tax plan for the sale of their shares, small business owners need to have an overall understanding of what a QSBC actually is.
Definition of Qualified Small Business Corporation
The starting point is the concept of the Canadian Controlled Private Corporation (“CCPC”). Owning a CCPC allows a business owner to pay a lower corporate income tax rate of approximately 15% (depending on province in which they operate), and many taxpayers assume that the shares of a CCPC must automatically qualify for the LCGE when they contemplate a sale.
This is not the case, because while all QSBCs must be CCPCs, not all CCPCs are QSBCs.
A CCPC can be broadly defined as a small, closely held Canadian corporation. It must be resident in Canada, and its shares cannot be traded on any public exchange. CCPCs that have active business income can take advantage of the reduced corporate income tax rate on their active business income. Passive income, such as income from rents or royalties will not be given preferential treatment and is subject to certain additional taxes to prevent a lower rate of tax in a corporation than if the passive income was earned personally.
Layered on top of this, in order for a taxpayer’s shares to qualify as a QSBC, Canada’s Income Tax Act requires additional tests to be met before the shareholder may claim the LCGE.
First, at the time of the sale, it must be the capital stock of a small business corporation which was owned by the taxpayer, the taxpayer’s spouse or by a partnership of which the taxpayer is a member.
Second, throughout the twenty four months prior to the share sale, the shares must be shares in a CCPC of which more than fifty percent of its assets were used mainly in an active business carried on in Canada. As such, business owners must be wary that their corporation’s assets do not pile up and disturb the ratio of active versus passive income at least two years before contemplating a sale. It should also be noted that the second requirement allows for the ownership of CCPC shares by a connected corporation in order to account for those who choose to hold the shares of their business through a holding company for other non-tax related reasons.
Additionally, and perhaps the most important test, is that all or substantially all of the business’ assets must be used in an active business carried on in Canada at the time of sale. The CRA’s administrative position on what constitutes “all or substantially all” is that more than 90% of the business’ assets should be utilized to earn active business income.
Finally, the shares for which a taxpayer wishes to claim the LCGE cannot have been owned by any other person in the immediately preceding twenty-four month period. This provision is intended to prevent tax arbitrage in the manner of the sale of shares from one taxpayer with no remaining LCGE to another who has not yet claimed the LCGE.
Tax Planning to Claim the Lifetime Capital Gains Exemption is Necessary
As pointed out there are several pitfalls that can obviate a taxpayer’s ability to claim the LCGE. Small business owners with a business that they are planning on selling in the near to medium future should retain experienced counsel to conduct an analysis to ensure that the corporation’s shares are and remain QSBC shares.
If the QSBC rules do not currently apply, careful planning, including the reorganization of the corporate structure can usually bring a business into compliance with the QSBC rules. These reorganizations are often referred to as purifying the corporation. As long as this carefully planned “purity” is maintained, the taxpayer can then contemplate a sale of shares by the end of the two-year period. Another important tax planning tip is if a holding company is used the shares of that holding company have to be sold in order to be able to claim the LCGE. So it is important when tax planning to use the Lifetime Capital Gains Exemption to make sure that there are no inappropriate assets in the holding company.
Cut Through the Confusion
Our Canadian income tax lawyers have extensive experience with the sale of small businesses and the QSBC and Lifetime Capital Gains Exemption regimes. We can help small business owners identify any improper assets that may jeopardize the QSBC characterization, as well as advise on strategies to best reorganize in contemplation of a share sale down the road. This area is fraught with traps for unprepared taxpayers, so small business owners would be wise to consult with our knowledgeable Canadian tax lawyers to ensure that no mistakes are made and the full lifetime capital gains exemption is available on sale of the shares. We are skilled and capable of working with you directly or with your accounting professional to ensure that you can take advantage of the LCGE.