Introduction - Canadian Controlled Private Corporations and the Lifetime Capital Gains Exemption
The Canadian tax system provides various benefits to Canadian controlled private corporations (CCPCs) in order to incentivize small businesses. Key benefits include access to the small business deduction, which allows CCPCs to pay a lower corporation tax rate on active income; improved tax treatment of employee stock option plans; and the use of an individual's lifetime capital gains exemption (LCGE). You can read more about the small business deduction here and about employee stock options here. As of 2019, the LCGE allows an individual to exempt $866,912 of capital gains from taxation, with the specific exemption amount increasing on a yearly basis. Given that only 50% of capital gains are taxable, that is an exemption of $433,456 in taxable income - at the highest tax bracket in Ontario, that represents a tax saving of approximately $230,000. However, not all CCPC shares qualify for the lifetime capital gains exemption; specifically, a share must meet the requirements as a QSBC share in order for the individual selling the share to utilize their LCGE.
Definition of Qualified Small Business Corporation Shares
In order for a share to be a qualified small business corporation share, it must meet both an asset test and a holding test.
The Asset Test
Specifically, a QSBC share must be a share of a small business corporation. The asset test for the LCGE is also found in s.110.6(1) under paragraphs (a) and (c) of the definition of QSBC shares. This asset test imposes requirements both in the 24 month period before the disposition as well as at the actual disposition time. In the 24 months before the disposition, the corporation whose shares are being sold must have at least 50% of the fair market value of its assets being attributed to assets used principally in an active business carried on primarily in Canada by the corporation. The term used principally in this context means that more than 50% of a particular asset needs to be used for the active business - if that requirement is met, then 100% of that asset's fair market value is considered used principally in an active business.
As such, the corporation would need to list all of its assets and categorize each asset as principally active or passive and then determine whether this requirement is met. Furthermore, paragraph (a) of the definition of qualified small business share indicates that the corporation must be a small business corporation at the time of disposition. To qualify as a small business corporation, a corporation must be a Canadian controlled private corporation and it must have all or substantially all of its fair market value of its assets attributable to assets used principally in an active business. Although it has not been definitively determined by the courts as to how much "substantially all" of a corporation's assets actually is, the CRA's position is that it means 90% or more of the corporation's assets.
In addition, under subparagraph (ii), ownership of shares or indebtedness of connected corporations can count towards the asset test. A corporation is connected to another corporation when one corporation owns more than 10% of both the issued share capital and fair market value of all issued shares of the other corporation as set out in s.186(4). However, the connected corporations must have more than 50% of the fair market value of their assets attributable to assets used principally in an active business and throughout the 24 months preceding the determination time, no one other than the corporation or a related person or partnership can have owned the shares of that connected corporation. Call our top Toronto tax firm to learn more about how the test applies to your situation.
The Holding Test
The holding test for the LCGE is created by paragraph (b) under the definition of "qualified small business corporation share" found in s.110.6(1) and is modified by s.110.6(14)(f).
The result of these two provisions is that, although s.110.6(1) only requires that the shares were not owned by anyone other than the individual or a person related to the individual and not that the individual has owned the share for the full 24months, s.110.6(14)(f) effectively restricts an individual from claiming the LCGE on shares issued to them less than 24 months prior.
Pro Tax Tip - Plan for the Future
For a small business owner, the LCGE is one of the most advantageous tax benefits available, representing tax savings of up to $230,000. However, as shown earlier, not every corporation meets the requirements of a QSBC. The 90% asset test may be a problem for corporations that retain significant amounts of cash or passive investments, though this is something an experienced Canadian tax lawyer can help you deal with through a process called purification. Essentially, all of the target corporation's non-active assets can be transferred to a connected corporation on a tax-free basis using certain provisions of the Income Tax Act, allowing the target corporation to meet the 90% asset test. But what is more problematic is the 24-month asset test which, if the corporation doesn't currently meet, cannot be rectified immediately and will require at least 24 months.
Furthermore, these tax savings are on a per individual basis, meaning that each member of a family can claim their own LCGE. This can be done in several different ways. The most obvious solution is to have shares of the corporation transferred to or acquired by different family members. The downside being that, once the shares are transferred, the primary business owner loses control of those shares. Additionally, given that the LCGE can currently exempt $866,912 in capital gains, it can be difficult to determine how many shares need to be transferred to each family member to reach that number if a sale of the corporation has not yet been planned, with it being easy to go either over or under once the corporation is actually sold. A more flexible solution is to use a family trust which will allow the primary shareholder to retain full control of the corporation while also allowing the actual division of value to take place once the sale occurs, meaning you can determine exactly how much value goes to each family member. Note that this type of capital gain splitting only makes sense if done in advance - if shares are transferred right before a sale, the transferor would have to realize the full capital gain and there would be no gain to avoid for the transferee. The transfer needs to be done in advance to permit the shares to grow in value so that a capital gain will occur upon disposition. This is why it is especially important for small business owners to make sure they receive tax planning advice sooner rather than later - something our experienced Toronto tax lawyers can do.
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.