Friday, December 4, 2015

Canadian Tax Primer 15: Capital Gains Exemption and Shares of Active Business Corporations

As indicated in Tax Primer 14 (click here to read it), each Canadian-resident individual can claim up to $813,600 in tax-free capital gains on a sale of shares of an active business corporation.

The technical rules in the Income Tax Act actually refer to the sale of shares of a “small business corporation”.  Like too many tax terms, however, this technical term is misleading.  A corporation’s shares can qualify for the capital gains exemption even if the shares are worth $10 million.  So this tax primer will use the term “active business corporation”.

To be an active business corporation, a corporation must meet the following requirements.
  1. It must be a taxable Canadian corporation.
  2. It must be a privately-held corporation (not listed on a stock exchange).
  3. It must not be controlled by any combination of non-residents and corporations that are listed on a stock exchange.
  4. At the time in question, it must use substantially all its assets in carrying on an active business primarily in Canada.
  5. During the preceding 24 months, it must have used at least 50% of its assets in carrying on an active business primarily in Canada. 

For example, the capital gains exemption will often apply in respect of a sale of shares of a family-held corporation that carries on an active business – provided that the corporation has been structured properly.

While this may seem bizarre, access to the capital gains exemption can be lost if the corporation is too successful.  For example, assume that you have a very successful family business corporation and you decide to leave profit inside the corporation to bolster the retained earnings figure on the balance sheet.  The corporation does not need this surplus cash for its operations, so the corporation invests the surplus income in mutual funds and GIC’s.  If the value of the investments grows too large (for example, if the mutual funds do too well), the corporation will have too many investment assets and its shares will no longer qualify for the capital gains exemption.  Substantially all the corporation’s assets will no longer consist of assets used in the active business because the investments will make up too large a proportion of the corporate value.

The Canada Revenue Agency treats “substantially all” as meaning 90%.  While this is not necessarily the correct legal position, it is generally best to keep the value of non-business assets below 10% of the value of all corporate assets.  As one invests in the hope that investments will grow significantly in value, this means that it is best to hold investments outside the active business corporation.

Many successful entrepreneurs get tripped up on this aspect of the rule.  Fortunately, this problem can easily be avoided through the use of a holding corporation to receive surplus cash from the active business corporation through the payment of tax-free intercorporate dividends.  The holding corporation can then invest the surplus cash.  If the business corporation unexpectedly needs access to cash for a business use, the holding corporation can simply lend funds back to the business corporation and can even secure that loan (as if the holding corporation were a bank).

As noted above, each individual resident in Canada can claim the capital gains exemption.  If you have an incorporated family business and hope to sell the shares some day in the future, it is important to structure the share ownership so as to make maximum use of the exemption.  This is best done far in advance of any sale, as value has to accrue on shares held for the benefit of other family members.

For example, assume that you and your spouse have two children.  Using the 2015 exemption level, this gives rise to four potential exemption claims.  Four times $813,600 is equal to $3,254,400.  However, the other family members must have an ownership interest in the shares for this level of exemption to apply.

One option is to have the shares held by a family trust.  If each member of the family is a beneficiary of the trust, the trust can sell the shares and allocate the capital gain out to the beneficiaries so that the beneficiaries can claim the capital gains exemption on their respective shares of the capital gain.  However, the trustee (usually, the entrepreneur) manages the shares while they are held inside the trust and so can decide when to sell the shares and can have the final say on the negotiation of any share sale terms.  As well, the trust can protect the shares from matrimonial claims if a child’s marriage breaks up (or if a common-law relationship turns sour).

In order for the trust to be able to allocate the gain out to the beneficiaries, the capital gain must accrue while the shares are held inside the trust.  If you are the sole shareholder of the corporation, there is no point in transferring the shares to the trust just before a sale.  At that point, the value will be in the shares held by you.  Transfer of that value to a trust will give rise to a capital gain that will be solely your gain.  There will be no time for the shares to increase in value inside the trust if the sale is completed one month after the trust acquires the shares.

Only individuals can claim the capital gains exemption.  Accordingly, the corporate structure must ensure that growth can accrue to individuals but that surplus cash can be transferred on a tax-deferred basis to a holding corporation.  These may seem like conflicting objectives, but proper structuring can achieve both goals.  In order to maximize use of the exemption, it is important to put this structure into place as soon as possible and in any event well in advance of a sale.

Sometimes, a buyer will insist on buying assets rather than shares.  In this situation, it is possible to get the best of both worlds by engaging in a hybrid sale in which the seller sells shares for part of the value and the corporation sells assets for the rest of the value.  In this regard, see our blog post from May 11, 2015 “Purchase of Sale of a Business:  having your cake and eating it, too” (click here to read it).

Even if it is not possible to sell shares of the corporation or to use the hybrid transaction technique, the capital gains exemption can still be of use.  If the corporation sells its assets, it will replace its business by cash and become an investment corporation.  At that point, the corporation’s shares will cease to qualify for the capital gains exemption.  Prior to the sale, it might be wise to lock in the exemption by triggering a sale of the corporate shares so as to increase the tax cost of those shares.  This can reduce the capital gains tax that will be payable in future on the death of a shareholder (see Tax Primer 8 which discusses the subject of deemed dispositions on death by clicking here).  This can make it easier for heirs to manage the tax burden that is triggered by a death.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.