Tuesday, April 2, 2013

Capital Gains Exemption Increase

In the 2013 federal budget, the government announced its intention to increase the capital gains exemption from $750,000 to $800,000 and to increase the exemption level annually by inflation.  These changes will be effective in 2014.  Maximizing the advantage of this exemption, however, might require some corporate restructuring.
Under the current capital gains exemption, each individual resident in Canada can realize up to $750,000 (to be $800,000 in 2014) in tax-free capital gains on the sale of qualifying properties.  Subject to the fine print of specific rules, qualifying property consists of the following.
  • Shares of a private Canadian corporation (an “active business corporation”) that uses substantially all its assets (measured by fair market value) in the course of carrying on an active business in Canada.
  • Qualifying commercial farm property.
  • Qualifying commercial fishing property.

This article will concentrate on how the exemption applies to a sale of shares of an active business corporation.
A private Canadian corporation qualifies as an active business corporation only if, at the time of the sale of its shares, the corporation meets two separate assets tests.
  • At the time of sale, the corporation must use “substantially all” its assets in the course of carrying on an active business in Canada.  The Canada Revenue Agency interprets “substantially all” as 90%.
  •  Throughout the 24 months preceding the sale, the corporation must have used at least 50% of its assets in the course of carrying on an active business.

The asset tests means that shares can cease to qualify for the exemption if the corporation is too successful.  For example, an active business corporation pays a 13.5% tax rate on its first $500,000 of profit.  If the corporation earns $100 in profit and retains that cash, it has $86.50 in after-tax profit to invest.  If the corporation pays that $86.50 as a dividend to an individual, the individual will have to pay income tax on the dividend and the after-tax cash will be reduced to about $56.  In order to defer this second level of tax, the owner of the corporation might decide to keep the surplus cash inside the corporation.  However, that surplus cash will be an investment asset rather than an active business asset.  This is the case even if the cash is being accumulated for future expansion because the cash is then being accumulated for a future (not a current) business use.
If a buyer offers to buy the shares, therefore, the corporation will not qualify for the exemption.  While it might be possible to purify the corporation by paying a dividend to the owner, this will be a taxable dividend.  As well, this will be possible only if the non-active assets have not exceeded 50% of the corporate assets at any point during the preceding 24 months.
In such a case, it is wise to segregate the surplus cash inside a separate holding corporation well in advance of any future sale of shares.  Properly structured, it is possible to pass surplus cash on a tax-deferred basis to a holding corporation and invest the surplus funds inside the holding corporation.  As a result, the holding corporation will be able to invest $86.50 for each $100 of business profit and the shares of the business corporation will not cease to qualify for the capital gains exemption.
In any restructuring of a corporation, it is also important to consider whether other family members should also hold shares of the business corporation.  The exemption is available on a per-shareholder basis.  If the future value of the business might exceed $800,000, it might be advantageous for other family members to have an interest in the business corporation shares.  Other family members can be given an indirect interest in shares held inside a family trust and still qualify to claim the exemption on a sale of shares by the family trust.  This can allow the entrepreneur to retain control of the business corporation.
The increase in the capital gains exemption level is a welcome announcement.  In order to take advantage of the exemption, however, it is important to consider the current corporate structure and any changes that may be necessary in that structure.  If changes are necessary, those changes need to be implemented well in advance of any contemplated sale of shares.  In most cases, it will be too late to change the structure once the corporation is put up for sale.
Blair P. Dwyer

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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.