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.
- It must be a taxable Canadian corporation.
- It must be a privately-held corporation (not listed on a stock exchange).
- It must not be controlled by any combination of non-residents and corporations that are listed on a stock exchange.
- At the time in question, it must use substantially all its assets in carrying on an active business primarily in Canada.
- 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.