What’s the Deal With the Capital Gains Exemption?

I have a friend who is looking to sell shares after receiving an offer on his business. He wanted to know how much capital gain he would be able to shield by using the capital gains exemption. I told him that before we can calculate that, there are certain tests that need to be met. I am going to attempt to explain, as I did to him, the tests to be met along with other considerations to think of when selling your small business shares.

The lifetime capital gain exemption (LCGE or CGE for short), allows Canadian small business owners to shield some of their capital gain upon sale, provided your shares are qualified small business corporation share (QSBC). For this to happen, certain tests need to be met. The CGE for 2024 is $1.25m. So if you have an ACB of $100 and sell your business for $2m, the first $1.25m capital gain will be shielded from tax. The remainder will be taxable. The following are the tests to be met:

Test #1: Small business corporation test

At the time of selling your business, the shares you own must be what is known as a small business corporation. In accounting language, your shares are a Canadian-controlled private corporation where substantially all (90% or more) of the FMV of the assets are used principally in an active business carried on primarily in Canada.

In non-accounting language, 90% or more of the fair market value of the assets used in your business at the time of sale must be used to carry on a business in Canada. What are some assets that would put you offside of this rule? Usually any type of redundant asset like excess cash, investments, land not in use by the business or intercompany loans. Any purchase price above the FMV of the assets to derive goodwill would be considered used in an active business. This rule is based only on the fair market value of the assets and doesn’t take the liabilities into consideration. What I usually do is create a spreadsheet laying out the cost of all the assets and then converting all the assets into their current FMV. Then total all of the assets up to 100% and deriving each asset out of the 100% to see if your business qualfies.

Test #2: Holding Period Test

This tests requires that you or someone related to you has owned the shares in the previous 24 months. It is intended to prevent someone unrelated to you selling you shares and you flipping them quickly to use your capital gains exemption.

Test #3: Fair Market Value Asset Test

This third and final test is what I usually see trips a lot of small business owners up. The test is that within the past 24 months prior to the sale, more than 50% of the FMV of the assets were used in an active business. This rule could possibly extend the time period of when you can sell your business and claim the CGE because if you have held excess assets over the past few years, you might have two wait two years to clean the company up and sell it.

These 3 tests are what you need to know to determine whether your business would qualify for the LCGE. There are many more issues and complexities that can go into this type of planning as well.

 Purification

What happens if you hold excess assets in the prior two years OR based on the sale date? It means you have to “purify” your corporation and remove the assets that are “tainting” the capital gains exemption. You can sell the assets to pay off some liabilities (which creates a taxable event), pay yourself a bonus or dividend (another taxable event), reduce your paid-up capital if it is a big number, or transfer the excess assets into another corporation.

Paragraph 110.6(14)(f) – Avoiding the Holding Period Test

One trick that you might not be aware of is the ability to roll your un-incorporated business/sole proprietorship or partnership into a corporation and sell to qualify for the CGE, without waiting the full 24 months of ownership. There is a rule in the Income Tax Act [for the tax nerds it is Paragraph 110.6(14)(f)] that deems newly incorporated shares issued as payment for 90% or more of the assets used in an active business carried on by the individual or partnership, to have been owned by a related party, and NOT an unrelated party. Because these newly incorporated shares would be considered as owned by a related party, they would meet the Holding Period Test and allow you to claim the CGE within a short period of time.

One thing to keep in mind is that it must be a newly incorporated company, not an inactive company that has been around for some time that issues the shares. This will not qualify for a way around the holding period test.

HoldCo. Owns The Opco.

Many operating companies these days are owned by a holding company. I talked about if you need a holding company here. The problem with having a Holdco owning the shares of your Opco is that the capital gains exemption is only if you hold the shares personally, not corporately. In order to qualify for the CGE when there is a holdco and opco, you would have to sell your holdco shares. To do that, you would have to purify it of the excess cash sitting in their which would be taxable to you personally. The Holding Period Test above can also become 90% instead of 50% in certain situations as well.

Safe Income

If anyone is contemplating a sale of their operating company, it would be beneficial to know the safe income on their shares. Safe income is a complicated topic but at a high level it allows a shareholder to pay tax-free dividends into another corporation they control, in contemplation of a sale, without having that dividend reclassified as a capital gain. If a purchaser wants to buy the shares with just the operations of the business, you would want to move excess assets out of that company as a way to make the shares less valuable and therefore less tax owing on sale.  By paying a dividend to a company you control, the dividend is tax-free and no tax consequence occurs, usually. CRA says that because the dividend was in contemplation of a sale to avoid paying more in taxes, they would reclassify the dividend as a capital gain. Safe income needs to be kept in mind when purifying a company. If you have $1,000 of excess cash with $100 of safe income and you pay the $1,000 inter-corporate dividend when contemplating a sale, the $900 above the safe income amount would be taxed as a capital gain

This is a rudimentary breakdown of the 3 tests and other things to consider that go into whether or not your business can qualify for the CGE. It is usually good practice each year to see where your business stands for qualficiation of the CGE and to discuss what your plans are for the business in the next few years with your tax advisor so they can plan accordingly. You don’t want to go to sell your business and then realize it might be too late to qualify, as it could cost you thousands upon thousands of dollars in taxes owing.

DISCLAIMER: The articles posted on TaxCrunch should not be considered specific advice to anyone readying. Please reach out to a professional advisor to seek guidance on any issues mentioned in this post before acting upon anything written here. All posts are time sensitive to what is law at the time written and are subject to changes in legislation.