Tax Tip[] Capital Gains Exemption

Tax Planning Bomb Shell

“Changes to strategies that have been the basis
for shareholder remuneration planning for decades
will be eliminated”

On July 18, 2017 the Department of Finance issued draft legislation which, if passed into law, will limit many of the advantages of using private corporations.  The changes are fundamental and will have widespread impact.

The changes fall into four basic categories as follows:

  • Income splitting
  • Capital gains exemption
  • Capital gains within a corporate group
  • Deferral of tax using private corporations

Income Splitting

Beginning in 2018, the kiddie tax rules will be extended substantially.  Instead of being limited to persons under the age of 18, they will now apply to all Canadian resident individuals where a person receives income from a related private corporation, unless the amount is reasonable in the circumstances having regard to certain criteria.  These criteria include the labour contribution of the individual and the capital committed.  A more stringent test applies for persons between the ages of 18 and 24.  Essentially the idea is to determine the amount of compensation (in whatever form) that would be reasonable in the circumstances, and any amount in excess of this would become part of the individual’s “split income” taxable at the top personal tax rate.

Obviously rules such as these are complex, and require detailed study.  They will also create a great deal of uncertainty and subjectivity as to how they are applied.

Capital Gains Exemption

Three changes are proposed to the capital gains exemption.  Individuals under the age of 18 would no longer be able to claim the capital gains exemption.  More precisely, gains accrued during a taxation year before the individual attains the age of 18 will not be eligible.  Secondly, any amount of a taxable capital gain which is included in split income will not be eligible for the capital gains exemption.  Lastly, gains accrued during the time that property was held by a trust will no longer be eligible.

These new rules will come into effect in 2018.  An election will be available to realize gains on hand in order to provide transitional relief. Curiously a date in 2018 may be selected for this purpose.

We anticipate that this election will be widely used, and that valuations will be required in an enormous number of cases in 2018 to support the value used.

Capital Gains within a Corporate Group

It has become popular to realize capital gains within a corporate group, and pay out the proceeds, particularly via the capital dividend.  This is because the tax rate on a capital gain (realized within the corporate group and distributed to shareholders) is lower than the tax rate on taxable dividends.  As a result of this becoming widespread, steps are being taken to close down this planning approach.

The draft legislation will extend the scope of section 84.1 which results in a dividend rather than a capital gain where the section is triggered.  Because the capital gain will be recharacterized as a dividend, no amount will be added to the capital dividend account.  There may also be a denial of an increase in the adjusted cost base, potentially resulting in double taxation which, according to the materials, is consistent with the intent of the provisions.  Unfortunately, no distinction is made between the application of this provision to post-mortem and pre-mortem planning.

An additional anti-avoidance rule will be inserted to deal with surplus stripping via capital gains, in the event that new section 84.1 is not sufficient, on its own, to deny the benefit.

This change is to be effective from announcement date (i.e. July 18, 2017).

Accumulating Funds in Private Corporations

While the first three items above are dealt with in 27 pages of draft legislation, the issue of accumulating funds in private corporations is dealt with conceptually, explaining the issues, and outlining two possible approaches.  In simple terms, the Department of Finance has identified that a significant tax deferral arises where active business income is retained within a corporate group.  Because corporate tax rates are so much lower than personal tax rates, there has been a continuing trend to retain excess funds within the corporate group and make passive investments, thereby deferring the tax that would be paid if the excess funds were distributed as a dividend.  Nobody should be surprised at this.  Indeed, one should be surprised if anyone is surprised!

This tax deferral is considered to give owners of private corporations an advantage over their counterparts who do not have such opportunities (for example a person who receives a salary).  The starting point for accumulating investment assets is clearly different when a corporate tax rate of 15% or 25% is applied to the income rather than a personal tax rate of 53%.  How to design a system to deal with this is conceptually very difficult.  Whether or not taking action is appropriate is another very relevant question.

In this, the Department of Finance has asked for input from interested parties, perhaps in part because there is no simple solution to this issue.

Implications

The implications of these potential changes are significant.  Not only will they limit income splitting opportunities, multiplication of the capital gains exemption, and other tax strategies, they will also add very significant complexity to the taxation of private corporations and their shareholders.  Given the additional complexities created in recent years with changes to section 55 (Safe Income and Intercorporate Dividends) and the changes to the Small Business Deduction (expansion of circumstances where the $500,000 small business limit must be shared), this will clearly compound upon what is already a very difficult area.

Introducing a reasonableness test, failing which dividends from private corporations will be taxed at the top tax rate, is a sweeping change, which will confer a huge amount of discretion onto CRA.  Limiting the capital gains exemption to natural individuals, and preventing its use where shares are held through trusts, will alter the landscape considerably.

While the Department of Finance has indicated that it wishes to conduct a consultation on these issues, with a deadline for submissions in early October, our experience in recent years indicates that once proposals are at the draft legislation stage, little in the way of substantial change can be brought about.

We will be reviewing these rules in greater detail, and issuing further notes on various aspects of the proposals, as well as any changes to them which may arise.


TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.

The Capital Gains Exemption

“Capital gains exemption planning is complicated.”

A Canadian individual is generally eligible for an $800,000 exemption (indexed to inflation after 2014) on capital gains on the sale of qualified small business corporation (QSBC) shares, as well as certain fishing or farming property.
There are a number of requirements that must be met for the shares of a QSBC to be eligible for the exemption. One of the rules is often misinterpreted to state that the shares of the QSBC must be owned by the individual for at least 24 months prior to their sale.

That interpretation is not correct. The actual condition states that the individual or a related person or partnership can be the only owners of the shares in the 24 months prior to sale. This does not mean that the individual claiming the exemption had to own the shares for 24 months. The test can be met if a combination of the individual and a related person or partnership hold the shares in the 24 months prior to sale. Another twist on the 24-month rule is explained in Tax Tip 08-01).

Suppose mother owns 100% of the shares of a QSBC and would like to bring her daughter into the business. In order to do so, mother could gift the desired portion of her shares to her daughter. Mother will have a deemed disposition, at the time of the gift, at the fair market value of the shares at that time. Mother can use her exemption to avoid tax on the deemed gain, and the daughter will have a cost base equal to the value of the shares when she received them from Mother. If the mother’s shares qualify for the exemption, the transfer will likely not trigger any income tax for the other.

If mother and daughter sell their shares 18 months later and all of the other QSBC conditions are met, the daughter’s shares will be eligible for the exemption even though the daughter did not own the shares throughout the 24 months prior to the sale. The daughter’s shares will have met the condition of not being owned by any person or partnership that was unrelated to the Daughter in the 24 months prior to the sale.

The result would have been different if 18 months prior to sale, Daughter instead subscribed for new shares of Opco rather than receiving them as a gift from Mother. If the daughter subscribed for shares, the daughter would have held the shares for only 18 months and would not qualify for the exemption.

This example has logistical and practical limitations and is for illustration purposes only. There may be other ways to achieve the illustrated results.

Capital gains exemption planning is complicated. We would be pleased to discuss your options with you further.


TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.

Will You be ABIL to Use Your Capital Gains Exemption?

“It is important to remember the interaction of ABILs and the CGE.”

Under the Income Tax Act, a “business investment loss” (BIL) is a capital loss resulting from a debt or share investment in a “small business corporation”. This is a Canadian-controlled private corporation that meets certain conditions relating to the use of its assets in an active business carried on in Canada (it need not actually be “small”).

Half of the BIL is called an “allowable business investment loss”, or ABIL. Unlike regular allowable capital losses (which can be deducted only against taxable capital gains), an ABIL is deductible against all types of income for up to 10 years. After that the ABIL becomes a net capital loss that can only be used against taxable capital gains.

ABILs provide preferential relief because they convert capital losses into losses that can be used against regular income such as business or employment income.  However, the Department of Finance decided that this preferential treatment is significant enough that it would be too generous to allow an individual to use their capital gains exemption (CGE) to the extent they had already claimed an ABIL.  Similarly, the  Department of Finance sees the CGE to be beneficial enough to require that the amount of ABIL that can be claimed be reduced to the extent of CGE that the taxpayer has used.  Therefore, the Income Tax Act has provisions preventing both kinds of deductions. In both cases there are mechanisms in place that provide for full ABIL or CGE claims once the losses or gains exceed the  ABIL’s or CGE’s claimed in prior years .

It is important to remember the interaction of ABILs and the CGE.  As noted in Tax Tip 10-15, we have seen cases where an individual crystallized their capital gains exemption to trigger a notional gain that was tax-free (without actually selling to a third party), and was dismayed to find out later that they couldn’t claim an ABIL on a real loss.  Similarly, if someone was expecting to be able to use the full capital gains exemption, they will be unpleasantly surprised if they find that a previous ABIL reduces their entitlement.

Please consult your TSG advisor for further assistance.


TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.

Accessing The Capital Gains Exemption

“initially structuring the business as a sole proprietorship or partnership… may allow for the $750,000 capital gains exemption.”

It is commonly understood that an individual can generally use the $750,000 capital gains exemption where they dispose of their private company shares that meet the definition of a “qualified small business corporation share” (“QSBC”). The definition of QSBC contains several technical requirements, including what is referred to as the “two year test.” The two year test generally provides that the shares will not be eligible for the exemption if they have been owned by anyone other than the individual or any person (or partnership) related to the individual within the 24 months prior to the sale. This test is usually not met where a corporation was created to start a business less than 24 months before the sale.

The Income Tax Act provides that the 24 month holding period does not apply to treasury shares issued on incorporating a sole proprietorship or partnership. Therefore, initially structuring the business as a sole proprietorship or partnership (and later incorporating the business prior to the sale) may allow for the $750,000 capital gains exemption (equal to approximately $175,000 in tax savings) that would otherwise not have been available in situations where a sale occurs within 24 months of incorporating. This strategy will not work if the sole proprietorship or partnership did not actually carry on a business prior to the incorporation of the business.

There are also other tax benefits in initially operating the business as a sole proprietorship or partnership. For instance, business losses that are realized in the early phases of a business may be used to offset other individual income (such as employment income) which would otherwise be taxed in an individual’s hands. These business losses can be carried back three years and carried forward 20 years.

If these losses were realized instead by a corporation, the losses would be “trapped” in the corporation and would only be available to offset other corporate income taxed at corporate rates, which are scheduled to decline to 25%. In Ontario, the difference between the top personal rate of 46.41% and the possible corporate tax rate of 25% is 21.41%. Personal use of the losses can cut the tax bill in half.

The individual will need balance the simplicity of operating as a sole proprietorship (or partnership) against the personal exposure to the potential liabilities of the business. At a minimum, the individual should be advised to purchase personal liability insurance as protection. As with any tax planning, practical matters such as personal liability, ease of transfer of the business, banking relationships, licensing arrangements, leases cannot be ignored.


TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.

The Capital Gains Exemption And Incorporating Professionals

“Sale of sole proprietor can be tax-free with planning.”

The first $750,000 of the capital gain on qualified small business corporation (“QSBC”) shares is exempt from personal income tax by virtue of the capital gains exemption. There are three basic tests for the capital gains exemption:

  1. 24-month holding period test: Throughout the 24 months immediately preceding the sale, the shares were not owned by anyone other than the individual or a person related to the individual.
  2. 24-month asset test: Throughout the 24 months immediately preceding the sale, at least 50% of the fair market value of the assets were used principally in an active business carried on primarily in Canada while the share owned by the individual was of a Canadian controlled private corporation (“CCPC”).
  3. Point in time asset test: At the time of sale, at least 90% of the fair market value of the assets of the corporation must be used principally in an active business carried on primarily in Canada.

Since professional associations have recently permitted the incorporation of professionals, it has become more popular for professionals to incorporate their practices to take advantage of lower corporate tax rates and access to the capital gains exemption.

As a relieving measure, two of the three tests for the capital gains exemption are relaxed in those circumstances where the professional corporation has not been in existence for a minimum of 24 months. There is a provision in the Actthat states that prior to the incorporation of the professional practice, theshares of the corporation shall be deemed to be owned by a related person provided that at least 90% of the assets of the unincorporated practice were transferred to the corporation. If the condition is met, then the 24-month holding period test will be met as well because a related person of the individual selling the shares shall be deemed to own the shares for the required amount of time.

The 24-month asset test is also relaxed by virtue that it only has to be met for the period that the corporation was a CCPC. Therefore, if the professional practice were incorporated just prior to the sale, this test would only have to be met for the period of time that the corporation was in existence.

The point in time test still has to be met for the individual to qualify for the capital gains exemption. However, if this test is not immediately met, there are various purification techniques that the professional can pursue with his tax advisor to ensure qualification for the capital gains exemption.


TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.