Changes to the Lifetime Capital Gains Exemption
On July 18, 2017, Canada introduced draft legislation that, if implemented, will significantly change the way business owners and professionals pay tax.
In particular, the draft legislation is attempting to close alleged “loopholes” in the current tax regime, which the Department of Finance believes are exploited by wealthy Canadians. The draft legislation proposes to end or make uneconomic many tax planning strategies used by Canadian business owners and a wide array of professionals.
One tax plan that the Department of Finance is targeting is the use of the Lifetime Capital Gain Exemption by small business owners, farmers, fishermen, and their families, when selling shares of a small business, farm property, or fish property.
Capital Gains and the Lifetime Capital Gains Exemption Requirements
Presently in Canada, capital gains are taxed at a preferential rate. Under the current regime, a taxpayer only includes 50% of a capital gain in his/her income calculation for the relevant taxation year.
However, under subsection 110.6 of the Income Tax Act, individuals selling shares of a qualified small business corporation (“QSBC”), qualified farm property (“QFP”), or a qualified fishing property (“QFIP”), enjoy an exemption with regard to the capital gain realized on the sale of their shares, up to a proscribed amount. In 2017, the available Lifetime Capital Gains Exemption for individuals that sell shares of QSBC or QFP/QFIP was $835,717 and $1,000,000, respectively.
To access the Lifetime Capital Gains Exemption, the person claiming the exemption must be an individual. As such, it is not available for corporate entities. Also, with some exceptions, the individual must reside in Canada during the taxation year that they claim the exemption. Finally, the property must be a QSBC, QFAP, or QFIP.
Qualified Small Business Corporation, Qualified Farm Property, and Qualified Fishing Property
To be considered qualified small business corporation, qualified farm property, or qualified fishing property, several tests must be met regarding the type of asset the corporation owns and how long the taxpayer holds the asset (this blog post will primarily address QSBCs (as this is the most prevalent property to be affected by the draft legislation).
In order to be a QSBC, first, when the shares are sold, the shares must be shares of a Small Business Corporation (“SPC”). An SPC must be a Canadian Controlled Private Corporation (“CCPC”) with at least 90% of its asset being used in an active business that carries on its business predominantly (at least 50%) in Canada.
Second, the holding period requirement dictates that no one, besides the shareholder (or a related person/partnership) may own the shares in the corporation during the two years leading up to the sale.
The qualification tests for Farm and Fishery property also contain similar asset and holding period tests.
Current Lifetime Capital Gains Exemption Tax Strategies
A common tax planning strategy to minimize the tax liabilities when selling a QSPC, QFAP, or QFIP, is to effectively multiply the Lifetime Capital Gains Exemption by having shares held by multiple related persons. A person is considered “related” under the Income Tax Act if they are blood relatives or are related through marriage. As such, family members are often transferred shares of the corporation to maximize the available exemption. When family members are under the age of 18, their Lifetime Capital Gains Exemption is typically accessed by utilizing a family trust.
The taxation strategy discussed above allows a family to access multiple Lifetime Capital Gains Exemption amounts on a single transaction. For example; a business with 100 common shares held by five family members, each holding 20 shares, would be able to exempt up to $4,178,585 of capital gains from the eventual sale of the business. If the business sold for proceeds of $6,000,000, only $1,821,415 would be subject to taxation.
Impact of the Proposed Legislation on the Lifetime Capital Gains Exemption
The draft legislation proposes a substantial curtailment to situations where the Lifetime Capital Gains Exemption is available. In particular, the draft legislation would prevent and severely restrict the Lifetime Capital Gains Exemption in scenarios where:
- An individual claiming the Lifetime Capital Gains Exemption was under 18 when the capital gains accrued;
- The individual is an adult, and the capital gains resulting from the sale are covered by the new rules being proposed in relation to income splitting, where a reasonableness test will be used to determine the availability of the Lifetime Capital Gains Exemption; or
- During the period that the capital gains accrued, a trust held the property.
The proposed changes affecting the Lifetime Capital Gains Exemption will continue the theme of the draft legislation and significantly reduce the benefit of using younger family members in tax planning strategies.
Inevitably, the proposed changes will result in increased complexity for Canadian taxpayers. Attempting to determine whether a taxpayer’s income splitting strategy is “reasonable” under the draft legislation will create unwelcome uncertainty for thousands of taxpayers and their advisors.
R&A Tax Law has the expertise to advise clients who are planning to use the Lifetime Capital Gains Exemption for the sale of their business about how the potential changes will affect their tax strategies. Should you be considering using the Lifetime Capital Gains Exemption, contact us today!
This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in this article. If you have specific legal questions you should consult a lawyer.